Analyzing Financing Activities: Review

Chapter 3
Analyzing Financing
Activities
REVIEW
Business activities are financed through either liabilities or equity. Liabilities are
obligations requiring payment of money, rendering of future services, or dispensing of
specific assets. They are claims against a company's present and future assets and
resources. Such claims are usually senior to holders of equity securities. Liabilities
include current obligations, long-term debt, capital leases, and deferred credits. This
chapter also considers securities straddling the line separating liabilities from equity.
Equity refers to claims of owners to the net assets of a company. While claims of owners
are junior to creditors, they are residual claims to all assets once claims of creditors are
satisfied. Equity investors are exposed to the maximum risk associated with a business,
but are entitled to all residual rewards associated with it. Our analysis must recognize the
claims of both creditors and equity investors, and their relationship, when analyzing
financing activities. This chapter describes business financing and how this is reported
to external users. We describe two major sources of financing—credit and equity—and
the accounting underlying reports of these activities. We also consider off-balance-sheet
financing, including Special Purpose Entities (SPEs), the relevance of book values, and
liabilities "at the edge" of equity. Techniques of analysis exploiting our accounting
knowledge are described.
Instructor's Solutions Manual 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
 Contingencies and Commitments
Contingencies
Commitments
 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
 Liabilities at the “Edge” of Equity
Redeemable Preferred Stock
Minority Interest
 Appendix 3A: Lease Accounting – Lessor
3-2 Financial Statement Analysis, 8th Edition

ANALYSIS OBJECTIVES
 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.
 Analyze contingent liability disclosures and describe risks.
 Identify off-balance-sheet financing and its consequences to risk analysis.
 Analyze and interpret liabilities at the edge of equity.
 Explain capital stock and analyze and interpret its distinguishing features.
 Describe retained earnings and their distribution through dividends.

QUESTIONS
1. The two major source of liabilities, for both current and noncurrent liabilities, are
operating and financing activities. Current liabilities of an operating nature—such as
accounts payable and operating expense accruals—represent 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 month-
end 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.

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.

Thus, as the margin of safety decreases, the relative level of company risk
increases.

9. Analysis of the terms and conditions of recorded liabilities is an area deserving an
analyst's careful attention. Here, the analyst must examine critically the description of
debt, its terms, conditions, and encumbrances with a desire to satisfy him/her as to
the ability of the company to meet principal and interest payments. Important
analyses in the evaluation of liabilities are the examination of features such as:
 Contractual terms of the debt agreement, including payment schedule
 Restrictions on deployment of resources and freedom of action
 Ability to engage in further financing
 Requirements relating to maintenance of working capital, debt to equity ratio, etc.
 Dilutive conversion features to which the debt is subject.
 Prohibitions on disbursements such as dividends
Moreover, we review the audit report since we expect auditors to require satisfactory
recording and disclosure of all existing liabilities. Auditor tests include the scrutiny of
board of director meeting minutes, the reading of contracts and agreements, and
inquiry of those who may have knowledge of company obligations and liabilities.
The analysis of contingencies (and commitments) also is aided by financial statement

analysis. However, the analysis of contingencies and commitments is more
challenging because these liabilities typically do not involve the recording of assets
and/or costs. Here, the analyst must rely on information provided in notes to the
financial statements and in management commentary found in the text of the annual
report and elsewhere. Due to the uncertainties involved, the descriptions of
commitments, and especially contingent liabilities, in the notes are often vague and
indeterminate. This means that the burden of assessing the possible impact of
contingencies and the probabilities of their occurrence is passed to the analyst. Yet,
the analyst assumes that if a contingency (and/or commitment) is sufficiently serious,
the auditor can qualify the audit report.
The analyst, while utilizing all information available, must nevertheless bring his/her
own critical evaluation to bear on the assessment of all existing liabilities and
contingencies to which the company may be subject. This process must draw not
only on available disclosures and reports, but also on an understanding of industry
conditions and practices.
10. a. A lease is classified and accounted for as a capital lease if at the inception of the
lease it meets one of four criteria: (1) the lease transfers ownership of the
property to the lessee by the end of the lease term; (2) the lease contains an
option to purchase the property at a bargain price; (3) the lease term is equal to 75
percent or more of the estimated economic life of the property; or (4) the present
value of the rentals and other minimum lease payments, at the beginning of the
lease term, equals 90 percent of the fair value of the leased property less any
related investment tax credit retained by the lessor. If the lease does not meet any
of those criteria, it is to be classified and accounted for as an operating lease.
With regard to the last two of the above four criteria, if the beginning of the lease
term falls within the last 25 percent of the total estimated economic life of the
leased property, neither the 75 percent of economic life criterion nor the 90
percent recovery criterion is to be applied for purposes of classifying the lease
and as a consequence, such leases will be classified as operating leases.

b. Summary of accounting for leases by lessees:
1. The lessee records a capital lease as an asset and an obligation at an amount
equal to the present value of minimum lease payments during the lease term,
excluding executory costs (if determinable) such as insurance, maintenance,
and taxes to be paid by the lessor together with any profit thereon. However,
the amount so determined should not exceed the fair value of the leased
property at the inception of the lease. If executory costs are not determinable
from provisions of the lease, an estimate of the amount shall be made.
2. Amortization, in a manner consistent with the lessee's normal depreciation
policy, is called for over the term of the lease except where the lease transfers
title or contains a bargain purchase option; in the latter cases amortization
should follow the estimated economic life.
3. In accounting for an operating lease the lessee will charge rentals to expenses
as they become payable, except when rentals do not become payable on a
straight-line basis. In the latter case they should be expensed on such a basis
or on any other systematic or rational basis that reflects the time pattern of
benefits serviced from the leased property.
11. a. The major classifications of leases by lessors are:

1. Sales-type leases
2. Direct financing leases
3. Operating leases
The criteria for classifying each type are as follows: If a lease meets any one of
the four criteria for capitalization (see question 10a above) plus two additional
criteria (see below), it is to be classified and accounted for as either a sales-type
lease (if manufacturer or dealer profit is involved) or a direct financing lease. The
additional criteria are (1) collectibility of the minimum lease payments is
reasonable predictable, and (2) no important uncertainties surround the amount of
unreimbursable costs yet to be incurred by the lessor under the lease. A lease not
meeting these criteria is to be classified and accounted for as an operating lease.
b. The accounting procedures for leases by lessors are:
Sales-type leases
1. The minimum lease payments plus the unguaranteed residual value accruing
to the benefit of the lessor are recorded as the gross investment in the lease.
2. The difference between gross investment and the sum of the present value of
its two components is recorded as unearned income. The net investment
equals gross investment less unearned income. Unearned income is amortized
to income over the lease term so as to produce a constant periodic rate of
return on the net investment in the lease. Contingent rentals are credited to
income when they become receivable.
3. At the termination of the existing lease term of a lease being renewed, the net
investment in the lease is adjusted to the fair value of the leased property to
the lessor at that date, and the difference, if any, recognized as gain or loss.
The same procedure applies to direct financing leases (see below.)
4. The present value of the minimum lease payments discounted at the interest
rate implicit in the lease is recorded as the sales price. The cost, or carrying
amount, if different, of the leased property, and any initial direct costs (of
negotiating and consummating the lease), less the present value of the
unguaranteed residual value is charged against income in the same period.

5. The estimated residual value is periodically reviewed. If it is determined to be
excessive, the accounting for the transaction is revised using the changed
estimate. The resulting reduction in net investment is recognized as a loss in
the period in which the estimate is changed. No upward adjustment of the
estimated residual value is made. (A similar provision applies to direct
financing leases.)
Direct-financing leases
1. The minimum lease payments (net of executory costs) plus the unguaranteed
residual value plus the initial direct costs are recorded as the gross
investment.
2. The difference between the gross investment and the cost, or carrying
amount, if different, of the leased property, is recorded as unearned income.
Net investment equals gross investment less unearned income. The unearned
income is amortized to income over the lease term. The initial direct costs are
amortized in the same portion as the unearned income. Contingent rentals are
credited to income when they become receivable.
Operating leases
The lessor will include property accounted for as an operating lease in the
balance sheet and will depreciate it in accordance with his normal depreciation
policy. Rent should be taken into income over the lease term as it becomes
receivable except that if it departs from a straight-line basis income should be
recognized on such basis or on some other systematic or rational basis. Initial
costs are deferred and allocated over the lease term.
12. Where land only is involved the lessee should account for it as a capital lease if either
of the enumerated criteria (1) or (2) is met. Land is not usually amortized.
In a case involving both land and building(s), if the capitalization criteria applicable to
land (see above) are met, the lease will retain the capital lease classification and the
lessor will account for it as a single unit. The lessee will have to capitalize the land
and buildings separately, the allocation between the two being in proportion to their
respective fair values at the inception of the lease.
If the capitalization criteria applicable to land are not met, and at the inception of the
lease the fair value of the land is less than 25 percent of total fair value of the leased
property both lessor and lessee shall consider the property as a single unit. The
estimated economic life of the building is to be attributed to the whole unit. In this
case if either of the enumerated criteria (3) or (4) is met the lessee should capitalize
the land and building as a single unit and amortize it.
If the conditions above prevail but the fair value of land is 25 percent or more of the
total fair value of the leased property, both the lessee and the lessor should consider
the land and the building separately for purposes of applying capitalization criteria (3)
and (4). If either of the criteria is met by the building element of the lease it should be
accounted for as a capital lease by the lessee and amortized. The land element of the
lease is to be accounted for as an operating lease. If the building element meets
neither capitalization criteria, both land and buildings should be accounted for as a
single operating lease.
Equipment which is part of a real estate lease should be considered separately and
the minimum lease payments applicable to it should be estimated by whatever means
are appropriate in the circumstances. Leases of certain facilities such as airport, bus

