财务报表分析（英文版）答案

Chapter 03 - Analyzing Financing Activities

Chapter 3

Analyzing Financing Activities

REVIEW Business activities are financed through either liabilities or equity. Liabilities are obligations requiring payment of money, rendering of future services, or dispensing of specific assets. They are claims against a company's present and future assets and resources. Such claims are usually senior to holders of equity securities. Liabilities include current obligations, long-term debt, capital leases, and deferred credits. This chapter also considers securities straddling the line separating liabilities from equity. Equity refers to claims of owners to the net assets of a company. While claims of owners are junior to creditors, they are residual claims to all assets once claims of creditors are satisfied. Equity investors are exposed to the maximum risk associated with a business, but are entitled to all residual rewards associated with it. Our analysis must recognize the claims of both creditors and equity investors, and their relationship, when analyzing financing activities. This chapter describes business financing and how this is reported to external users. We describe two major sources of financing—credit and equity—and the accounting underlying reports of these activities. We also consider off-balance-sheet financing, including Special Purpose Entities (SPEs), the relevance of book values, and liabilities \the edge\of equity. Techniques of analysis exploiting our accounting knowledge are described.

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Chapter 03 - Analyzing Financing Activities

OUTLINE

? Liabilities

Current Liabilities Noncurrent Liabilities Analyzing Liabilities

? Leases

Lease Accounting and Reporting – Lessee Analyzing Leases

? Postretirement benefits

Pension Accounting

Other Postretirement Benefits (OPEBs) Analyzing Postretirement Benefits

? Contingencies and Commitments

Contingencies Commitments

? Off-Balance-Sheet Financing

Through-put and Take-or-pay agreements Product financing arrangements Special Purpose Entities (SPEs)

? Shareholders’ Equity

Capital Stock Retained Earnings

Computation of Book Value Per Share

? Liabilities at the ―Edge‖ of Equity

Redeemable Preferred Stock Minority Interest

? Appendix 3A: Lease Accounting – Lessor

? Appendix 3B: Accounting Specifics for Postretirement Benefits

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ANALYSIS OBJECTIVES

? Identify and assess the principal characteristics of liabilities and equity.

? Analyze and interpret lease disclosures and explain their implications and the

adjustments to financial statements.

? Analyze postretirement disclosures and assess their consequences for firm

valuation and risk.

? Analyze contingent liability disclosures and describe risks.

? Identify off-balance-sheet financing and its consequences to risk analysis. ? Analyze and interpret liabilities at the edge of equity.

? Explain capital stock and analyze and interpret its distinguishing features.

? Describe retained earnings and their distribution through dividends.

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Chapter 03 - Analyzing Financing Activities

QUESTIONS 1. The two major source of liabilities, for both current and noncurrent liabilities, are

operating and financing activities. Current liabilities of an operating nature—such as accounts payable and operating expense accruals—represent claims on resources from operating activities. Current liabilities such as notes payable, bonds, and the current maturities of long-term debt reflect claims on resources from financing activities.

2. The major disclosure requirements (in SEC FRR, Section 203) for financing-related

current liabilities such as short-term debt are:

a. Footnote disclosure of compensating balance arrangements including those not

reduced to writing

b. Balance sheet segregation of (1) legally restricted compensating balances and (2)

unrestricted compensating balances relating to long-term borrowing arrangements if the compensating balance can be computed at a fixed amount at the balance sheet date.

c. Disclosure of short-term bank and commercial paper borrowings:

i. Commercial paper borrowings separately stated in the balance sheet.

ii. Average interest rate and terms separately stated for short-term bank and

commercial paper borrowings at the balance sheet date.

iii. Average interest rate, average outstanding borrowings, and maximum month-end outstanding borrowings for short-term bank debt and commercial paper combined for the period.

d. Disclosure of amounts and terms of unused lines of credit for short-term

borrowing arrangements (with amounts supporting commercial paper separately stated) and of unused commitments for long-term financing arrangements.

Note that the above disclosures are required for filings with the SEC but not necessarily for disclosures in published annual reports. It should also be noted that SFAS 6 states that certain short-term obligations should not necessarily be classified as current liabilities if the company intends to refinance them on a long-term basis and can demonstrate its ability to do so.

3. The conditions required by SFAS 6 that demonstrate the ability of the company to

refinance it short-term debt on a long-term basis are:

a. The company has actually issued a long-term obligation or equity securities to

replace the short-term obligation after the date of the company's balance sheet but before its release.

b. The company has entered into an agreement with a bank or other source of capital

that permits the company to refinance the short-term obligation when it becomes due.

Note that financing agreements that are cancelable for violation of a provision that can be evaluated differently by the parties to the agreement (such as ―a material adverse change‖ or ―failure to maintain satisfactory operations‖) do not meet the

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second condition. Also, an operative violation of the agreement should not have occurred.

