(07 37175) Financial Statement Analysis

& Business Valuation

Lecture 4

Liabilities and equity

Day 4

Dr. Chun Yu Mak

Assistant Professor in Accounting & Finance
 Learning objectives
 Concept of liabilities
 Contingencies
 Off-balance-sheet financing
 Lease contract
 Pension
 Shareholders’ equity

Learning outcomes
After this lecture, you must know:
 Understanding the above topics and can
apply on the real examples like
understanding the firms’ annual reports.
 Liabilities
 A liability is a probable future payment of assets or services that a
company is presently obligated to make as a result of past transactions or
events.

 Current liabilities: Obligations whose settlement requires use of current

assets or the incurrence of another current liability within one year or the
operating cycle, whichever is longer.
- Operating: tax payables, unearned revenues, advance payments, account
payables, other accruals of operating expenses.
- Financing: short-term borrowing, current portion of long-term debt.

 Non-current liabilities: Obligations not payable within one year or the

operating cycle, whichever is longer.
- Operating: purchase commitments
- Financing: bonds/long-term debt covenant, capital lease obligation (but
capital lease assets is operating nature), etc.
- Liabilities restrictions: Amount of dividend distribution, work capital,
debt-to-equity ratio, seniority of asset claim, acquisition & divestment,
liability issuance.
 Analysis

 Pay attention on the liability restrictions of bond/debt

covenant.
 Misclassification of liabilities or any refinancing of
liabilities (i.e. transferring short-term to long-term liab.)
 Reference to external auditor’s report
 Reconciling interest expenses and amount of liabilities.
 Bear in mind:
For an industrial firm, its financing activities are non-
value-add activities, presuming that it relies on its
operating activities to derive income (Penman 2014, Ch.7).
 Contingencies

They are potential losses and gains whose resolution depends on one
or more future events. According to US GAAP,

Contingent liabilities -- contingencies with potential claims on resources

-- they must be recorded/recognised as a loss on
B/S if two conditions must be met:
(i) probable an asset is impaired or a liability
incurred, and
(ii)the amount of loss is reasonably estimable;

Contingent assets -- contingencies with potential additions to resources

-- a contingent asset (and gain) is not recorded until
the contingency is resolved.
-- a contingent asset (and gain) can be disclosed in
Notes to the account if probability of realization
is high.
 Analysis

Sources of useful information:

 Notes to the account, Managers’/Chairman’s statements.

Useful analyses:
 Scrutinize management estimates
 Analyze notes regarding contingencies, including
o Description of contingency and its degree of risk
o Amount at risk and how treated in assessing risk exposure
o Charges, if any, against income
 Recognize a bias to not record or underestimate contingent
liabilities
 Beware of big baths — loss reserves are contingencies
 Analyze deferred tax notes for undisclosed provisions for future
losses
Example: BT annual report – notes to the accounts 19 and 31.
 Off-Balance-Sheet Financing
It is the non-recording of financing obligations.

Motivation: To keep debt off the balance sheet

Transactions sometimes used as off-balance-sheet financing:

Involving Special Purpose Entities (SPEs)
 Sell receivables with recourse and record them as without recourse
contract by ignoring the contingent assets and contingent liabilities
 Contract of sales-lease back of assets
 Synthetic lease (i.e. eBay Inc).
 Product financing arrangements, where a company sells and agrees
to either repurchase inventory or guarantee a selling price
 Operation of Special Purpose Entity (SPE)
Third
party Equity investment for establishing SPE
Issuing bonds
- A kind of collateralize debt obligations
assets (CDO)
Sponsoring SPE Bond Market
Company
cash cash
Issuing
cash credit
Equity debt default
investors Investment swap
customers bank (CDS)
Example1: Capital One - Securitization

Security interest
receivables in receivables
Sponsoring
Company SPE Bond Market
cash cash
cash

debtors
 Example 2: Product Financing Arrangements

Forward Security interest in

contract forward contract
Sponsoring Bond Market
Company SPE
Financing plant cash
construction

Example 3: Synthetic lease

Lease Security interest in

contract lease contract
Sponsoring SPE
Company Bond Market
Financing building cash
construction
Operating lease
but own the
building & off-BS
 Analysis
Sources of useful information:
 Notes to the account, Managers’/Chairman’s statements.

