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3-1
OUTLINE
Liabilities
Current Liabilities
Noncurrent Liabilities
Analyzing Liabilities
Leases
Lease Accounting and Reporting Lessee
Analyzing Leases
Postretirement benefits
Pension Accounting
Other Postretirement Benefits (OPEBs)
Analyzing Postretirement Benefits
Off-Balance-Sheet Financing
Through-put and Take-or-pay agreements
Product financing arrangements
Special Purpose Entities (SPEs)
Shareholders Equity
Capital Stock
Retained Earnings
Computation of Book Value Per Share
3-2
ANALYSIS OBJECTIVES
Analyze and interpret lease disclosures and explain their implications and the
adjustments to financial statements.
Explain capital stock and analyze and interpret its distinguishing features.
3-3
QUESTIONS
1. The two major source of liabilities, for both current and noncurrent liabilities, are
operating and financing activities. Current liabilities of an operating naturesuch as
accounts payable and operating expense accrualsrepresent 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.
2. 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 monthend 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 demonstrate its ability to do so.
3. 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.
3-4
4. Since the interest rate that will prevail in the bond market at the time of issuance of
bonds can never be predetermined, bonds usually are sold in excess of par
(premium) or below par (discount). This premium or discount represents, in effect, an
adjustment of the coupon rate to the effective interest rate. The premium received is
amortized over the life of the issue, thus reducing the coupon rate of interest to the
effective interest rate incurred. Conversely, the discount also is amortized, thus
increasing the effective interest rate paid by the borrower.
5. The accounting for convertibility and warrants impacts income and equity as follows:
a. The convertible feature is attractive to investors. As a result, the debt will be
issued at a slightly lower interest rate and the resulting interest expense is less
(and conversely, equity is increased). Also, diluted earnings per share is reduced
by the assumed conversion. At conversion, a gain or loss on conversion may
result when equity instruments are issued.
b. Similarly, warrants attached to bonds allow the bonds to pay a lower interest rate.
As a result, interest expense is reduced (and conversely, equity is increased).
Also, diluted earnings per share is affected because the warrants are assumed
converted.
6. It is important to the analysis of convertible debt and stock warrants to evaluate the
potential dilution of current and potential shareholders if the holders of these options
choose to convert them to stock. This potential dilution would represent a real wealth
transfer for existing shareholders. Currently, this potential dilution is given little
formal recognition in financial statements.
7. SFAS 47 requires note disclosure of commitments under unconditional purchase
obligations that provide financing to suppliers. It also requires disclosure of future
payments on long-term borrowings and redeemable stock. Required disclosures
include:
For purchase obligations not recognized on purchaser's balance sheet:
a. Description and term of obligation.
b. Total fixed and determinable obligation. If determinable, also show these amounts
for each of the next five years.
c. Description of any variable obligation.
d. Amounts purchased under obligation for each period covered by an income
statement.
For purchase obligations recognized on purchaser's balance sheet, payments for
each of the next five years.
For long-term borrowings and redeemable stock:
a. Maturities and sinking fund requirements for each of the next five years.
b. Redemption requirements for each of the next five years.
8. a.
Information about debt covenant restrictions are available in the details of the
bond indentures of a company. Moreover, key restrictions usually are identified
and discussed in the financial statement notes.
b. The margin of safety as it applies to debt contracts refers to the slack that the
company has before it would violate any of the debt covenant restrictions and be
in technical default. For example, if the debt covenant mandates a maximum debt
to assets ratio of 50% and the current debt to assets ratio is 40%, the company is
said to have a margin of safety of 10%. Technical default is costly to a company.
3-5
Thus, as the margin of safety decreases, the relative level of company risk
increases.
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3-8
3-9
3-10
13. The principal items of information required to be disclosed by lessees are: (1) future
minimum lease payments, separately for capital leases and operating leases, in total
and for each of the five succeeding years; and (2) rental expense for each period for
which an income statement is reported.
Information required to be disclosed by lessors includes: (1) future minimum lease
payments to be received, separately for sales-type and direct financing leases and for
operating leases, and (2) the other components of the investment in sales-type and
direct financing leases: estimated residual values, and unearned income.
14. For the lessor, when a lease is considered an operating lease, the leased asset
remains on its books. For the lessee, it will not report an asset or an obligation on its
balance sheet.
15. When a lease is considered a capital lease for both the lessor and the lessee, the
lessor will report lease payments receivable on its balance sheet. The lessee will
report the leased asset and a lease obligation totaling the present value of future
lease payments.
16. a. Rent expense
b. Interest expense and depreciation expense
17. a. Leasing revenue
b. Interest revenue (and possibly gain on sale in the initial year of the lease)
18.
3-11
b. The projected benefit obligation (PBO) takes into consideration the effect of future
salary increases as is necessary in order to determine the full obligations in
pension plans such as those based on career-average pay or final pay.
SFAS 87 recognizes an additional minimum liability. Since this additional liability is
based on the accumulated rather than on the projected benefit obligation, it
represents a compromise position between the full fledged recognition of pension
liabilities and their much less adequate recognition before SFAS 87.
20. The recognition of certain pension costs is delayed for accounting purposes.
Prior service costs are amortized into pension expense and the pension liability
over the remaining service life of the benefiting employees.
The transition asset or liability is amortized into pension expense and the pension
asset or liability.
Excess gains or losses on plan assets (beyond the expected rate of return) are
recognized in periods after they occur.
Gains or losses on changes in the liability are recognized after occurrence.
Each of these items can create a difference between the reported pension liability and
the economic obligation of the plan.
21. The reason pension costs are reduced by the expected (rather than actual) return on
plan assets is that use of the actual return would subject pension costs to the
fluctuations of the financial markets, creating volatility in annual costs.
22. Periodic pension costs are smoothed by several aspects of pension accounting
including: (1) use of expected versus actual return on plan assets, (2) valuing pension
assets on a market-related versus a market basis (3) amortization of deferred cost
elements such as prior service cost, net gains/losses, and unrecognized transition
costs. This smoothed cost figure is less likely to reflect the underlying economics
when the elements being deferred are more permanent in nature.