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Chapter 03 - Analyzing Financing Activities

Problem 3-5—continued

Part c continued:

Summary of Adjustments Ratio Adjusted book value Adjusted debt to equity Fixed-asset utilization

JDS $24.00 75% 3.17

MLS $22.75 38% 3.36

Final Results of Analysis:

Based on Westfield’s investment criteria of investing in companies with low adjusted Price-to-Book and considering the adjusted solvency and asset utilization ratios, MLS is the better purchase candidate. The analysis justification follows: i. ii. iii.

ab

Ratio JDS 2.15 75% 3.17

a

MLS Company favored 2.18 approximately equal

36% MLS – lower adjusted debt to equity 3.36 MLS – higher asset utilization

b

Price to adjusted book Adjusted debt to equity Fixed-asset utilization

$51.50 / $24.00 = 2.15. $49.50 / $22.75 = 2.18.

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Chapter 03 - Analyzing Financing Activities

Problem 3-6 (20 minutes)

a. In the case of environmental liabilities, there are several unknowns that are especially difficult to predict. The unknowns relate to the clean up and to the lawsuits that result from the hazardous waste. Specifically:

? The company cannot predict the timing of an environmental tragedy such as that which occurred in the Union Carbide factory.

? The company doesn’t know if it will be identified as a potentially responsible party in a yet uncovered hazardous waste site. This can include a former site of the company.

? If the company is identified as a potentially responsible party, we do not know the portion of the clean up costs that it will be required to pay.

? The company doesn’t know what costs would be incurred in the actual clean up of the site.

? The company needs to determine which internal costs should be included in the cost of the clean up. For example, if it uses its laborers for site clean up activities, the direct cost of labor can become a part of the overall cost of cleanup.

? The company must guess whether lawsuits will be filed against the company related to the hazardous waste site.

? The company must estimate the probability of loss or settlement in the lawsuit and the amount of the damages to be paid

b. We must factor the possibility of catastrophic environmental loss into the pricing of the company. For some industries, the probability assigned to occurrence might be very small. Thus, we will not assign a large weighting factor. However, in some industries, the base-line probability can be significant. In addition, we will update these probabilities based on additional information. For example, after the Bhopal tragedy, analysts discounted the valuations of key competitors. This indicates that analysts revised their beliefs about the possibility of loss upwards from earlier estimations. In classic valuation models, an analyst can reflect this risk in the discount factor applied to future earnings or future cash flows.

c. Some industries especially predisposed to environmental risks include: oil producers, chemical manufacturers, tobacco producers, insulation manufacturers and distributors, medical firms, bio-tech firms.

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Chapter 03 - Analyzing Financing Activities

Problem 3-7 (30 minutes)

a. The service cost of $22.1 million for Year 11 is the present value of actuarial benefits earned by employees in Year 11.

b. Year 11: Discount rate = 8.75% Year 10: Discount rate = 9.00%

A higher discount rate will lead to a lower present value of service cost. In this case, with the reduction in discount rate from 9% to 8.75%, the service cost is increased.

c. The interest cost is computed by multiplying the projected benefit obligation (PBO) as of the end of the prior year by the discount rate of 8.75%.

d. The actual return on assets in Year 11 is $73.4 million [113]. It consists of investment income plus the realized or unrealized appreciation or depreciation of plan assets during the year. The expected return on plan assets is computed by multiplying the expected long-term rate of return (9%) on plan assets by the market value of plan assets at the beginning of the period or $773.9 million [120]. This means the expected return is $69.65 million (computed as $773.9 x 9%).

The actual return subjects pension cost to more fluctuation from volatility in the financial market—and, accordingly, increasing volatility in the annual pension cost. As a result, expected return is used in determining pension expense. The difference between actual and expected return will be amortized over an appropriate period.

e. Accumulated benefit obligation (ABO) is the employer's obligation to employees' pension based on current and past compensation levels rather than future levels. Therefore, it could amount to the employer's current obligation if the plan were discontinued presently.

f. The projected benefit obligation (PBO) is the employer's obligation to employees' pension based on future compensation level. The difference between PBO and ABO is due to the inclusion of a provision of 5.75% increase in future compensation level by PBO. In Year 11, the difference between PBO and ABO is $113.3 million [120].

g. Yes; indeed, there is prepaid pension expense of $172.5 million in Year 11 [120].

Problem 3-8 (20 minutes)

Periodic pension cost computation ($ millions)

Service Cost ($586 x 1.10) .............................................................................. $645 Interest Cost (PBO x Discount Rate = $2,212 x 0.085) ................................. 188 Return on plan assets ($3,238 x 0.115) ......................................................... (372) Amortization of deferred loss ($48 / 30 years) .............................................. 2 3-48

Chapter 03 - Analyzing Financing Activities

Periodic pension cost .................................................................................... $463 3-49

Chapter 03 - Analyzing Financing Activities

CASES

Case 3-1 (60 minutes)

a. Colgate administers defined benefit plans for substantial majority of its employees. The primary OPEBs provided by Colgate and health care and life insurance benefits. b.

1. The economic positions are follows (in $ millions):

2005 2006

Domestic

(225.6) (188.3)

Pensions

International

(303.0) (315.9)

OPEB

(400.8) (437.4)

Total

(929.4) (941.6)

Negative numbers indicate underfunded status. Colgate’s plans are underfunded and so are net liabilities.

