FINA 470 Exam 2
***LIFO Liquidations
(1) Companies maintain LIFO inventories in separate cost pools. (2) When inventory quantities are reduced, each cost layer is matched against current selling prices. (3) In periods of rising prices, dipping into lower cost layers can inflate profits. ---------------------------------------------------------------- ***LIFO Reserve- difference between inventories of FIFO and LIFO method LIFO increases R/E and Total Equity ***2pt question on LIFOReserve and tax amount after- go to office hours! - take Reserve and multiply it by the tax rate.
Liabilities
- Capital (Stockholders' Equity) - Off balance sheet transactions
Analysis of Cash and Cash Equivalents
- Companies risk a reduction in liquidity should the market value of short-term investments decline. - Cash and cash equivalents are sometimes required to be maintained as compensating balances to support existing borrowing arrangements or as collateral for indebtedness.
Economic Profit vs. Holding Gain
- In periods of rising prices, FIFO produces higher gross profits than LIFO because lower cost inventories are matched against sales revenues at current market prices. This is sometimes referred to as FIFO's phantom profits. The FIFO gross profit is actually a sum of two components: an economic profit and a holding gain: Economic profit = 30 units x ($800 - $600) = $6,000 Holding gain = 30 units x ($600 - $500) = $3,000
Companies operations are financed by various sources:
- Liabilities - Capital (Stockholders' Equity) - Off balance sheet transactions
CFO desired goals:
- Steady earnings. - Limited disclosure - Footnote only if possible - Least impact on earnings - Least fluctuation in earnings - Least recorded amount of a liability
Off Balance Sheet Financing ~ Special purpose subsidiaries:
- Trust preferred subsidiaries - Real estate subsidiaries - Mortgage securitizations - Enron utilization
Chapter 4
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Pensions
...
Lease Accounting and Reporting (2 Types)
1. Capital Lease Accounting 2. Operating Lease Accounting
What would be the company's pension expense given the following: - Service cost is $125,000 - Interest cost is $ 25,000 - Expected return on assets $50,000
ANSWER: Total expense $100,000
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
Analyzing Receivables
Assessment of earnings quality is often affected by an analysis of receivables and their collectibility Analysis must be alert to changes in the allowance—computed relative to sales, receivables, or industry and market conditions. Two special analysis questions: (1) COLLECTION RISK Review allowance for uncollectibles in light of industry conditions Apply special tools for analyzing collectibility: • Determining competitors' receivables as a percent of sales—vis-à-vis the company under analysis • Examining customer concentration—risk increases when receivables are concentrated in one or a few customers • Investigating the age pattern of receivables—overdue and for how long • Determining portion of receivables that is a renewal of prior receivables • Analyzing adequacy of allowances for discounts, returns, and other credits (2) AUTHENTICITY OF RECEIVABLES Review credit policy for changes Review return policies for changes Review any contingencies on receivables
Capitalizing
Capitalizing treats inventory costs like product costs—costs are capitalized as an asset and subsequently charged against future period(s) revenues benefiting from their sale (Example - Direct labor)
What are the basic differences between Commitments and Contingencies?
Contingencies -- potential losses and gains whose resolution depends on one or more future events. Commitments -- potential claims against a company's resources due to future performance under contract
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
Comparing Depreciation Methods
Depreciation Expense per Yr= (Cost - Salvage Value)/ Useful life in periods
Capital (Stockholders' Equity)
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
Expensing
Expensing treats inventory costs like period costs—costs are reported in the period when incurred (Example - Office supplies)
*Test Questions
Fixed Assets: 100,000 10yrs Accum. Depr: (30,000) 3yrs ___________________________ 70,000 Depreciation Exp 10,000
2. Operating Lease Accounting
For leases other than capital leases—the lessee (lessor) accounts for the minimum lease payment as a rental expense (income)
Step 2: How much needs to be "accrued" at the time of an employee's retirement?
Funds required at employees' retirement: Present value of 10 payments of $20,000 per annum with a discount rate of 8% per annum = $134,200
*Goodwill Test question
Goodwill comes about in acquisitions (acquiring a company) Difference in price paid by the value; cant be negative
Step 3: How much is required to be expensed each year so that the amount needed to be "accrued" at the time of an employee's retirement is achieved? How do we determine the number of years?