terminal, or port facilities from governmental units or authorities are to be classified
as operating leases.
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. The criteria as well as the disclosure requirements embodied in the lease accounting
standard are fairly comprehensive—especially in comparison to most other
standards. Nevertheless, the analyst, mindful of the historical tendencies and
developments in this area, must be alert to the possibility that management, aided by
the seemingly inexhaustible ingenuity of their accountants, lawyers, and other
financial advisers, will attempt to devise ways to circumvent this standard. Under this
standard, companies most capitalize most leases where there is an effective transfer
of substantially all of the benefits and risks of ownership from lessor to lessee. The
effect of these changes will result in the increase of both debt and fixed assets, the
impairment in debt/equity ratios, the reduction in current and acid-test ratios (the
current portion of long-term lease obligations will increase current liabilities) and the
increase of expenses in the early stages of a lease. Because of the requirement that
companies use their "normal” depreciation policies in accounting for the depreciation
of leased property, the income of companies using accelerated depreciation methods
for book purposes are more substantially affected.
The provisions of this standard, which entail assumptions of fair values, selling
prices, salvage/residual values, implicit rates of interest, and incremental borrowing
rates, are not so tight as to preclude substantial distortion in accounting from
manipulation of these relatively "soft" factors. This means the analyst must be alert
and vigilant when analyzing the impact of leases on financial statements.
15. 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.
16. 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.
17. a. Rent expense

b. Interest expense and depreciation expense
18. a. Leasing revenue

b. Interest revenue (and possibly gain on sale in the initial year of the lease)
19. Property, plant, and equipment can be financed by having an outside party acquire
the facilities while the company agrees to do enough business with the facility to
provide funds sufficient to service the debt. Examples of these kinds of arrangements

are through-put agreements, in which the company agrees to run a specified amount
of goods through a processing facility or "take or pay" arrangements in which the
company guarantees to pay for a specified quantity of goods whether needed or not.
A variation of the above arrangements involves the creation of separate entities for
ownership and the financing of the facilities (such as joint ventures or limited
partnerships) which are not consolidated with the company's financial statements
and are, thus, excluded from its liabilities.
Companies have attempted to finance inventory without reporting on their balance

sheets the inventory or the related liability. These are generally product financing
arrangements in which an enterprise sells and agrees to repurchase inventory with
the repurchase price equal to the original sales price plus carrying and financing
costs or other similar transactions such as a guarantee of resale prices to third
parties.
20. a. The accumulated benefit obligation (ABO) is an estimate of the employer's

obligation for pensions based on current and past compensation levels. No
assumption regarding future compensation levels is included and for pension
plans, such as flat benefit plans or those with non-pay related formulas the
accumulated benefit obligation accurately measures the entire or final obligation.
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.
21. 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.
22. 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.
23. 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.

24. 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.
25. 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).
26. 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.
27. 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 unfunded—these are backed by assets under the control of companies rather
than assets in the hands of independent trustees.
28. 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.
29. 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.
30. 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
warranties or product defects, self-insured risks, and possible catastrophe losses
of property and casualty insurance companies.
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 company’s 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.
31. 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 results—the 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).
32. Commitments are potential claims against a company’s 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.
33. 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.
34. 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.
35. 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.
Information about significant concentrations of credit risk from an individual

counter-party or groups of counterparties for all financial instruments is also
required.
These disclosures help financial analysis by revealing existing economic events that
can reduce the relevance and reliability of the balance sheet as reported by
management. With the information in these disclosures, the analyst can revise
his/her personal models to factor in the impact of off-balance-sheet items or
otherwise adjust the analyses for these items.
36. SFAS 140 replaced SFAS 125 and defines new rules for the sale of accounts
receivable to special purpose entities (SPEs). In order to treat the transfer as a sale
(rather than a borrowing), the SPE must be a Qualifying SPE. Otherwise, the SPE
must be consolidated unless third-party investors make equity investments that are,
 Substantive (more than 3% of assets)
 Controlling (e.g., more than 50% ownership)
 Bear the first dollar risk of loss
 Take the legal form of equity
If any of the above conditions is not met, the transfer of the receivable is considered
as a loan with the receivables pledged as security for such loan.
37. Analysts should identify off-balance-sheet financing arrangements and either factor
these arrangements into their models or otherwise adjust the analyses for the
additional risk created by off-balance-sheet financing arrangements.
38. Some equity securities have mandatory redemption provisions that make them more
akin to debt than they are to equity—a typical example is preferred stock. Whatever
their name, these securities impose upon the issuing companies various obligations
to dispense funds at specified dates. Such provisions are inconsistent with the true
nature of an equity security. The analyst must be alert to the existence of such

“equity securities” and examine for substance over form when making financial
statement adjustments.

39. In order to facilitate their understanding and analysis, reserves and provisions can be
redivided into a number of major categories.
The first category is most correctly described as comprising provisions for
obligations that have a high probability of occurrence, but which are in dispute or are
uncertain in amount. As is the case with many financial statement descriptions,
neither the title nor the location in the financial statement can be relied upon as a
rule-of-thumb guide to the nature of an account. The best key to analysis is a
thorough understanding of the business and the financial transactions that give rise
to the account. The following are representative items in this group: provisions for
product guarantees, service guarantees, and warranties that are established in
recognition of future costs that are certain to arise although presently impossible to
measure. Another type of obligation that must be provided for is the liability for
“unredeemed coupons” such as trading stamps. To the company issuing these
coupons, there is no doubt about the liability to redeem them for merchandise or
cash. The only uncertainty concerns the number of coupons that will be presented
for redemption. Consequently, a provision is established for these types of items by a
charge to income at the time products covered by guarantees (or related to these
coupons) are sold—the amount is established on the basis of experience or on the
basis of any other reliable factor.
The second category comprises reserves for expenses and losses, which by
experience or estimates are very likely to occur in the future and that should properly
be provided for by current charges to operations. One group within this category is
comprised of reserves for operating costs such as maintenance, repairs, painting, or
overhauls. Thus, for example, since overhauls can be expected to be required at
regularly recurring intervals, they are provided for ratably by charges to operations to
avoid charging the entire cost to the year in which the actual overhaul takes place.
A third category comprises provisions for future losses stemming from decisions or
actions already taken. Included in this group are reserves for relocations,
replacement, modernization, and discontinued operations.
A fourth category includes reserves for contingencies. For example, reserves for
self-insurance are designed to provide the accumulation against which specific types
of losses, not covered by insurance, can be charged. Although the term
self-insurance contradicts the very concept of insurance, which is based on the
spreading of risks among many business units, it nevertheless is a practice that has a
good number of adherents. Other contingencies provided against by means of
reserves are those arising from foreign operations and exchange losses due to
official or de facto devaluations.
A fifth group of future costs that must be provided for is that of employee
compensation. These costs, in turn, give rise to provisions for vacation pay, deferred
compensation, incentive compensation, supplemental unemployment benefits, bonus
plans, welfare plans, and severance pay. The related category of estimated liabilities
includes provisions for claims arising out of pending or existing litigation.
Of importance to the analyst is the adequacy of the reserves and provisions that are
often established on the basis of prior experience or on the basis of other estimates.
Concern with adequacy of amount is a prime factor in the analysis of all reserves and
provisions, whatever their purpose. Reserves and provisions appearing above the
equity section are almost invariably created by means of charges to income. They are
designed to assign charges to the income statement based on when they are
incurred rather than when they are paid in cash.

40. Reserves for future losses represent a category of accounts that require particular
scrutiny. While conservatism in accounting calls for recognition of losses as they can
be determined or clearly foreseen, companies tend, particularly in loss years, to
over-provide for losses not yet incurred. Such “losses not yet incurred” often involve
disposal of assets, relocations, and plant closings. Overprovision shifts expected
future losses to the present period, which likely already shows adverse results.
One problem with such reserves is that once established there is no further
accounting for the expenses and losses that are charged against them. Only in
certain financial statements required to be filed with the SEC (such as Form 10-K) are
details of changes in reserves required. Recent requirements have, however,
tightened the disclosure rules in this area.
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.
41. 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.
42. 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.
The composition of equity capital is important because of provisions affecting the

residual rights of common equity. Such provisions include dividend participation
rights, and the great variety of options and conditions that are characteristic of the
complex securities frequently issued under merger agreements, most of which tend
to dilute common equity. Analysis of restrictions imposed on the distribution of
retained earnings by loan or other agreements will usually shed light on a company's
freedom of action in such areas as dividend distributions and the required levels of
working capital. Such restrictions also shed light on the company's bargaining
strength and standing in credit markets. Moreover, a careful analysis of restrictive
covenants will enable the analyst to assess how far a company is from being in
default of these provisions.
43. Preferred stock often carries features that make it preferred in liquidation and
preferred as to dividends. Also, it is often entitled to par value in liquidation and can
be entitled to a premium. On the other hand, the rights of preferred stock to dividends
are generally fixed—although they can be cumulative, which means that preferred
shareholders are entitled to arrearages of dividends before common stockholders
receive any dividends. These features of preferred stock as well as the fixed nature of
the dividend give preferred stock some of the earmarks of debt with the important
difference that preferred stockholders are not generally entitled to demand
redemption of their shares. However, there are preferred stock issues that have set
redemption dates and require sinking funds to be established for that purpose—these
issuances are essentially debt.
Characteristics of preferred stock that make them more akin to common stock are
dividend participation rights, voting rights, and rights of conversion into common
stock.
44. Accounting standards state (APB 10): “Companies at times issue preferred (or other
senior) stock which has a preference in involuntary liquidation considerably in
excess of the par or stated value of the shares. The relationship between this
preference in liquidation and the par or stated value of the shares may be of major
significance to the users of the financial statements of those companies and the
Board believes it highly desirable that it be prominently disclosed. Accordingly, the
Board recommends that, in these cases, the liquidation preference of the stock be
disclosed in the equity section of the balance sheet in the aggregate, either
parenthetically or in short rather than on a per share basis or by disclosure in notes."
Such disclosure is particularly important since the discrepancy between the par and
liquidation value of preferred stock can be very significant.

45. This question is answered in a SEC release titled Pro Rata Distribution to
Shareholders:
Several instances have come to the attention of the Commission in which
registrants have made pro rata stock distributions that were misleading. These
situations arise particularly when a registrant makes distributions at a time when its
retained earnings or its current earnings are substantially less than the fair value of
the shares distributed. Under present generally accepted accounting rules, if the
ratio of distribution is less than 25 percent of shares of the same class outstanding,
the fair value of the shares issued must be transferred from retained earnings to
other capital accounts. Failure to make this transfer in connection with a
distribution or making a distribution in the absence of retained or current earnings
is evidence of a misleading 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.
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.
46. Accounting standards requires 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.
47. 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.