2. The position reported in the balance sheet is as follows ($ million):

2005 2006

Domestic

Pensions

International

(142.2) (315.9)

OPEB

(200.5) (437.4)

Total

(87.8) (941.6)

254.9 (188.3)

Negative/positive numbers indicate liability/asset. Colgate’s postretirement benefit plans are net liabilities on the balance sheet.

3. The amounts are primarily reported as noncurrent liabilities, but also

included in noncurrent assets and current liabilities.

4. In 2005, Colgate reported postretirement benefits under SFAS 87.

This standard reports only accumulated (or prepaid) pension cost on the balance sheet instead of the net economic position (funded status). This causes the divergence.

5. The projected benefit obligation (PBO) and accumulated benefit

obligation (PBO) are as follows ($ million):

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Chapter 03 - Analyzing Financing Activities

Exercise 3-5—continued

Off-balance-sheet debt—such as industrial revenue bonds or pollution control financing where a municipality sells tax-free bonds guaranteed for payment—are cases where a supposedly debt-free balance sheet could look much worse if these obligations were recorded.

Finally, the practice of deferred taxes—such as taking some expenses for tax, but not book purposes, or through differences in timing for recognition of sales—is one that, while recorded on the balance sheet, is normally not recognized as a long-term obligation. However, if the rate of investment slows dramatically for some reason or if the sales trend is reversed, the sudden coming due of these tax liabilities could be a major problem.

(CFA Adapted)

Exercise 3-6 (20 minutes)

a. An estimated loss from a loss contingency is accrued with a charge to income if both of the following conditions are met:

? Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

? The amount of loss can be reasonably estimated.

b. In this case, disclosure should be made for an estimated loss from a loss contingency that need not be accrued by a charge to income when there is at least a reasonable possibility that a loss may have been incurred. The disclosure should indicate the nature of the contingency and should estimate the possible loss or range of loss or state that such an estimate cannot be made.

Disclosure of a loss contingency involving an unasserted claim is required when it is probable that the claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable.

Exercise 3-7 (15 minutes)

a. One reason that managers might want to resist recording a liability related to an ongoing lawsuit is that the recorded liability can cause deterioration in the financial position of the company. A second reason is that the opposing attorneys may use the disclosure inappropriately as an admission of liability.

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Chapter 03 - Analyzing Financing Activities

Exercise 3-7—continued

b. If a manager believes that it is inevitable that a liability will be recorded, the manager may want to time the recognition of the liability opportunistically. For example, if the company has a relatively bad period, the liability can be recorded in conjunction with a ―big bath.‖ If the company has a very good period, the manager might find that the liability can be recorded in that period without causing an unexpectedly bad earnings report.

Exercise 3-8 (40 minutes)

[Note: Unless otherwise indicated, much of the information to answer this exercise can be found in item [68] of Campbell’s financial statements.]

a. The causes of the $101.6 million increase are identified in the table below (see

Campbell’s Consol. Statement of Owners’ Equity and Changes in Number of Shares): Millions 11 10 Net Income .......................................................... $401.5 $ 4.4 (28) Cash Dividends ................................................... (142.2) (89) (126.9) (87) Treasury Stock Purchase ................................... (175.6) (41.1) (87) Treasury Stock Issued

Capital Surplus .............................................. 45.4 (91) 11.1 (87) Treasury Stock ............................................... 12.4 (91) 4.6 (87) Translation Adjustment ...................................... (29.9) (92) 61.4 (87) Sale of foreign operations .................................. (10.0) (93)

Increase in Stockholders' Equity ....................... 101.6a (86.5)b

a

1,793.4 [54] - 1,691.8 101.6

b

1,691.8 [54]

1,778.3 [87] (86.5)

b. The average price for treasury share purchases is computed as:

[($175.6 million1 / 3.395 million treasury shares purchased)] = $51.72

1

Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders’ Equity

c. Book Value per Share of Common Stock is computed as:

[$1,793.4 [54] / 127.0* ] = $14.12

*135.6 [49] - 8.6 [52] – note: There is no preferred stock outstanding (Note: This value equals the company's computed amount [185] of $14.12.)

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Chapter 03 - Analyzing Financing Activities

Exercise 3-8—continued

d. The book value per share of common stock is $14.12. However, shares were

purchased during the year at an average of about $52 per share (an indicator of market value during the year). In fact, according to note 24 to the financial statements the stock traded in the $70 - $80 range in the fourth quarter of Year 11. There are several reasons why the market value of the stock is much higher than the book value of the stock. First, the market value impounds the investors’ beliefs about the future earning power of the company. Investors apparently have high expectations regarding future profitability. Second, the book value is recorded using accounting conventions such as historical cost and conservatism. Each of these conventions is designed to optimize the reliability of the information but can cause differences between the market and book values of a company’s stock.

Exercise 3-9 (30 minutes)

a. The principal transactions and events that reduce the amount of retained earnings include the following:

1. Operating losses (including extraordinary losses and other debit adjustments). 2. Stock dividends.

3. Dividends distributing corporate assets such as cash or in-kind. 4. Recapitalizations such as quasi-reorganizations.

b. The principal reason for making the distinction between contributed capital and retained earnings (earned capital) in the stockholders' equity section is to enable stockholders and creditors to identify dividend distributions as actual distributions of earnings or as returns of capital. This identification also is necessary to comply with most state statutes that provide that there should be no impairment of the corporation's legal or stated capital by the return of such capital to owners in the form of dividends. This concept of legal capital provides some measure of protection to creditors and imposes a liability upon the stockholders in the event of such impairment.

