Analysing Financing Activities

Companies operations are financed by various

sources:
• Liabilities
• Leasing
• Capital (Stockholders’Equity)
• Off balance sheet transactions
 Companies’ Financing Sources

Liabilities

Leasing

Capital (Stockholders’ Equity)

Off balance sheet transactions

 Two major types of liabilities

Obligations that arise from operating

activities--examples are accounts payable,
Operating
unearned revenue, advance payments,
Liabilities taxes payable, postretirement liabilities,
and other accruals of operating expenses

Obligations that arise from financing

activities--examples are short- and long-
Financing
term bank loan, bonds, notes, leases, and
Liabilities the current portion of long-term debt
(CPLTD)
 Liabilities – Classification in Financial
Statements
Current (short-term) Noncurrent (Long-Term)
Liabilities Liabilities

Obligations whose settlement Obligations not payable within

requires use of current assets or one year or the operating cycle,
the incurrence of another whichever is longer.
current liability within one year
or the operating cycle,
whichever is longer.
• Typical long-term financial liabilities include bank loans and
bonds payable

• Both are usually reported at amortised cost on the B/S

• At maturity, the amortised cost of the bond (carrying amount)

will be equal to the face value of the bond
– E.g, If a company issues $10.000.000 of bonds at a price of 97.50 (a
discount to par), the bonds are reported as a liability of $9.750.000
– Over the bond’s life, the discount of $250.000 is amortised so that
the bond will be listed as a liability of $10.000.000 at maturity
– Similarly, any bond premium would be amortised for bonds issued
at a price in excess of face or par value
 Liabilities – Important Features in Analysing
(interest bearing) Liabilities
• Terms of indebtedness (such as maturity, interest rate, payment
pattern, unutilized credit lines 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.

 Other types of liabilities

• Deferred tax liabilities: results from temporary timing

differences between a company’s income as reported for tax
purposes (taxable income) and income as reported for
financial statement purposes (reported income)

• Pension liabilities: it is happened only for pension

arrangements with defined benefit plan. If the fair value of
the assets of defined-benefit plans pension is less than the
estimated pension obligation, the pension plan become
underfunded, hence pension liabilities occurs.
 Companies’ Financing Sources

Liabilities

Leasing

Capital (Stockholders’ Equity)

Off balance sheet transactions

 Liabilities – 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

A Finance (Capital) Lease – is, in substance, a purchase of an asset

that is financed with debt. The lessee will add equal amounts to both
assets and liabilities on the B/S. Over the lease term, the lessee will
recognise depreciation expense and interest expense

An Operating Lease – is essentially a rental agreement. No asset or

liability is reported by the lessee and the periodic lease payments are
simply recognised as rental expense in I/S
 Leasing – Key Points

Capital leases and Operating leases both have

an interest and a principle portion of the
payment.
 Leasing – 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 less any related
investment tax credit retained by lessor

(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 an 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 – Frequency of Capital and Operating
Leases
 Leases – Accounting for Leases (an illustration)
Lease Facts:

• A company leases an asset on January 1, 2000 -- it has no other

assets or liabilities

• Estimated economic life of leased asset is 5 years with no salvage

value -- company will depreciate the asset on a straight-line basis
over its life

• Lease has a fixed non-cancelable term of 5 years with annual

MLPs of $2,505 paid at the end of each year

• Interest rate on the lease is 8% per year

 Leases – Accounting for Leases (an illustration)

Lease Amortization Schedule

Interest and Principal Components of
Beg. Year MLP Year-end
Year Liability Liability
Interest Principal Total

2000 $10,000 $ 800 $ 1,705 $ 2,505 $8,295

2001 8,295 664 1,841 2,505 6,454
2002 6,454 517 1,988 2,505 4,466
2003 4,466 358 2,147 2,505 2,319
2004 2,319 186 2,319 2,505 0
Totals $2,525 $10,000 $12,525

Straight-line depreciation
$2,000 per year ([$10,000 - $0]/5 years)
Leases – Accounting for Leases (an illustration)

Income Statement Effects of Alternative Lease Accounting

Leases – Accounting for Leases (an illustration)

Balance Sheet Effects of Capitalised Leases

 Leases – Effects of Lease Accounting
• 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
Leases – Effects of Lease Accounting
 Companies’ Financing Sources

Liabilities

Leasing

Capital (Stockholders’ Equity)

Off balance sheet transactions

 Shareholders’ Equity – Basics of Equity
Financing
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
 Elements of Shareholders’ Equity

