Financial

Statement
&
Analysis
Valuation Sixth Edition

Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 7
Liability Recognition and
Nonowner Financing

© Cambridge Business Publishers, 2021

Learning
Objective 1
Evaluate accounting for accrued
liabilities.

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Current Liabilities

 Current section of the balance sheet reports

liabilities that will mature with a year.

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Accrued Liabilities
 AKA: Accrued expenses & Accruals
 Accrued liabilities are adjustments made to the
balance sheet:
 After all transactions have been recorded
 Prior to the issuance of the financial statements
 So that the financial statements fairly present the financial
condition of the company
 These adjustments recognize liabilities (and the
related expense on the income statement) that are
not the result of external transactions
 Accrued liabilities are incurred in the current period
and, therefore, must be recognized in the current
period. © Cambridge Business Publishers, 2021 5
Types of Accrued Liabilities
Two broad categories of accruals:
1. Routine contractual liabilities
 Wages to employees for work performed, but not yet paid
 Unpaid interest that is due in the current period
 Income taxes owed, but not yet paid, on profit earned in the
period
 Other expense items like rent and utilities, incurred but not yet
paid

2. Contingent liabilities―depend on the occurrence of a

future uncertain event in order to determine whether a
liability exists and in what amount
 Litigation brought against the company―the outcome and
amount depend upon adjudication
 Warranty liabilities for products sold―the amount depends on
future claims for product repair or replacement
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Accruals for Contractual Liabilities
Example—Wages Payable
 If the liability for unpaid wages is not reflected on
balance sheet:
 Liabilities will be understated
 Wage expense will not be reflected in the income statement
 Profit for the period will be overstated

 To correct for this, accountants make an accounting

adjustment.
 When the wages are paid, cash and wages payable both
decrease:

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Accruals for Contractual Liabilities
Example—Deferred Revenue

 AKA: Unearned revenue

 Deferred revenue represents deposits or other
prepayments from customers that the company has
not yet earned.
 Deferred revenue is an accrued liability until the company
provides the goods or performs the service according to the
contract.
 Once the company satisfies the performance obligations, the
liability is reduced and (earned) revenue is recognized.

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Accruals for Contingent Liabilities
 Some liabilities are less certain because the ultimate
settlement of the liability is contingent on the outcome
of a future event.
 Examples include
 Guarantees on the debt of another entity
 Lawsuits
 Product warranties and recalls
 Environmental disasters and remediation

 Companies record an a contingent liability when two

conditions are met:
1. It is probable that one or more future events will confirm that a
liability existed at the financial statement date.
2. The amount required to settle the liability in the future can be
reasonably determined at the financial statement date.
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Accruals for Contingent Liabilities
Example—Warranties
 Warranty liabilities are commitments that
manufacturers make to repair or replace defective
products within a specified period of time.
 If the obligation is probable and the amount estimable
with reasonable certainty, GAAP requires that companies:
 Record the expected cost of warranties as a liability

 Record the related expected warranty expense in the income

statement in the same period that the sales revenue is reported
 When the defective product is later replaced (or
repaired), the liability is reduced and the company
records the cost of necessary to satisfy the claim.

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Harley Davidson’s
Warranty Footnote Disclosure

$116,840
Expense

 At the beginning of 2018, Harley-Davidson reported a

warranty and recall liability (reserve) of $94,250.
 During 2018 Harley-Davidson:
 Added $53,367 for warranties issued on products sold in 2018.
 Added $63,473 for product recalls and changes to pre-existing
warranty liabilities.
 Paid out $79,300 to settle warranty claims. The settlements include
cash paid to customers for refunds, wages paid for repairs, and the
cost of parts used in repairs.
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Analysis of
Warranty Footnote Disclosures
 GAAP requires that warranty liabilities reflect estimated
cost the company expects to incur as a result of warranty
claims.
 Companies might intentionally
 Underestimate warranty liability to report higher current income

 Overestimate warranty liability to depress current income and

create an liability (cookie jar reserve) to absorb future warranty
costs
 This would shift income from the current period to the
future.
 We must closely examine warranty liabilities and
scrutinize deviations from the historical relation to sales
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Analyst Adjustments 7.1

 Warranty expenses are rife with estimates: product

failure rates, likelihood customers will make claims if
products fail, the cost of repairs, etc.
 Firms can deliberately manage warranty expense to
achieve desired financial reporting outcomes.
 Analysts can “undo” potential earnings management by
adjusting warranty numbers.
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Analyst Adjustments 7.1
 As one approach to adjusting warranty numbers, analysts
determine an historical average as follows:

 We use the 1.83505% average to compute expected

expense and reformulate the income statement and
balance sheet:

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Learning
Objective 2
Analyze short-term debt.

