Transcript Understanding Financial Statements NINTH EDITION

Understanding
Financial Statements
NINTH EDITION
{
Lyn M. Fraser
Aileen Ormiston
Analyzing
Financing
Activities
{
Liabilities and shareholders’
equity
Also called the statement of condition or
statement of financial position
Assets = Liabilities + Stockholders’ equity
Assets = What the firm owns
Liabilities = What the firm owes to outsiders
Stockholders’ equity = What the firm owes to
Internal owners
The Balance Sheet
Liabilities
Classification
Current (short-term)
Liabilities
must be satisfied in one year or one
operating cycle and include
•
Accounts payable
•
Notes payable
•
Current portion of long-term debt
•
Accrued liabilities
•
Unearned revenue
•
Deferred taxes
Noncurrent (Long-Term)
Liabilities
Obligations not
payable within one
year or the operating
cycle, whichever is
longer.
Liabilities
Alternative Classification
Operating
Liabilities
Financing
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
Obligations that arise from financing
activities--examples are short- and
long-term debt, bonds, notes, leases,
and the current portion of long-term
debt
Current Liabilities
Turkcell note 24
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Trade Payables
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Notes Payable
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Short-term obligations that arise from credit extended
by suppliers for the purchase of goods and services
Account is eliminated when the bill is satisfied
Significant changes from period to period often result
from changes in sales volume, economic conditions or
credit policies available to firm from its suppliers
Short-term obligations in the form of promissory
notes
Lines of credit to suppliers or financial institutions
Current Portion of Long-term Debt
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the portion of the principal that will be repaid during the
upcoming year
Current Liabilities
Accrued Liabilities
•
Result from recognition of an expense prior to actual
payment of cash
•
Under accrual accounting, expenses are recognized when INCURRED and
thus ACCRUED, not when paid in cash
In this case, cash flow succeeds expense recognition
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Recorded as reserve accounts
Reserve accounts are
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set up to estimate obligations for certain items
identified in the notes
Unearned Revenue or Deferred Credits
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Result from payments received in advance for services or products
Transferred to a revenue account when service is performed or
product is delivered
Under accrual accounting, revenue is recognized when EARNED, not
when cash is received
In this case, cash flow precedes revenue recognition
Current Liabilities
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Result of temporary differences in the recognition of
revenue and expense for taxable income relative to
reported income
Intended to take advantage of all available tax
deferrals to reduce actual tax payments, while
showing the highest possible amount of reported net
income
Classified as current or noncurrent on the
balance sheet
Can appear on the balance sheet as a current
asset, current liability, noncurrent asset, or
noncurrent liability
Current Liabilities
Deferred Income Taxes
Temporary differences can be caused by choice
of accounting method for
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Depreciation
Installment sales
Long-term contracts and leases
Warranties and service contracts
Pensions and other employee benefits
Subsidiary investment earnings
Current Liabilities
Deferred Income Taxes
Deferred Taxation
Machinery
Cost
Life
Rate
EBD
IFRS
50.000
Tax Legis
50.000
10
5
10%
20%
50.000
50.000
IFRS
year 1
year 2
year 3
year 4
year 5
year 6
year 7
year 8
year 9
year 10
Total
EBD
50.000
50.000
50.000
50.000
50.000
50.000
50.000
50.000
50.000
50.000
Depr
5.000
5.000
5.000
5.000
5.000
5.000
5.000
5.000
5.000
5.000
50.000
Tax Leg.
year 1
year 2
year 3
year 4
year 5
year 6
year 7
year 8
year 9
year 10
Total
EBT
45.000
45.000
45.000
45.000
45.000
45.000
45.000
45.000
45.000
45.000
EBD
50.000
50.000
50.000
50.000
50.000
50.000
50.000
50.000
50.000
50.000
tax
9.000
9.000
9.000
9.000
9.000
9.000
9.000
9.000
9.000
9.000
90.000
Depr
10.000
10.000
10.000
10.000
10.000
50.000
EBT
40.000
40.000
40.000
40.000
40.000
50.000
50.000
50.000
50.000
50.000
tax
8.000
8.000
8.000
8.000
8.000
10.000
10.000
10.000
10.000
10.000
90.000
Turkcell note 17
Obligations with maturities beyond one
year
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Long-term debt (financial liabilities)
Capital lease obligations
Postretirement benefits other than pensions
Provisions
Commitments and contingencies
Hybrid securities
Noncurrent Liabilities
Noncurrent Liabilities
Long-term debt
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Bonds
Long-Term Notes Payable
Mortgages
Obligations under leases
Long-Term Warranties
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Are, in substance, a “purchase” rather than a
“lease”
Affect both balance sheet and income statement
Disclosures found in the notes, often under
both the property, plant, and equipment note
and the commitments and contingencies note
Noncurrent Liabilities
Capital lease obligations
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
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)
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
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
Turkcell note 24
Turkcell note 30
Converting Operating Leases to Capital Leases
Determining the Present Value of Projected Operating Lease
2010
Non cancellable leases:
less than one year
between one and five year
more than five years
$ 18.024,00
16107
7221
$ 41.352,00
payment
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Leases
18024
3221,4
3221,4
3221,4
3221,4
3221,4
1805,25
1805,25
1805,25
1805,25
41352
discount
factor 5%
0,952381
0,907029
0,863838
0,822702
0,783526
0,746215
0,710681
0,676839
0,644609
0,613913
present
value
17165,71
2921,90
2782,77
2650,25
2524,05
2403,86
1282,96
1221,86
1163,68
1108,27
35225,32
interest
1761,27
948,13
834,47
715,12
589,80
458,23
320,07
245,81
167,84
85,96
lease
obligation
lease
balance
35225,32
16262,73
18962,58
2273,27
16689,31
2386,93
14302,38
2506,28
11796,10
2631,60
9164,50
2763,17
6401,33
1485,18
4916,14
1559,44
3356,70
1637,41
1719,29
1719,29
0,00
Can appear under the liability section
of the balance sheet
Can have a significant impact on
corporate balance sheets
Can also impact profitability by
substantially increasing the
recognition of annual postretirement
benefit expense
Noncurrent Liabilities
Postretirement benefits other than pensions
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Commitments refer to contractual
agreements that will have a significant
financial impact on the company in the
future.