Knowledge of the distinction between contributed capital and earned capital provides a guide to the amount of dividends that can be distributed by the corporation. Assets represented by the earned capital, if in liquid form, may properly be distributed as dividends; but invested assets represented by contributed capital should ordinarily remain for continued operation of the corporation. If assets represented by contributed capital are distributed to shareholders, the distribution should be identified as a return of capital and, hence, is in the nature of a liquidating dividend. Knowledge of the amount of capital that has been earned over a period of years after adjustment for dividends also is of value to stockholders in judging dividend policy and

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Chapter 03 - Analyzing Financing Activities

obtaining an indication of past profits to the extent not distributed as dividends.

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Exercise 3-9—continued

c. The acquisition and reissuance of its own stock by a firm results only in the contraction or expansion of the amount of capital invested in it by stockholders. In other words, an acquisition of treasury shares by a corporation is viewed as a partial liquidation and the subsequent reissuance of these shares is viewed as an unrelated capital-raising activity. To characterize as gain or loss the changes in equity resulting from a corporation's acquisition and subsequent reissuance of its own shares at different prices is a misuse of accounting terminology. When a corporation acquires its own shares, it is not \anything nor has it incurred a \The price paid represents the amount by which the corporation has reduced its net assets or \reissues these shares it has not \anything. It has increased its total capitalization by the amount received.

It is the practice of referring to the acquisition and reissuance of treasury shares as a buying and selling activity that gives the superficial impression that, in this process, the firm is acquiring and disposing of assets and that, if different amounts per share are involved, a gain or loss results. Note, when a corporation \treasury shares it is not acquiring assets; nor is it disposing of any assets when these shares are subsequently \

Exercise 3-10 (25 minutes)

a. There are four basic rights inherent in ownership of common stock. The first right is that common shareholders may participate in the actual management of the corporation through participation and voting at the corporate stockholders meeting. Second, a common shareholder has the right to share in the profits of the corporation through dividends declared by the board of directors (elected by the common shareholders) of the corporation. Third, a common shareholder has a pro rata right to the residual assets of the corporation if it liquidates. Fourth, common shareholders have the right to maintain their interest (percent of ownership) in the corporation if the corporation issues additional common shares, by being given the opportunity to purchase a proportionate number of shares of the new offering. This fourth right is most commonly referred to as a \

b. Preferred stock is a form of capital stock that is afforded special privileges not normally afforded common shareholders in return for giving up one or more rights normally conveyed to common shareholders. The most common right given up by preferred shareholders is the right to participate in management (voting rights). In return, the corporation grants one or more preferences to the preferred shareholders. The most common preferences granted to preferred shareholders are these:

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Chapter 03 - Analyzing Financing Activities

Problem 3-2—continued c.

Payments of Interest and Principal

Total Interest Payment of Principal Year Payment at 8% Principal Balance $39,930.00 1 10,000 $3,194.40 $6,805.60 33,124.40 2 10,000 2,649.95 7,350.05 25,774.35 3 10,000 2,061.95 7,938.05 17,836.30 4 10,000 1,426.90 8,573.10 9,263.20 5 10,000 736.80 9,263.20 $50,000 $10,070.00 $39,930.00 — d.

Expenses to Be Charged to Income Statement

Lease Total Year Expense Amortization Interest Expenses

1 $10,000 $ 7,986.00 $ 3,194.40 $11,180.40 2 10,000 7,986.00 2,649.95 10,635.95 3 10,000 7,986.00 2,061.95 10,047.95 4 10,000 7,986.00 1,426.90 9,412.90 5 10,000 7,986.00 736.80 8,722.80 $50,000 $39,930.00 $10,070.00 $50,000.00

e. The income and cash flow implications from this capital lease are apparent in the solutions to parts c and d. The student should note that reported expenses exceed the cash flows in earlier years, while the reverse occurs in later years.

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Chapter 03 - Analyzing Financing Activities

Problem 3-3 (30 minutes)

a. A lease should be classified as a capital lease when it transfers substantially all of the benefits and risks inherent to the ownership of property by meeting any one of the four criteria for classifying a lease as a capital lease. Specifically:

? Lease J should be classified as a capital lease because the lease term is equal to 80 percent of the estimated economic life of the equipment, which exceeds the 75 percent or more criterion.

? Lease K should be classified as a capital lease because the lease contains a bargain purchase option.

? Lease L should be classified as an operating lease because it does not meet any of the four criteria for classifying a lease as a capital lease.

b. Borman records the following liability amounts at inception:

? For Lease J, Borman records as a liability at the inception of the lease an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon. However, if the amount so determined exceeds the fair value of the equipment at the inception of the lease, the amount recorded as a liability should be the fair value.

? For Lease K, Borman records as a liability at the inception of the lease an amount determined in the same manner as for Lease J, and the payment called for in the bargain purchase option should be included in the minimum lease payments.