How much is required to be expensed each year so that the amount needed to be "accrued" at the time of an employee's retirement is achieved? Answer - PV of an Annuity --------------------------- How do we determine the number of years in which to accrue the expense? Answer - The estimated remaining years of employment.
Leasing - Key Points
Implicit interest rate in operating leases. Capital leases - assume the estimated asset value is equal to the estimated liability.
Long-lived assets
Long lived assets- resources that are used to generate revenues (or reduce costs) in the long run - Tangible fixed assets such as property, plant, and equipment - Deferred charges such as research and development (R&D) expenditures, and natural resources
Analysis of Off-Balance-Sheet Financing Sources of useful information:
Notes and MD&A and SEC Filings
Double-Declining-Balance Method
PP Slide 33 Chapter 4
Analyzing Depreciation and Depletion
PP Slide 34
Valuation of Receivables
Receivables are reported at their NET REALIZABLE VALUE — total amount of receivables less an allowance for uncollectible accounts Management estimates the allowance for uncollectibles based on experience, customer fortunes, economy and industry expectations, and collection policies
Current (Short-term) Assets
Resources or claims to resources that are expected to be sold, collected, or used within one year or the operating cycle, whichever is longer.
Noncurrent (Long-term) Assets
Resources or claims to resources that are expected to yield benefits that extend beyond one year or the operating cycle, whichever is longer.
Securitization of Receivables
Securitization (or factoring) is when a company sells all or a portion of its receivables to a third party Receivables can be sold with or without recourse to a buyer (recourse refers to guarantee of collectibility) Sale of receivables with recourse does not effectively transfer risk of ownership
***Factors in Computing Depreciation Calculate the depreciation of various different items on exam* PP Slide 31 on Chapter 4
The calculation of depreciation requires three amounts for each asset: 1. Cost. 2. Salvage Value. - amount left at the end 3. Useful Life. 4. Depreciation Method Cost - Depreciation= Useful life ^^then divide the difference by the number of years*
Why is interest cost a portion of pension expense?
To compensate for the liability amount being discounted.
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
Enron
Tried to keep debt off their books. Sold debt into the market and their subsidiary could not pay in the case of a default
Analysis of Prepaids
Two analysis issues: (1) For reasons of expediency, noncurrent prepaids sometimes are included among prepaid expenses classified as current--when their magnitude is large, they warrant scrutiny (2) Any substantial changes in prepaid expenses warrant scrutiny
Valuation Analysis
Valuation emphasizes objectivity of historical cost, the conservatism principle, and accounting for the money invested Limitations of historical costs: • Balance sheets do not purport to reflect market values • Not especially relevant in assessing replacement values • Not comparable across companies • Not particularly useful in measuring opportunity costs • Collection of expenditures reflecting different purchasing power
35. Define the term big bath.
When a company decides to "take a big bath," the company will recognize as many discretionary expenses and losses as possible in the current year. Such a strategy usually accompanies a period of unusually poor operating results—the managerial belief is that the market will not further downgrade the stock from the "one-time" charge and that the market will be less scrutinizing of such a charge. A major result of a big bath is the inflated increase in future periods' net income figures. Also, when a company takes a big bath, it often causes reserves and/or liabilities to be overstated. For example, the company might record an overstated restructuring charge or contingent liability. When a company employs a "big bath" strategy, analysts should assess whether certain reserves and liabilities are actually overstated and adjust their models accordingly. (The income statement loss is probably overstated as well).
Average Cost
When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. (Cost of Goods Available for Sale) / (Units available on the date of sale)
Restrictions (or Covenants) on Retained Earnings
constraints or requirements on retention of retained earnings
***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
***Contingent liabilities Know for exam!
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
Prior Period Adjustments
mainly error corrections of prior periods' statements
MLP (minimum lease payment)
minimum lease payments (MLP) of the lessee to the lessor according to the lease contract
Appropriations of Retained Earnings
reclassifications of retained earnings for specific purposes
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
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
Step 8 If we were concerned that a company may be understanding their total debt position by structuring leases as operating lease instead of capital leases what actions could an analyst take?
Answer - Adjust financial statement
Step 7 If we were concerned that a company may be understanding their total debt position by structuring leases as operating lease instead of capital leases what would be a "red" flag?
Answer - Operating lease term longer than five years
**Who can assist with determining and calculating the needed information? Test Question, Know Answer! >>
Answer: An Actuary
Features of OPEB Accounting
(1)Other Pension Employee Benefits ("OPEB") costs are recognized when incurred rather than when actually paid out. (2)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.