EXERCISES
Exercise 3-1 (20 minutes)
a.
Long-term debt [79]
C 39.7 740.3 beg
D 142.3 141.1 A
1.8 B
701.2 end
Current portion of long-term debt [71]

32.3 beg
E 39.1 39.7 C
32.9 end
A = Proceeds from issuance of debt for spin-off [39].

B = Proceeds from long-term debt [42].
C = Reduction of long-term debt to current portion [43].
D = This is the unexplained decrease in long-term debt. Item 142 in Appendix A
describes long-term decrease due primarily to debt spun off with the Fisher Price
business. This implies the unexplained reduction is probably related to the
reduction of assets of discontinued operations.
E = This represents the amount of long-term debt paid in Year 11.
b. According to disclosure in the "Liquidity and Capital Resources" section [item

142] of the MD&A, the issuance of this debt is primarily driven by the
company's common share repurchase program (see also its Note 7).
c. In the current economic environment (prime rate around 8%), only a few of the
debt instruments held by Quaker appear to be candidates for refinancing at a
lower interest rate. Namely, the industrial revenue bonds that yield over 11%
and some of the higher yielding Series B bonds may be candidates for
refinancing.
d. Quaker’s debt levels appear appropriate. At the end of Year 11, the company
has short-term debt and current maturities of long-term debt obligations
totaling approximately $112 million and long-term debt totaling approximately
$700 million. This is less than a third of the total assets of the company.
These debt levels are also in line with similar sized manufacturing companies
in similar industries. At current debt levels, Quaker does not appear to have
any solvency or liquidity concerns. Further, it likely has some financial
flexibility should it identify productive projects that require funding.

a. The economic effects of a long-term capital lease on the lessee are similar to
that of an equipment purchase using installment debt. Such a lease transfers
substantially all of the benefits and risks incident to the ownership of property
to the lessee, and obligates the lessee in a manner similar to that created
when funds are borrowed. To enhance comparability between a firm that
purchases an asset on a long-term basis and a firm that leases an asset under
substantially equivalent terms, the lease should be capitalized.
b. A lessee should account for a capital lease at its inception as an asset and an
obligation at an amount equal to the present value at the beginning of the
lease term of minimum lease payments during the lease term, excluding any
portion of the payments representing executory costs, together with any profit
thereon. However, if the present value exceeds the fair value of the leased
property at the inception of the lease, the amount recorded for the asset and
obligation should be the fair value.
c. A lessee should allocate each minimum lease payment between a reduction of

the obligation and interest expense so as to produce a constant periodic rate
of interest on the remaining balance of the obligation.
d. Von should classify the first lease as a capital lease because the lease term is
more than 75 percent of the estimated economic life of the machine. Von
should classify the second lease as a capital lease because the lease contains
a bargain purchase option.
a. A lessee would account for a capital lease as an asset and an obligation at the
inception of the lease. Rental payments during the year would be allocated
between a reduction in the obligation and interest expense. The asset would
be amortized in a manner consistent with the lessee's normal depreciation
policy for owned assets, except that in some circumstances the period of
amortization would be the lease term.
b. No asset or obligation would be recorded at the inception of the lease.

Normally, rental on an operating lease would be charged to expense over the
lease term as it becomes payable. If rental payments are not made on a
straight-line basis, rental expense nevertheless would be recognized on a
straight-line basis unless another systematic or rational basis is more
representative of the time pattern in which use benefit is derived from the
leased property, in which case that basis would be used.

a. The gross investment in the lease is the same for both a sales-type lease and
a direct-financing lease. The gross investment in the lease is the minimum
lease payments (net of amounts, if any, included therein for executory costs
such as maintenance, taxes, and insurance to be paid by the lessor, together
with any profit thereon) plus the unguaranteed residual value accruing to the
benefit of the lessor.
b. For both a sales-type lease and a direct-financing lease, the unearned interest
income would be amortized to income over the lease term by use of the
interest method to produce a constant periodic rate of return on the net
investment in the lease. However, other methods of income recognition may
be used if the results obtained are not materially different from the interest
method.
c. In a sales-type lease, the excess of the sales price over the carrying amount of
the leased equipment is considered manufacturer's or dealer's profit and
would be included in income in the period when the lease transaction is
recorded.
In a direct-financing lease, there is no manufacturer's or dealer's profit. The

income on the lease transaction is composed solely of interest.

A number of major companies have a meager debt ratio. Still, even when a
company shows little if any debt on its balance sheet, it can have considerable
long-term liabilities. This situation can reflect one or more of several factors such
as the following:
Lease commitments, while detailed in notes, are not recorded in the balance
sheets of many companies. This could be a critical problem for companies that
have expanded by leasing rather than buying property. These lease
commitments, while reflecting different attributes of pure debt, are just as surely
long-term obligations.
Many companies have very large unfunded postretirement liabilities. These often
are not recorded on the balance sheet, but are disclosed in the notes. At one
time, a case could have been made that such obligations were not a problem, for
as long as the business operated, payments would be made, and if it went
bankrupt, the liability would end. Now, under most laws, the company has a real
long-term obligation to employees.
Several companies guarantee the debt of another company. The most typical is a
nonconsolidated lease subsidiary. Although disclosed in the notes, this debt,
which is real and can be large, is not recorded on the parent's balance sheet.
Off-balance-sheet debt—such as industrial revenue bonds or pollution control

financing where a municipality sells tax-free bonds guaranteed for payment—are
cases where a supposedly debt-free balance sheet could look much worse if
these obligations were recorded.
Finally, the practice of deferred taxes—such as taking some expenses for tax, but
not book purposes, or through differences in timing for recognition of sales—is
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)

a. An estimated loss from a loss contingency is accrued with a charge to income

if both of the following conditions are met:
 Information available prior to issuance of the financial statements indicates
that it is probable that an asset had been impaired or a liability had been
incurred at the date of the financial statements. It is implicit in this
condition that it must be probable that one or more future events will occur
confirming the fact of the loss.
 The amount of loss can be reasonably estimated.
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.
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.
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.

[Note: Unless otherwise indicated, much of the information to answer this exercise can
be found in item [68] of Campbell’s financial statements.]
a. The causes of the $101.6 million increase are identified in the table below (see
Campbell’s Consol. Statement of Owners’ Equity and Changes in Number of
Shares):
Millions 11
10
Net Income............................................................ $401.5 $ 4.4 (28)
Cash Dividends..................................................... (142.2) (89) (126.9) (87)
Treasury Stock Purchase..................................... (175.6) (41.1) (87)
Treasury Stock Issued
Capital Surplus................................................ 45.4 (91) 11.1 (87)
Treasury Stock................................................ 12.4 (91) 4.6 (87)
Translation Adjustment........................................ (29.9) (92) 61.4 (87)
Sale of foreign operations................................... (10.0) (93)
Increase in Stockholders' Equity........................ 101.6a (86.5)b

a b
1,793.4 [54] 1,691.8 [54]
- 1,691.8 1,778.3 [87]
101.6 (86.5)
b. The average price for treasury share purchases is computed as:

[($175.6 million1 / 3.395 million treasury shares purchased)] = $51.72
1
Treasury stock purchases from Statement of Cash Flows and Statement of Shareholders’
Equity
c. Book Value per Share of Common Stock is computed as:

[$1,793.4 [54] / 127.0* ] = $14.12
*135.6 [49] - 8.6 [52] – note: There is no preferred stock outstanding

(Note: This value equals the company's computed amount [185] of $14.12.)
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 company’s
stock.

a. The changes in shareholders’ equity for Quaker in Years 11 and 10 are

attributed to the following transactions and events:
11 10
Stockholders' Equity (6/30) [91]..................................... 901.0 1,017.5

Stockholders' Equity (7/1) [91]....................................... 1,017.5 1,137.1
Decrease in Shareholders' Equity................................. (116.5) (119.6)
Net Income [11]................................................................ 205.8 169.0
Cash Dividend paid [38]................................................. (123.0) (110.5)
Common stock issued for Stock Purchase and
Incentive Plan [113] [104].......................................... 28.2 16.1
Repurchases of Common Stock [105].......................... -- (223.2)
Translation Adjustments [114] [106].............................. (23.6) 27.3
Distribution of Equity to Shareholders from spin-off
of Fisher-Price [112] ................................................. (200.0) --
Deferred Compensation [115] [107] .............................. (3.9) 1.7
Change Account for........................................................ (116.5) (119.6)
b. Book value of common stock

901,000,000a / 76,328,721b = $11.80 [130]
Book value of preferred stock

4,800,000c / 1,271,962d = $3.77
a
Total common stockholders' equity [91]
b
Common shares outstanding (issued [85] - treasury [90])
c
Preferred stock (net of deferred compensation) [82-83-84]
d
Shares outstanding (issued [82] - treasury [84])
c. Details regarding the preferred stock are included in note 8 to Quakers

financial statements. The Deferred Compensation account relates to an
employee stock ownership plan. According to note 20 to the financial
statements, Quaker’s stock traded between $55.13 and $64.88 during the last
quarter of Year 11. Investors apparently have high expectations regarding
future profitability that are not reflected in its book value per share.

a. A "secret reserve" is created when stockholders' equity is understated.