? For Lease L, Borman does not record a liability at the inception of the lease.

c. Borman records the MLPs as follows:

? For Lease J, Borman allocates each minimum lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability.

? For Lease K, Borman allocates each minimum lease payment in the same manner as for Lease J.

? For Lease L, Borman charges minimum lease (rental) payments to rental expense as they become payable.

d. From an analysis viewpoint, both capital and operating leases represent economic liabilities as they involve commitments to make fixed payments. The fact that companies can structure leases as \leases\to avoid balance sheet recognition is problematic from the perspective of analysis of assets. If the leased assets are used to generate revenues, they should be considered in ratios such as return on assets and other measures of financial performance and condition.

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Chapter 03 - Analyzing Financing Activities

Problem 3-4 (25 minutes)

a. Detachable stock purchase warrants are equity instruments that have a separate fair value at the issue date. Consequently, the portion of the proceeds from bonds issued with detachable stock purchase warrants allocable to the warrants should be accounted for as paid-in capital. The remainder of the proceeds should be allocated to the debt portion of the transaction. This usually results in issuing the debt at a discount (or, occasionally, a reduced premium).

b. A serial bond progressively matures at a series of stated installment dates, for example, one-fifth each year. A term (straight) bond completely matures on a single future date.

c. If a bond is issued at a premium, interest expense and the carrying value of the debt will decrease over the life of the bond as the premium is amortized towards zero. If a bond is issued at a discount, interest expense and the carrying value of the debt will increase over the life of the bond as the discount is amortized towards zero. In each case, the carrying value of the debt is the face value of the debt at the maturity date (plus or minus any premium or discount).

d. The gain or loss from the reacquisition of a long-term bond prior to its maturity is the difference between the amount paid to settle the debt and the carrying value of the debt. The gain or loss should be included in the determination of net income for the period reacquired. These gains (losses) are no longer treated as extraordinary items, net of related income taxes, unless they meet the text of both unusual and infrequent.

e. Accounting standards require many useful bond-related disclosures including: amounts borrowed, interest rates, due dates, encumbrances, restrictive covenants, and events of default. While bonds are reported at their fair value at the date of issuance, subsequent changes in fair value are not recognized on the balance sheet. If the analyst is interested in the fair value of a firm’s bonds, the analyst must examine the note disclosures and make appropriate adjustments to market.

(AICPA Adapted)

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Chapter 03 - Analyzing Financing Activities

Problem 3-5 (45 minutes)

a. Ratio calculations for Jerry’s Department Stores (JDS) and Miller Stores (MLS)

1. Price-to-book ratio:

Ratio

Book value

Price/book value

JDS

MLS

= $7,500 / 400 shares = $18.75 = $49.50 / $18.75 = 2.64

= $6,000 / 250 shares = $24.00 = $51.50 / $24.00 = 2.15

2. Total debt to equity ratio:

Ratio

Total debt to equity [Total debt = (S-T debt + L-T debt)] / Equity

JDS

MLS

=$1,000 + $2,500 / $7,500 = $3,500 / $7,500

= 46.67%

= $0 + 2,700 / $6,000 = $2,700 / $6,000 = 45.00%

3. Fixed-asset utilization (turnover):

Ratio

Sales / fixed assets

JDS

MLS

= $18,500 / $5,500 = 3.36

= $21,250 / $5,700 = 3.73

b. Investment Choice and Justification Based on Part A

Based on Westfield’s investment criteria for investing in the company with the lowest price-to-book ratio (P/B) and considering solvency and asset utilization ratios, JDS is the better purchase candidate. The analysis justification follows: i. ii. iii.

Ratio JDS 2.15 45% 3.73

MLS 2.64 47% 3.36

Company Favored JDS: lower P/B JDS: lower debt or ratios are very similar JDS: higher turnover

Price-to-book ratio (P/B) Total debt to equity Asset turnover

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Chapter 03 - Analyzing Financing Activities

Problem 3-5—continued

c. Investment Choice and Justification Based on Note Information

Note: Details underlying the Balance Sheet Adjustments ($ millions): JDS: i. Leases – recognition of MDS’s present value lease payments will add $1,000 to

JDS’s property, plant, and equipment (PP&E) and is offset by a $1,000 addition to JDS’s long-term debt.

ii. Receivables – recognition of JDS’s sale of receivables with recourse will

increase assets (accounts receivable) by $800 and short-term debt used to finance accounts receivable by $800.

MLS: iii. Pension – recognition of current excess funding for the pension plan will add

$1,600 to assets and $1,600 to owners’ equity ($3,400 plan assets - $1,800 projected benefit obligation).

Adjusted Calculations Made ($ millions)

JDS:

Needed adjustments: Assets Liabilities (PP&E) (Long-term debt [LTD]) +$1,000 +$1,000 (Accounts receivable) (Short-term debt [STD]) +$800 +$800 i. Book value per common share: No net adjustment to JDS owners’ equity of

$6,000; thus, $6,000 / 250 million shares = $24.00 book value per share

ii.