Current Asset
- cash - cash equivalents - liquidity
How are liabilities classified in the financial statements?
1. 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. 2. Noncurrent (long-term) liabilities- obligations not payable within one year or the operating cycle, whichever is longer.
Step 9 What specific steps would be taken to convert an operating lease to a capital lease?
1. Determine both the amount and the number of lease payments. The first five years are provided. Then, estimate the number of years remaining after the first five by dividing total remaining payments by fifth year payment amount. The total number is years is the total above plus five. 2. Compute the PV of the various lease payments to determine that net present value of the asset. Note: This will be the amount of both the asset to be recorded and the related liability 3. To compute the net present value, we need to know what discount rate to use. Determining this rate can be challenging! We can determine the discount rate by: Trial and error based on information related to other capital leases. Long-term debt rate. 4. The present value of the various lease payments will be our "revised" asset base and our related liability base. 5. Based on our computed lease liability amount, we can compute an amortization table to determine how much of each payment will be principal and how much will be interest.
How does a company determine the annual cost of a defined benefit pension plan? Three steps:
1. Determine how much is the annual benefit and for how many years. 2. Determine the PV of the above payments. 3. Determine how many years to "spread" the cost.
Who are the three "Parties" to a pension plan?
1. Employer (contributions to Pension Fund) 2. Pension Fund (invests the money and gets returns), then pays (benefits to employee) 3. Employee
What are the two major types of liabilities?
1. Operating Liabilities- obligations that arise from operating activities. - Ex. accounts payable, taxes payable, unearned revenue, etc. 2. Financing Liabilities- obligations that arise from financing activities. - Ex. short and long-term debt, bonds, notes, leases, etc
Two kinds of Retirement Plans 1. Pension Plan 2. Contribution Plan
1. Pension Plan -- Employer-promises monetary benefits to employees after retirement, e.g., monthly stipend until death. 2. Contribution Plan - Plan specify the amount of pension contribution that the employer makes to the plan.
What are the five major elements of Shareholders' Equity?
1. Preferred stock 2. Common Stock 3. Paid in capital 4. Retained earnings 5. Treasury stock
Receivables
1. RECEIVABLES are amounts due from others that arise from the sale of goods or services, or the loaning of money 2. ACCOUNTS RECEIVABLES refer to oral promises of indebtedness due from customers 3. NOTES RECEIVABLES refer to formal written promises of indebtedness due from others
Benefits of SPEs:
1. SPEs may provide a lower-cost financing alternative than borrowing from the credit markets directly. 2. 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.
Analyzing Intangibles and Goodwill
1. Search for unrecorded intangibles and goodwill—often misvalued and most likely exist off-balance-sheet 2. Examine for superearnings as evidence of goodwill 3. Review amortization periods—any likely bias is in the direction of less amortization and can call for adjustments 4. Recognize goodwill has a limited useful life--whatever the advantages of location, market dominance, competitive stance, sales skill, or product acceptance, they are affected by changes in business
What are some key features in analyzing liabilities?
1. Terms of indebtedness (such as maturity, interest rate, payment pattern, and amount). 2. Restrictions on deploying resources and pursuing business activities. 3. Ability and flexibility in pursuing further financing. 4. Obligations for working capital, debt to equity, and other financial figures. 5. Dilutive conversion features that liabilities are subject to. 6. Prohibitions on disbursements such as dividends.
Allocation
Allocation—process of periodically expensing a deferred cost (asset) to one or more future expected benefit periods; determined by benefit period, salvage value, and allocation method Terminology • Depreciation for tangible fixed assets • Amortization for intangible assets • Depletion for natural resources
34. Explain a loss contingency. Provide examples. Explain the two conditions necessary before a company can record a loss contingency against income.
A loss contingency is any existing condition, situation, or set of circumstances involving uncertainty as to possible loss that will be resolved when one or more future events occur or fail to occur. Examples of loss contingencies are: litigation, threat of expropriation, uncollectibility of receivables, claims arising from product warranties or product defects, self insured risks, and possible catastrophe losses of property and casualty insurance companies. The two conditions that must be met before a provision for a loss contingency can be charged to income are: (1) it must be probable that an asset had been impaired or a liability incurred at a date of a company's financial statements. Implicit in that condition is that it must be probable that a future event or events will occur confirming the fact of the loss. (2) the amount of loss must be reasonably estimable. The effect of applying these criteria is that a loss will be accrued only when it is reasonably estimable and relates to the current or a prior period.