23. Postretirement accounting includes several estimates that affect net income and total
liabilities. For example, the following variables are often important for calculating
pension or other postretirement benefits:
Number of years the employee will work for the company
Turnover rate of workforce
Future salary levels of employees
Age of the employee at death
Actual return on plan assets in future years
Interest costs on pension liability
All of these variables are difficult to estimate but necessary in accounting for
postretirement benefit plans. In addition, postretirement benefits such as healthcare
insurance require assumptions about the future cost of healthcare or healthcare
insurance.
24. Management can exercise latitude over the amount of pension expense recorded
through its selection of expected return on plan assets and its choice of assumptions
regarding future levels of inflation (interest).
3-12
25. Pension costs can appear as part of a company's operating expenses (e.g., cost of
goods sold or compensation expense) or capitalized into assets such as inventory.
26. One major difference relates to the accounting for the unfunded OPEB obligation.
When a company adopts SFAS 106, the unfunded OPEB obligation at the date of
adoption, also referred to as the "transition obligation" can be recognized as either
(1) a cumulative effect of an accounting change (included as a charge to income) or
(2) over future periods as a component of the annual OPEB expense over a period
not to exceed 20 years. Thus, if a company elects to amortize its transition obligation
over future years, then, unlike under pension accounting, it will not be required to
recognize immediately a minimum liability on the balance sheet for the unfunded
OPEB obligation attributable to present retired and active employees that are eligible
to receive benefits.
Another major difference of OPEB accounting from pension accounting relates to
funding. Because there are no legal requirements for OPEB benefits, similar to ERISA
requirements for pensions, and also because funding OPEB benefits does not enjoy
the favorable tax treatment accorded to the funding of pension plans, few companies
fund their OPEB liabilities or are likely to do so in the near future. Thus, we have
sizable unrecorded, as well as increasing amounts of recorded, OPEB liabilities that
are unfundedthese are backed by assets under the control of companies rather
than assets in the hands of independent trustees.
27. Under SFAS 106, the required disclosures include:
a. Description of the plan
b. Net periodic postretirement benefit cost and its components.
c. Reconciliation of funded status of the plan with amounts reported in balance
sheet.
d. Assumed health-care cost trend rate used to measure covered benefit costs for
the next year. Also, a description of the direction and pattern of change in the
assumed trend rates thereafter.
e. Weighted average discount rate, rate of compensation, and expected long-term
rate of return used to measure the APBO.
f. Effect on various amounts reported of a 1% increase in health-care cost trend
rate.
g. Amounts and types of employer securities held.
28. While the estimation process for OPEB costs is similar to that of estimating pension
costs it is more difficult and more subjective. First, data about costs are more difficult
to obtain. Pension benefits involve either fixed dollar amounts or a defined dollar
amount, based on pay levels. Health benefits, by contrast, are estimates not easily
computed by actuarial formula. Many factors enter in to such estimates, including
deductibles, ages, marital status, number of dependents, etc. Second, more
assumptions than those governing pension calculations are needed. For example, in
addition to retirement dates, life expectancy, turnover, and discount rates, there is a
need for estimates of the medical costs trend rate, Medicare reimbursements, etc.
29. a. 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
3-13
3-14
b. 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 companys 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.
30. 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 resultsthe 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).
31. Commitments are potential claims against a companys 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.
32. Commitments are not recorded liabilities because commitments are not completed
transactions. Commitments become liabilities when the transaction is completed.
For example, consider a commitment by a manufacturer to purchase 100,000 units of
materials per year for 5 years. Each time a purchase is made at the agreed upon
price, part of the purchase commitment expires and a purchase is recorded. The
remaining part continues as an obligation by the manufacturer to purchase materials.
33. Off-balance-sheet financing refers to the nonrecording of certain financing
obligations. Examples of off-balance-sheet financing include operating leases when
they are in-substance capital leases, joint ventures and limited partnerships, and
many recourse obligations on sold receivables.
34. Under SFAS 105, companies are required to disclose the following information about
financial instruments with off-balance-sheet risk of accounting loss:
a. The face, contract, or notional principal amount.
b. The nature and terms of the instruments and a discussion of their credit and
market risk, cash requirements, and related accounting policies.
c. The accounting loss the company would incur if any party to the financial
instruments failed completely to perform according to the terms of the contract,
and the collateral or other security, if any, for the amount due proved to be of no
value to the company.
d. The company's policy for requiring collateral or other security on financial
instruments it accepts, and a description of collateral on instruments presently
held.
3-15
3-16
3-17
The reason why overprovisions of reserves occur is that the income statement
effects are often accorded more importance than the residual balance sheet effects.
While a provision for future expenses and losses establishes a reserve account that
is analytically in the "never-never land" between liabilities and equity accounts, it
serves the important purpose of creating a cushion that can absorb future expenses
and losses. This shields the all-important income statement from them and their
related volatility. The analyst should endeavor to ascertain that provisions for future
losses reflect losses that can reasonably be expected to have already occurred rather
than be used as a means of artificially benefiting future income by adding excessive
provisions to present adverse results.
40. An ever-increasing variety of items and descriptions are included in the "deferred
credits" group of accounts. In many cases these items are akin to liabilities; in
others, they either represent deferred income yet to be earned or serve as
income-smoothing devices. A lack of agreement among accountants as to the exact
nature of these items or the proper manner of their presentation compounds the
confusion confronting the analyst. Thus, regardless of category or presentation, the
key to their analysis lies in an understanding of the circumstances and the financial
transactions that brought them about.
At one end of the spectrum we find those items that have characteristics of liabilities.
Here we can find items such as advances or billings on uncompleted contracts,
unearned royalties and deposits, and customer service prepayments. The
outstanding characteristics of these items is their liability aspects even though, as in
the case of advances of royalties, they may, after certain conditions are fulfilled, find
their way into the company's income stream. Advances on uncompleted contracts
represent primarily methods of financing the work in progress while deposits of rent
received represent, as do customer service prepayments, security for performance of
an agreement. At the other end of the spectrum are deferred credits that exhibit many
qualities similar to equity. The key to effective analysis is the ability to identify those
items most like liabilities from those most like equity.