Adjusted total debt-to-equity ratio:

Historical LTD

LTD STD

Adjusted total debt

$2,700

+1,000 + 800 $4,500 Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%

iii.

Fixed-asset utilization (turnover) =

MLS:

$5,700 Historical fixed assets

+1,000 PP&E (JDS leases) $6,700 JDS adjusted fixed assets Adjusted fixed-asset utilization (sales/adjusted fixed assets): $21,250 / $6,700 = 3.17

Needed adjustments:

Assets

(Pension) +$1,600

Owner’s Equity +$1,600

i. Book value per common share:

$7,500 historical equity + $1,600 = $9,100 Adjusted equity; thus,

$9,100 / 400 million shares = $22.75 adjusted book value per share

ii. iii.

Adjusted total debt-to-equity ratio:

Debt (no adjustments) / Adjusted equity = Adjusted debt / equity $3,500 / $9,100 = 38%

Fixed-asset utilization (turnover):

Sales / Fixed assets (no adjustments) $18,500 / $5,500 = 3.36

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43.

43. In order to facilitate their understanding and analysis, reserves and provisions can be

redivided into a number of major categories.

The first category is most correctly described as comprising provisions for obligations that have a high probability of occurrence, but which are in dispute or are uncertain in amount. As is the case with many financial statement descriptions, neither the title nor the location in the financial statement can be relied upon as a rule-of-thumb guide to the nature of an account. The best key to analysis is a thorough understanding of the business and the financial transactions that give rise to the account. The following are representative items in this group: provisions for product guarantees, service guarantees, and warranties that are established in recognition of future costs that are certain to arise although presently impossible to measure. Another type of obligation that must be provided for is the liability for ―unredeemed coupons‖ such as trading stamps. To the company issuing these coupons, there is no doubt about the liability to redeem them for merchandise or cash. The only uncertainty concerns the number of coupons that will be presented for redemption. Consequently, a provision is established for these types of items by a charge to income at the time products covered by guarantees (or

related to these coupons) are sold—the amount is established on the basis of experience or on the basis of any other reliable factor.

The second category comprises reserves for expenses and losses, which by experience or estimates are very likely to occur in the future and that should properly be provided for by current charges to operations. One group within this category is comprised of reserves for operating costs such as maintenance, repairs, painting, or overhauls. Thus, for example, since overhauls can be expected to be required at regularly recurring intervals, they are provided for ratably by charges to operations to avoid charging the entire cost to the year in which the actual overhaul takes place.

A third category comprises provisions for future losses stemming from decisions or actions already taken. Included in this group are reserves for relocations, replacement, modernization, and discontinued operations.

A fourth category includes reserves for contingencies. For example, reserves for self-insurance are designed to provide the accumulation against which specific types of losses, not covered by insurance, can be charged. Although the term self-insurance contradicts the very concept of insurance, which is based on the spreading of risks among many business units, it nevertheless is a practice that has a good number of adherents. Other contingencies provided against by means of reserves are those arising from foreign operations and exchange losses due to official or de facto devaluations.

A fifth group of future costs that must be provided for is that of employee compensation. These costs, in turn, give rise to provisions for vacation pay, deferred compensation, incentive compensation, supplemental unemployment benefits, bonus plans, welfare plans, and severance pay. The related category of estimated liabilities includes provisions for claims arising out of pending or existing litigation.

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Of importance to the analyst is the adequacy of the reserves and provisions that are often established on the basis of prior experience or on the basis of other estimates. Concern with adequacy of amount is a prime factor in the analysis of all reserves and provisions, whatever their purpose. Reserves and provisions appearing above the equity section are almost invariably created by means of charges to income. They are designed to assign charges to the income statement based on when they are incurred rather than when they are paid in cash.

44. Reserves for future losses represent a category of accounts that require particular

scrutiny. While conservatism in accounting calls for recognition of losses as they can be determined or clearly foreseen, companies tend, particularly in loss years, to over-provide for losses not yet incurred. Such ―losses not yet incurred‖ often involve disposal of assets, relocations, and plant closings. Overprovision shifts expected future losses to the present period, which likely already shows adverse results.

One problem with such reserves is that once established there is no further accounting for the expenses and losses that are charged against them. Only in certain financial statements required to be filed with the SEC (such as Form 10-K) are details of changes in reserves required. Recent requirements have, however, tightened the disclosure rules in this area.

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The reason why over-provisions of reserves occur is that the income statement effects are often accorded more importance than the residual balance sheet effects. While a provision for future expenses and losses establishes a reserve account that is analytically in the \the important purpose of creating a cushion that can absorb future expenses and losses. This shields the all-important income statement from them and their related volatility. The analyst should endeavor to ascertain that provisions for future losses reflect losses that can reasonably be expected to have already occurred rather than be used as a means of artificially benefiting future income by adding excessive provisions to present adverse results. 45. An ever increasing variety of items and descriptions are included in the \

credits\they either represent deferred income yet to be earned or serve as income-smoothing devices. A lack of agreement among accountants as to the exact nature of these items or the proper manner of their presentation compounds the confusion confronting the analyst. Thus, regardless of category or presentation, the key to their analysis lies in an understanding of the circumstances and the financial transactions that brought them about.