How would you account for the following change? Plan assets $1,000,000 Expected return 8% Expected earnings $80,000 (Reduction of pension expense) Actual return 3% Actual earnings $30,000 Average life of plan assets 10 years
Accounting Entries: Year : Cash $30,000 Expected return $80,000 (Reduction of current pension expense) Deferred asset $50,000 (An amount that will be amortized in future periods that will increase pension expense.) Year 2 Amortization of deferred asset $5,000 (Expense) Deferred asset $5,000
50. Identify what items are treated as prior period adjustments.
Accounting standards require that, except for corrections of errors in financial statements of a prior period and adjustments that result from realization of income tax benefits of preacquisition operating loss carry forwards of purchased subsidiaries, all items of profit and loss recognized during a period (including accruals of estimated losses from loss contingencies) be included in the determination of net income for that period. The standard permits limited restatements in interim periods of a company's current fiscal year.
What is the impact on the plan if we have any of the following: - Additional pension benefits - Increase in life expectancy - Increase in expected employee turnover
Additional pension benefits: - Increase liability and future expense Increase in life expectancy: - Increase liability and future expense Increase in expected employee turnover: - Decrease liability and future expense
Step 2: How much is the annual depreciation of a $10,000 assets with an expected life of 5 Years?
Answer - $2,000
Capitalization
Capitalization—process of deferring a cost that is incurred in the current period and whose benefits are expected to extend to one or more future periods For a cost to be capitalized, it must meet each of the following criteria: • It must arise from a past transaction or event • It must yield identifiable and reasonably probable future benefits • It must allow owner (restrictive) control over future benefits
What is the impact on the plan if we have any of the following: Change in discount rate Change in expected return on assets Change in compensation growth rate
Change in discount rate: - Higher rate lower liability Change in expected return on assets: - Higher return lower cost Change in compensation growth rate: - Increase in rate higher liability
Step 3 What is the income statement effect of accounting for a lease as an operating lease compared to a capital lease?
Chapter 3, Slide 55 ------------------------------ Reasons not to use Capital Lease: - easier accounting - keep debt off the books - show more earnings in the earlier years
Step 4: What is the balance sheet effect of accounting for a lease as an operating lease compared to a capital lease?
Chapter 3, Slide 57
Step 5: What type of information is disclosed in the financial statements related to leases?
Chapter 3, Slide 59
36. Explain when a commitment becomes a recorded liability.
Commitments are potential claims against a company's resources due to future performance under a contract. Examples of commitments include contracts to purchase products or services at specified prices, purchase contracts for fixed assets calling for payments during construction, and signed purchase orders.
Managing Pension Plan
Company's prefer defined CONTRIBUTION PLANS since the amount of expense can be modified each year and the expense amount can easily be determined. The expense amount of a defined benefit plan is much more difficult to determine and the amount in future period can fluctuate significantly.
Evaluation of the following assumptions:
Compensation increases 5.5% per year (Average for the last ten years) Employee turnover 7.2% per year (Average for the last five years) Expected asset yield 7.5% per year (Average for the last twenty years) Expected discount rate 8.0% per year (Average for the last twenty years) ---------------------------------------------------------- The higher the discount rate, the lower the liability that is reported
4-16 Explain when an expenditure should be capitalized versus when it should be expensed.
Costs are capitalized as assets when these expenditures are expected to bring the entity value beyond the current year. If the value associated with the expenditure will be used up in the current period, the expenditure is expensed.
Cash
Currency, coins and amounts on deposit in bank accounts, checking accounts, and some savings accounts.
Accounting Entries: Year : Cash $30,000 Expected return $80,000 (Reduction of current pension expense) Deferred asset $50,000 (An amount that will be amortized in future periods that will increase pension expense.) Year 2 Amortization of deferred asset $5,000 (Expense) Deferred asset $5,000
Delete
How would you account for the following change? Year 1 Deferred assets $150,000 Projected benefit obligations $150,000 Year 2 Amortization of deferred asset $10,000 (Expense) Deferred assets $10,000
Delete
Depreciation
Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use.