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Accounting for Short-Term Debt

 When the company borrows short-term funds, it

reports the cash received on the balance sheet
together with an increase in liabilities (notes
payable).
 The note is reported as a current liability because
the company expects to repay it within a year.
 The borrower incurs (and the lender earns) interest
on the note as time passes.
 GAAP requires the borrower to accrue the interest
liability and the related interest expense each time
financial statements are issued.
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Accounting for Short-Term Debt
 Assume that Verizon borrows $1,000 cash on January 1st.
 The note bears 12% interest, payable quarterly.

 Assume that Verizon prepared financial statements March

31st.
 Verizon calculates interest as follows on March 31st.

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Current Maturities of Long-Term
Debt

 Principal payments on long-term debt, that must be

made during the upcoming 12 months are reported as
current liabilities called current maturities of long-term
debt.
 Note that the current maturity is the principal portion
only of the payments that will be made in the upcoming
year.
 Consider a typical loan amortization schedule:

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Learning
Objective 3
Analyze long-term debt pricing.

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Long-Term Debt
Pricing

 When companies require a large amount of

financing, the issuing bonds in capital markets is a
cost-efficient way to raise funds.
 Bonds are structured like any other borrowing:
 The borrower receives cash and agrees to pay it back with
interest.
 Generally, the entire face amount (principal) of the bond is
repaid at maturity (at the end of the bond’s life).
 Interest payments are made in the interim (usually
semiannually).

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Issuance of Bonds

 Companies that raise funds in the bond market normally

work with an underwriter (like Goldman Sachs) to set the
terms of the bond issue.
 The underwriter:
 Sells individual bonds (usually in $1,000 denominations) to its retail
clients and professional portfolio managers (like The Vanguard
Group)
 Receives a fee for underwriting the bond issue

 These bonds are investments for individual investors,

other companies, retirement plans and insurance
companies.

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Interest Rates and Bond Prices

 Issued bonds can trade in the secondary market just like

stocks.
 Bond prices fluctuate even though the company’s
obligation to repay principal and interest remains fixed
throughout the life of the bond.
 The bond’s fixed rate of interest can be higher or lower
than the interest rates offered on other securities of
similar risk.
 Because bonds compete with other possible investments,
bond prices are set relative to the prices of other
investments.
 Just like in any competitive market―the laws of supply
and demand will cause bond prices to rise and fall.
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Two Types of Interest Rates

 Coupon (contract or stated) rate

 AKA: Contract rate, Stated rate
 The coupon rate of interest is stated in the bond contract
 We use coupon rate to compute the dollar amount of interest
payments that are paid (in cash) to bondholders during the
life of the bond issue

 Market (yield or effective) rate

 AKA: Yield, Effective Rate
 This is the interest rate that investors expect to earn on the
investment in this debt security
 This rate is used to price the bond

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Cash Flows to Bondholders
 Bondholders normally expect to receive two types of
cash flow
1. Periodic interest payments (usually semiannual) during the
bond’s life
 Interest payments are called an annuity because they are equal
in amount and made at regular intervals.
2. Single payment of the face (principal) amount of the bond at
maturity
 Repayment of principal is called a lump-sum because it occurs
only once.
 The bond price equals the present value of the
annuity payments plus the present value of the
lump-sum payment.
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Pricing of Bonds Issued at Par
 Assume a company issues the following bond:
 Face amount of $10 million
 A 6% annual coupon rate (which is a 3% semiannual rate)
 Matures in 10 years (in 20 semiannual periods)

 If the market demands 3% semiannually, the bond price

is $10 million and the bond is issued at par:

© Cambridge Business Publishers, 2021 25

Pricing of Bonds Issued at a
Discount
 If instead, investors demand a 4% semiannual return for the
3% semiannual coupon bond.
 Because the bond carries a coupon rate lower than what
investors demand, the bond is less desirable and sells at a
discount.
 The bond now sells for $8,640,999, computed as follows:

 Because the bond carries a coupon rate lower than what

investors demand, the bond is less desirable and sells at a
discount.
 In general, bonds sell at a discount whenever the coupon
rate is less than the market rate.
© Cambridge Business Publishers, 2021 26
Pricing of Bonds Issued at a
Premium
 If instead, investors demand a 2% semiannual return for
the
3% semiannual coupon bond.
 Because the bond carries a coupon rate that is higher than
what investors demand, the bond is more desirable and
sells at a premium.
 The bond now sells for $11,635,129, computed as follows:

 In general, bonds sell at a premium whenever the coupon

rate is greater than the market rate.

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Effective Cost of Debt

 Bonds are priced to yield the return (market rate)

demanded by investors.
 Thus, the effective rate of a bond always equals the
yield demanded by investors, regardless of the bond’s
coupon rate.
 This means that companies cannot influence the effective
cost of debt by raising or lowering the coupon rate.
 Doing so will only result in a bond premium or discount.

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Interest Expense vs. Interest
Payments
 The effective cost of debt is used to determine interest
expense reported in the issuer’s income statement.
 Because of bond discounts and premiums, interest
expense is usually different from the cash interest paid.

Bonds sold at a
discount: 99.631% -
0.3% = 99.331% of
face value

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Verizon’s Coupon vs. Effective Rate

 We can use Excel to calculate the effective cost of debt.

 Assume the notes were

sold on April 8, 2019
 Bonds mature in 8 years
 Assume interest paid
annually
 Verizon received
proceeds of 99.331% of
face value = €1,241,637,500
 Effective rate was 0.9623%

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Learning
Objective 4
Analyze long-term debt.

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Balance Sheet Reporting
 Companies report debt NET of discounts (or including
premium).
 Details are reported in the debt footnote.
 For Verizon:

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Balance Sheet Reporting
 Footnotes provide a schedule of the maturities of long-
term debt.
 Verizon's footnotes report the following in 2018:

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Income Statement Reporting

 Interest expense reported on the income statement

represents the effective cost of debt, including:
 The cash interest paid (the coupon rate)
 PLUS a portion of the additional borrowing costs associated
with the discount (or less a portion of the benefit associated
with the premium)
 The process of recognizing additional interest
expense associated with a non-par bond is called
amortization.
See Appendix 7B for
details about bond
amortization.

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Financial Statement Effects
of Bond Repurchase
 AKA: Bond redemption or extinguishment
 Companies can and sometimes do repurchase their
bonds prior to maturity.
 Verizon reports a “loss on the early extinguishment of
debt” of $700 million in 2018 as described in the financial
statement footnotes as follows:

 When a bond repurchase occurs, a gain or loss usually

results, and is computed as follows:

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Gains and Losses
on Bond Retirements
 When a bond repurchase occurs, a gain or loss usually
results, and is computed as follows:

 The net bonds payable, also referred to as the book value

or carrying value, is the net amount reported on the
balance sheet.
 If the issuer pays more to retire the bonds than the
amount carried on its balance sheet, it reports a loss on
its income statement.
 The issuer reports a gain on bond retirement if the
repurchase price is less than the net bonds payable.

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Fair Value Disclosures
 GAAP requires companies to report current fair values of
their debt in footnotes (but not on the balance sheet).
 Changes in fair values are not included in net income
because:
 Gains and losses reverse with subsequent fluctuations in interest
rate.s
 The bonds are repaid at par at maturity.

 Verizon discloses the following in its footnotes:

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Learning
Objective 5
Evaluate credit quality and
interpret credit ratings.

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Credit Analysis
 While equity investors are focused on upside potential,
lenders are primarily concerned with credit risk: the risk
that they will not recoup the amount loaned or the
interest.
 Borrowers with higher credit risk have lower quality of
debt.
 Lenders’ focus on the company’s ability to repay the
borrowed amounts, which is largely determined by two
factors:
1. Level of indebtedness—amount of principal and interest that
must be repaid
2. Excess cash that the company is able to generate—this provides
the cash needed to repay the debt
 The term “excess cash” means the cash the company is
able to generate over andBusiness
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Market Rate of Interest

 Lenders require a higher interest rate as the

borrower’s credit risk increases (and the quality of
its debt declines).
 The market rate of interest (yield) is defined as:

 The risk-free rate is the yield on U.S. Government

borrowings such as treasury bills, notes, and bonds.
 The risk premium depends on the level of credit risk
associated with the borrower.

