Lecture 5 liabilities

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  • Lecture 5 liabilities

    1. 1. Reporting and Analyzing Nonowner Financing Activities
    2. 2. What is a Liability? <ul><li>“ Probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” </li></ul><ul><li>Present obligations. </li></ul><ul><li>Unavoidable obligations. </li></ul><ul><li>Transaction or event must have already happened. </li></ul>
    3. 3. The Balance Sheet Equation <ul><li> </li></ul><ul><li>Assets = Liabilities + Equity </li></ul><ul><li>Investments in Non-owner Owner </li></ul><ul><li>the business financing financing </li></ul><ul><li>What you own = How you paid for it </li></ul>$$ Borrowed by the company $$ Invested by owners or $$ Earned by the company Stuff Purchased by the company
    4. 4. Business Background <ul><li>The mix of debt and equity for a company is called the capital structure: </li></ul>Debt - funds from creditors Equity - funds from owners
    5. 5. Liabilities Measurement <ul><li>Liabilities are measured at their current cash equivalent (the amount a creditor would accept to cancel the debt) at the time incurred. </li></ul>Maturity < 1 year Maturity > 1 year Current Liabilities Noncurrent Liabilities
    6. 7. Current Liabilities
    7. 8. Accruals <ul><li>The term accrue means to build up gradually. </li></ul><ul><li>Accruals refer to amounts in asset and liability accounts that build up over time. </li></ul><ul><li>Adjustments to record accruals are made at the end of an accounting period. </li></ul>
    8. 9. Accruals End of accounting period. Examples include interest earned during the period or wages earned by employees but not yet paid. Cash received or paid. Revenues earned or expense incurred
    9. 10. Warranty Accrual
    10. 11. 105,106
    11. 12. Deferred Revenues <ul><li>Cash is collected from the customer before the revenue is actually earned. </li></ul>Deferred revenue is a liability account. Cash is received in advance. Deferred revenue is recorded.
    12. 13. Deferred Revenues <ul><li>Cash is collected from the customer before the revenue is actually earned. </li></ul>Earned revenue is recorded. As the earnings process is completed . . . Deferred revenue is recorded. Cash is received in advance.
    13. 14. 106
    14. 15. Pensions 101 <ul><li>Plan Assets </li></ul><ul><li>- </li></ul><ul><li>Projected Benefits </li></ul><ul><li>= </li></ul><ul><li>“ Funded Status” </li></ul>
    15. 16. Pensions 101 Plan Assets – Projected Benefits = “Funded Status” <ul><li>Plan Assets: </li></ul><ul><ul><li>Fair Value at Beginning </li></ul></ul><ul><ul><ul><li>+ Actual Return on Assets </li></ul></ul></ul><ul><ul><ul><li>+ Employer Contribution </li></ul></ul></ul><ul><ul><ul><li>- Benefit Payments </li></ul></ul></ul><ul><ul><li>= Fair Value at End </li></ul></ul><ul><li>Straight forward, no judgment </li></ul>
    16. 17. Pensions 101 Plan Assets – Projected Benefits = “Funded Status” <ul><li>Projected Benefits: </li></ul><ul><ul><li>Liability at Beginning </li></ul></ul><ul><ul><ul><li>+Service Cost : PV effect of 1 more year of employee service means higher benefit when retire </li></ul></ul></ul><ul><ul><ul><li>+Interest Cost : PV effect of employees 1 year closer to retirement </li></ul></ul></ul><ul><ul><ul><li>+Actuarial Losses : PV effect of actuarial assumptions, e.g. life span </li></ul></ul></ul><ul><ul><ul><li>- Benefits Paid </li></ul></ul></ul><ul><ul><li>= Liability at End </li></ul></ul><ul><li>Highly judgmental - Effected by assumptions on </li></ul><ul><ul><li>Discount rate </li></ul></ul><ul><ul><li>Interest rate </li></ul></ul><ul><ul><li>Actuarial assumptions </li></ul></ul>
    17. 18. HP Pensions <ul><li>Footnote 16 </li></ul><ul><li>Page 135 - 143 </li></ul>
    18. 19. Example: Notes Payable
    19. 20. Current Portion of Long-Term Debt <ul><li>Any portion of a note payable that is due within one year, or the operating cycle, whichever is longer. </li></ul>Total Notes Payable Current Notes Payable Noncurrent Notes Payable
    20. 21. Sources for Long-Term Loans Relatively small debt needs can be filled from single sources. Banks Insurance Companies or Pension Plans or
    21. 22. Sources for Publicly Issued Debt Significant debt needs are often filled by issuing bonds to the public. Cash Bonds
    22. 23. Understanding the Business <ul><li>Advantages of bonds: </li></ul><ul><li>Bonds are debt, not equity, so the ownership and control of the company are not diluted. </li></ul><ul><li>Interest expense is tax-deductible. </li></ul><ul><li>The low interest rates on bonds allow for positive financial leverage. </li></ul><ul><li>Disadvantages of bonds: </li></ul><ul><li>Risk of bankruptcy; the debt must be paid back regularly, or creditors will force legal action. </li></ul><ul><li>Negative impact on cash flows. </li></ul>
