Contingencies and Commitments

Basics of Contingencies

Contingencies -- potential losses and gains whose resolution depends on one or more future events.

Contingent liabilities -- contingencies with potential claims on resources

         -- to record a contingent liability (and loss) two conditions must be met:

(i) probable i.e. an asset  will be impaired or a

         liability incurred, and 

(ii) the amount of loss is reasonably estimable;

         -- to disclose a contingent liability (and loss) there must be at least a reasonable possibility of incurrence

 

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 if

            probability of realization is very high 

Analyzing Contingencies 

Sources of useful information:

Notes, MD&A, and Deferred Tax Disclosures

 

Useful analyses:

• Scrutinize management estimates

• Analyze notes regarding contingencies, including

   Description of contingency and its degree of risk

   Amount at risk and how treated in assessing risk exposure

   Charges, if any, against income

• Recognize a bias to not record or underestimate contingent liabilities

• Beware of big baths — loss reserves are contingencies

• Review SEC filings for details of loss reserves

• Analyze deferred tax notes for undisclosed provisions for future losses

 

Note: Loss reserves do not alter risk exposure, have no cash flow consequences, and do not provide insurance 

Basics of Commitments -- potential claims against a company’s resources due to future performance under contract 

Analyzing Commitments 

Sources of useful information:

Notes and MD&A and SEC Filings

 

Useful analyses:

• Scrutinize management communications and press releases

• Analyze notes regarding commitments, including

 Description of commitment and its degree of risk

 Amount at risk and how treated in assessing risk exposure

 Contractual conditions and timing

• Recognize a bias to not disclose commitments

• Review SEC filings for details of commitments 

Basics of Off-Balance-Sheet Financing

Off-Balance-Sheet Financing  is the non-recording of financing obligations

 

Motivation

To keep debt off the balance sheet—part of ever-changing landscape, where as one accounting requirement is brought in to better reflect obligations from a specific off-balance-sheet financing transaction, new and innovative means are devised to take its place

 

Transactions sometimes used as off-balance-sheet financing:

• Operating leases that are indistinguishable from capital leases

• Through-put agreements, where a company agrees to run 

goods through a processing facility

• Take-or-pay arrangements, where a company guarantees to pay 

for goods whether needed or not

• Certain joint ventures and limited partnerships

• Product financing arrangements, where a company sells and agrees to

  either repurchase inventory or guarantee a selling price

• Sell receivables with recourse and record them as sales rather than liabilities

• Sell receivables as backing for debt sold to the public

• Outstanding loan commitments 

Analysis of Off-Balance-Sheet Financing  

Sources of useful information:

Notes and MD&A and SEC Filings

 

Companies disclose the following info about 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 filings for details of financing arrangements 

Illustration of SPE Transaction to Sell Accounts Receivable 

• A special purpose entity is formed by the sponsoring company and is capitalized with equity investment, some of which must be from independent third parties.
• The SPE leverages this equity investment with borrowings from the credit markets and purchases earning assets from or for the sponsoring company.
• The cash flow from the earning assets is used to repay the debt and provide a return to the equity investors.

Illustration of SPE Transaction to Sell Accounts Receivable 

Benefits of SPEs:

SPEs may provide a lower-cost financing alternative than borrowing from the credit markets directly. 

Under present GAAP, so long as the SPE is properly structured, the SPE is accounted for as a separate entity, unconsolidated with the sponsoring company.

Shareholders’ Equity 

Basics of Equity Financing 

Equity — refers to owner (shareholder) financing; its usual characteristics include:

• Reflects claims of owners (shareholders) on net assets

• Equity holders usually subordinate to creditors

• Variation across equity holders on seniority

• Exposed to maximum risk and return

Equity Analysis — involves analyzing equity characteristics, including:

• 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

Equity Classes — two basic components:

• Capital Stock

• Retained Earnings

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

• Stock buybacks

• Reverse stock splits 

Components of Capital Stock

Contributed (or Paid-In) Capital — total financing received from shareholders for capital shares; usually divided into two parts:

• Common (or Preferred) Stock — financing equal to par or

  stated value;if stock is no-par, then equal to total financing 

• Contributed (or Paid-In) Capital in Excess of Par or Stated

  Value — financing in excess of any par or stated value 

Treasury Stock (or buybacks) - shares of a company’s stock reacquired after having been previously issued and fully paid for. 

•  Reduces both assets and shareholders’ equity
•  contra-equity account (negative equity).
•  typically recorded at cost

Classification of Capital Stock 

Preferred Stock — stock with features not possessed by common stock;  typical preferred stock features include:

• Dividend distribution preferences

• Liquidation priorities

• Convertibility (redemption) into common stock

• Call provisions

• Non-voting rights

 

Common Stock — stock with ownership interest and bearing ultimate risks and rewards (residual interests) of company performance

Basics of Retained Earnings  

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

 

Cash and Stock Dividends

• Cash dividend — distribution of cash (or assets) to shareholders

• Stock dividend — distribution of capital stock to shareholders

 

Prior Period Adjustments — mainly error corrections of prior periods’ statements

 

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 

Spin-Offs and Split-Offs 

Spin-off, the distribution of subsidiary stock to shareholders as a dividend; assets (investment in subsidiary) are reduced as is retained earnings.

Split-off, the exchange of subsidiary stock owned by the company for shares in the company owned by the shareholders; assets (investment in subsidiary) are reduced and the stock received from the shareholders is treated as treasury stock.