41. The accounting for the equity section as well as its presentation, classification, and
note disclosure have certain basic objectives. The most important of these are:
a. To classify and distinguish among the major sources of owner capital contributed
to the entity.
b. To set forth the priorities of the various classes of stockholders and the manner in
which they rank in partial or final liquidation.
c. To set forth the legal restrictions to which the distribution of capital funds are
subject to for whatever reason.
d. To disclose the contractual, legal, managerial, and financial restrictions that the
distribution of current and retained earnings is subject to.
The accounting principles that apply to the equity section do not have a marked
effect on income determination and, as a consequence, do not hold many pitfalls for
the analyst. From the analyst's point of view, the most significant information here
relates to the composition of the capital accounts and to the restrictions that they are
subject to.
3-18
3-19
practice. Distributions of over 25 percent (which do not normally call for transfers of
fair value) may also lend themselves to such an interpretation if they appear to be
part of a program of recurring distribution designed to mislead shareholders.
3-20
It has long been recognized that no income accrues to the shareholder as a result of
such stock distributions or dividends, nor is there any change in either the corporate
assets or the shareholders' interest therein. However, it is also recognized that many
recipients of such stock distributions, which are called or otherwise characterized as
dividends, consider them to be distributions of corporate earnings equivalent to the
fair value of the additional shares received. In recognition of these circumstances, the
American Institute of Certified Public Accountants has specified in Accounting
Research Bulletin No. 43, Chapter 7, paragraph 10, that "... the corporation should in
the public interest account for the transaction by transferring from earned surplus to
the category of permanent capitalization (represented by the capital stock and capital
surplus accounts) an amount equal to the fair value of the additional shares issued.
Unless this is done, the amount of earnings which the shareholder may believe to
have been distributed will be left, except to the extent otherwise dictated by legal
requirements, in earned surplus subject to possible further similar stock issuances or
cash distributions. Both the New York and American Stock Exchanges require
adherence to this policy by their listed companies.
45. 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.
46. a. Minority interests are the claims of shareholders of a majority owned subsidiary
whose total net assets are included in a consolidated balance sheet.
b. Consolidated financial statements often show minority interests as liabilities:
however, they are fundamentally different in nature from legally enforceable
obligations. Minority shareholders do not have any legally enforceable rights for
payments of any kind from the parent company. Therefore, the financial analyst
can justifiably classify minority interest as equity funds in most cases.
3-21
EXERCISES
Exercise 3-1 (20 minutes)
a.
Long-term debt [46]
A
B
159.7
0.3
G
H
24.3
250.3
805.8
beg
0.1
99.8
100.0
199.6
C
D
E
F
1.9
772.6
I
end
3-22
3-23
3-24
Exercise 3-5continued
Off-balance-sheet debtsuch as industrial revenue bonds or pollution control
financing where a municipality sells tax-free bonds guaranteed for paymentare
cases where a supposedly debt-free balance sheet could look much worse if
these obligations were recorded.
Finally, the practice of deferred taxessuch as taking some expenses for tax, but
not book purposes, or through differences in timing for recognition of salesis
one that, while recorded on the balance sheet, is normally not recognized as a
long-term obligation. However, if the rate of investment slows dramatically for
some reason or if the sales trend is reversed, the sudden coming due of these tax
liabilities could be a major problem.
(CFA Adapted)
b. In this case, disclosure should be made for an estimated loss from a loss
contingency that need not be accrued by a charge to income when there is at
least a reasonable possibility that a loss may have been incurred. The
disclosure should indicate the nature of the contingency and should estimate
the possible loss or range of loss or state that such an estimate cannot be
made.
Disclosure of a loss contingency involving an unasserted claim is required
when it is probable that the claim will be asserted and there is a reasonable
possibility that the outcome will be unfavorable.
Exercise 3-7 (15 minutes)
a. One reason that managers might want to resist recording a liability related to
an ongoing lawsuit is that the recorded liability can cause deterioration in the
financial position of the company. A second reason is that the opposing
attorneys may use the disclosure inappropriately as an admission of liability.
3-25
Exercise 3-7continued
b. If a manager believes that it is inevitable that a liability will be recorded, the
manager may want to time the recognition of the liability opportunistically.
For example, if the company has a relatively bad period, the liability can be
recorded in conjunction with a big bath. If the company has a very good
period, the manager might find that the liability can be recorded in that period
without causing an unexpectedly bad earnings report.
Exercise 3-8 (40 minutes)
[Note: Unless otherwise indicated, much of the information to answer this exercise can be found
in item [68] of Campbells financial statements.]
a. The causes of the $101.6 million increase are identified in the table below (see
Campbells Consol. Statement of Owners Equity and Changes in Number of
Shares):
Millions
10
Net Income............................................................
Cash Dividends.....................................................
Treasury Stock Purchase.....................................
Treasury Stock Issued
Capital Surplus................................................
Treasury Stock................................................
Translation Adjustment........................................
Sale of foreign operations...................................
Increase in Stockholders' Equity........................
a
1,793.4
- 1,691.8
101.6
[54]
11
$401.5
(142.2) (89)
(175.6)
$ 4.4 (28)
(126.9) (87)
(41.1) (87)
45.4 (91)
12.4 (91)
(29.9) (92)
(10.0) (93)
11.1 (87)
4.6 (87)
61.4 (87)
101.6a
(86.5)b
1,691.8 [54]
1,778.3 [87]
(86.5)
Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders
Equity
3-26
Exercise 3-8continued
d. The book value per share of common stock is $14.12. However, shares were
purchased during the year at an average of about $52 per share (an indicator of
market value during the year). In fact, according to note 24 to the financial
statements the stock traded in the $70 - $80 range in the fourth quarter of Year 11.
There are several reasons why the market value of the stock is much higher than
the book value of the stock. First, the market value impounds the investors
beliefs about the future earning power of the company. Investors apparently have
high expectations regarding future profitability. Second, the book value is
recorded using accounting conventions such as historical cost and conservatism.