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: 1. Service cost: actuarial present value of pension benefit earned by employees 2. 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 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. Nonrecurring pension costs consist of two components: 1. Actuarial Gain or Loss: change in PBO that occurs when one or more actuarial assumptions are revised in estimating PBO 2. Prior Service Cost: effect of changes in pension plan rules on PBO
Analyzing Postretirement Benefits
Five-step procedure for analyzing postretirement benefits: 1. Determine and reconcile the reported and economic benefit cost and liability (or asset). 2. Make necessary adjustments to financial statements. 3. Evaluate actuarial assumptions (discount rate, expected return, growth rate) and their effects on financial statements. 4. Examine pension risk exposure (arises to the extent to which plan assets have a different risk profile than the pension obligation). 5. Consider the cash flow implications of postretirement benefit plans.
1. Capital Lease Accounting **Know these 4 criterias for the exam. If you trip any of the 4 criteria then you own it.
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
How would you account for the following change? Increase in life expectancy $40,000 Higher employee turnover $20,000 Increase in expected compensation $30,000 Lower expected discount rate $100,000 Average remain years of service for employee - 15 years
How would you account for the following change? Year 1 Deferred assets $150,000 Projected benefit obligations $150,000 Year 2 Amortization of deferred asset $10,000 (Expense) Deferred assets $10,000
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
Impairment
Impairment—process of writing down asset value when its expected (undiscounted) cash flows are less than its carrying (book) value Two distortions arise from impairment: • Conservative biases distort long-lived asset valuation because assets are written down but not written up • Large transitory effects from recognizing asset impairments distort net income.
**19. Describe differences between defined benefit and defined contribution pension plans. How does the accounting differ across these types of plan?
In a defined contribution plan, the employer promises to currently contribute a fixed sum of money to the employee's retirement fund, so it is the contribution that is defined. In a defined benefit plan, the employer promises to pay a periodic pension benefit to the employee after retirement (typically until death), so it is the benefit that is defined. The risk (or reward) of the investment performance in the former case is borne by the employee and in the latter by the employer. Accounting for defined contribution plans is simple: whenever a contribution is made it is recorded as an expense. Defined benefit plans' accounting is complex and involves currently recording a liability based on future expected benefit payments and an asset to the extent the plan is funded. Pension expense in this case depends on the changes in pension obligation and the return on plan assets.
^^^Chapter 3 Slide 51**
Interest yr1= 8%*10,000 Interest yr 2= 8%*CF
Inventories
Inventories are goods held for sale, or goods acquired (or in process of being readied) for sale, as part of a company's normal operations
4-10 Compare and contrast the effects of LIFO and FIFO inventory costing methods on earnings in an inflationary period.
LIFO tends to yield lower reported earnings when prices rise as compared to FIFO. The following illustration highlights these effects: Period Units in Inventory Cost per Unit Total Cost Period 1.................. 5 $5 $25 Period 2.................. 5 10 50 Period 3.................. 5 15 75 Under LIFO, if 10 units are sold, then cost of goods sold is $125, computed as (5 x $15) + (5 x $10). Also, the LIFO inventory value is $25, computed as 5 x $5. If units are sold for $20, then gross profit is $75, computed as (10 x $20) $125. Under FIFO, if 10 units are sold, then cost of goods sold is $75, computed as (5 x $5) + (5 x $10). Gross profit would be $125, computed as $200- $75. Inventory would be valued at $75, computed as 5 x $15—inflating the balance sheet. *This shows that FIFO tends to increase income and taxes in inflationary periods.
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- 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
How does a company determine the annual cost of a defined contribution pension plan?
Most common type of defined contribution pension plan is a 401-K.
Step 1: Need to determine the following related to each employee:
Need to determine the following related to each employee: - Life expectancy - Employee turnover - Compensation growth - Expected rates of return - Interest rates
Minimum requirements (ERISA) Employee retirement Income Security Act
No current deductions for over funded plans
Analyzing Contingencies Sources of useful information:
Notes, MD&A, and Deferred Tax Disclosures
***First-In, First-Out (FIFO)
Oldest Costs>>>Costs of Goods Sold Recent Costs>>>Ending Inventory
Step 6 If a company was concerned about having to much debt related to equity, which of the following would reflect less debt on the company's books? Operating or Capitalized leases
Operating
Leasing - Key Points
Operating leases are simpler to account far, but capitalizing leases is conceptually superior. Consider the tax advantage of the one with the highest tax bracket. Book and tax can be different.