Disclosure of financial instruments with off-balance-sheet risk of

loss:
 Face, contract, or principal amount
 Terms of the instrument and info on its credit and market risk,
cash requirements, and accounting loss incurred if a party to the
contract fails to perform
 Collateral or other security, if any, for the amount at risk
 Info about concentrations of credit risk from a counterparty or
groups of counterparties

Useful analyses:
 Scrutinize management communications and press releases
 Analyze notes about financing arrangements
 Recognize a bias to not disclose financing obligations
 Review SEC/LSE filings for details of financing arrangements
 Leases
 It is a contractual agreement between a lessor (owner) and a lessee
(user or renter) that gives the lessee the right to use an asset owned
by the lessor for the lease term. Minimum lease payments (MLP) of
the lessee to the lessor according to the lease contract.

1) Capital lease (or called financing lease): For leases that transfer
substantially all benefits and risks of ownership of an asset—
accounted for as an asset acquisition and a liability incurrence by
the lessee, and as a sale and financing transaction by the lessor.

2) Operating lease: For leases other than capital leases—the lessee

(lessor) accounts for the minimum lease payment as a rental
expense (income).

 Opportunity for earnings management: Promoting sales, tax

considerations, window-dressing-a source of off-balance sheet
finance by choosing operating lease.
 US GAAP - Conditions for identifying capital lease
For a lease to be identified as a capital lease, it must meets any of four
criteria:

 Lease transfers ownership of property to lessee by end of the lease

term.

 Lease contains an option to purchase the property at a bargain price.

 Lease term is 75% or more of estimated economic life of the

property.

 Present value of rentals and other minimum lease payments at

beginning of lease term is 90% or more of the fair value of leased
property less any related investment tax credit retained by lessor.

Otherwise, it is identified as an operating lease.

 IFRS 16 – Lease contract

For a lease to be identified as a capital lease, it must meet the

following criterion:

 Firms use a lease asset for more than one year.

Otherwise, it is identified as an operating lease.

 Lease: Example 1

Lease Facts
• A company leases an asset on January 1,
2005 -- it has no other assets or liabilities
• Estimated economic life of leased asset
is 5 years with no salvage value -- company will
depreciate the asset on a straight-line basis over its life
• Lease has a fixed non-cancelable term of 5 years
with annual MLPs of $2,505 paid at the end of each year
• Interest rate on the lease is 8% per year
 Leases: Example 1
Present value $10,000 - NOT adopt the market price of the asset!
2505 2505 2505
 $(   ..  )
1.08 1.08 2
1.085

Lease Amortization Schedule

Beg. Interest and Principal Year-
Year Components of MLP end
Year Liability Liability
Interest Principal Total

2000 $10,000 $ 800 $ 1,705 $ $8,295

2001 8,295 664 1,841 2,505 6,454
2002 6,454 517 1,988 2,505 4,466
2003 4,466 358 2,147 2,505 2,319
2004 2,319 186 2,319 2,505 0
Totals $2,525 $10,000 2,505
$12,52
5

Straight-line depreciation
$2,000 per year ([$10,000 - $0]/5 years)
 Leases: Example 1

Effects of Alternative Lease Accountings on Income Statement

Operating
Lease Capital Lease

Rent Interest Depreciation Total

Year Expense Expense Expense Expense
2000 $ 2,505 $ 800 $ 2,000 $ 2,800
2001 2,505 664 2,000 2,664
2002 2,505 517 2,000 2,517
2003 2,505 358 2,000 2,358
2004 2,505 186 2,000 2,186