The five key elements:

• Preferred stock
• Common Stock
• Paid in capital
• Retained earnings
• Treasury stock
 Elements of Shareholders’ Equity –
Classification of Capital Stock
Preferred Stock — stock with features not possessed by common
stock; typical preferred stock features include:
• Dividend distribution preferences
• Liquidation priorities
• Convertibility (redemption) into common stock
• Call provisions
• Non-voting rights

Common Stock — stock with ownership interest and bearing

ultimate risks and rewards (residual interests) of company
performance
 Shareholders’ Equity – Components of 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 – Basics of Retained
Earnings
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

• Cash dividend — distribution of cash (or assets) to shareholders
• 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 – Reporting Capital Stock

Sources of increases in capital stock outstanding:

• Issuances of stock
• Conversion of debentures
• Issuances of stock in acquisitions and mergers
• Issuances pursuant to stock options and warrants exercised

Sources of decreases in capital stock outstanding:

• Purchases and retirements of stock
• Stock buybacks
• Reverse stock splits
 Companies’ Financing Sources

Liabilities

Leasing

Capital (Stockholders’ Equity)

Off balance sheet transactions

 Off-balance-sheet Financing – Illustration of
SPE
• A special purpose entity (SPE) 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.
 Off-balance-sheet Financing

Special purpose entities:

• Trust preferred subsidiaries

• Real estate subsidiaries
• Mortgage securitizations
• Enron utilization
Off-balance-sheet Financing – 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, as 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 – 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 off-balance-sheet financing
transaction, new and innovative means are devised to take its place
 Off-balance-sheet Financing – Basics of Off-
balance-sheet Financing
Transactions sometimes used as off-balance-sheet financing:
• Operating leases that are indistinguishable from capital leases
• Through-put agreements, where a company agrees to run goods
through a processing facility
• Take-or-pay arrangements, where a company guarantees to pay
for goods whether needed or not
• Certain joint ventures and limited partnerships
• Product financing arrangements, where a company sells and
agrees to either repurchase inventory or guarantee a selling
price
• Sell receivables with recourse and record them as sales rather
than liabilities
• Sell receivables as backing for debt sold to the public
• Outstanding loan commitments
 Off-balance-sheet Financing – Analysis of Off-
balance-sheet Financing
Sources of useful information: Notes of Financial Statements and MD&A

Companies disclose the following info about financial instruments with off-
balance-sheet risk of loss:
• Face, contract, or principal amount
• Terms of the instrument and info on its credit and market risk, cash
requirements, and accounting Loss incurred if a party to the contract fails to
perform
• Collateral or other security, if any, for the amount at risk
• Info about concentrations of credit risk from a counterparty or groups of
counterparties

Useful analysis:
• Scrutinize management communications and press releases
• Analyze notes about financing arrangements
• Recognize a bias to not disclose financing obligations
 Contingencies and Commitments – Basics of
Contingencies
Contingencies – potential losses and gains whose resolution depends on one or
more future events.

Contingent liabilities – contingencies with potential claims on resources.

To record a contingent liability (and loss) two conditions must be met:
(i) Probable i.e. an asset will be impaired or a liability incurred, and
(ii) the amount of loss is reasonably estimable;
– to disclose a contingent liability (and loss) there must be at least a reasonable
possibility of incurrence

Contingent assets – contingencies with potential additions to resources

• a contingent asset (and gain) is not recorded until the contingency is
resolved
• a contingent asset (and gain) can be disclosed if probability of realization is
very high
 Contingencies and Commitments – Analysing
Contingencies
Sources of useful information: Notes of FS, MD&A, and Deferred Tax Disclosures

Useful analyses:
• Scrutinize management estimates
• Analyze notes regarding contingencies, including
• Description of contingency and its degree of risk
• Amount at risk and how treated in assessing risk exposure
• Charges, if any, against income
• Recognize a bias to not record or underestimate contingent liabilities
• Beware of big baths — loss reserves are contingencies
• Review SEC filings for details of loss reserves
• Analyze deferred tax notes for undisclosed provisions for future losses

Note: Loss reserves do not alter risk exposure, have no cash flow consequences,
and do not provide insurance
 Contingencies and Commitments – Basics of
Commitments and Its Analysis
Commitments – potential claims against a company’s resources
due to future performance under contract
Sources of useful information: Notes of FS and MD&A

Useful analyses:
• 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