At one end of the spectrum we find those items that have characteristics of liabilities. Here we can find items such as advances or billings on uncompleted contracts, unearned royalties and deposits, and customer service prepayments. The outstanding characteristics of these items is their liability aspects even though, as in the case of advances of royalties, they may, after certain conditions are fulfilled, find their way into the company's income stream. Advances on uncompleted contracts represent primarily methods of financing the work in progress while deposits of rent received represent, as do customer service prepayments, security for performance of an agreement. At the other end of the spectrum are deferred credits that exhibit many qualities similar to equity. The key to effective analysis is the ability to identify those items most like liabilities from those most like equity.

46. The accounting for the equity section as well as its presentation, classification, and

note disclosure have certain basic objectives. The most important of these are:

a. To classify and distinguish among the major sources of owner capital contributed

to the entity.

b. To set forth the priorities of the various classes of stockholders and the manner in

which they rank in partial or final liquidation.

c. To set forth the legal restrictions to which the distribution of capital funds are

subject to for whatever reason.

d. To disclose the contractual, legal, managerial, and financial restrictions that the

distribution of current and retained earnings is subject to.

The accounting principles that apply to the equity section do not have a marked effect on income determination and, as a consequence, do not hold many pitfalls for the analyst. From the analyst's point of view, the most significant information here relates to the composition of the capital accounts and to the restrictions that they are subject to.

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The composition of equity capital is important because of provisions affecting the residual rights of common equity. Such provisions include dividend participation rights, and the great variety of options and conditions that are characteristic of the complex securities frequently issued under merger agreements, most of which tend to dilute common equity. Analysis of restrictions imposed on the distribution of retained earnings by loan or other agreements will usually shed light on a company's freedom of action in such areas as dividend distributions and the required levels of working capital. Such restrictions also shed light on the company's bargaining strength and standing in credit markets. Moreover, a careful analysis of restrictive covenants will enable the analyst to assess how far a company is from being in default of these provisions.

47. Preferred stock often carries features that make it preferred in liquidation and

preferred as to dividends. Also, it is often entitled to par value in liquidation and can be entitled to a premium. On the other hand, the rights of preferred stock to dividends are generally fixed—although they can be cumulative, which means that preferred shareholders are entitled to arrearages of dividends before common stockholders receive any dividends. These features of preferred stock as well as the fixed nature of the dividend give preferred stock some of the earmarks of debt with the important difference that preferred stockholders are not generally entitled to demand redemption of their shares. However, there are preferred stock issues that have set redemption dates and require sinking funds to be established for that purpose—these issuances are essentially debt.

Characteristics of preferred stock that make them more akin to common stock are dividend participation rights, voting rights, and rights of conversion into common stock.

48. Accounting standards state (APB 10): ―Companies at times issue preferred (or other

senior) stock which has a preference in involuntary liquidation considerably in excess of the par or stated value of the shares. The relationship between this preference in liquidation and the par or stated value of the shares may be of major significance to the users of the financial statements of those companies and the Board believes it highly desirable that it be prominently disclosed. Accordingly, the Board recommends that, in these cases, the liquidation preference of the stock be disclosed in the equity section of the balance sheet in the aggregate, either parenthetically or in short rather than on a per share basis or by disclosure in notes.\

Such disclosure is particularly important since the discrepancy between the par and liquidation value of preferred stock can be very significant.

49. This question is answered in a SEC release titled Pro Rata Distribution to

Shareholders:

Several instances have come to the attention of the Commission in which registrants have made pro rata stock distributions that were misleading. These situations arise particularly when a registrant makes distributions at a time when its retained earnings or its current earnings are substantially less than the fair value of the shares distributed. Under present generally accepted accounting rules, if the ratio of distribution is less than 25 percent of shares of the same class outstanding, the fair value of the shares issued must be transferred from retained earnings to other capital accounts. Failure to make this transfer in connection with a distribution or making a

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distribution in the absence of retained or current earnings is evidence of a misleading practice. Distributions of over 25 percent (which do not normally call for transfers of fair value) may also lend themselves to such an interpretation if they appear to be part of a program of recurring distribution designed to mislead shareholders.

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Chapter 03 - Analyzing Financing Activities

It has long been recognized that no income accrues to the shareholder as a result of such stock distributions or dividends, nor is there any change in either the corporate assets or the shareholders' interest therein. However, it is also recognized that many recipients of such stock distributions, which are called or otherwise characterized as dividends, consider them to be distributions of corporate earnings equivalent to the fair value of the additional shares received. In recognition of these circumstances, the American Institute of Certified Public Accountants has specified in Accounting Research Bulletin No. 43, Chapter 7, paragraph 10, that \the public interest account for the transaction by transferring from earned surplus to the category of permanent capitalization (represented by the capital stock and capital surplus accounts) an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings which the shareholder may believe to have been distributed will be left, except to the extent otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions. Both the New York and American Stock Exchanges require adherence to this policy by their listed companies.

50. Accounting standards require that, except for corrections of errors in financial

statements of a prior period and adjustments that result from realization of income tax benefits of preacquisition operating loss carry forwards of purchased subsidiaries, all items of profit and loss recognized during a period (including accruals of estimated losses from loss contingencies) be included in the determination of net income for that period. The standard permits limited restatements in interim periods of a company's current fiscal year.