Generally, such reserves, often called hidden assets, are created or enlarged
by practices that understate assets and/or overstate liabilities. Such practices
often result from the application of the accounting convention or principle of
conservatism.
b. Both of the practices cited tend to cause assets to be stated at lower amounts
than would be the case with other acceptable alternatives. The use of LIFO
during a period of steadily rising prices tends to cause the inventory cost to
be stated in terms of prices that prevailed when the method was adopted.
When such prices are compared to current prices they are low; hence income
and stockholders' equity are correspondingly low. The expensing of all human
resource costs as they are incurred, in effect, denies that such costs have
produced any future benefits. To the extent that such expenditures produce
future benefits, a portion of the costs should be capitalized as intangible
assets. "Secret reserves" exist to the extent that assets have been
understated by the expensing of all human resource costs immediately.
c. It is not impossible to create a "secret reserve" by overstating liabilities. This

could most readily occur in recording estimated liabilities such as for product
warranties or pensions at amounts in excess of actuarially determined
amounts or for the restoration of property at the termination of a lease. Any
such overstatement of the ultimate liability overstates current expenses and
thereby understates stockholders' equity. A "secret reserve" also would exist
when a firm has long-term, fixed interest debt outstanding during periods
when interest rates are increasing and much higher than on the debt.
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.

Exercise 3-10—continued
continued… 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.
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)

a. The principal transactions and events that reduce the amount of retained
earnings include the following:
1. Operating losses (including extraordinary losses and other debit
adjustments).
2. Stock dividends.
3. Dividends distributing corporate assets such as cash or in-kind.
4. Recapitalizations such as quasi-reorganizations.
b. The principal reason for making the distinction between contributed capital and
retained earnings (earned capital) in the stockholders' equity section is to enable
stockholders and creditors to identify dividend distributions as actual
distributions of earnings or as returns of capital. This identification also is
necessary to comply with most state statutes that provide that there should be no
impairment of the corporation's legal or stated capital by the return of such
capital to owners in the form of dividends. This concept of legal capital provides
some measure of protection to creditors and imposes a liability upon the
stockholders in the event of such impairment.
Knowledge of the distinction between contributed capital and earned capital
provides a guide to the amount of dividends that can be distributed by the
corporation. Assets represented by the earned capital, if in liquid form, may
properly be distributed as dividends; but invested assets represented by
contributed capital should ordinarily remain for continued operation of the
corporation. If assets represented by contributed capital are distributed to
shareholders, the distribution should be identified as a return of capital and,
hence, is in the nature of a liquidating dividend. Knowledge of the amount of
capital that has been earned over a period of years after adjustment for dividends
also is of value to stockholders in judging dividend policy and obtaining an
indication of past profits to the extent not distributed as dividends.
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."

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:
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.

Exercise 3-12—continued
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).
a. These cash distributions are not dividends. Instead, they are returns of
capital. Dividends are distributions of past earnings of the company. Since
this company has not earned any net income, there are no retained earnings
from which dividends could be paid. Thus, these cash distributions are being
made from capital previously contributed to the company by the owners.
b. There are at least a couple of reasons why a return of capital might be made.
First, the company may be going out of business. Second, in a closely held
company, influential owners may have mandated the payments. A distribution
of capital is usually the result of special circumstances confronted by a
company.
a. Purchasing its own shares is similar to the payment of dividends in that cash
assets are reduced in both situations. That is, in each case, the company is
distributing cash to shareholders. In the case of dividends, all shareholders
are receiving cash in a proportionate manner. In the case of share
repurchases, only selected shareholders receive cash distributions from the
company.
b. Managers might prefer to purchase its own company’s shares because this
serves to increase financial performance measures such as earnings per
share and return on shareholders equity.
c. Investors are taxed on dividends received from companies. The tax rate on
dividends is often quite high. Investors also are taxed on gains on the sale of
shares. Thus, investors often would prefer that companies buy back shares
rather than pay a dividend. In this way, investors that are happy with the
performance of the company can maintain or increase their ownership (it can
increase as a percent of the total). Investors that would like to reduce their
investment in the company can choose to do so by selling shares back to the
company pursuant to the offer of the company to repurchase shares. Also,

the gain on sale of stock by investors is usually taxed at a lower rate than
dividends.

a. Defined contribution plans are not affected by variables such as stock market
performance and employee tenure and life span. As a result, pension expense
and liability associated with defined contribution plans is more predictable
and less variable than are pension expense and liability associated with
defined benefit plans.
b. If managers can attract adequate talent with defined contribution plans, they
would prefer the defined contribution plans because of the predictability of
and less volatility associated with pension expense.
c. Defined contribution plans place the investment risk on the employee whereas
defined benefit plans place the risk on the company. Under a defined
contribution plan, the company pays a defined contribution into the
employees’ pension plan and then the employee invests the assets according
to their tolerance for risk and investment strategy. Thus, employees with a
low tolerance for risk might prefer the defined benefit plan because they
would not have to bear any of the investment risk. Conversely, employees
with a high tolerance for risk might prefer the defined contribution plan
because they might feel that they can invest the funds better and reap higher
benefits at retirement.
a. Two major accounting challenges resulting from the use of a defined benefit
pension plan are:
 Estimates or assumptions must be made concerning the future events that
will determine the amount and timing of benefit payments.
 Some method of attributing the cost of pension benefits to individuals’
years of service must be selected.
These two challenges arise because a company must recognize pension costs
before it pays pension benefits.
b. Carson determines the service cost component of the net pension cost as the
actuarial present value of pension benefits attributable to employee services
during a particular period based on the application of the pension benefit
formula.
c. Carson determines the interest cost component of the net pension cost as the
increase in the projected benefit obligation due to the passage of time.
Measuring the projected benefit obligation requires accrual of an interest cost
at an assumed discount rate.
d. Carson determines the actual return on plan assets component of the net
pension cost as the change in the fair value of plan assets during the period,
adjusted for (1) contributions and (2) benefit payments.

a. 1. The overall size of the post-retirement benefit obligation to be recognized

by the more labor-intensive firm (Firm L) will be larger than for the other
firm (Firm O) because it has a higher ratio of retirees to active employees,
possesses an older work force, and has a strong union. The more labor-
intensive nature of Firm L implies a larger number of future retirees to
provide for and thus a larger obligation. The higher ratio of retirees to
active employees would imply that Firm L, as the current older work force
retires, a greater obligation will be incurred. Firm L has a stronger union
than Firm O, which does not have a direct effect on the size of an
obligation under the present plan, but it may make it more difficult to
undertake "containment measures" such as a reduction in benefits that
would affect the size of any future obligation.
2. The overall size of the post-retirement benefit cost reported by Firm L will
be greater. Since Firm L is more labor intensive, this implies a larger
number of future retirees and thus a greater annual cost. The older work
force of Firm L suggests that more of its employees are nearing retirement
and their eligibility for benefits. Thus, the present value of benefits earned
in the current year (service cost) is likely to be higher for Firm L. Although
the stronger unionization of Firm L does not have a direct bearing on
current costs, it will be more difficult for Firm L to undertake "containment
measures" such as reduction in benefits which would affect the costs at
some later date.
b. The efficient market hypothesis has three forms: the weak, semi-strong, and
strong form. (1) The weak form refers only to historical trading data. As
accounting changes do not change such data, but they will change reported
net income, the new plans may have an impact on stock prices probably
causing them to decline. (2) The semi-strong form applies to publicly
available data. The new standard is public knowledge, but the exact impact on
the financial statements can only be estimated. To the extent that these
estimates are accurate, adoption of the plans will not affect stock prices since
it is already fully reflected in the stock prices. Adoption would affect stock
prices to the extent that the estimates fail to reflect non-public information.
Only the "surprise" part of the accounting impact will affect stock prices. (3)
Under the strong form, all information is fully reflected in stock prices, and
adoption of the plans will not have an effect on stock prices.
Under the circumstances, the semi-strong form appears to be most applicable

to the adoption of postretirement plans. Estimates for these plans are readily
available. If the estimates are accurate, then adoption of the accounting
should have no effect on stock prices. Inaccurate estimates would have an
effect on stock prices, as the new information becomes available.

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.]
b. This amount represents repayment of principal along with interest—it is also

equal to the present value of the future principal and interest payments,
discounted at the interest rate in effect at the time of issuance. Cash outflows
will mimic the principal repayment and interest payment schedules per the
debt contract(s).
c. The $28 million amount will be paid out. This amount will include $6.5 million
of interest implicit in the leases.
d. This is reported in the notes—Note 10 to the financial statements (the Lease

footnote). The lease payments will be expensed as they occur over the years.
e. The company paid an average interest rate of 11.53% on the beginning balance
of interest-bearing debt [($116.2 /($202.2 + $805.8)]. The debt structure did not
change substantially during Year 11. At the beginning of Year 12, the company
has interest bearing debt totaling $1,054.8 ($282.2 + $772.6). The relative mix
of debt has not changed substantially. Thus, it is reasonable to predict
interest expense by multiplying this beginning balance by the 11.53% average
rate experienced in the previous year. Therefore, the interest expense
projection is $121.6 million. (Note that the short-term debt is a bit larger in
percent of the total debt burden so the company may pay an average interest
amount of slightly less than the 11.53% paid in the previous year.)

a. 1/1/Year 1 Enter into Lease Contract:

Leased Property under Capital Leases ........................ 39,930
Lease Obligation under Capital Leases..................
39,930
12/31/Year 1 Payment of Rental:

Interest on Leases .......................................................... 3,194.40 (1)
Lease Obligations under Capital Leases ..................... 6,805.60
Cash ...........................................................................
10,000
Amortization of Property Rights:

Amor. of Leased Property under Capital Leases ........ 7,986 (2)
Leased Property under Capital Leases .................. 7,986
(1) $39,930 x .08 = $3,194.40

(2) $39,930  5 = $7,986
b.
Balance Sheet
December 31, Year 1
ASSETS LIABILITIES
Leased property under Lease Obligations under
capital leases…………… $31,944 (1) capital leases……. $33,124.40
(2)
Income Statement
For Year Ended December 31, Year 1
Amortization of leased property .................................................. $ 7,986.00
Interest on leases........................................................................... 3,194.40
Total lease-related cost for Year 1 ............................................... $11,180.40 (3)
(1) $39,930 - $7,986 = $31,944

(2) $39,930 - $6,805.60 = $33,124.40
(3) To be contrasted to rental costs of $10,000 when no capitalization takes place.