Postretirement Benefits
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
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
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***
47. Identify features of preferred stock that makes it similar to debt. Identify the features that make it more similar to common stock.
Preferred stock often carries features that make it preferred in liquidation and preferred as to dividends. Also, it is often entitled to par value in liquidation and can be entitled to a premium. On the other hand, the rights of preferred stock to dividends are generally fixed—although they can be cumulative, which means that preferred shareholders are entitled to arrearages of dividends before common stockholders receive any dividends. These features of preferred stock as well as the fixed nature of the dividend give preferred stock some of the earmarks of debt with the important difference that preferred stockholders are not generally entitled to demand redemption of their shares. However, there are preferred stock issues that have set redemption dates and require sinking funds to be established for that purpose—these issuances are essentially debt. Characteristics of preferred stock that make them more akin to common stock are dividend participation rights, voting rights, and rights of conversion into common stock.
Prepaid Expenses
Prepaid expenses are advance payments for services or goods not yet received that extend beyond the current accounting period—examples are advance payments for rent, insurance, utilities, and property taxes *not considered an intangible
What are the sources of increases and decreases in shareholders' equity?
Sources of increases in capital stock outstanding: • Issuances of stock • Conversion of debentures • 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
18. Companies use various financing methods to avoid reporting debt on the balance sheets. Identify and describe some of these off-balance sheet financing methods.
Property, plant, and equipment can be financed by having an outside party acquire the facilities while the company agrees to do enough business with the facility to provide funds sufficient to service the debt. Examples of these kinds of arrangements are through put agreements, in which the company agrees to run a specified amount of goods through a processing facility or "take or pay" arrangements in which the company guarantees to pay for a specified quantity of goods whether needed or not. A variation of the above arrangements involves the creation of separate entities for ownership and the financing of the facilities (such as joint ventures or limited partnerships) which are not consolidated with the company's financial statements and are, thus, excluded from its liabilities. Companies have attempted to finance inventory without reporting on their balance sheets the inventory or the related liability. These are generally product financing arrangements in which an enterprise sells and agrees to repurchase inventory with the repurchase price equal to the original sales price plus carrying and financing costs or other similar transactions such as a guarantee of resale prices to third parties.
***Last-In, First-Out (LIFO)
Recent Costs>>>Costs of Goods Sold Oldest Costs>>>Ending Inventory *want lower income for less taxes
**Pension Accounting Requirements
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 DEFFERAL 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.
Pension Accounting Requirements
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.
Pension Costs
Recurring: - Service cost - Interest cost - Expected return on assets Changes in assumptions and economics: - Actual return on assets different than expected. - Prior service cost (additional benefits) - Actuarial gain / losses due to change in assumptions
What is a reasonable rate of return on assets with the following mix?
Short term bonds 45% Long term bonds 25% Equities 30%
Cash Equivalents
Short-term, highly liquid investments that are: 1. Readily convertible to a known cash amount. 2. Close to maturity date and not sensitive to interest rate changes.
42. Identify types of equity securities that are similar to debt.
Some equity securities have mandatory redemption provisions that make them more akin to debt than they are to equity—a typical example is preferred stock. Whatever their name, these securities impose upon the issuing companies various obligations to dispense funds at specified dates. Such provisions are inconsistent with the true nature of an equity security. The analyst must be alert to the existence of such "equity securities" and examine for substance over form when making financial statement adjustments.
****(Know this slide for exam) Leased assets have an expected life of 5 years. Depreciation is straight line. Annual lease payment is $2,505. Interest rate is 8%. ------------------------ The total operating lease payment is considered to be an expense. Therefore if we consider this lease to be an operating lease, then the annual expense would be $2,505. ------------------------ If we consider the lease to be a capital lease then we must record an asset and a related liability associated with the leased property. --------------------------- How much of the lease payment represents interest and how much represents principle? How do we determine such?
Step 1: We need to determine the present value of the stream of payments. What is the PV of $2,505 for 5 years discounted at 8%? The PV of an annuity of 5 payment of $1 each discounted at 8% is a factor of 3.99271. Therefore the PV of an annuity of 5 payment of $2,505 each discounted at 8% is $10,000. ($2,505 times a factor of 3.99271)
3. Describe the conditions necessary to demonstrate the ability of a company to refinance its short term debt on a long term basis.