Total $ 12,525 $ 2,525 $ 10,000 $ 12,525

 Leases: Example 1

Effects of Capitalized Leases on Balance Sheet

Leased Lease
Date Cash Asset Liability Equity
1/1/2000 0 $ 10,000 $ 10,000 $ -
12/31/2000 (2,505) 8,000 8,295 (2,800)
12/31/2001 (5,010) 6,000 6,454 (5,464)
12/31/2002 (7,515) 4,000 4,466 (7,981)
12/31/2003 (10,020) 2,000 2,319 (10,339)
12/31/2004 (12,525) 0 0 (12,525)
Revisiting:
double entries for operating and capital leases
 Operating lease
At the end of years from 1 to 5:
Dr. P&L account – lease expense $2,505
Cr. Cash – lease expense $2,505

 Capital lease
At the moment of signing the capital lease contract in year 1:
a) Dr. Asset $10,000
Cr. Long-term liability $10,000
At the end of year 1:
b) Dr. Interest $800
Dr. Long-term liability – installment repayment for principal $1,705
Cr. Cash $2,505
c) Dr. P&L account $800
Cr. Interest $800
d) Dr. P&L account $2,000
Cr. Depreciation $2,000 (On B/S, Asset $10,000 – Depreciation $2,000)
Analysis: Examining the classification of leases

 Estimating the remained useful economic life of the

lease asset, in order to judge whether it should be
classified as capital lease or operating lease.
 If it should not be operating lease, then converting it
to capital lease.
 Determining the interest rate on operating lease,
assume it equals to interest rate of long-term debt.
 Determining the final lease payment.
 Calculating the operating lease asset value and
liability.
 Analysis: Example 2
Company: Best Buy

The composition of total rental expenses for all

operating leases during the past three years:

2004 2003 2002

Minimum rentals $467 $439 $366
Contingent rentals 1 1 1
$468 $440 $367

Future minimum lease obligations by year

(not including contingent rentals) for all operating
leases for February 28, 2004, were as follows:

Fiscal Year Operating Lease

2005 $454
2006 424
2007 391
2008 385
2009 379
Thereafter 2,621
 Converting Operating Leases to Capital Leases

Determining the Present Value of Projected Operating Lease

Adopting 5.8% as the interest rate of short term loan
Restated Financial Statements after Converting
Operating Leases to Capital Leases—Best Buy 2004

-excluding 454 under operating lease then

including 276 depreciation = 3321/12
-Interest expense: 193
-Tax is lower because of tax benefit of
interest expenses

-CL liab: 261

-FA: 3321
-lL liab: 3060
Restated Financial Statements after Converting
Operating Leases to Capital Leases on key ratios—Best
Buy 2004
 Lessee must disclose: Analysis
(1) future MLPs separately for capital leases and operating leases —
for each of five succeeding years and the total amount thereafter.
(2) rental expense for each period at the income statement.

Impact of Operating Lease when Capital Lease is Apt:

• Operating lease understates liabilities—improves solvency ratios
such as debt to equity.
• Operating lease understates assets—can improve return on
investment ratios.
• Operating lease delays expense recognition—overstates income in early
term of the lease and understates income later in lease term.
• Operating lease understates current liabilities by ignoring current
portion of lease principal payment—inflates current ratio & other
liquidity measures.
• Operating lease includes interest with lease rental (an operating
expense)—understates both operating income and interest expense,
inflates interest coverage ratios, understates operating cash flow, & overstates
financing cash flow.
 Postretirement Benefits

Two kinds of Postretirement

Benefits

Pension benefits -- Employer-promises monetary

benefits to employees after retirement, e.g., monthly
stipend until death

Other Postretirement Employee Benefits (OPEB)