© Cambridge Business Publishers, 2021 40

Market Rate of Interest
 Consider the risk-free rate and the rate for the
lowest risk corporate bonds (AAA) and for riskier
corporate bonds (BAA):

© Cambridge Business Publishers, 2021 41

What Are Credit Ratings?
 Companies that want to issue public debt normally seek a
credit rating on their proposed debt issue.
 Major credit rating agencies
include:
 S&P Global Ratings
 Moody’s Investors Service

 Fitch Ratings

 The aim of rating agencies is to

rate debt so that its credit risk
is more accurately conveyed to,
and priced by, the market.
 Each rating agency has its
own rating system.
© Cambridge Business Publishers, 2021 42
Credit Rating Agencies
 Credit rating agencies take a two-step approach to
evaluate the riskiness of a company’s debt.
 The first step is to assess the likelihood of default.
 The relative likelihood of default can be gauged by
analyzing:
 Historical and forecasted levels of debt
 Excess cash flow available to repay the debt

 The second step is to assess the potential loss that the

lender will suffer in the event of default.
 The potential loss given default is generally a function of the
structure of the debt.
 To quantify loss given default, rating agencies consider collateral,
loan terms, and covenants.

© Cambridge Business Publishers, 2021 43

What Determines Credit Ratings?
 Each rating agency uses its own rating system
 S&P Global Ratings’ process is depicted in the
following graphic:

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Verizon Credit Rating
Example
 S&P assesses Verizon as STRONG
when it comes to business risk.
 S&P determines that the
company’s financial risk is
INTERMEDIATE.
 This yields an anchor of a-.
 Most of the modifiers are neutral.
 Management and governance are
perceived as strong.
 But a comparable rating analysis
results in a negative modifier.
 S&P assigned Verizon a stand-
alone credit rating of BBB+.

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Verizon Credit Rating
Example
 S&P concludes its analysis by emphasizing its
expectation that Verizon will continue in its stated
objective to reduce debt.

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Credit Ratings and Financial Ratios
 Rating agencies use several financial ratios to assess default
risk.
 A partial list of ratios used by Moody’s is in the table below:

 In examining the ratios, recall that debt is increasingly more

risky as we move from©the first row, Aaa, to the last row Caa-C.
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Why Credit Ratings Matter

 So, how good are credit ratings at predicting

defaults?
 Moody’s provides the following graphic that
illustrates the default rates for each ratings category
5 years into the future:

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Appendix 7A
Time Value of Money

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Learning
Objective 6
Apply time value of money
concepts.

© Cambridge Business Publishers, 2021

Present Value Concepts

 Would you rather receive a dollar now or a dollar

one year from now?
 Most people would answer, a dollar now.
 Intuition tells us that a dollar received now is more
valuable than the same amount received sometime
in the future.
 The dollar received now could be invested and one
year from now, we would have the dollar and the
interest earned on that dollar.

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Present Value of a Single Amount
 Risk and interest factors yield the following
generalizations:
1. The right to receive an amount of money now (present
value) is worth more than the right to receive the same
amount later (future value).
2. The longer we must wait to receive an amount, the less
attractive the receipt.
3. The greater the interest rate the greater the amount we will
receive in the future.
 Putting 2 and 3 together we see that the difference between the present
value of an amount and its future value is a function of:
Principal × Interest Rate × Time
4. The more risk associated with any situation, the higher the
interest rate.
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Present Value Computation
 If we have $90.91 today and can invest it at 10% for
1 year, our investment will grow to $100:

 So, $90.91 is the present value of $100 to be

received in 1 year.
 Hence if the investment rate is 10%, we can also
calculate the present value by discounting the future
value as follows:

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Using Present Value Tables

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Using Present Value Tables
Present value tables are in Appendix A of the book―to use:
 Determine the number of interest compounding periods (three years
compounded semiannually are 6 periods).
 The extreme left-hand column indicates the number of periods.
 It is important to distinguish between years and compounding periods.
 The table is for compounding periods (years × number of compounding
periods
per year).
 Determine the interest rate per compounding period.
 Interest rates are usually quoted on a per year (annual) basis.
 The rate per compounding period is the annual rate divided by the number of
compounding periods per year. For example, an interest rate of 10% per year

would be 10% per period if compounded annually, and 5% per period if

compounded semiannually.
 Locate the present value factor (at the intersection of the row
of the appropriate number of compounding periods and the column
of the appropriate interest rate per compounding period).
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Using Present Value Tables
Examples