The conditions required by SFAS 6 that demonstrate the ability of the company to refinance it short term debt on a long term basis are: a. The company has actually issued a long term obligation or equity securities to replace the short term obligation after the date of the company's balance sheet but before its release. b. The company has entered into an agreement with a bank or other source of capital that permits the company to refinance the short term obligation when it becomes due. Note that financing agreements that are cancelable for violation of a provision that can be evaluated differently by the parties to the agreement (such as "a material adverse change" or "failure to maintain satisfactory operations") do not meet the second condition. Also, an operative violation of the agreement should not have occurred.
Why is return on plan assets considered a negative expense?
The earnings from plan assets is a source of funding the plan.
**28. What are the major actuarial assumptions underlying the postretirement benefits? Explain how a manager can manipulate these assumptions to window dress the financial statements.
The major actuarial assumptions underlying pension accounting are: (a) discount rate (b) compensation growth rate and (c) expected rate of return on pension assets. Less important assumptions include life expectancy and employee turnover. In addition OPEBs also make assumptions about healthcare cost trends. Managers can affect both the post-retirement benefit economic position (or economic cost) and the reported cost. For example, choosing a higher discount rate can reduce the pension obligation and thus improve economic position (funded status). Also, increasing the expected rate of return on plan assets can reduce the reported pension cost (net periodic pension cost).
2. Identify the major disclosure requirements for financing- related current liabilities.
The major disclosure requirements (in SEC FRR, Section 203) for financing-related current liabilities such as short term debt are: a. Footnote disclosure of compensating balance arrangements including those not reduced to writing b. Balance sheet segregation of (1) legally restricted compensating balances and (2) unrestricted compensating balances relating to long term borrowing arrangements if the compensating balance can be computed at a fixed amount at the balance sheet date. c. Disclosure of short term bank and commercial paper borrowings: i.Commercial paper borrowings separately stated in the balance sheet. ii. Average interest rate and terms separately stated for short term bank and commercial paper borrowings at the balance sheet date. iii. Average interest rate, average outstanding borrowings, and maximum month-end outstanding borrowings for short term bank debt and commercial paper combined for the period. d. Disclosure of amounts and terms of unused lines of credit for short term borrowing arrangements (with amounts supporting commercial paper separately stated) and of unused commitments for long term financing arrangements. Note that the above disclosures are required for filings with the SEC but not necessarily for disclosures in published annual reports. It should also be noted that SFAS 6 states that certain short term obligations should not necessarily be classified as current liabilities if the company intends to refinance them on a long term basis and can
4-12 Comment on the following: Depreciation accounting is imperfect for analysis purposes.
The observation is correct in pointing out that an analyst must subject the data regarding an entity's depreciation policies to critical analysis and scrutiny. The company can choose among several acceptable but vastly different depreciation methods. The reasons a particular choice(s) is made by the company and the effect on reported depreciation expense and accumulated depreciation should be assessed.
1. Identify and describe the two major sources of current liabilities.
The two major source of liabilities, for both current and noncurrent liabilities, are operating and financing activities. Current liabilities of an operating nature—such as accounts payable and operating expense accruals—represent claims on resources from operating activities. Current liabilities such as notes payable, bonds, and the current maturities of long-term debt reflect claims on resources from financing activities.
***Analyzing Inventories—Restatement of LIFO to FIFO *Know math behind the process.
Three step process: 1. Reported LIFO Inventory + LIFO reserve 2. Deferred tax payable + [LIFO reserve x Tax rate] 3. Retained earnings + [LIFO reserve x (1-Tax rate)] LIFO reserve is the amount by which current cost exceeds reported cost of LIFO inventories
Lease
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.
4-4 a. What is meant by the factoring of securitization of receivables? b. What does selling receivables with recourse mean? What does it mean to sell them without recourse? c. How does selling receivables (particularly with recourse) potentially distort the balance sheet?
a. Factoring or securitization of receivables refers to the practice of selling all or a portion of a company's receivables to a third party. b. When receivables are sold with recourse, the third party purchaser of the receivables retains the right to collect from the company that sold the receivable if the receivable proves uncollectible. When receivables are sold without recourse, the purchaser of the receivables assumes the collection risk. c. When receivables are sold with recourse, the balance sheet reports the cash received from the sale of the receivable. However, the balance sheet may or may not report the contingent liability to the receivables purchaser for uncollectible receivables purchased with recourse—this depends on who assumes the risk of ownership.