Each of these conventions is designed to optimize the reliability of the information
but can cause differences between the market and book values of a companys
stock.
3-27
Exercise 3-9continued
In a sense, the concept of "secret reserves" can be extended to include the
effects of holding an excess of monetary liabilities over monetary assets.
During a period of inflation the "reserve" is in terms of general purchasing
power whereas the previously discussed "reserves" have been due to
differences in money amounts.
d. There are several objections to the creation of "secret reserves." One is that
only insiders are likely to know of their existence and value. Statement
readers who are unaware of the existence of "secret reserves" may regard a
company's securities as overvalued when, in fact, they may be undervalued or
valued correctly. As a result, stockholders may be willing to part with their
shares for too little consideration.
The creation of "secret reserves" also tends to shift income between periods
and usually has a smoothing effect on reported income. If an asset is
understated or a liability is overstated in the current period, it usually means
that some expense is going to be correspondingly overstated with the result
that current income is understated. In some subsequent period the service
potential of the unrecognized or undervalued asset will be consumed. If its
cost were understated or not recognized, expenses of the later period also will
be understated and income of the later period will be overstated. Somewhat
the same effect can be achieved through overaccrual of estimated expenses.
There are practical limits as to how large an estimated liability for estimated
expenses can become before it will be discovered and investigated. In the
period when the carrying value of the estimated liability reaches its upper
limit, usually no accrual or an inadequate accrual is recognized.
Such reserves also are an application of the concept of organization slack.
During expansionary periods a cushion is accumulated by overstating
expenses or understating revenues. This cushion can be utilized when the
environment becomes unfavorable such as during a period of depressed
income caused by either external or internal factors. Thus "secret reserves"
are a form of organization slack that gives management "squirming room" and
helps it to smooth unfavorable reports under the assumption that bad news
should be softened to prevent expectations (aspirations) from fluctuating
widely.
The purpose of financial statements is to inform, not to mislead. The
existence of "secret reserves" makes the statement misleading to the extent
that assets are understated or liabilities are overstated because the extent of
the under- or overstatement is not reported.
e. 1. A company's stock is said to be "watered" when its stockholders' equity is
overstated because assets are correspondingly overstated or because
liabilities are understated.
3-28
Exercise 3-9continued
2. "Watered stock" most commonly arises when assets for which the stock is
issued are overvalued. One common motivation for such an issuance is to
avoid showing a discount on capital stock when stock has been recorded
as issued at par for assets having a fair market value equal to or greater
than par when the value of the assets received was much less. Somewhat
less likely is the understatement of liabilities in connection with the
issuance of stock. If stock is issued for property subject to a mortgage,
understating or ignoring the actual liability could result in an overvaluation
of the stock.
3. The writing down of overstated assets or the writing up of understated
liabilities would eliminate "water" from the stock. The offsetting charge to
such credits might be made to retained earnings or preferably to another
capital account. If some of the excess shares were recaptured, the
appropriate charge would be to a capital stock account.
(AICPA Adapted)
3-29
Exercise 3-10continued
c. The acquisition and reissuance of its own stock by a firm results only in the
contraction or expansion of the amount of capital invested in it by
stockholders. In other words, an acquisition of treasury shares by a
corporation is viewed as a partial liquidation and the subsequent reissuance
of these shares is viewed as an unrelated capital-raising activity. To
characterize as gain or loss the changes in equity resulting from a
corporation's acquisition and subsequent reissuance of its own shares at
different prices is a misuse of accounting terminology. When a corporation
acquires its own shares, it is not "buying" anything nor has it incurred a
"cost." The price paid represents the amount by which the corporation has
reduced its net assets or "partially liquidated." Similarly, when the corporation
reissues these shares it has not "sold" anything. It has increased its total
capitalization by the amount received.
It is the practice of referring to the acquisition and reissuance of treasury
shares as a buying and selling activity that gives the superficial impression
that, in this process, the firm is acquiring and disposing of assets and that, if
different amounts per share are involved, a gain or loss results. Note, when a
corporation "buys" treasury shares it is not acquiring assets; nor is it
disposing of any assets when these shares are subsequently "sold."
Exercise 3-11 (25 minutes)
a. There are four basic rights inherent in ownership of common stock. The first
right is that common shareholders may participate in the actual management
of the corporation through participation and voting at the corporate
stockholders meeting. Second, a common shareholder has the right to share
in the profits of the corporation through dividends declared by the board of
directors (elected by the common shareholders) of the corporation. Third, a
common shareholder has a pro rata right to the residual assets of the
corporation if it liquidates. Fourth, common shareholders have the right to
maintain their interest (percent of ownership) in the corporation if the
corporation issues additional common shares, by being given the opportunity
to purchase a proportionate number of shares of the new offering. This fourth
right is most commonly referred to as a "preemptive right."
b. Preferred stock is a form of capital stock that is afforded special privileges
not normally afforded common shareholders in return for giving up one or
more rights normally conveyed to common shareholders. The most common
right given up by preferred shareholders is the right to participate in
management (voting rights). In return, the corporation grants one or more
preferences to the preferred shareholders. The most common preferences
granted to preferred shareholders are these:
3-30
Exercise 3-11continued
1. Dividends are paid to common shareholders only after dividends have
been paid to preferred shareholders.
2. Claims of preferred shareholders are senior to common shareholders for
residual assets (after creditors have been paid) in the case of corporation
liquidation.
3. Although the board of directors is under no obligation to declare dividends
in any particular year, preferred shareholders are granted a cumulative
provision stating that any dividends not paid in a particular year must be
paid in subsequent years before common shareholders are paid any
dividend.
4. Preferred shareholders are granted a participation clause that allows them
to receive additional dividends beyond their normal dividend if common
shareholders receive dividends of greater percentage than preferred
shareholders. This participation is on a one-to-one basis (fully
participating); common shareholders are allowed to exceed the rate paid to
preferred shareholders by a defined amount before preferred shareholders
begin to participate: or, the participation clause can carry a maximum rate
of participation to which preferred shareholders are entitled.
5. Preferred shareholders have the right to convert their preferred shares to
common shares at a set future price no matter what the current market
price of the common stock is.