    23. 24. Characteristics of Bonds Payable At Bond Issuance Date Bonds payable are long-term debt for the issuing company. $ Bond Issue Price $ Bond Certificate Company Issuing Bonds Investor Buying Bonds
    24. 25. Characteristics of Bonds Payable Periodic Interest Payments At STATED RATE $ $ Face Value Payment at End of Bond Term PAR VALUE $ $ Company Issuing Bonds Investor Buying Bonds
    25. 26. Bond Issuance <ul><li>Company decides what the stated rate will be on the bond – What rate of interest their bond will pay </li></ul><ul><li>This is often different from the market rate of interest – What the market is paying in general for like credit risks </li></ul>
    26. 27. Why the Difference in Rates?? <ul><li>Companies use rate to manage cash flow </li></ul><ul><li>Gold Mine example </li></ul><ul><ul><li>Need lots of money to dig the mine </li></ul></ul><ul><ul><li>Will take 5 years to get to the gold </li></ul></ul><ul><ul><li>Little money to pay interest in the meantime </li></ul></ul><ul><ul><li>Can issue a bond with less interest than market and still get their money </li></ul></ul><ul><ul><li>“ Discounted” Bond </li></ul></ul>
    27. 28. Discounted Bond <ul><li>Issuer offers to pay LESS than market rate of interest </li></ul><ul><li>Bond purchaser agrees in turn to pay LESS up front to the issuing company </li></ul>
    28. 29. Why the Difference in Rates?? <ul><li>Companies use rate to manage cash flow </li></ul><ul><li>Biotech Example </li></ul><ul><ul><li>Need $$ to develop new drug, 80% chance they will succeed </li></ul></ul><ul><ul><li>Have lots of money from other drugs to pay interest </li></ul></ul><ul><ul><li>Can offer above market interest to get people to buy the bonds, cover the risk </li></ul></ul><ul><ul><li>“ Premium” Bond </li></ul></ul>
    29. 30. Premium Bond <ul><li>Issuer offers to pay MORE than market rate of interest </li></ul><ul><li>Bond purchaser agrees in turn to pay MORE up front to the issuing company </li></ul>
    30. 31. Debt Ratings: drive the market rate used for the calculation lower rating = more discounting
    31. 32. Factors Affecting Bond Ratings
    32. 33. Selected Financial Ratios for Various Bond Rating Classes
    33. 34. 123
    34. 35. 124
    35. 36. Off Balance Sheet Liabilities <ul><li>GAAP allows certain liabilities to be “off balance sheet”, not included in liabilities </li></ul><ul><ul><li>Contingent Liabilities </li></ul></ul><ul><ul><li>Operating Leases </li></ul></ul><ul><ul><li>SPE Liabilities </li></ul></ul>
    36. 37. Contingent Liabilities <ul><li>Contingent on some future event or activity; examples include warranties and lawsuits. </li></ul><ul><li>Alternative treatments for loss contingencies </li></ul><ul><ul><li>Ignore </li></ul></ul><ul><ul><li>Disclose in footnotes </li></ul></ul><ul><ul><li>Estimate and put on Balance Sheet </li></ul></ul><ul><li>Changes in estimate may be made in subsequent periods, when future event is concluded. </li></ul>
    37. 38. Contingent Liabilities ...highly judgmental disclosure rules
    38. 39. Capital Vs. Operating Leases <ul><li>GAAP identifies two different approaches in the reporting of leases by the lessee : </li></ul><ul><li>Capital lease method </li></ul><ul><li>Operating lease method </li></ul>
    39. 40. 144
    40. 41. Capital Leases <ul><li>Must treat a lease as a capital lease if it meets any one of these tests: </li></ul><ul><li>Ownership is transferred at end of lease </li></ul><ul><li>Bargain purchase option at end of lease </li></ul><ul><li>Term is > 75% of life of asset </li></ul><ul><li>Present Value of payment stream > 90% of fair value of asset </li></ul>
    41. 42. Capital Vs. Operating Leases
    42. 43. 144
    43. 44. SPE <ul><li>SPE – Special Purpose Entities </li></ul><ul><li>Separate “related” companies holding debt </li></ul><ul><li>If properly structured, SPE is not consolidated with parent company results </li></ul><ul><ul><li>Control </li></ul></ul><ul><ul><li>Financing </li></ul></ul>
    44. 45. SPE: Asset Securitization <ul><li>Sponsoring company forms a subsidiary that is capitalized entirely with equity </li></ul><ul><ul><li>creates a bankruptcy remote transaction </li></ul></ul><ul><li>Subsidiary purchases assets from the sponsoring company and sells them to a securitization (off-balance-sheet) trust (the SPE), which purchases the assets using borrowed funds. </li></ul><ul><li>Cash flows from the acquired assets are used by the SPE to repay its debt. </li></ul>
    45. 46. Ford Motor Credit SPE
    46. 47. Enron takes SPE’s to a new level
    47. 48. Next Week <ul><li>Financing provided by owners: </li></ul><ul><li>Shareholders Equity </li></ul>

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