***4-5 a. Discuss the consequences for each of the acceptable inventory methods in recording costs of inventories and in determination of income. b. Comment on the variation in practice regarding the inclusion of costs in inventories. Give examples of at least two sources of such cost variations.
a. Few useful generalizations about the effect of differing methods of inventory valuation on financial analysis can be made. Yet, we provide some guidance. • In the case of LIFO, we know that under conditions of fluctuating price levels, it will have a smoothing effect on income. Moreover, the LIFO method yields, in times of price inflation, an unrealistically low inventory amount. This, in turn, lowers the current ratio and tends to increase the inventory turnover ratio. We also know that the LIFO method affords management an opportunity to manipulate profits by allowing inventory to be depleted in poor years, thus drawing on the low cost pool to inflate income. A judgment on all of these consequences can only be made on the basis of an assessment of all surrounding circumstances. For example, a slight change in a current ratio of 4:1 may be of no significance, whereas the same change in a ratio of 1.5:1 may be of far greater importance. • The use of FIFO for the valuation of inventories will generally result in a higher inventory on the balance sheet and a lower cost of goods sold (and higher income) in comparison to LIFO. • The AVERAGE COST METHOD smoothes out cost fluctuations by using a weighted average cost in valuing inventories and in pricing cost of goods sold. The resulting net income will be close to an average of the net income under LIFO and FIFO. • The "lower of cost or market" principle of inventory accounting has additional implications for the analyst. In times of rising prices it tends to undervalue inventories regardless of the cost method used. This, in turn, will depress the current ratio below its true level since the other current assets (as well as current liabilities) are not valued on a consistent basis with the methods used in valuing inventories. b. In practice we can find wide variations in the kinds of costs that are included in inventory. Practice varies particularly with respect to the inclusion or exclusion of (1) various classes of overhead costs, (2) freight in, and (3) general and administrative costs. This variety in practices can have a significant effect on comparability across companies.
4-3 a. Identify the main concerns in analysis of accounts receivable. b. Describe information, other than that usually available in financial statements, that we should collect to assess the risk of noncollectibility of receivables.
a. The two most important questions facing the financial analyst with respect to receivables are: (1) Is the receivable genuine, due, and enforceable?, and (2) Has the probability of collection been properly assessed? While the unqualified opinion of an independent auditor lends some assurance with regard to these questions, the financial analyst must recognize the possibility of an error of judgment as well as the lack of complete independence. b. Description of the receivables in the notes to financial statements usually do not contain sufficient clues to allow a reliable judgment as to whether a receivable is genuine, due, and enforceable. Consequently, knowledge of industry practices and supplementary sources of information must be used for additional assurance, e.g.: • In some industries, such as compact discs, toys, or books, a substantial right of merchandise return exists and allowance must be made for this. • Most provisions for uncollectible accounts are based on past experience although they should also make allowances for current and emerging industry conditions. In practice, the accountant is likely to attach more importance to the former than to the latter. The analyst must, in such cases, use one's own judgment and knowledge of industry conditions to assess the adequacy of the provision for uncollectible accounts. • Information that would be helpful in assessing the general level of collection risks with receivables is not usually found in published financial statements. Such information can, of course, be sought from the company directly. Examples of such information are: (1) What is customer concentration? What percent of total receivables is due from one or a few major customers? Would failure of any one customer have a material impact on the company's financial condition? (2) What is the age pattern of the receivables? (3) What proportion of notes receivable represent renewals of old notes? (4) Have allowances been made for trade discounts, returns, or other credits to which customers are entitled? • The analyst, in assessing current financial position and a company's ability to meet its obligations currently—as expressed by such measures as the current ratio—must recognize the full impact of accounting conventions that relate to classification of receivables as "current." For example, the operating cycle concept allows the inclusion of installment receivables, which may not be fully collectible for years. In balancing these against current obligations, allowance for such differences in timing of cash flows should be made.
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
Acquisition cCost
includes the purchase price and all expenditures needed to prepare the asset for its intended use
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
Off-Balance-Sheet Financing
is the non-recording of financing obligations
Contingencies
potential losses and gains whose resolution depends on one or more future events.
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
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.
Equity Classes (2 components):
• Capital Stock • Retained Earnings
Cash and Stock Dividends
• Cash dividend — distribution of cash (or assets) to shareholders • Stock dividend — distribution of capital stock to shareholders
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
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 Finance 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
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
What is a spin off compared to a split off?
• 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.