Analyzing Financing Activities

Liabilities - Classification

Current (short-term) 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.

Noncurrent (Long-Term) Liabilities - Obligations not payable within one year or the operating cycle, whichever is longer.

Alternative Classification

Operating Liabilities - Obligations that arise from operating activities--examples are accounts payable, unearned revenue, advance payments, taxes payable, postretirement liabilities, and other accruals of operating expenses

Financing Liabilities - Obligations that arise from financing activities--examples are short- and long-term debt, bonds, notes, leases, and the current portion of long-term debt

Important Features in Analyzing Liabilities

• Terms of indebtedness (such as maturity, interest rate, payment pattern, and amount).
• Restrictions on deploying resources and pursuing business activities.
• Ability and flexibility in pursuing further financing.
• Obligations for working capital, debt to equity, and other financial figures.
• Dilutive conversion features that liabilities are subject to.
• Prohibitions on disbursements such as dividends.

Leasing Facts

Lease – 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.

MLP – minimum lease payments (MLP) of the lessee to the lessor according to the lease contract

Lease Accounting and Reporting

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

A lessee classifies and accounts for a lease as a capital lease if,

at its inception, the lease meets any of four criteria:

(i) lease transfers ownership of property to lessee by end of the lease term

(ii) lease contains an option to purchase the property at a bargain price

(iii) lease term is 75% or more of estimated economic life of the property

(iv) 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

 

(2) Operating Lease Accounting   For leases other than capital leases—the lessee (lessor) accounts for the minimum lease payment as a rental expense (income)

Lease Disclosure and Off-Balance-Sheet Financing

Lease Disclosure

Lessee must disclose: (1) future MLPs separately for capital leases and operating leases — for each of five succeeding years and the total amount thereafter, and (2) rental expense for each period on income statement is reported

 

Off-Balance-Sheet Financing

Off-Balance-Sheet financing is when a lessee structures a lease so it is accounted for as an operating lease when the economic characteristics of the lease are more in line with a capital lease—neither the leased asset nor its corresponding liability are recorded on the balance sheet

Effects of Lease Accounting 

Impact of Operating Lease versus Capital Lease:

• 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

Converting Operating Leases to Capital Leases

Restated Financial Statements after Converting Operating Leases to Capital Leases—Best Buy 2004

 Recasting Best Buy’s Income Statement

• Operating expenses decrease by $177 million (elimination of $454 million rent expense reported in 2004 and addition of $277 million of depreciation expense).
• Interest expense increases by $193 million (to $201 million)
• Net income decreases by $10 million [$16 million pretax x (1 - .35), the assumed marginal corporate tax rate] in 2004.

 Recasting Best Buy’s Balance Sheet

• The balance sheet impact is more substantial
• Total assets and total liabilities both increase markedly—by $3.321billion at the end of 2004, which is the present value of the operating lease liability. 
• The increase in liabilities consists of increases in both current liabilities ($261 million) and noncurrent liabilities ($3.06 billion).

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

Elements of the Pension Process

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

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.

Pension Accounting Requirements 

Basic framework was first specified under SFAS 87. But, due to its certain flaws, FASB recently issued SFAS 158.

Recognized Status on the Balance Sheet

•  Recognizes the funded status of the pension plans on the balance sheet. 
•  Pension assets and obligations are netted against each other (as funded status) rather than separately reported both as an asset and a corresponding liability.
•  Companies do not report the funded status of pension plans as a separate line item on the balance sheet, instead, it is embedded in various assets and liabilities.

Recognized Pension Cost

•  The recognized pension cost included in net income (i.e., the net periodic pension cost) is a smoothed version (smoothing process, defers volatile, one-time items) of the actual economic pension cost for the period.
•  Expected return on plan assets is recognized in reported pension expense.
•  Difference between the actual and expected return is deferred. These deferred amounts are gradually recognized through a process of amortization.
• Thus, net periodic pension cost includes service cost, interest cost, expected return on plan assets and amortization of deferred items.

Articulation of Balance Sheet and Income Statement Effects

•  The net deferral for the period is included in other comprehensive income for the period
•  The cumulative net deferral is included in accumulated other comprehensive income, a component of shareholders’ equity.

Features of OPEB Accounting   

(similar to pension accounting)

OPEB accounting is currently governed by SFAS 158

OPEB costs are recognized when incurred rather than when actually paid out. 

Assets of the OPEB plan are offset against the OPEB obligation, and returns from these assets are offset against OPEB costs.

(3) Actuarial gains and losses, prior service costs, and the excess of actual return over expected return on plan assets are deferred and subsequently amortized.

OPEB Accounting Terminology  

Accumulated Postretirement Benefit Obligation (APBO) – employer’s OPEB obligation 

Expected Postretirement Benefit Obligation (EPBO) – the present value of future

OPEB payments associated with the employees. 

Overview of OPEB Accounting    

Recognized Status on the Balance Sheet

• The total EPBO is allocated over the employees’ expected service with the company. The proportionate obligation, termed the accumulated postretirement benefit obligation (APBO), is recognized on the balance sheet. APBO is that portion of the EPBO “earned” by employee services as of a given date. 
• The funded status of OPEB is the difference between the APBO and the fair value of assets designated to meet this obligation (if any).

Recognized OPEB Cost

• OPEB cost recognized in net income includes the following components:
• Service cost — actuarial present value of OPEB “earned” by employees during the period; portion of EPBO attributable to the current year.
• Interest cost — imputed growth in APBO during the period using an assumed discount rate.
• Expected return on plan assets — equal to the opening fair market value
• of OPEB plan assets multiplied by the long-term expected rate of return on those
• assets.
• Amortization of net gain or loss — The actuarial gains/losses are added to the difference between actual and expected return on plan assets, and the net amount (termed net gain or loss) is deferred. The cumulative net gain or loss is amortized on a straight-line basis over the employee’s service. 
• Amortization of prior service cost —  Retroactive benefits’ changes from plan
• amendments, or prior service costs, are deferred and amortized on a straight-line basis over the employee’s expected remaining service period.

Articulation of Balance Sheet and Net Income

As with pensions, the smoothed net postretirement benefit cost will not articulate with changes to the funded status in the balance sheet.

The net deferrals during a year are included in other comprehensive income for that year and the cumulative net deferrals are included in accumulated other comprehensive income.

Analyzing Postretirement Benefits

• Five-step procedure for analyzing postretirement benefits:
• Determine and reconcile the reported and economic benefit cost and liability (or asset). 
• Make necessary adjustments to financial statements.
• Evaluate actuarial assumptions (discount rate, expected return, growth rate) and their effects on financial statements.
• Examine pension risk exposure (arises to the extent to which plan assets have a different risk profile than the pension obligation).
• Consider the cash flow implications of postretirement benefit plans.