Contingencies refer to potential liabilities
of the firm such as possible damage
awards assessed in lawsuits.
Intended to draw attention to the fact that
required disclosures can be found in the notes
to the financial statements
Noncurrent Liabilities
Commitments and contingencies
 a potential liability arising from a past
transaction and that depends on a future
event
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could be disclosed in the body of the balance
sheet with the liabilities
could be disclosed within notes to financial
statements
 certainty of the amount and the payment
will be disclosed
Provisions and Contingent
Liabilities
Is the amount of
the
liability known?
Recognize liability
on the balance
sheet
YES
NO
Can the amount of
Liability be reasonably
Estimated?
YES
YES
Is the liability likely to
occur? (Probable)
NO
NO
Disclose in the notes
To the financial
Statements
(CONTINGENT LIABILITY)
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Basics of Commitments
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Sources of useful information:
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Commitments -- potential claims against a company’s resources
due to future performance under contract
Analyzing Commitments
Notes and MD&A
Useful analyses:
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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
Contingencies and Commitments
Turkcell Note 32
Product Warranty Liabilities
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When goods and services are sold under warranty
coverage
A good example of provision
matching principle - warranty expenses of sales in a
period should be recorded in the same period
Subsequent expenditures of warranties are charged
against warranty liability
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Have the characteristics of both debt and
equity
Also called mandatorily redeemable
preferred stock
Financial instrument is preferred stock, but
the issuing company must retire the shares at
a future date.
Noncurrent Liabilities
Hybrid Securities
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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
Liabilities
Important Features in Analyzing Liabilities
Off-Balance-Sheet Financing
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 offbalance-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
• 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
Off-Balance-Sheet Financing
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
Off-Balance-Sheet
Financing
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.
Off-Balance-Sheet
Financing
Related party transactions
Ownership equity is the residual
interest in assets that remains after
deducting liabilities
Shareholders’ Equity
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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
Shareholders’ Equity-Basics of Equity
Financing
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
Shareholders’ Equity- Reporting
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
Shareholders’ Equity –
Components of Capital Stock
Preferred Stock — stock with features not possessed
by common stock; typical preferred stock features include:
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• Dividend distribution preferences
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• Liquidation priorities
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• Convertibility (redemption) into common stock
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• Call provisions
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• Non-voting rights
Common Stock — stock with ownership interest and
bearing ultimate risks and rewards (residual interests)
of company performance
Shareholders’ Equity
Do not ordinarily receive a fixed return
Have voting privileges in proportion to
ownership interest
Dividends are declared at the discretion of a
company’s board of directors
Stockholders’ Equity
Common Stock Shareholders
Reflects the amount by which the original
sales price of the stock shares exceeded par
value
Stockholders’ Equity
Paid-In Capital
Additional
Is the sum of every dollar a company has
earned since its inception, less any payments
made to shareholders in the form of cash or
stock dividends
Beginning retained earnings
± Net income (loss) – Dividends
= Ending retained earnings
Stockholders’ Equity
Earnings
Retained
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
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Cash dividend — distribution of cash (or assets) to shareholders
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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
Shareholders’ Equity
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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.
Shareholders’ Equity
Other accounts that can appear in the equity
section include:
Preferred stock
Accumulated other comprehensive income
Treasury stock
Revaluation Fund
Stockholders’ Equity
Other Equity Accounts
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Adjustments to fair value for
available-for-sale securities
Foreign currency translation
adjustment
Gains/losses on cash flow hedge
derivatives
Gains/losses on investment hedge
instruments
Adjustments related to underfunding
a defined benefit pension plan
Nonowner changes to equity
Other comprehensive income (GAAP)
Provides details of changes in
Equity
 Stock
 Other comprehensive income
 Retained earnings
 Includes beginning and ending
balances in accounts
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Statement of Shareholders’ Equity