-- Employer-provided non-pension (usually
nonmonetary) benefits after retirement, e.g., health care
and life insurance
 Postretirement Benefits
Pension Basics
Pension Plan – agreement by the employer to provide pension benefits involving
3entities: employer-who contributes to the plan; employee-who derives benefits; and
pension fund
Pension Fund – account administered by a trustee, independent of employer,
entrusted with responsibility of receiving contributions, investing them in a proper
manner, & disbursing pension benefits to employees
Vesting – specifies employee’s right to pension benefits regardless of whether
employee remains with the company or not; usually conferred after employee has
served some minimum period with the employer

Pension Plan Categories

Defined benefit – a plan specifying amount of pension benefits that employer promises
to provide retirees; employer bears risk of pension fund performance

Defined contribution – a plan specifying amount of pension contributions that

employers make to the pension plan; employee bears risk of pension fund performance

Focus of Pension Analysis

Defined benefit plans constitutes the major share of pension plans and are
the focus of analysis given their implications to future company
performance and financial position
Postretirement Benefits

Elements of the Pension Process

Employer Pension Employee

Fund
Benefits
Contributions
(Disbursements)

Investment and returns

 Postretirement Benefits
Illustration of Pension Accumulation and Disbursement for a Defined
Benefits Plan – Example 1

Annual payments into the

Fund required to accumulate
Funds required at employees’ Annual benefits of
to $134,200 in 15
retirement: $20,000 paid to
years with a discount
Present value of 10 payments of employee for 10 years
rate of 8%per
$20,000 per annum with a
annum
discount rate of 8% per annum

Contributions = Benefits =
$4,942 per annum $134,200 $20,000 per annum

15 years 10 years

Preretirement Retirement Postretirement

 Postretirement Benefits
Alternative Definitions of Pension Obligation
Accumulated benefit obligation (ABO) – actuarial present value of future pension
benefits payable to employees at retirement based on their current compensation and
service to-date

Project benefit obligation (PBO) – actuarial estimate of future pension benefits payable to
employees on retirement based on expected future compensation and service to-date

Relation between Plan Assets and Funded Status

Plan Assets – The funds contributed to the plan are called plan assets because these are
invested in capital markets

Funded Status of the Plan – Difference between the value of the plan assets and the PBO
which represents the net economic position of the plan

Note: Plan is overfunded (underfunded) when value of plan assets exceeds (is less
than) PBO
 Postretirement Benefits
Economic Pension Cost
Economic pension cost -- net cost arising from changes in net economic position
(or funded status) for a period; includes both recurring and nonrecurring
components along with return on plan assets.

Recurring pension costs consist of two components:

Service cost – actuarial present value of pension benefit earned by employees
Interest Cost – increase in projected benefit obligation arising when pension
payments are one period closer to being made; computed by multiplying
beginning-period PBO by the discount rate
Nonrecurring pension costs consist of two components:
Actuarial Gain or Loss – change in PBO that occurs when one or more
actuarial assumptions are revised in estimating PBO
Prior Service Cost – effect of changes in pension plan rules on PBO
Return on plan assets:
Actual return on plan assets – pension plan’s earnings, consisting
of investment income—capital appreciation and dividend and interest
received, less management fees; plus realized and unrealized
appreciation (or minus depreciation) of other plan assets; Used to offset cost
to arrive at a net economic pension cost.
Shareholders’ Equity
 Shareholders’ Equity
Ordinary Shares (UK)/Common Stock (US) — refers to owner
financing; its usual characteristics include:
• Reflects claims of owners (shareholders) on net assets
• Ordinary shareholders usually subordinate to creditors and
preference shareholders (in the following)
• Variation across equity holders on seniority
• Exposed to maximum risk and return

Preferred Stock (US) (UK Preference share) —

• Dividend distribution preferences (prior to common
shareholders)
• Liquidation priorities
• Convertibility (redemption) into common stock
• Call provisions
• Sinking fund provisions
• No voting right
 Shareholders’ Equity
• Contributed (or Paid-In) Capital in excess of par or stated
value/Share Premium account — financing in excess of any par
or stated value.