Problem 3-2—continued
c.
Payments of Interest and Principal

Total Interest Payment of Principal
Year Payment at 8% Principal Balance
$39,930.00
1 10,000 $3,194.40 $6,805.60 33,124.40
2 10,000 2,649.95 7,350.05 25,774.35
3 10,000 2,061.95 7,938.05 17,836.30
4 10,000 1,426.90 8,573.10 9,263.20
5 10,000 736.80 9,263.20
$50,000 $10,070.00 $39,930.00 —
d.
Expenses to Be Charged to Income Statement

Lease Total
Year Expense Amortization Interest Expenses
1 $10,000 $ 7,986.00 $ 3,194.40 $11,180.40
2 10,000 7,986.00 2,649.95 10,635.95
3 10,000 7,986.00 2,061.95 10,047.95
4 10,000 7,986.00 1,426.90 9,412.90
5 10,000 7,986.00 736.80 8,722.80
$50,000 $39,930.00 $10,070.00 $50,000.00
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.

a. A lease should be classified as a capital lease when it transfers substantially

all of the benefits and risks inherent to the ownership of property by meeting
any one of the four criteria for classifying a lease as a capital lease.
Specifically:
 Lease J should be classified as a capital lease because the lease term is
equal to 80 percent of the estimated economic life of the equipment, which
exceeds the 75 percent or more criterion.
 Lease K should be classified as a capital lease because the lease contains
a bargain purchase option.
 Lease L should be classified as an operating lease because it does not
meet any of the four criteria for classifying a lease as a capital lease.
b. Borman records the following liability amounts at inception:

 For Lease J, Borman records as a liability at the inception of the lease an
amount equal to the present value at the beginning of the lease term of
minimum lease payments during the lease term, excluding that portion of
the payments representing executory costs such as insurance,
maintenance, and taxes to be paid by the lessor, including any profit
thereon. However, if the amount so determined exceeds the fair value of
the equipment at the inception of the lease, the amount recorded as a
liability should be the fair value.
 For Lease K, Borman records as a liability at the inception of the lease an
amount determined in the same manner as for Lease J, and the payment
called for in the bargain purchase option should be included in the
minimum lease payments.
 For Lease L, Borman does not record a liability at the inception of the
lease.
c. Borman records the MLPs as follows:

 For Lease J, Borman allocates each minimum lease payment between a
reduction of the liability and interest expense so as to produce a constant
periodic rate of interest on the remaining balance of the liability.
 For Lease K, Borman allocates each minimum lease payment in the same
manner as for Lease J.
 For Lease L, Borman charges minimum lease (rental) payments to rental
expense as they become payable.
d. From an analysis viewpoint, both capital and operating leases represent

economic liabilities as they involve commitments to make fixed payments. The
fact that companies can structure leases as "operating leases" to avoid
balance sheet recognition is problematic from the perspective of analysis of
assets. If the leased assets are used to generate revenues, they should be
considered in ratios such as return on assets and other measures of financial
performance and condition.

a. Detachable stock purchase warrants are equity instruments that have a

separate fair value at the issue date. Consequently, the portion of the
proceeds from bonds issued with detachable stock purchase warrants
allocable to the warrants should be accounted for as paid-in capital. The
remainder of the proceeds should be allocated to the debt portion of the
transaction. This usually results in issuing the debt at a discount (or,
occasionally, a reduced premium).
b. A serial bond progressively matures at a series of stated installment dates, for

example, one-fifth each year. A term (straight) bond completely matures on a
single future date.
c. If a bond is issued at a premium, interest expense and the carrying value of

the debt will decrease over the life of the bond as the premium is amortized
towards zero. If a bond is issued at a discount, interest expense and the
carrying value of the debt will increase over the life of the bond as the
discount is amortized towards zero. In each case, the carrying value of the
debt is the face value of the debt at the maturity date (plus or minus any
premium or discount).
d. The gain or loss from the reacquisition of a long-term bond prior to its
maturity is the difference between the amount paid to settle the debt and the
carrying value of the debt. The gain or loss should be included in the
determination of net income for the period reacquired and, if material,
classified as an extraordinary item, net of related income taxes.
e. Accounting standards require many useful bond-related disclosures

including: amounts borrowed, interest rates, due dates, encumbrances,
restrictive covenants, and events of default. While bonds are reported at their
fair value at the date of issuance, subsequent changes in fair value are not
recognized on the balance sheet. If the analyst is interested in the fair value of
a firm’s bonds, the analyst must examine the note disclosures and make
appropriate adjustments to market.
(AICPA Adapted)

a. The 11% term bonds are sold at a discount (less than face value) because the
effective annual interest rate (yield) of 12% is higher than the stated interest
rate of 11%. The bonds provide for the payment of interest of 11%; however,
this rate is less than the prevailing or market rate for bonds of similar quality
at the time of issuance. Therefore, the market value of the bonds at the date of
sale must be less than face value so that investors receive the effective annual
interest rate (yield) on their investments.
b. There are three major items in connection with this bond issuance:
(1) In a balance sheet prepared immediately after the term bond issue is sold,
a noncurrent liability, titled term bonds payable, is reported at an amount
equal to the face value of the bonds less the entire discount. At December 31,
Year 5, a noncurrent liability, titled term bonds payable, is reported in the
balance sheet at the face value of the bonds, less the remaining unamortized
discount. This means, for example, that the amortization of bond discount for
November and December of Year 5 increases the amount of term bonds
payable reported, net of discount.
(2) The bond issue costs incurred in preparing and selling the bond issue can
be presented in one of three ways in a balance sheet prepared at the time the
term bond issue is sold. The alternatives are:
 Noncurrent asset (Deferred charge)
 Reduction of the noncurrent liability (Term bonds payable)
 Not presented in balance sheet (expensed as incurred in Year 5)
At December 31, Year 5, the bond issue costs are presented in one of three
ways that depend on how they were initially recorded:
 If the bond issue costs were presented in the balance sheet as a
noncurrent asset, deferred charge, the amortization of bond issue costs for
November and December of Year 5 would decrease the amount of the
deferred charge.
 If the bond issue costs were presented in the balance sheet as a reduction
of the noncurrent liability, term bonds payable, the amortization of bond
issue costs for November and December of Year 5 would increase the
amount of the term bonds payable, net of discount.
 If the bond issue costs were expensed as incurred in Year 5, there would
be no effect from the date that the term bond issue was sold to December
31 of Year 5.
(3) A current liability, accrued interest payable, would be presented in a

balance sheet prepared immediately after the term bond issue is sold for the
accrued interest received for October of Year 5. At December 31 of Year 5, the
accrued interest payable would include accrued interest received for October
of Year 5 and the accrued interest for November and December of Year 5.

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)
a. There are several reasons why Superior Oil stock might sell for more than
Getty stock. One obvious factor to examine is whether, for a given amount of
shareholders' equity, there are fewer shares issued and outstanding for
Superior Oil.
b. It is not possible to reach any conclusions about relative profitability simply

by looking at the stocks’ selling prices. To determine profitability, information
about earnings and dividends per share would need to be known.
c. In terms of absolute amounts, Superior Oil had the greatest price rise, $21
compared to Getty's $2 increase. However, Getty Oil had the greater relative
increase, 3.2 percent compared to 1.4 percent for Superior Oil. For
shareholders, the relative increase is generally more important than the
absolute increase (because an investor can easily choose where to invest
his/her monies), so the Getty Oil shareholders benefited more than those of
Superior Oil did for the same amount of money invested.
d. There would be no effect on the equity of stockholders as reported on the

Getty Oil Company's balance sheet (or any other of its financial statements).
The only change would be the change of the shareholders' names in the
corporate records maintained to keep track of share ownership and dividend
payments.

a. Ratio calculations for Jerry’s Department Stores (JDS) and Miller Stores (MLS)
1. Price-to-book ratio:
Ratio JDS MLS
Book value = $6,000 / 250 shares = $7,500 / 400 shares

= $24.00 = $18.75
Price/book value = $51.50 / $24.00 = $49.50 / $18.75

= 2.15 = 2.64
2. Total debt to equity ratio:

Ratio JDS MLS
Total debt to equity = $0 + 2,700 / $6,000 =$1,000 + $2,500 / $7,500

[Total debt = (S-T debt
+ L-T debt)] / Equity = $2,700 / $6,000 = $3,500 / $7,500
= 45.00% = 46.67%
3. Fixed-asset utilization (turnover):

Ratio JDS MLS
Sales / fixed assets = $21,250 / $5,700 = $18,500 / $5,500

= 3.73 = 3.36
b. Investment Choice and Justification Based on Part A
Based on Westfield’s investment criteria for investing in the company with the
lowest price-to-book ratio (P/B) and considering solvency and asset utilization
ratios, JDS is the better purchase candidate. The analysis justification
follows:
Ratio JDS MLS Company Favored
i. Price-to-book ratio (P/B) 2.15 2.64 JDS: lower P/B
ii. Total debt to equity 45% 47% JDS: lower debt or

ratios are very similar
iii. Asset turnover 3.73 3.36 JDS: higher turnover

c. Investment Choice and Justification Based on Note Information
Note: Details underlying the Balance Sheet Adjustments ($ millions):
JDS:
i. Leases – recognition of MDS’s present value lease payments will add $1,000 to
JDS’s property, plant, and equipment (PP&E) and is offset by a $1,000 addition
to JDS’s long-term debt.
ii. Receivables – recognition of JDS’s sale of receivables with recourse will
increase assets (accounts receivable) by $800 and short-term debt used to
finance accounts receivable by $800.
MLS:
iii. Pension – recognition of current excess funding for the pension plan will add
$1,600 to assets and $1,600 to owners’ equity ($3,400 plan assets - $1,800
projected benefit obligation).
Adjusted Calculations Made ($ millions):

JDS:
Needed adjustments:
Assets Liabilities
(PP&E) (Long-term debt [LTD])
+$1,000 +$1,000
(Accounts receivable) (Short-term debt [STD])
+$800 +$800
i. 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
ii. Adjusted total debt-to-equity ratio:
$2,700 Historical LTD
+1,000 LTD
+ 800 STD
$4,500 Adjusted total debt
Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%
iii. Fixed-asset utilization (turnover) =
$5,700 Historical fixed assets
+1,000 PP&E (JDS leases)
$6,700 JDS adjusted fixed assets
Adjusted fixed-asset utilization (sales/adjusted fixed assets):
$21,250 / $6,700 = 3.17
MLS:
Needed adjustments:
Assets Owner’s Equity
(Pension) +$1,600 +$1,600
i. Book value per common share:

$7,500 historical equity + $1,600 = $9,100
Adjusted equity; thus,
$9,100 / 400 million shares = $22.75 adjusted book value per share
ii. Adjusted total debt-to-equity ratio:
Adjusted debt (no adjustments) / Adjusted equity = Adjusted debt / equity
$3,500 / $9,100 = 38%
iii. Fixed-asset utilization (turnover):
Sales / Fixed assets (no adjustments)
$18,500 / $5,500 = 3.36

Part c continued:
Summary of Adjustments:
Ratio JDS MLS
Adjusted book value $24.00 $22.75
Adjusted debt to equity 75% 38%
Fixed-asset utilization 3.17 3.36
Final Results of Analysis:
Based on Westfield’s investment criteria of investing in companies with low

adjusted Price-to-Book and considering the adjusted solvency and asset
utilization ratios, MLS is the better purchase candidate. The analysis
justification follows:
Ratio JDS MLS Company favored
i. Price to adjusted book 2.15a 2.18b approximately equal
ii. Adjusted debt to equity 75% 36% MLS – lower adjusted debt to
equity
iii. Fixed-asset utilization 3.17 3.36 MLS – higher asset utilization
a
$51.50 / $24.00 = 2.15.
b
$49.50 / $22.75 = 2.18.

a. In the case of environmental liabilities, there are several unknowns that are
especially difficult to predict. The unknowns relate to the clean up and to the
lawsuits that result from the hazardous waste. Specifically:
 The company cannot predict the timing of an environmental tragedy such
as that which occurred in the Union Carbide factory.
 The company doesn’t know if it will be identified as a potentially
responsible party in a yet uncovered hazardous waste site. This can
include a former site of the company.
 If the company is identified as a potentially responsible party, we do not
know the portion of the clean up costs that it will be required to pay.
 The company doesn’t know what costs would be incurred in the actual
clean up of the site.
 The company needs to determine which internal costs should be included
in the cost of the clean up. For example, if it uses its laborers for site clean
up activities, the direct cost of labor can become a part of the overall cost
of cleanup.
 The company must guess whether lawsuits will be filed against the
company related to the hazardous waste site.
 The company must estimate the probability of loss or settlement in the
lawsuit and the amount of the damages to be paid
b. We must factor the possibility of catastrophic environmental loss into the

pricing of the company. For some industries, the probability assigned to
occurrence might be very small. Thus, we will not assign a large weighting
factor. However, in some industries, the base-line probability can be
significant. In addition, we will update these probabilities based on additional
information. For example, after the Bhopal tragedy, analysts discounted the
valuations of key competitors. This indicates that analysts revised their
beliefs about the possibility of loss upwards from earlier estimations. In
classic valuation models, an analyst can reflect this risk in the discount factor
applied to future earnings or future cash flows.
c. Some industries especially predisposed to environmental risks include: oil

producers, chemical manufacturers, tobacco producers, insulation
manufacturers and distributors, medical firms, bio-tech firms.

a. The service cost of $22.1 million for Year 11 is the present value of actuarial
benefits earned by employees in Year 11.
b. Year 11: Discount rate = 8.75%
Year 10: Discount rate = 9.00%
A higher discount rate will lead to a lower present value of service cost. In this
case, with the reduction in discount rate from 9% to 8.75%, the service cost is
increased.
c. The interest cost is computed by multiplying the projected benefit obligation
(PBO) as of the end of the prior year by the discount rate of 8.75%.
d. The actual return on assets in Year 11 is $73.4 million [113]. It consists of
investment income plus the realized or unrealized appreciation or depreciation of
plan assets during the year. The expected return on plan assets is computed by
multiplying the expected long-term rate of return (9%) on plan assets by the
market value of plan assets at the beginning of the period or $773.9 million [120].
This means the expected return is $69.65 million (computed as $773.9 x 9%).
The actual return subjects pension cost to more fluctuation from volatility in the
financial market—and, accordingly, increasing volatility in the annual pension
cost. As a result, expected return is used in determining pension expense. The
difference between actual and expected return will be amortized over an
appropriate period.
e. Accumulated benefit obligation (ABO) is the employer's obligation to
employees' pension based on current and past compensation levels rather
than future levels. Therefore, it could amount to the employer's current
obligation if the plan were discontinued presently.
f. The projected benefit obligation (PBO) is the employer's obligation to
employees' pension based on future compensation level. The difference
between PBO and ABO is due to the inclusion of a provision of 5.75% increase
in future compensation level by PBO. In Year 11, the difference between PBO
and ABO is $113.3 million [120].
g. Yes; indeed, there is prepaid pension expense of $172.5 million in Year 11
[120].
Note: the text problem omits the Year 6 service cost of $586.
Periodic pension cost computation ($ millions):
Service Cost ($586 x 1.10)................................................................................ $645
Interest Cost (PBO x Discount Rate = $2,212 x 0.085).................................. 188
Return on plan assets ($3,238 x 0.115)........................................................... (372)
Amortization of deferred loss ($48 / 30 years)............................................... 2
Amortization of transition asset...................................................................... (19)
Periodic pension cost ...................................................................................... $444

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 non-
vested 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%.

a. Kodak's major categories of liabilities are payables, short term borrowings,

deferred taxes, long-term borrowings, postemployment obligations, and other
long-term liabilities. The interest-bearing items are the short-term
borrowings, and the long-term borrowings.
b. Long-term borrowings totaled $1,314 million at the beginning of 2001 and

finished the year at $1,822 million, which represents an increase of $508
million. The majority of the increase is attributable to newly issued notes.
c. The fair value of the noncurrent portion of Kodak's long-term borrowings at

the end of 2001 is $1,664 million compared with a book value of $1,666. Market
values of debt will vary inversely with the levels of interest rates, resulting in
unrecognized gains or losses.
d. Kodak has a shelf registration that allows it to issue $1.35 billion additional
debt securities. It is unlikely that Kodak would issue all of these debt
securities.
e. The other long-term borrowings consist of deferred compensation payable to

employees totaling $164 million, a minority interest in Kodak totaling $84
million, environmental liabilities totaling $162 million, deferred income taxes
totaling $81 million, and various other obligations totaling $229 million.
f. Kodak's contingencies are classified by the company as environmental

contingencies and other contingencies. The environmental contingencies
relate to pollution prevention, waste treatment and disposal, and remediation
to injured parties. Future outlays not recorded on the balance sheet include
unrecorded contingent obligations related to identified and not yet identified
environmental liabilities, minimum lease payments on operating leases,
payments pursuant to debt guarantees, and other losses.

a. Kodak reports a pension asset (prepaid pension cost) totaling $482 million
(U.S.) and $164 million (non-U.S.) and $325 million (U.S.) and $118 million
(non-U.S.) for the years 2001 and 2000, respectively.
b. Kodak's U.S. pension plan is over funded by $660 million and $1,760 million at
the end of 2001 and 2000, respectively. Kodak's non-U.S. pension plan is
under funded by $157 million and over funded by $74 million at the end of
2001 and 2000, respectively. Kodak's OPEB obligation is $3.046 billion and
$2.602 billion at the end of 2001 and 2000 respectively. Both of these OPEB
amounts are unfunded.
The balance sheet can be restated to reflect these additional obligations. For
example, the effect of this adjustment on the debt to assets ratio is shown
below:
Unadjusted
($10,468 /$13,362) = 78.3%
Adjusted
[($10,468 +$3212 + $6563) / $(13,362+178 1] = 84.5%
1
U.S. pension plan-Funded status of $660 versus reported asset of $482.
2
Non-U.S. plan - Funded status of ($157 million) versus reported asset of $164 million.
3
OPEB: Funded status of $(3,046) versus reported liability of $(2,390).
c. Economic Deferred Amortized Reported

2001 U.S. Pension Cost:
Service cost 94 94
Interest cost 406 406
Return on assets 4181 1017 (599)2
Actuarial (gain) losses 182 182 0 0
Prior service cost 0 1 1
Transition asset 0 0 (59) (59)
Net pension cost 11003 1199 (58) (157)4
1
Actual loss
2
Reported gain
3
Economic cost (expense)
4
Reported income
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.
d. The key actuarial assumptions made by Kodak appear reasonable and are in
line with comparably sized firms in comparable industries. Kodak does not
appear to be using the pension plan to manage its earnings.

a. Book value of common stock is equal to total assets less liabilities and claims
of securities senior to the common stock (e.g., preferred stock) at amounts
reported on the balance sheet. Book value can also be reduced by
unrecorded claims of senior securities.
2001 Analysis:
Book value = ($13,362 - $10,468) = $2,894
Number of shares outstanding = 290.929701 million
Book value per share = $9.95
Market price per share = $29.43
Price-to-book ratio = 2.96
Inference: Since the market price is greater than the book value of the
company, the market expects residual income to be positive.
b. Kodak issued shares of common stock under employee stock plans. The
share issue price for 2001 is calculated as follows: [($57 million proceeds at
issuance / 1.393105 million shares issued) = $40.92 per share]. Shares
originally costing Kodak $82 million to purchase were issued at a sales price
of $57 million. Hence, the reduction of additional paid in capital.
c. The par value of Kodak’s common shares is $2.50. Its details follow:
(in millions) 2001 2000
Authorized 950 950
Issued 391.3 391.3
Outstanding 290.9 290.5
d. 2001 2000 1999

d Common shares purchased (mil) .947 21.575 13.482
Average share repurchase price $43.291 $50.94 $68.61
1
[$41 million / .94767 million]

a. Ratio Analysis
AMR Delta UAL
Year 8 Year 7 Year 8 Year 7 Year 8 Year 7
Liquidity
Current ratio 0.865 0.895 0.735 0.702 0.513 0.562
Solvency
Total debt to equity 2.330 2.356 2.630 3.237 4.657 5.617
Long-term debt to equity 1.488 1.459 1.492 1.879 2.929 3.371
Times interest earned 6.817 4.867 9.310 7.509 4.463 6.220
Return on Investment
Return on total assets 7.17% 8.18% 6.21%
Return on equity 20.23% 28.17% 29.23%
Note: We treat preference share capital as debt and include preference dividend with interest.
All three companies appear to be in poor liquidity position. UAL’s liquidity is