51. a. Minority interests are the claims of shareholders of a majority owned subsidiary

whose total net assets are included in a consolidated balance sheet.

b. Consolidated financial statements often show minority interests as liabilities:

however, they are fundamentally different in nature from legally enforceable obligations. Minority shareholders do not have any legally enforceable rights for payments of any kind from the parent company. Therefore, the financial analyst can justifiably classify minority interest as equity funds in most cases.

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EXERCISES Exercise 3-1 (20 minutes) a.

Long-term debt [46] 805.8 beg A 159.7 B 0.3 0.1 C 99.8 D 100.0 E 199.6 F G 24.3 H 250.3 1.9 I 772.6 end

A = Retirement of 13.99% Zero Coupon Notes.

B = Repayment of 9.125% Note.

C = Additional borrowing on 7.5% Note. D = Borrowing on 9% Note

E = Borrowing on Medium-Term Notes. F = Borrowing on 8.875% Debentures G = Repayment of Other Notes H = Reclassification of Note

I = Increase in capital lease obligation

b. Campbell Soup’s debt footnote indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The remaining long-term debt matures in excess of 5 years. Given Campbell’s operating cash flow of $805.2 million, solvency does not appear to be a problem. Further, Campbell reports net income of $401.5, well in excess of its interest expense of $116.2 in Year 11, an interest coverage ratio of 6.7 [$667.4 + $116.2]/ $116.2). The company should also be able to meet its interest obligations.

Campbell reports total liabilities of $2,355.6 million ($1278+$772.6+$305) against stockholders’ equity of $1,793.4 million, a 1.3 times multiple. The amount of debt does not appear to be excessive. Nor does the company appear to be underutilizing its equity.

Given present debt levels that are not excessive and adequate cash flow, the company should be able to finance additional investments with debt if desired by management.

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Exercise 3-2 (20 minutes)

a. The economic effects of a long-term capital lease on the lessee are similar to that of an equipment purchase using installment debt. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, and obligates the lessee in a manner similar to that created when funds are borrowed. To enhance comparability between a firm that purchases an asset on a long-term basis and a firm that leases an asset under substantially equivalent terms, the lease should be capitalized.

b. A lessee should account for a capital lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding any portion of the payments representing executory costs, together with any profit thereon. However, if the present value exceeds the fair value of the leased property at the inception of the lease, the amount recorded for the asset and obligation should be the fair value.

c. A lessee should allocate each minimum lease payment between a reduction of the obligation and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the obligation.

d. Von should classify the first lease as a capital lease because the lease term is more than 75 percent of the estimated economic life of the machine. Von should classify the second lease as a capital lease because the lease contains a bargain purchase option.

Exercise 3-3 (15 minutes)

a. A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments during the year would be allocated between a reduction in the obligation and interest expense. The asset would be amortized in a manner consistent with the lessee's normal depreciation policy for owned assets, except that in some circumstances the period of amortization would be the lease term.

b. No asset or obligation would be recorded at the inception of the lease. Normally, rental on an operating lease would be charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental expense nevertheless would be recognized on a straight-line basis unless another systematic or rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis would be used.

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Exercise 3-4 (18 minutes)

a. The gross investment in the lease is the same for both a sales-type lease and a direct-financing lease. The gross investment in the lease is the minimum lease payments (net of amounts, if any, included therein for executory costs such as maintenance, taxes, and insurance to be paid by the lessor, together with any profit thereon) plus the unguaranteed residual value accruing to the benefit of the lessor.

b. For both a sales-type lease and a direct-financing lease, the unearned interest income would be amortized to income over the lease term by use of the interest method to produce a constant periodic rate of return on the net investment in the lease. However, other methods of income recognition may be used if the results obtained are not materially different from the interest method.

c. In a sales-type lease, the excess of the sales price over the carrying amount of the leased equipment is considered manufacturer's or dealer's profit and would be included in income in the period when the lease transaction is recorded.

In a direct-financing lease, there is no manufacturer's or dealer's profit. The income on the lease transaction is composed solely of interest.

Exercise 3-5 (25 minutes)

A number of major companies have a meager debt ratio. Still, even when a company shows little if any debt on its balance sheet, it can have considerable long-term liabilities. This situation can reflect one or more of several factors such as the following:

Lease commitments, while detailed in notes, are not recorded in the balance sheets of many companies. This could be a critical problem for companies that have expanded by leasing rather than buying property. These lease commitments, while reflecting different attributes of pure debt, are just as surely long-term obligations.

Many companies have very large unfunded postretirement liabilities. These often are not recorded on the balance sheet, but are disclosed in the notes. At one time, a case could have been made that such obligations were not a problem, for as long as the business operated, payments would be made, and if it went bankrupt, the liability would end. Now, under most laws, the company has a real long-term obligation to employees.

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Several companies guarantee the debt of another company. The most typical is a nonconsolidated lease subsidiary. Although disclosed in the notes, this debt, which is real and can be large, is not recorded on the parent's balance sheet.

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