• Retained Earnings — earned capital of a company; reflects

accumulation of undistributed earnings or losses since inception;
retained earnings is the main source of dividend distributions.

•Reserves – for example, asset revaluation.

 Shareholders’ Equity

Reporting Capital Stock

Sources of increases in capital stock outstanding:

• Issuances of stock
• Conversion of debentures and preferred stock
• Issuances pursuant to stock dividends and splits
• Issuances of stock in acquisitions and mergers
• Issuances pursuant to stock options and warrants
exercised

Sources of decreases in capital stock outstanding:

• Purchases and retirements of stock
• Purchases of treasury stock
• Reverse stock splits
 Shareholders’ Equity
Shareholder’s Equity Section of Kimberly Corp. for
periods ending in Year 4 and 5
Year 5 Year 4

Prefered stock, 7% cumulative, par value

$100 (authorized 4,000,000; outstanding
3,602,811) $ 360,281,100 $ 360,281,100
Common Stock, par vaulue $16.67
(authorized 90,000,000 shares; outstanding
54,138,137 shares at December 31, Year 5
and 54,129,987 shares at December 31,
Year 4 902,302,283 902,166,450
Retained earnings 2,362,279,244 902,166,450
Total shareholder's equity $3,624,862,627 $ 2,220,298,288
*Note: Preferred stock is nonparticipating and callable at 105. Dividends for Year 5 are in arrears
 Shareholders’ Equity
Calculated Book Value per Share

Preferred Common Total

Preferred stock* (at $100 par) $ 360,281,100 $ 360,281,100
Dividends in arrears (7%) 25,219,677 25,219,677
Common stock $ 902,302,283 902,302,283
Retained earnings (net of amount attributed
to dividend in arrears 2,337,059,567 2,337,059,567
Total $ 385,500,777 $ 3,239,361,850 $ 3,624,862,627
Divided by number of shares outstanding 3,602,811 54,138,137
Book value per share $ 107.00 $ 59.84
*The call premium does not normally enter into computation of book value per share because the call
provision is at the option of the company
 Analysis
Equity characteristics:
 Classifying and distinguishing different equity sources
 Examining rights for equity classes and priorities in liquidation
 Evaluating legal restrictions for equity distribution
 Reviewing restrictions on retained earnings distribution
 Assessing terms and provisions of potential equity issuances

Cash and Stock Dividends

 Cash dividend — distribution of cash (or assets) to shareholders
 Stock dividend — distribution of capital stock to shareholders

Appropriations of Retained Earnings

 Reclassifications of retained earnings for specific purposes

Restrictions (or Covenants) on Retained Earnings

 Constraints or requirements on retention of retained earnings
 Lecture review

 Concept of liabilities
 Contingencies

 Off-balance-sheet financing

 Lease contract

 Pension

 Shareholders’ equity
References:
 Text book Ch.3, Subramanyam’s book – Financial Statement Analysis,
11th Edition, McGrawHill.

Supplementary:
Alfredson, K., et al. (2009), Appling International Financial Reporting
Standard, 2ndEd., Wiley, ISBN 0-470-81967-7, Ch. 6, pp.149 –166.

Penman, Stephen H., Financial Statement Analysis and Security

Valuation, 5th Ed., McGrawHill, 2014. ISBN-13: 978-007-126780-9. Ch.7

 Palepu, Healy and Bernard (2013), Business Analysis & Valuation: IFRS
Edition, 3rd Ed., Thomson. ISBN 978-1-4080-5642-4, Ch. 4, pp.143 – 147,
154 – 163.

Questions for tutorial classes :

Exercises: 3-1, 3-7, Problem 3-7 (Campbell Soup Pension)

Canvas:
All handouts, tutorial class questions and answers, past exam papers can
be downloaded on Canvas.