especially troubling. From a balance sheet perspective, all companies show
an excess of creditor financing in their capital structure. Once again, UAL is
the most worrisome with total debt (long-term debt) at 4.66 (2.93) times equity.
Still, these ratios seem to be improving over this short time period.
All three companies are profitable. The ROA is respectable and the ROE is
extremely good—ROE is much higher than ROA partly because of extreme
leverage. Because of good profitability, all companies seem to be in a good
position to pay interest expenses, despite high debt-to-equity ratios.
Overall, the three companies (in particular UAL) reveal higher than usual
liquidity and solvency risk. Although the high profitability (at least at present)
appears to mitigate these risks to a large extent.
b. Sensitivity Analysis
The sensitivity analysis examines the impact of both a 5% and a 10% drop in
revenues on the profitability and key ratios of these companies. We assume that 25%
of operating expenses are variable (75% are fixed). Recast income statements
appear below:
AMR Delta UAL
Drop in Revenue 5% 10% 5% 10% 5% 10%
Revised Income Statement for Yr
8
Operating Revenue 18,245 17,285 13,431 12,724 16,683 15,805
Operating Expenses (16,656) (16,445) (12,289) (12,134) (15,882) (15,681)
Operating Income 1,589 840 1142 590 801 124
Other Income & Adjustments 198 198 141 141 133 133
Interest Expense* (372) (372) (197) (197) (361) (361)
Income before Tax 1,415 666 1,086 534 573 (104)
Tax Provision (596) (333) (454) (261) (192) 45
Continuing Income 819 333 632 273 381 (59)
% drop in Continuing Income 37% 75% 36% 72% 54% 107%

Case 3-5—continued
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 Delta UAL
Drop in Revenue 5% 10% 5% 10% 5% 10%
Liquidity
Current Ratio 0.865 0.865 0.735 0.735 0.513 0.513
Solvency
Total Debt to Equity 2.330 2.330 2.630 2.630 4.657 4.657
Long Term Debt to Equity 1.488 1.488 1.492 1.492 2.929 2.929
Times Interest Earned 4.803 2.788 6.511 3.712 2.587 0.712
Return on Total Assets 4.91% 2.66% 5.56% 2.94% 3.62% 1.03%
Return on Equity 12.68% 5.14% 17.97% 7.77% 13.56% -2.10%
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.
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 Delta UAL
Year 8 Capital Operating Capital Operating Capital Operating
A. Compute implicit rate on capital leases
MLP due Year 9 273 1012 100 950 317 1320
MLP due Year 10 341 951 67 950 308 1329
MLP due Year 11 323 949 57 940 399 1304
MLP due Year 12 274 904 57 960 341 1274
MLP due Year 13 191 919 48 960 242 1305
MLP due Year 14 and after 1,261 12,480 71 10,360 1759 17,266
Present value 1,918 312 2,289
Approximate interest rate to
equate lease payments with 6.25% 8.5% 7%
present value (trial and error)
Present value of operating

leases using implicit rate for 10,066 8,146 13,223
capital leases
AMR Delta UAL

Year 8 Year 8 Year 8
B. Estimate Interest and Depreciation on Operating Lease
Present Value of Operating Leases 10,066 8,146 13,223
Interest Rate 6.25% 8.5% 7%
Interest Expense 629 692 926
Value of Operating Lease Assets 10,066 8,146 13,223

Average Remaining Operating 19 16 18
Lease Term
Depreciation Expense 530 509 735
C. Estimate Effect of Operating Lease Conversion on Income Statement

Increase in Depreciation (530) (509) (735)
Expense
Decrease in Lease Rental 1,012 950 1,320
Expense
Effect on Operating Income 482 441 585
Increase in Interest Expense (629) (692) (926)

Effect on Income before Tax (147) (251) (341)
Decrease in Tax Provision (35%) 51 88 119

Effect on Continuing Income (96) (163) (222)

Part e continued:
AMR Delta UAL

D. Determine Principal and Interest Component of Next Year's MLP
Next Year MLP 1,012 950 1,320
Estimated Interest Component 629 692 926
Estimated Principal Component 383 258 394
E. Decompose Operating Lease Liability into Current and Non-Current Components

Total Operating Lease Liability 10066 8146 13223
Estimated Current Portion 383 258 394
Estimated Non-Current Portion 9683 7888 12829
RESTATED BALANCE SHEET

$ Millions AMR Delta UAL
Assets
Current Assets 4,875 3,362 2,908
Freehold Assets (Net) 12,239 9,022 10,951
Leased Assets (Net) 12,213 8,445 15,326
Intangibles & Other 3,042 1,920 2,597
Total 32,369 22,749 31,782
Liabilities
Current Liabilities:
Current Portion of Capital 537 321 570
Lease
Other Current Liabilities 5,485 4,514 5,492
Long Term Liabilities:
Lease Liability 11,447 8,137 14,942
Long Term Debt 2,436 1,533 2,858
Other Long Term 5,766 4,046 3,848
Liabilities
Preferred Stock 175 791
Shareholder's Equity
Contributed Capital 3,257 3,299 3,518
Retained Earnings 4,729 1,776 1,024
Treasury Stock (1,288) (1,052) (1,261)
Total 32,369 22,749 31,782
RESTATED INCOME STATEMENT

$ Millions AMR Delta UAL
Operating Revenue 19205 14138 17561
Operating Expenses (16,385) (12004) (15498)
Operating Income 2,820 2134 2063
Other Income & Adjustments 198 141 133
Interest Expense* (1,001) (889) (1287)
Income before Tax 2017 1386 909
Tax Provision (807) (559) (310)
Continuing Income 1,210 827 599
* Includes preference dividends.

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 Delta’s 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 Delta’s 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 Delta’s capital leases, on
average, were contracted 4-5 years before AMR or UAL, which is consistent
with the higher interest rate on Delta’s capital leases. To some extent, this
problem is alleviated (at least on a comparative basis) because Delta’s
operating leases also appear to have been contracted around three years
earlier to AMR’s or UAL’s. 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. Another issue is that we
depreciate the asset over the remaining lease term. However, the length of
operating lease is often less than the economic life of the asset. To that
extent, we are overestimating the depreciation expense.

g. Ratio Analysis on Restated Financial Statements

AMR Delta UAL
Liquidity
Current Ratio .81 .70 .48
Solvency
Total Debt to Equity 3.83 4.65 8.69
Long Term Debt to Equity 2.93 3.45 6.84
Times Interest Earned 3.01 2.56 1.71
Return on Investment*
Return on Total Assets 5.75% 6.18% 4.52%
Return on Equity 18.07% 20.56% 18.26%
*computed on adjusted year-
end asset and equity
balances
Note: We treat preference share capital as debt and include preference dividend with interest.
Capitalizing the operating leases significantly worsens the liquidity and

solvency picture of all three companies. The impact on current ratio is not
dramatic, but the current ratios are bad to start with. In particular UAL’s
current ratio of less than 50% is cause for concern.
The solvency picture deteriorates significantly after lease capitalization. We

realize that all three companies are extremely reliant on creditor financing,
particularly through lease financing that constitutes between 25% to 50% of
the total assets. The debt to equity ratios are significantly above acceptable
levels. UAL’s debt to equity is particular high. Part of the reason for the high
debt equity ratios is that these companies had all but wiped out their retained
earnings during the recession in the early 1990s, which makes their equity
base very low. While this is an explanation for the high debt to equity ratios, it
does not absolve the risk associated with such extreme debt orientation in the
capital structure.
Despite the excellent profitability of all three companies, the interest coverage
ratios are not as impressive as they appeared before the operating leases
were capitalized. By classifying a significant part of their leases as operating,
all three companies were able to underreport interest expense by over two-
thirds. In particular, UAL’s interest coverage looks weak even when its
profitability is spectacularly high.
The ROA has not deteriorated significantly although total assets have
increased by at least a third for all companies. The reason is that operating
income was significantly underreported earlier because the interest costs
pertaining to operating leases were being treated as operating expenses. ROE
has reduced significantly for all three companies, mainly because of drop in
continuing income. The ROE is still good although not as spectacular as
reported.

h. Sensitivity Analysis on Restated Financial Statements

AMR Delta UAL
Drop in Revenue 5% 10% 5% 10% 5% 10%
Revised Income Statement for Yr 8
Operating Revenue 18245 17285 13431 12724 16683 15805
Operating Expenses (16180) (15975) (11854) (11704) (15304) (15111)
Operating Income 2065 1310 1577 1020 1379 694
Other Income & Adjustments 198 198 141 141 133 133
Interest Expense* (1,001) (1,001) (889) (889) (1287) (1287)
Income before Tax 1,262 507 829 272 225 (460)
Tax Provision (531) (213) (334) (110) (76) 155
Continuing Income 731 294 495 162 149 (305)
% drop in Continuing Income 40% 76% 60% 80% 75% 151%
Revised Ratios (1998)

Liquidity
Current Ratio 0.810 0.810 0.695 0.695 0.480 0.480
Solvency
Total Debt to Equity 3.833 3.833 4.419 4.419 6.805 6.805
Long Term Debt to Equity 2.934 2.934 3.267 3.267 5.316 5.316
Times Interest Earned 3.014 1.506 1.932 1.306 1.175 0.643
Return on Total Assets 3.74% 0.91% 2.18% 0.71% 0.469 -0.960%
%
Return on Equity 18.07% 4.89% 11.79% 3.86% 3.659 -7.490%
%
The sensitivity analysis after the capitalization of operating leases further

highlights the high degree of risk in these companies. With a 10% drop in
revenue all the three companies have little or no “cushion” to pay their
interest costs. UAL in particular is highly unlikely to be able to meet its
interest commitments in such a scenario (also realize that for operating
leases, both the interest and principal portions need to be paid).
The results also highlight that the return on assets and equity will be
considerably affected with a downturn in demand. In short, capitalizing
operating leases shows that the solvency of the companies is clearly a risk,
and this risk could come to the forefront if and when these companies
experience even a moderate drop in revenues, which is not unlikely if history
is any indicator.

