Financial Statement Analysis K R Subramanyam John J Wild McGraw Hill Irwin Copyright 2009 by The McGraw Hill Companies Inc All rights rese 3 2 Analyzing Financing Activities 3 CHAPTER 3 3 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 3 4 Liabilities Alternative Classification Operating Operating Liabilities Liabilities Financing Financing Liabilities Liabilities Obligations Obligationsthat thatarise arisefrom fromoperating operating activities examples activities examplesare areaccounts accounts payable payable unearned unearnedrevenue revenue advance advance payments payments taxes taxespayable payable postretirement postretirementliabilities liabilities and andother other accruals accrualsof ofoperating operatingexpenses expenses Obligations Obligationsthat thatarise arisefrom fromfinancing financing activities examples activities examplesare areshortshort and and long term long termdebt debt bonds bonds notes notes leases leases and andthe thecurrent currentportion portionof oflong term long term debt debt 3 5 Liabilities 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 3 6 Leases 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 3 7 Leases 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 3 8 Leases 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 3 9 Leases 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 3 10 Leases Converting Operating Leases to Capital Leases Determining the Present Value of Projected Operating Lease 3 11 Leases Restated Financial Statements after Converting Operating Leases to Capital Leases Best Buy 2004 3 12 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 3 13 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 3 14 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
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