Chapter 5 Liability and Equity Analysis 1 Concepts

Chapter 5 Liability and Equity Analysis 1

Concepts of Liabilities • Liabilities: Liabilities are defined as economic obligations that arise from benefits received in the past. These are external claims on assets of the firm. These arise from contractual obligations and have reasonable certainty of amount and timing. Liabilities include: – Cash received from customers against future sales of product and services; – Credit purchases of goods and services in the current year of the operating cycle (e. g. , accounts payable) – commitments to public and private providers of debt financing; – obligations to tax authority, – commitment to employees for unpaid wages, pensions and other retirement benefits; and – obligations from court or government fines and environmental cleanup orders. 2

Criteria for Recognizing Liabilities and Implementation challenges First Criterion: An obligation has incurred Second Criterion: The amount and timing of the obligation is measurable with reasonable certainty Record a liability Challenges of Liability reporting • It is uncertain whether a firm has incurred an obligation • The amount and timing of obligation is difficult to measure • Liability values have changed 3

Reporting Challenges for Liabilities 1. 2. 3. Has an obligation been incurred? Example: Cash flows from a note receivables sold to a bank and bank has recourse against the firm should the receivable default. Is there any liability incurred? How to measure the obligation? Examples: § Obligations to laid off employees in case of restructuring. § Frequent flyer obligation of airlines (Case study: next slide). § Obligation for environmental pollution. European Union regulation of disposal management cost to be borne by the producers is a potential cost not properly accounted. § Pension and other post-employment benefit liabilities. § Product warranties. Is liability created at the time of sales reflected by estimated cost of returns? Or, should the firm wait for the expiry of warranty period? Accounting suggests for a liability recognition on the basis of probable losses. Accordingly, GM reported in 1998 that it had a $14. 6 billion liability for “warranties, dealers, and customer allowances, claims and discounts. ” Intel had to make a huge replacement of chips in 1994 and suddenly created a $475 million liability for that. Changes in the value of liabilities. Example: Fixed rate liabilities are sometimes sensitive to changes in interest rate. Liabilities are reported at their historical costs, although fair value of interest bearing debt instrument is reported in the footnote. Fair value becomes imprecise when a firm is in financial distress. It is difficult to report the restructuring of troubled debt. 4

Case: Frequent Flyer Obligations • • Since 1980 s, many airlines have frequent flyer programs for their passengers which offers bonus award miles every time the passenger flies with the same airline. Has the firm incurred liability? The argument of ‘no’ is based on the fact that the airlines have discretion to modify and even abandon their mileage program. For example, in 1987, United Airlines (UAL) made it difficult for passengers to earn free flights. Airlines can also regulate the commitment by limiting the number of seats available to frequent flyers. The amount of liability is questionable as well. Given normal load factors and the incremental costs of an additional passenger, the opportunity and out-of-pocket costs of frequent flyer awards could be minimal. Of course, changing the requirements for mileage awards can be costly as UAL was sued over its plan changes. Current accounting rules provide no definite guidance on how to report these obligations, potentially providing an opportunity for management to exercise judgment. In its 1999 annual report, United Airlines noted that approximately 6. 1 million frequent flyer awards were outstanding. Based on historical data, the firm estimated that 4. 6 million of these awards would ultimately be redeemed, and recorded a liability for $195 million. 5

Common Misconceptions About Liability Accounting 1. 2. It’s prudent to provide for a rainy day. Conservative accounting is not always good accounting. Because: Ø (i) It assumes that the investor can not see through the B/S. Ø (ii) The basic purpose of B/S to reflect the firm’s true standing is violated. Ø (iii) The purpose is not served as the investors over time recognizes which firm are conservative and which are not. Off-B/S financing is better than on B/S financing because unsophisticated financial statement users are then likely to underestimate the firm’s true leverage. It seems unlikely that investors are continuously be fooled by off balance sheet liabilities. Of course, operating lease financing may be necessary to reduce the risk of ownership and technological obsolescence. 6

Concepts of Equity • Equity: Internal claims on assets that represent the gap between assets and liabilities. It is the residual claims. Equity funds can come from issues of common and preferred stock, from profits that are reinvested, and from any reserve set aside from profits. Valuation of equity plays the most important role in the valuation of the firm. Equity=assets-liability? • Controversy: – (i) Valuation of assets, – (ii) hybrid securities, and – (iii) allocation of equity values between reserves, capital, and retained earnings. • Since equity is the residual claim so the valuation depends on the valuation of assets and liabilities. Consequently, the challenges of valuation of assets and liabilities also apply to equity valuation. In addition to that following challenges are specific to equity. 7

Reporting Challenges of Equity 1. Hybrid securities: Convertible debt is a hybrid security that commands a lower interest rate than straight debenture since the holder also receives the option to convert the debt into common stock. Accounting rules do not recognize the value attached to the conversion right. So, the convertible bond is just like ordinary bond until converted. If the debt converts, it can be recorded using either the book value or market value methods. The book value method does not recognize any gain or loss on conversion. The market value approach records the difference between book value and market value as operating gain or loss. This raises question about how to compare two firms that use same effective capital structure, but where one uses hybrid securities and other does not. The firm with hybrid securities will appear to be highly leveraged, using book values of debt and equity, because conversion right is not recorded. As a result, valuation of equity becomes questionable. 8

Reporting Challenges of Equity(Contd. ) 2. Classification of unrealized gains and looses. One method is to take it in income statement and then to retained earnings as soon as it accrues. This is called Clean surplus. Another method is to take as income only when it is realized called Dirty Surplus. These gains include: i. Financial instruments that are available for sale. ii. Financial instruments used to hedge uncertain future cash flows including insurance policies, forward contract, options, swap, etc. iii. Foreign currency translations of foreign operations whose transactions occur in the local currency rather than parent currency. 9

Foreign exchange risk exposure • The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. If an exporter denominates its export in foreign currency, a 10% decline in the value of that currency (dollar) will reduce the taka value of its receivable by 10%. Transaction exposure includes export denominated in foreign currency, interest received from overseas investment, import denominated in foreign currency, interest owed on foreign loan. • Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. Cash flows that do not require conversion of currencies do not reflect transaction exposure. Yet, these cash flows may also be influenced significantly by exchange rate movements, which is included in economic exposure. • The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates. 10

Managing Madison Inc. ’s Economic Exposure C$=$. 85 Sales: (Figures in Millions) C$=$. 75 (1) U. S. $300. 00 $304. 00 $307. 00 (2) Canadian (C$4) 3. 0 (3) Total $303. 00 $307. 20 $310. 40 Cost of gods sold: (4) U. S. $ 50. 00 (5) Canadian C$200= 150. 00 (6) Total $200. 00 $210. 00 $220. 00 (7) Gross profit $103. 00 $ 97. 20 Operating expenses: (8) U. S. - Fixed $ 30. 00 (9) U. S. – Variable (ex. , sales com) (10) Total $ 60. 30 $ 60. 72 (11) EBIT $ 42. 70 $ 36. 48 Interest expense: (12) U. S. $ 3. 00 7. 50 C$10= 8. 00 C$10= 8. 50 (14) Total $ 10. 50 $ 11. 00 (15) EBT $ 32. 20 $ 25. 48 3. 20 C$=$. 80 3. 40 C$200= 160. 00 C$200= 170. 00 $ 90. 40 $ 30. 00 30. 30 $ 61. 04 $ 29. 36 $ 30. 72 31. 04 3. 00 (13) Canadian C$10= $ 11. 50 $ 17. 86 *Non-transactional economic exposure *Transactional Economic Exposure *Translation Exposure 11