i. 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 tactics—for
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.

a.
Pension Benefits Health and Life Benefits Totals
Year 8 Year 7 Year 8 Year 7 Year 8 Year 7
Net Economic Position
Fair Market Value of Plan Assets 43,447 38,742 2,121 1,917 45,568 40,659
PBO 27,572 25,874 5,007 4,775 32,579 30,649
Net Economic Position 15,875 12,868 (2,886) (2,858) 12,989 10,010
Reported Position on Balance Sheet 7,752 6,574 (2,420) (2,446) 5,332 4,128
Difference 8,123 6,294 (466) (412) 7,657 5,882
Original Restated
Balance Sheets Year 8 Year 7 Year 8 Year 7
Assets
Current Assets 243,662 212,755 243,662 212,755
PP&E 35,730 32,316 35,730 32,316
Intangible Assets 23,635 19,121 23,635 19,121
Other 52,908 39,820 52,908 39,820
Total 355,935 304,012 355,935 304,012
Liabilities & Equity
Current Liabilities 141,579 120,668 141,579 120,668
Long Term Borrowing 59,663 46,603 59,663 46,603
Other Liabilities 111,538 98,621 103,881 92,739
Minority Interest 4,275 3,682 4,275 3,682
Equity Share Capital 7,402 5,028 7,402 5,028
Retained Earnings 31,478 29,410 39,135 35,292
Total 355,935 304,012 355,935 304,012
Relevant Ratios
Debt to Equity 7.25 6.98 6.00 5.91
Long-Term Debt to Equity 3.97 3.81 3.22 3.17
Return on Equity 21.54% 21.52% 18.29% 18.64%
Inference: Net assets (other liabilities) are understated (overstated) by $7.66

billion in Year 8 ($5.89 billion in Year 7). Both the debt to equity and the return on
equity ratios decrease when the true economic position is depicted in the
balance sheet.

b.
Pension Benefits Retiree Health and Life Benefits Total

Post Retirement Expense Restatement Year 8 Year 7 Change Year 8 Year 7 Change Year 8 Year 7 Change
Permanent Income
Reported Expense 1,016 331 685 (313) (455) 142 703 (124) 827
One-time charge 0 412 (412) 0 165 (165) 0 577 (577)
Permanent Income 1,016 743 273 (313) (290) (23) 703 453 250
Economic Income
Actual Return on Assets 6,363 6,587 (224) 316 343 (27) 6,679 6,930 (251)
Service Cost (625) (596) (29) (96) (107) 11 (721) (703) (18)
Interest Cost (1,749) (1,686) (63) (319) (299) (20) (2,068) (1,985) (83)
Actuarial Changes (1,050) (1,388) 338 (268) (301) 33 (1,318) (1,689) 371
Early Retirement Costs 0 (412) 412 0 (165) 165 0 (577) 577
Economic Income or Expense 2,939 2,505 434 (367) (529) 162 2,572 1,976 596
Reconciliation of Economic and Reported Expense

Economic Income 2,939 2,505 (367) (529) 2,572 1,976
Less One-Time Charges
Actuarial Changes 1,050 1,388 268 301 1,318 1,689
Diff. in expected & actual return (3,339) (3,866) (167) (206) (3,506) (4,072)
Add Amortization
Prior Service Cost (153) (145) (8) 11 (161) (134)
SFAS 87 154 154 0 0 154 154
Net Actuarial Gain 365 295 (39) (32) 326 263
Reported Pension Cost 1,016 331 (313) (455) 703 (124)
c. The actuarial assumptions appear reasonable. (1) The expected return on

assets has been maintained at a steady 9.5%, which is marginally higher than
the average. Yet, this return appears somewhat conservative when compared
to the actual return on assets. (2) The discount rate has mirrored the long-term
interest rate, which has been decreasing over this period. (3) The
compensation rate has been slightly increased in Year 8, which reflects the
tighter labor market and wage cost escalation occurring in the U.S. economy.
Both the increase in compensation rate and the reduction in discount rate
have resulted in considerably increasing the PBO. The lower discount rates
have marginally reduced interest cost by $64 million ($58 million) in Year 8
(Year 7), when compared to previous year. Overall, there appears to be no
evidence of earnings management using actuarial assumptions.

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 employer’s 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:
Pension Benefits
($ Millions) Year 8 Year 7 Change
Effect on Operations
Expected Return on Plan Assets 3,024 2,721 303
Service Cost for Benefits Earned (625) (596) (29)
Interest Cost on Benefit Obligation (1,749) (1,686) (63)
Prior Service Cost (153) (145) (8)
SFAS 87 Transition Gain 154 154 0
Net Actuarial Gain Recognized 365 295 70
Special Early Retirement Cost (412) 412
Post Retirement Benefit Income(Cost) 1,016 331 685
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, Barron’s 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 Excluding One-Time
Charge
Year 8 Year 7 Year 8 Year 7
Pension Income 1,016 331 1,016 743
Net Earnings 9,296 8,203 9,296 8,615
Earnings Growth Rate 13.32% 12.68% 7.90% 18.34%

Part d continued: When we examine the timing of the large one-time charge, it
appears that there is a kernel of truth to the Barron’s 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 Barron’s 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 GE’s earnings smoothing techniques, see the Wall Street Journal article
(WSJ, 11/3/94).
e. The pension related cash flows for GE are the employer’s 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 GE’s
performance or financial position. GE’s 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 attempts to capture the economic reality

a. The number of claims by categories are: (1) Smoking and health cases alleging
personal injury brought on behalf of individual plaintiffs—510 cases; (2) Smoking
and health cases alleging personal injury and purporting to be brought on behalf
of a class of individual plaintiffs—60 cases; and (3) Health care cost recovery
cases brought by governmental and nongovernmental plaintiffs seeking
reimbursement for health care expenditures allegedly caused by cigarette
smoking (actions by all 50 states, several commonwealths and territories of the
United States—95 cases, as well as cases in several foreign countries—27 cases).
b. The company recorded the following pre-tax charges related to tobacco litigation:
$3.081 billion and $1.457 billion during Year 8 and Year 7, respectively, to accrue
for the company's share of all fixed and determinable portions of the company's
obligations under the tobacco settlements with various states. In addition, the
company accrued $300 million during Year 8 and $1.359 billion in total for its
unconditional obligations under an agreement in principle to contribute to a
tobacco growers' trust fund. These amounts relate to the third category.
c. Charges totaling $3.381 billion were recorded as losses in the Year 8 income
statement related to tobacco litigation.
d. The eventual losses will likely dwarf what is currently recorded on the Balance
Sheet of Philip Morris. There are vast amounts of loss that are currently deemed
to not meet one of the 2 requirements to accrue contingent liability. In most
cases, the company likely contends that the amount of the loss is not yet
reasonably estimable.
e. 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

Analyzing Financing Activities: Review

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Chapter 3

Instructor's Solutions Manual 3-1

3-2 Financial Statement Analysis, 8th Edition

 Identify and assess the principal characteristics of liabilities and equity.

 Analyze postretirement disclosures and assess their consequences for firm

 Analyze contingent liability disclosures and describe risks.

 Identify off-balance-sheet financing and its consequences to risk analysis.

 Analyze and interpret liabilities at the edge of equity.

 Describe retained earnings and their distribution through dividends.

Instructor's Solutions Manual 3-3

3-4 Financial Statement Analysis, 8th Edition

Instructor's Solutions Manual 3-5

7. SFAS 47 requires note disclosure of commitments under unconditional purchase

3-6 Financial Statement Analysis, 8th Edition

Instructor's Solutions Manual 3-7

The analysis of contingencies (and commitments) also is aided by financial statement

3-8 Financial Statement Analysis, 8th Edition

11. a. The major classifications of leases by lessors are:

b. The accounting procedures for leases by lessors are:

Instructor's Solutions Manual 3-9

3-10 Financial Statement Analysis, 8th Edition

Information required to be disclosed by lessors includes: (1) future minimum lease

17. a. Rent expense

18. a. Leasing revenue

Instructor's Solutions Manual 3-11

Companies have attempted to finance inventory without reporting on their balance

20. a. The accumulated benefit obligation (ABO) is an estimate of the employer's

SFAS 87 recognizes an additional minimum liability. Since this additional liability is

3-12 Financial Statement Analysis, 8th Edition

Another major difference of OPEB accounting from pension accounting relates to

28. Under SFAS 106, the required disclosures include:

Instructor's Solutions Manual 3-13

30. a. A loss contingency is any existing condition, situation, or set of circumstances

3-14 Financial Statement Analysis, 8th Edition

34. Off-balance-sheet financing refers to the nonrecording of certain financing

Information about significant concentrations of credit risk from an individual

Instructor's Solutions Manual 3-15

3-16 Financial Statement Analysis, 8th Edition

Instructor's Solutions Manual 3-17

3-18 Financial Statement Analysis, 8th Edition

The composition of equity capital is important because of provisions affecting the

Instructor's Solutions Manual 3-19

b. Consolidated financial statements often show minority interests as liabilities:

3-20 Financial Statement Analysis, 8th Edition

Exercise 3-1 (20 minutes)

Current portion of long-term debt [71]

A = Proceeds from issuance of debt for spin-off [39].

b. According to disclosure in the "Liquidity and Capital Resources" section [item

Instructor's Solutions Manual 3-21

c. A lessee should allocate each minimum lease payment between a reduction of

Exercise 3-3 (15 minutes)

b. No asset or obligation would be recorded at the inception of the lease.

3-22 Financial Statement Analysis, 8th Edition

In a direct-financing lease, there is no manufacturer's or dealer's profit. The

Instructor's Solutions Manual 3-23

Off-balance-sheet debt—such as industrial revenue bonds or pollution control

3-24 Financial Statement Analysis, 8th Edition

a. An estimated loss from a loss contingency is accrued with a charge to income

Disclosure of a loss contingency involving an unasserted claim is required