6. Preferred shareholders also can agree to have their stock callable by the
corporation at a higher price than when the stock was originally issued.
This item is generally coupled with another preference item to make the
issue appear attractive to the market.
c. 1. Treasury stock is stock previously issued by the corporation but
subsequently repurchased by the corporation. It is not retired stock, but
stock available for issuance at a subsequent date by the corporation.
2. A stock right is a privilege extended by the corporation to acquire
additional shares (or fractional shares) of its capital stock.
3. A stock warrant is physical evidence of stock rights. The warrant specifies
the number of rights conveyed, the number of shares to which the
rightholder is entitled, the price at which the rightholder can purchase
additional shares, and the life of the rights (time period over which the
rights can be exercised).
3-31
3-32
3-33
3-34
PROBLEMS
Problem 3-1 (30 minutes)
a. 1. $200 million
2. As the maturity date approaches the liability will be shown at increasingly
larger amounts to reflect the accrual of interest that will be due at maturity.
3. The annual journal entry is:
Interest expense.......................................................
#
Unamortized discount....................................
[Note: No cash is involved since it is a zero coupon note.]
3-35
39,930
3,194.40 (1)
6,805.60
7,986 (2)
7,986
b.
ASSETS
Leased property under
capital leases
(2)
Balance Sheet
December 31, Year 1
LIABILITIES
Lease Obligations under
$31,944 (1) capital leases.
$33,124.40
Income Statement
For Year Ended December 31, Year 1
Amortization of leased property ..................................................
Interest on leases...........................................................................
Total lease-related cost for Year 1 ...............................................
$ 7,986.00
3,194.40
$11,180.40 (3)
3-36
Problem 3-2continued
c.
Payments of Interest and Principal
Total
Interest
Payment of
Payment
at 8%
Principal
Year
1
2
3
4
5
10,000
10,000
10,000
10,000
10,000
$50,000
$3,194.40
2,649.95
2,061.95
1,426.90
736.80
$10,070.00
$6,805.60
7,350.05
7,938.05
8,573.10
9,263.20
$39,930.00
Principal
Balance
$39,930.00
33,124.40
25,774.35
17,836.30
9,263.20
d.
Year
1
2
3
4
5
e. The income and cash flow implications from this capital lease are apparent in
the solutions to parts c and d. The student should note that reported
expenses exceed the cash flows in earlier years, while the reverse occurs in
later years.
3-37
3-38
3-39
3-40
Problem 3-5continued
c. Bond discount for bonds sold between interest dates should be amortized
over the period the bonds are outstanding. That is, the period from the date
of sale (November 1, Year 5) to the maturity date (October 1, Year 10).
d. Proceeds from the sale of the 9% nonconvertible bonds with detachable stock
purchase warrants should be accounted for as both paid-in capital and
long-term debt. The detachable stock purchase warrants are equity
instruments that have a separate fair value at the issue date. Therefore, the
portion of the proceeds allocable to the warrants should be accounted for as
paid-in capital. The bonds are debt instruments. Therefore, the remainder of
the proceeds, including the premium, should be accounted for as long-term
debt.
(AICPA Adapted)
3-41
JDS
MLS
Book value
Price/book value
= $51.50 / $24.00
= 2.15
= $49.50 / $18.75
= 2.64
JDS
MLS
= $0 + 2,700 / $6,000
= $2,700 / $6,000
= 45.00%
= $3,500 / $7,500
= 46.67%
JDS
MLS
= $21,250 / $5,700
= 3.73
= $18,500 / $5,500
= 3.36
3-42
Ratio
JDS
MLS
Company Favored
i.
2.15
2.64
ii.
45%
47%
iii.
Asset turnover
3.73
3.36
Problem 3-7continued
c.
Liabilities
(Long-term debt [LTD])
+$1,000
(Short-term debt [STD])
+$800
Book value per common share: No net adjustment to JDS owners equity of
$6,000; thus, $6,000 / 250 million shares = $24.00 book value per share
Adjusted total debt-to-equity ratio:
$2,700
+1,000
+ 800
$4,500
Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%
iii.
Historical LTD
LTD
STD
Adjusted total debt
MLS:
Needed adjustments:
Assets
(Pension) +$1,600
i.
Owners Equity
+$1,600
ii.
iii.
3-43
Problem 3-7continued
Part c continued:
Summary of Adjustments
Ratio
Adjusted book value
Adjusted debt to equity
Fixed-asset utilization
JDS
$24.00
75%
3.17
MLS
$22.75
38%
3.36
JDS
MLS
2.15a
Company favored
2.18b
approximately equal
ii.
Adjusted debt to equity
equity
75%
36%
iii.
3.17
3.36
Fixed-asset utilization
3-44
3-45
3-46
$645
188
(372)
2
$463
CASES
Case 3-1 (25 minutes)
a. Defined benefit plan
b. Net pension asset totaling $172.5 million (current 19.8 + long-term 152.7)
c. VBO (present value of pension benefits to vested employees at current salary
levels) = $679.6; ABO (present value of pension benefits to vested and nonvested employees at current salary levels) = ($714.4); PBO (present value of
vested and non-vested benefits at projected future salary levels) = $827.7.
d. $857.7million
e. Plan assets consist primarily of shares of or units in common stock, fixed
income, real estate, and money market funds.
f. Net economic position = Fair value of assets less fair value of obligation
= $857.7 - $827.7
= $30 million overfunded
g. Several costs are not yet in the pension liability including the unrecognized
net loss, unrecognized prior service cost, and unrecognized net assets at
transition. As a result, the reported pension asset is significantly larger than
the over funded economic position of the plan.
h. $54.9 million
i. The long-term rate of return on plan assets assumed by Campbell is 9%. This
is reasonable and similar to the assumptions of comparable companies.
j. The long-term rate of compensation increase of 5.75% is reasonable and in
line with the assumption used by comparable companies, which is fine from
the perspective of an equity analyst. From the viewpoint of a potential
employee, this suggests that the average raise for the typical performer will be
5.75%.