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Present Value of an Annuity

 Often, future cash flows involve the same amount

being paid or received each period.
 Examples of annuities include:
 Semiannual interest payments on bonds
 Quarterly dividend receipts
 Monthly insurance premiums

 If the payment or the receipt (the cash flow) is

equally spaced over time and each cash flow is the
same dollar amount, we have an annuity.

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Simple Annuity
Example
 Assume $100 is to be received at the end of each of
the next three years as an annuity.
 As shown below, the present value of this annuity
can be computed from Table 1 by computing the
present value of each receipt separately and
summing them (assume a 5% annual rate):

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Using Present Value Tables

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Using Table 2
Present Value of Ordinary Annuity
 Table 2 (Appendix A) provides a single multiplier for
computing the present value of an ordinary annuity.
 Referring to Table 2 in the row for three periods and the
column for 5%, we see that the multiplier is 2.72325:

 When applied to the $100 annuity amount, the multiplier

gives a present value of $272.33, the same present value
we derived by summing the three separate multipliers
from Table 1.
 Using annuity tables is simpler.
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Bond Valuation
 A bond agreement specifies a pattern of future cash
flows:
 A series of interest payments (cash outflow)

 A single payment of the face amount at maturity (cash outflow)

 The market rate on the date of the sale is the rate we

use to determine the bond’s market value (its price).
 The selling price of a bond is determined as follows:

1. Use Table 1 to compute the present value of the future principal

payment at the prevailing market rate.
2. Use Table 2 to compute the present value of the future series of
interest payments (the annuity) at the prevailing market rate.
3. Add the present values from Steps 1 and 2.
© Cambridge Business Publishers, 2021 61
Par Bond
Example

 Determine the price of a $100,000, 8%, four-year bond

paying interest semiannually.
 The bond is sold when the prevailing market rate was 8%
(4% semi-annual rate).

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Discount Bond
Example

 Determine the price of a $100,000, 8%, four-year bond

paying interest semiannually.
 The bond is sold when the prevailing market rate was
10%
(5% semi-annual rate).

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Premium Bond
Example

 Determine the price of a $100,000, 8%, four-year bond

paying interest semiannually.
 The bond is sold when the prevailing market rate was 6%
(3% semi-annual rate).

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Time Value of Money Computations
Using a Calculator
 We can use a financial calculator for time value of
money computations.
 There are five function keys for these calculations.
 If we know values for four of those five, the
calculator will compute the fifth.
 Those function keys are:

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Pricing Bonds
Using a Financial Calculator

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Time Value of Money
Using Excel
 We can use Excel or other spreadsheet software, to
perform time value of money calculations.
 There are a number of time value of money functions
that involve the same six variables:

 The Excel functions for present value and future value

are:
 = pv(rate,nper,pmt,fv,type)
 = fv(rate,nper,pmt,pv,type)
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Pricing a Bond Using Excel

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Future Value Concepts
 The future value of a single sum is the amount that a
specific investment is worth at a future date if invested at
a given rate of compound interest.
 To illustrate:
 We put $6,000 in a savings account that pays 6% annual interest.
 We intend to leave the principal and interest in the account for five
years.
 Assume interest is credited to the account at the end of each year.

 The balance in the account at the end of five years is

determined using Table 3 in Appendix A. The factor
1.33823 is at the intersection of the row for five periods
and the column for 6%.

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Future Value of an Annuity
 If, instead of investing a single amount, we invest a
specified amount each period, then we have an annuity.
 To illustrate, suppose we invest $2,000 at the end of
each year for five years at an 8% annual rate of return.
 To determine the accumulated amount of principal and
interest at the end of five years, we use Table 4 in
Appendix A, which furnishes the future value of a dollar
invested at the end of each period.
 The factor 5.86660 is in the row for five periods and the
column for 8%, and the calculation is as follows:

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Financial
Statement
&
Analysis
Valuation Sixth Edition

Cambridge Business Publishers

www.cambridgepub.com