Analyzing Financing

Activities
INAM-UL-HAQUE
Analysis Objective:
● Identify and assess the principal characteristics of
liabilities and equity.
● Analyze and interpret lease disclosures and explain their
implications and the adjustments to financial
statements.
● Analyze postretirement disclosures and assess their
consequences for firm valuation and risk.
OVERVIEW
LIABILITIES
● Liabilities are financing obligations that require future
payment of money, services, or other assets.
● They are outsiders’ claims against a company’s present
and future assets and resources.
● Liabilities can be either financing or operating
● Liabilities are commonly reported as either current or
noncurrent
Current Liabilities

● Current (or short-term) liabilities are obligations whose

settlement requires the use of current assets or the
incurrence of another current liability.
● The period over which companies expect to settle
current liabilities is the longer of one year or the
operating cycle
Current Liabilities:

● Conceptually, companies should record all

liabilities at the present value of the cash outflow
required to settle them.
● In practice, current liabilities are recorded at their
maturity value, and not their present value, due to
the short time period until their settlement.
TYPES OF CURRENT LIABILITIES:

● The first type arises from operating activities and

includes taxes payable, unearned revenues, advance
payments, accounts payable, and other accruals of
operating expenses, such as wages payable.
● The second type of current liabilities arises from
financing activities and includes short-term borrowings,
the current portion of long-term debt, and interest
payable.
Noncurrent Liabilities:

● Noncurrent (or long-term) liabilities are obligations that

mature in more than one year (or the operating cycle if
longer than one year). They include loans, bonds,
debentures, and notes.
● Noncurrent liabilities can take various forms, and their
assessment and measurement requires disclosure of all
restrictions and covenants.
Noncurrent Liabilities:

● Disclosures include interest rates, maturity dates,

conversion privileges, call features, and subordination
provisions.
● They also include pledged collateral, sinking fund
requirements, and revolving credit provisions.
Companies must disclose defaults of any liability
provisions, including those for interest and principal
repayments.
Noncurrent Liabilities:

● A bond is a typical noncurrent liability. The bond’s par (or

face) value along with its coupon (contract) rate
determines cash interest paid on the bond.
● Bond issuers sometimes sell bonds at a price either
below par (at a discount) or in excess of par (at a
premium). The discount or premium reflects an
adjustment of the bond price to yield the market’s
required rate of return.
Noncurrent Liabilities:

A discount is amortized over the life of the bond

and increases the effective interest rate paid by
the borrower.
Conversely, any premium is also amortized but it
decreases the effective interest rate incurred.
Noncurrent Liabilities:

● Standard setters are contemplating radical changes to

REPORT long term debt (specifically bonds) in Balance
Sheet.
● Instead of reporting bond values at amortized cost, bonds
will be reported at their respective fair values (i.e. at their
market values) on the balance sheet date.
● All changes in bond values will be flowed through the
income statement
Noncurrent Liabilities:

● One troubling issue that arises when long-term debt is

measured at fair value is that the value of a company’s
reported long-term debt will decrease when the
company’s credit standing worsens (this is because
decreased creditworthiness will lower the market values
of bonds).
● This reduction in reported bond values will create income
for the company.
Noncurrent Liabilities:

● The justification that FASB provides for this peculiar effect

is that a reduction in a company’s credit standing will
occur only if there is a substantial reduction in the fair
value of the company’s assets. This reduction in assets’
fair value will cause a substantial loss during the period.
Offsetting this loss through income created by decrease
in fair value of debt will correctly reflect the share of
losses borne by the equity and debt holders.
ILLUSTRATION 3.1 :
CONVERTIBLE DEBT SWEETENER:

● Bond issuers offer a variety of incentives to promote the sale of

bonds and reduce the interest rate required.
● These include convertibility features and attachments of warrants to
purchase the issuer’s common stock.
● Disclosure is also required for future payments on long-term
borrowings and for any redeemable stock.
● This would include:
○ Maturities and any sinking funds requirements for each of the next five years.
○ Redemption requirements for each of the next five years
Analyzing Liabilities:

● Auditors are one source of assurance in our

identification and measurement of liabilities.
● Auditors use techniques like direct confirmation, review
of board minutes, reading of contracts and agreements,
and questioning of those knowledgeable about company
obligations to satisfy themselves that companies record
all liabilities.
Analyzing Liabilities:

● Double-entry accounting
● There is no entry required for most commitments and
contingent liabilities. In this case, our analysis often
must rely on notes to financial statements
● accuracy and reasonableness of debt amounts CAN BE
CHECKED by reconciling them to a company’s
disclosures for interest expense and interest paid in
cash.
FEATURES IN ANALYZING LIABILITIES:
L E A S E S:

● A lease is a contractual agreement between a lessor

(owner) and a lessee (user).
● It gives a lessee the right to use an asset, owned by the
lessor, for the term of the lease.
● In return, the lessee makes rental payments, called
minimum lease payments (or MLP).
● Lease terms obligate the lessee to make a series of
payments over a specified future time period.
CAPITAL LEASE:

● A lease that transfers substantially all the benefits and

risks of ownership is accounted for as an asset
acquisition and a liability incurrence by the lessee.
Similarly, the lessor treats such a lease as a sale and
financing transaction.
● Leased asset and the lease obligation are recognized on
the balance sheet
OPERATNG LEASE:

● The lessee (lessor) accounts for the minimum lease

payment as a rental expense (revenue), and no asset or
liability is recognized on the balance sheet.
OFF BALANCE SHEET FINANCING:

● Off-balance-sheet financing refers to the fact that neither

the leased asset nor its corresponding liability are
recorded on the balance sheet when a lease is
accounted for as an operating lease even though many
of the benefits and risks of ownership are transferred to
the lessee.
FREQUENCY OF LEASE TYPES:
CAPITAL ONLY; 1%; 1% NEITHER; 5%; 5%

BOTH
OPERATING TYPES
55% 39%
+ POINT:

● Lease financing is popular for several reasons.

○ Sellers use leasing to promote sales by providing financing to buyers.
Interest income from leasing is often a major source of revenue to
those sellers.

○ In turn, leasing often is a convenient means for a buyer to finance its

asset purchases.

○ Tax considerations also play a role in leasing, overall tax payments can
be reduced
ACCOUNTING & REPORTING OF LEASE:
● A lessee classifies and accounts for a lease as a capital
lease if:
○ the lease transfers ownership of the property to the lessee by
the end of the lease term
○ the lease contains an option to purchase the property at a
bargain price
○ the lease term is 75% or more of the estimated economic life of
the property
○ the present value of the minimum lease payments (MLPs) at the
beginning of the lease term is 90% or more of the fair value of
the leased property.
ACCOUNTING & REPORTING OF LEASE:
● When a lease is classified as a capital lease, the lessee records it (both
asset and liability) at an amount equal to the present value of the minimum
lease payments over the lease term.
● The leased asset must be depreciated in a manner consistent with the
lessee’s normal depreciation policy.
● Likewise, interest expense is accrued on the lease liability, just like any other
interest-bearing liability.
● In accounting for an operating lease, however, the lessee charges rentals
(MLPs) to expense as they are incurred; and no asset or liability is
recognized on the balance sheet.
ACCOUNTING & REPORTING OF LEASE:

● The accounting rules require that all lessees disclose,

usually in notes to financial statements:
○ (1) future minimum lease payments separately for capital leases and
operating leases for each of the five succeeding years and the total
amount thereafter and

○ (2) rental expense for each period that an income statement is

reported.
Accounting for Leases—An Illustration

● A company leases an asset on January 1, 2005—it has no other assets or

liabilities.
● Estimated economic life of the leased asset is five years with an expected
salvage value of zero at the end of five years.
● The company will depreciate this asset on a straight-line basis over its
economic life.
● The lease has a fixed non cancellable term of five years with annual
minimum lease payments of $2,505 paid at the end of each year.
● Interest rate on the lease is 8% per year.
Lease Amortization Schedule
Explanation:

● The present value is $10,000 (computed as 3.992 x $2,505)

(Ordinary Annuity)
● Interest equals the beginning-year liability multiplied by the interest
rate
(for year 2005 it is $10,000 x 0.08 = $ 800)
● The principal amount is equal to the total payment less interest
(for year 2005 it is $2,505 - $800 = $ 1705)
Income Statement Effects :
Explanation:
● In case of operating lease, the minimum lease payment is
reported as a periodic rental expense i.e ($2,505 per year)
● In case of capital lease, periodic interest expense and
depreciation expense are recognized
● Depreciation ($2,000 per year under straight line method)
● Total expense for both methods is identical.
● But, the capital lease method reports more expense in the
earlier years and less expense in later years
● Net Income …???
Under Operating Lease Method:
● Because this company does not have any other assets or liabilities, the
balance sheet under the operating lease method shows zero assets and
liabilities at the beginning of the lease.
● At the end of the first year, the company pays its MLP of $2,505, and
cash is reduced by this amount to yield a negative balance. Equity is
reduced by the same amount because the MLP is recorded as rent
expense.
● This process continues each year until the lease expires.
● At the end of the lease, the cumulative amount expensed, $12,525 (as
reflected in equity), is equal to the cumulative cash payment (as
reflected in the negative cash balance)
Under Capital Lease Method:
● An asset and liability equal to the present value of the lease ($10,000) is
recognized under the capital lease method.
● The negative cash balance reflects the MLP
● The leased asset and lease liability are not equal, except at inception and
termination of the lease.
● These differences occur because the leased asset declines by the amount of
depreciation ($2,000 annually), while the lease liability declines by the amount of
the principal amortization (for example, $1,705 in year 2005)
● Note the leased asset is always lower than the lease liability during the lease
term. This occurs because accumulated depreciation at any given time exceeds
the cumulative principal reduction.
● The decrease in equity in year 2005 is $2,800, which is the total of depreciation
and interest expense for the period
Balance Sheet Effects of Capitalized Leases
Lease Disclosures:

● Accounting rules require a company with capital leases

to report both leased assets and lease liabilities on the
balance sheet
● All companies must disclose future lease commitments
for both their capital and non cancellable operating
leases
Analyzing Leases:
Impact of Operating Leases:
○ Operating leases understate liabilities by keeping
lease financing off the balance sheet.
○ Not only does this conceal liabilities from the balance
sheet, it also positively impacts solvency ratios (such
as debt to equity) that are often used in credit
analysis.
○ Operating leases understate assets. This can inflate
both return on investment and asset turnover ratios.
● Operating leases delay recognition of expenses in comparison
to capital leases. This means operating leases overstate
income in the early term of the lease but understate income late
in the lease term.
● Operating leases understate current liabilities by keeping the
current portion of the principal payment off the balance sheet.
This inflates the current ratio and other liquidity measures.
● Operating leases include interest with the lease rental (an
operating expense). Consequently, operating leases understate
both operating income and interest expense. This inflates
interest coverage ratios such as times interest earned.
Summary:

● The ability of operating leases to positively affect key

ratios used in credit and profitability analysis provides a
major incentive for lessees to pursue this source of off
balance- sheet financing.
● Lessees also believe that classifying leases as operating
leases helps them meet debt covenants and improves
their prospects for additional financing.
Converting Operating Leases to Capital Leases

● Step 1: Collect input data

Step 2: Calculate the Present Value of Operating Lease Commitments
Step 3: Calculate Depreciation Expenses, Imputed
Interest, and Adjusted Interest Expenses
Step 4: Adjust Financials
PRACTICE QUESTIONS

● THEORETICAL QUESTIONS
○ 3.1 TO 3.7
○ 3.9 To 3.15
● EXERCISE QUESTIONS
○ 3.1 TO 3.4
● PROBLEMS
○ 3.1 TO 3.4