3-47
159.7
0.3
G
H
24.3
250.3
805.8
beg
0.1
99.8
100.0
199.6
C
D
E
F
1.9
772.6
I
end
b. Campbell Soup has issued a number of long-term Notes and Debentures, all
of which appear to be fixed rate. Thus, the company does not require
derivatives in order to manage interest rate risk. Further, Campbell Soups
debt footnote indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in
Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The
remaining long-term debt matures in excess of 5 years. Given Campbells
operating cash flow of $805.2 million, solvency does not appear to be a
problem.
3-48
Economic
Year 11 Pension Cost:
Service cost
Interest cost
Return on assets
Other
Net pension cost
22
69
(73)1
7
253
Deferred
6
6
Amortized
Reported
22
69
(67)2
7
314
Actual loss
Reported investment return
3
Economic cost (expense)
4
Reported income
1
2
The true economic cost of the pension plan (the increase in the obligation
offset by any increase in net assets) is represented in the column titled
economic. As a permanent income component, the smoothed reported
number is a better estimate for analysis purposes.
3-49
140,000,000
135,622,676
127,003,765 (part a)
Year 11
175.6 million
$175.6 million / $3.3954 million
shares = $51.72
c.
3-50
Year 8
AMR
Year 7
Year 8
Delta
Year 7
Year 8
UAL
Year 7
0.865
0.895
0.735
0.702
0.513
0.562
2.330
1.488
6.817
2.356
1.459
4.867
2.630
1.492
9.310
3.237
1.879
7.509
4.657
2.929
4.463
5.617
3.371
6.220
7.17%
8.18%
6.21%
20.23%
28.17%
29.23%
Note: We treat preference share capital as debt and include preference dividend with interest.
5%
10%
5%
Delta
10%
UAL
5%
10%
Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision (35% tax rate)
Continuing Income
% drop in Continuing Income
18,245
17,285
(16,656) (16,445)
1,589
840
198
198
(372)
(372)
1,415
666
(495)
(233)
920
433
30%
67%
13,431
12,724
(12,289) (12,134)
1142
590
141
141
(197)
(197)
1,086
534
(380)
(187)
706
347
29%
65%
16,683
15,805
(15,882) (15,681)
801
124
133
133
(361)
(361)
573
(104)
(201)
36
372
(68)
55%
108%
3-51
Case 3-5continued
Part b continued: The profitability of the airlines is reduced dramatically by
moderate revenue shortfalls under our assumptions. A mere 5% drop in
revenues can reduce income by a third (half for UAL), while a 10% drop in
revenues can all but wipe out the airlines profits. This happens because of the
high proportion of fixed costs in the cost structure. We also examine the
impact of the changes on key Year 8 ratios:
AMR
Drop in Revenue
Liquidity
Current Ratio
Solvency
Total Debt to Equity
Long Term Debt to Equity
Times Interest Earned
Return on Investment
Return on Total Assets
Return on Equity
5%
10%
5%
Delta
10%
UAL
5%
10%
0.865
0.865
0.735
0.735
0.513
0.513
2.330
1.488
4.803
2.330
1.488
2.790
2.630
1.492
6.513
2.630
1.492
3.711
4.657
2.929
2.587
4.657
2.929
0.712
5.38%
14.25%
3.13%
6.71%
6.10%
20.09%
3.47%
9.87%
3.57%
13.24%
0.98%
-2.42%
The balance sheet ratios do not change. The ROA and ROE mirror the drop in
profitability. The most interesting change occurs in interest coverage, which
drops significantly with reduced revenues. While AMR and Delta can still pay
their interest in the event of a demand slump, UAL may have difficulty meeting
its interest payments in the case of a 10% revenue drop.
c. Because of the volatile nature of profitability and consequent risk, airline
companies often find it difficult to raise debt at reasonable terms. Raising
equity is a possibility, but the equity cost of capital is high in this industry
(airline companies have some of the lowest P/E ratios in the market).
Consequently, leasing offers a convenient alternative to financing the high
capital investment requirements of this industry. The lessor is probably able
to offer better terms than other creditors for several reasons: (1) the lessor
may be connected to suppliers of capital equipment and can use leasing as a
marketing tool; and (2) in the event of insolvency the lessor is often in a better
position to recover the assets because ownership often rests with the lessor.
Finally, the bigger airline companies (such as AMR, Delta and UAL) prefer to
maintain a young fleet of aircraft, both because of obsolescence and because
of the high maintenance cost associated with maintaining older aircraft. In
such a scenario, it is easier to lease aircraft rather than purchase outright and
sell it later.
d. Examine Capital and Operating Leases and Their Classification: All three
companies are increasingly structuring their leases to be operating leases.
The outstanding MLP on operating leases for AMR, Delta and UAL is
approximately $17 billion, $15 billion and $24 billion, respectively, compared
to $2.7 billion, $0.4 billion and $3.4 billion for capital leases.
3-52
Case 3-5continued
The lease classification appears arbitrary. The capital and operating leases do
not seem to differ either on the basis of the type of asset leased or the length
of the lease. The average remaining life on the operating leases, for all three
companies, varies between 16 to 20 years, which is much more than those on
capital leases (see part e below). Overall, there does not seem to be any logic
underlying the lease classification, except that the companies have structured
the leases to avail themselves of the benefits of operating lease accounting.
e. Reclassification of Operating Leases as Capital Leases and Restatement of
Financial Statements
AMR
Year 8
Capital
Operating
1012
951
949
904
919
12,480
100
67
57
57
48
71
312
10,066
950
950
940
960
960
10,360
UAL
Capital
317
308
399
341
242
1759
2,289
Operating
1320
1329
1304
1274
1305
17,266
7%
8,146
13,223
Delta
UAL
Year 8
Year 8
8,146
8.5%
692
13,223
7%
926
10,066
19
8,146
16
13,223
18
530
509
735
Operating
8.5%
AMR
Year 8
B. Estimate Interest and Depreciation on Operating Lease
Present Value of Operating Leases
10,066
Interest Rate
6.25%
Interest Expense
629
Value of Operating Lease Assets
Delta
Capital
Statement
(509)
(735)
950
1,320
441
585
(629)
(147)
(692)
(251)
(926)
(341)
51
(96)
88
(163)
119
(222)
3-53
Case 3-5continued
Part e continued:
AMR
Delta
Year 8
Year 8
D. Determine Principal and Interest Component of Next Year's MLP
Next Year MLP
1,012
950
Estimated Interest Component
629
692
Estimated Principal Component
383
258
UAL
Year 8
1,320
926
394
AMR
Delta
UAL
Year 8
Year 8
Year 8
4,875
12,239
12,213
3,042
32,369
3,362
9,022
8,445
1,920
22,749
2,908
10,951
15,326
2,597
31,782
537
321
570
5,485
4,514
5,492
11,447
2,436
5,766
8,137
1,533
4,046
14,942
2,858
3,848
175
791
3,299
1,776
(1,052)
22,749
3,518
1,024
(1,261)
31,782
3,257
4,729
(1,288)
32,369
3-54
AMR
Year 8
19205
(16,385)
2,820
198
(1,001)
2017
(807)
1,210
Delta
Year 8
14138
(12004)
2134
141
(889)
1386
(559)
827
UAL
Year 8
17561
(15498)
2063
133
(1287)
909
(310)
599
Case 3-5continued
f. We made several assumptions in estimating the effects of the lease
classification. Some of the important assumptions are:
Interest Rate Parity across Capital and Operating Leases. We use the
average interest rate on the capital leases as a proxy for the interest rate on
operating lease. To the extent capital and operating leases are dissimilar,
the interest rate estimate is inaccurate or biased. This problem arises
especially if the capital leases and the operating leases, on average, have
been contracted during different time periods with different interest rate
regimes.
In this particular case, the interest rate on Deltas capital leases is
substantially higher than that on either AMR or UAL. While it is not
impossible, it is improbable that lease rates could differ so markedly across
similar companies in the same industry. The average remaining lease term
offers a clue: for Deltas capital leases it is 6-7 years compared to 10-12
years for AMR and UAL. Under the assumption that the average lease terms
are similar across companies, this implies that Deltas capital leases, on
average, were contracted 4-5 years before AMR or UAL, which is consistent
with the higher interest rate on Deltas capital leases. To some extent, this
problem is alleviated (at least on a comparative basis) because Deltas
operating leases also appear to have been contracted around three years
earlier to AMRs or UALs. It appears that the capital leases for all three
companies were entered into at an earlier time than the operating leases. If
these leases were entered at a time with a sufficiently different interest rate
regime, we need to make appropriate corrections to our interest rate
estimates.
Depreciation Policy. We set the lease asset and liability equal to each other.
In reality, the depreciation of the asset seldom equals the lease principal
payments. Some people use a simplifying assumption such as lease assets
should be equal to 80% the liability. However, these ad hoc rules are no
better than putting them equal to each other.
3-55
Case 3-5continued
Delta
UAL
Year 8
Year 8
.70
.48
4.65
3.45
2.56
8.69
6.84
1.71
6.18%
4.52%
20.56%
18.26%
Note: We treat preference share capital as debt and include preference dividend with interest.
3-56
Case 3-5continued
h. Sensitivity Analysis on Restated Financial Statements
AMR
5%
10%
Drop in Revenue
5%
Delta
10%
UAL
5%
10%
Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision
Continuing Income
% drop in Continuing Income
18245
17285
13431
12724
16683
15805
(16180)
(15975)
(11854)
(11704)
(15304)
(15111)
2065
198
(1,001)
1,262
(531)
731
40%
1310
198
(1,001)
507
(213)
294
76%
1577
141
(889)
829
(334)
495
60%
1020
141
(889)
272
(110)
162
80%
1379
133
(1287)
225
(76)
149
75%
694
133
(1287)
(460)
155
(305)
151%
0.810
0.810
0.695
0.695
0.480
0.480
3.833
2.934
3.014
3.833
2.934
1.506
4.419
3.267
1.932
4.419
3.267
1.306
6.805
5.316
1.175
6.805
5.316
0.643
3.74%
0.91%
2.18%
0.71%
18.07%
4.89%
11.79%
3.86%
0.469
%
3.659
%
-0.960%
-7.490%
3-57
Case 3-5continued
Accounting Motivations for Leasing and Lease Classification: In (c) above we
presented some economic arguments for the popularity of leasing in the
airline industry. After the analysis in g and h, we added an important
motivation that is purely related to financial reporting. By leasing a large
proportion of their assets and successfully classifying most leases as
operating, the airlines attempt to camouflage the high risk inherent in their
capital structure.
The big question is whether managers can so easily fool the market with these
accounting gimmicks. Research does indicate that the market seems to
consider the additional risk imposed by operating leases and to reflect what is
not shown on the financial statements. However, a surprising number of even
sophisticated investors fall prey to these window-dressing tacticsfor
example, many analyst reports and financial databases fail to adjust the
solvency and other ratios for operating leases.
This case highlights the importance for a financial analyst to understand the
accounting issues. It also highlights the importance of getting ones hands
dirty by doing a detailed and careful accounting analysis before embarking
on further financial analysis.
3-58
Difference
43,447
27,572
15,875
7,752
8,123
2,121
5,007
(2,886)
(2,420)
(466)
Balance Sheets
Original
Year 8 Year 7
PBO
Net Economic Position
Reported Position on Balance Sheet
Assets
Current Assets
PP&E
Intangible Assets
Other
Total
Liabilities & Equity
Current Liabilities
Long Term Borrowing
Other Liabilities
Minority Interest
Equity Share Capital
Retained Earnings
Total
Relevant Ratios
Debt to Equity
Long-Term Debt to Equity
Return on Equity
38,742
25,874
12,868
6,574
6,294
243,662
212,755
243,662
32,316
19,121
39,820
35,730 32,316
23,635 19,121
52,908 39,820
355,935
304,012
355,935
304,012
120,668
141,579
120,668
141,579
46,603
59,663 46,603
4,275
7,402
31,478
3,682
5,028
29,410
4,275
3,682
7,402
5,028
39,135 35,292
355,935
304,012
355,935
7.25
3.97
21.54%
6.98
3.81
6.00
3.22
21.52%
40,659
5,332
7,657
4,128
5,882
30,649
10,010
212,755
59,663
98,621
45,568
32,579
12,989
Restated
Year 8 Year 7
35,730
23,635
52,908
111,538
1,917
4,775
(2,858)
(2,446)
(412)
103,881
92,739
304,012
5.91
3.17
18.29% 18.64%
3-59
Case 3-6continued
b.
Post Retirement Expense Restatement
Permanent Income
Reported Expense
One-time charge
Permanent Income
Economic Income
Actual Return on Assets
Service Cost
Interest Cost
Actuarial Changes
Early Retirement Costs
Economic Income or Expense
Year 8
1,016
0
1,016
331
412
743
685
(412)
273
(313)
0
(313)
(455)
165
(290)
6,363
(625)
(1,749)
(1,050)
0
2,939
6,587
(596)
(224)
(29)
(63)
338
412
434
316
(96)
(319)
(268)
0
(367)
343
(107)
(299)
(301)
(165)
(529)
(367)
(1,686)
(1,388)
(412)
2,505
142
(165)
(23)
703
0
703
Change
(124)
577
453
827
(577)
250
(27) 6,679
11
(721)
(20) (2,068)
33 (1,318)
165
0
162 2,572
6,930
(703)
(251)
(18)
(83)
371
577
596
(529)
2,572
1,976
268
(167)
301
(206)
1,318
1,689
(3,506)
(4,072)
(8)
0
(39)
(313)
11
0
(32)
(455)
(161)
154
326
703
(134)
154
263
(124)
(1,985)
(1,689)
(577)
1,976
3-60
Case 3-6continued
d. To suggest that any change in the reported net pension income (or expense) must
be excluded when determining the legitimate earnings growth rate implies either
that pension plans are not an integral part of the company or that pension
expense (or income) should be constant over time. Both assumptions are not
necessarily correct. As explained in the textbook, while pension plans are
administered by separate trustees, the net assets (or liabilities) of the plans are
the employers responsibility. Moreover, while reported pension expense is
generally not volatile, there is no reason why it must remain the same each year.
Therefore, to determine whether the change in the pension income is warranted
we need to examine the changes in the components of reported pension costs:
($ Millions)
Effect on Operations
Expected Return on Plan Assets
Service Cost for Benefits Earned
Interest Cost on Benefit Obligation
Prior Service Cost
SFAS 87 Transition Gain
Net Actuarial Gain Recognized
Special Early Retirement Cost
Post Retirement Benefit Income(Cost)
Year 8
Pension Benefits
Year 7
Change
3,024
(625)
(1,749)
(153)
154
365
1,016
2,721
(596)
(1,686)
(145)
154
295
(412)
331
303
(29)
(63)
(8)
0
70
412
685
This analysis reveals that the main reasons for the increase in pension income
are the expected rate of return ($303 million) and the early retirement costs ($412
million). Both appear to be genuine. The higher return on plan assets is fully
attributable to the increase in the beginning market value of plan assets (from
$33.69 billion on January 1, Year 7 to $38.742 billion on January 1, Year 8). In
reality, pension accounting has underreported the actual return on assets by over
$3 billion (the actual return is $6,363 million versus reported $3,024 million). As
our analysis in (b) indicates, the reported pension cost underreports the true
economic cost by almost $3 billion. The $412 million increase in early retirement
cost arises not because GE overreported pension income for Year 8, but rather
because GE underreported pension income for Year 7, by taking a one-time
charge of $412 million. GE did reduce its discount rate by 0.25% in Year 8,
resulting in $64 million decrease in interest cost. However, this is less than 10% of
the overall increase in pension income. Also, this decrease appears legitimate,
considering that long-term interest rates dropped by more than 1% in Year 8.
Overall, Barrons claim that the earnings growth rate for GE has been artificially
inflated because of its pension plan appears to be unsubstantiated.
Still, before we confidently conclude that GE is not managing its earnings, it might
be interesting to examine pension income before and after excluding the one-time
early retirement charge and then examine the pattern of reported earnings:
Including One-Time Charge
Pension Income
Net Earnings
Earnings Growth Rate
Year 8
1,016
9,296
13.32%
Year 7
331
8,203
12.68%
Excluding One-Time
Charge
Year 8
1,016
9,296
7.90%
Year 7
743
8,615
18.34%
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Case 3-6continued
When we examine the timing of the large one-time charge, it
appears that there is a kernel of truth to the Barrons complaint, although not in
the sense that was implied. If GE had not taken the $412 million charge in Year 7,
its earnings growth would have been an outstanding 18.34% in Year 7, thereby
creating an expectation of similar growth in Year 8. The real growth rate in Year 8,
however would have been a disappointing 8%, which may have had adverse
market reactions. GE is adept at smoothing its income across periods so that it
can show a steady 13% growth in earnings. By doing this, GE is not artificially
increasing the long-term earnings growth rate (as the Barrons editorial alleges),
but rather it is reducing the volatility in reported earnings, thereby creating an
impression of a more stable (and hence, less risky) company. For more details
about GEs earnings smoothing techniques, see the Wall Street Journal article
(WSJ, 11/3/94).
Part d continued:
e. The pension related cash flows for GE are the employers contributions of $68
million ($64 million) in Year 8 (Year 7). Evidently these cash flows have little to do
with the economics of the pension plans or their effects on either GEs
performance or financial position. GEs situation is not unusual. Because defined
benefit pension plans can be either over or under funded, the actual cash
contributions by the company to the pension plans are entirely arbitrary (in
contrast, the cash contributions in the case of a defined contribution plan are a
real expense). Therefore, the pension cash flows have no connection with the
economic reality of the pension plans. The accounting standard setters
understand this and have progressively developed better pension accounting
standards that attempt to capture the economic reality
3-62
While certain contingent losses do not meet the threshold for accrual and
recognition in the balance sheet, analysts should adjust their models to reflect
much greater exposure to losses from tobacco litigation. The current balance
sheet should be adjusted to report much greater amounts of liability and tobacco
litigation charges and losses.
3-63