Liabilities

1. Liabilities

2. Liabilities • What are they? • Theoretically: probable future sacrifices of economic benefits • GAAP definition: probable future sacrifices of economic benefits arising from present obligations ….to transfer assets or to provide services ….in the future as a result of past transactions or events

3. Liabilities • What are they? • Practically (Recognition criteria): • Probable future sacrifices of resources • Can be measured (quantified) • Generally, can’t be avoided. • Arise through a past transaction or exchange.

4. Liabilities • The problem of what “probable” means- • Potential liabilities are known as “contingent liabilities. Some future event must occur for them to happen. (e.g., a judgment by a court of law) • Contingent liabilities are not usually reported in the balance sheet. Instead they are disclosed in the footnotes. • The exception is when they can be quantified and are “probably” going to cost the firm future resources to resolve.

5. Liability Classifications • Liabilities can be classified according to: • How and why they arise (e.g., from business operations, financial management activities, etc.) • Time remaining until due • GAAP classifies liabilities by time- i.e., current (will likely be paid within 1 year) and noncurrent (> 1 year). • This follows a creditor (as opposed to investor) viewpoint.

6. Liabilities- Types • Accounts payable- • Almost always considered a current liability. • Usually comes from vendors and other suppliers that proffer inexpensive credit to the firm to encourage the purchase of their goods and services. • Interest typically does not accrue. Interest is embedded in the purchase price. • Accounts payable turnover ratio (COGS/avg payables) measures efficiency in the use of trade credit. Note: Quick payment is not necessarily a good thing.

7. Liabilities-Types • Accrued liabilities (e.g., wages, utilities, taxes, etc.)- • These are book entries accountants make at the close of a fiscal year to get expenses charged to year in which they were incurred. • Almost always a current liability.

8. Liabilities-Types • Notes payable- • These can arise from financial management or business operations activity. • Two basic types- interest-bearing and non-interest bearing. • When a note is non-interest bearing, the effective interest must be determined and booked as such. • All notes have certain features, including a stated amount (the face amount), a due date, and a statement of who is paying who. Sometimes, they also have a stated interest rate.

9. Liabilities-Type • Notes Payable- example: • A non-interest bearing note is given to a vendor in exchange for goods and services. The note’s face value is $ 10,000. The note is due in 1 year. The typical interest charged in such a transaction would be 10%. • 1000/1.10 = $ 9091. • Thus interest must be $ 909, with principle borrowed (and thus sale price) = $ 9091.

10. Liabilities-Types • Notes payable- interest bearing • An interest bearing 6 month note is given in the amount of $ 10,000, with interest at 10%. • Interest = PxRxT = 10000 x 10% x 6/12 • = $ 5,000

11. Liabilities-Types • Deferred Revenue- • Collections of cash before revenue is earned.

12. Liabilities- Types • Reserves- These are liabilities for future expected losses/expenses. • Example: allowance for warranty expense.

13. Liabilities-Types • Long Term Debt- • Can be obtained from: • Banks and other financial institutions • Investors in public markets – these are called bonds. • Can be current (if due within 1 year) or noncurrent

14. Liabilities-Types • Leases- • Leases can be capital or operating. • If they are deemed to be operating, they are not reported on the balance sheet. • If they are deemed to be capital leases, the presumption is that, effectively, a sale has taken place with embedded financing. • The lease payment is thus, in substance, really a loan payment.

15. Leases • Four criteria determine how leases are accounted for: • Title passes to the lessee at the end of the lease term. • The contract calls for a bargain purchase option • The lease term is for at least 75% of the estimated useful life of the asset. • The present value of minimum lease payments > 90% of the FMV of the asset.

16. Leases • If any one of these criteria are met, the lease is considered to be a capital lease. • In this case, the leasehold asset is booked along with a lease obligation. • The amount of the obligation is determined by computing the present value of the minimum lease payments, using the lessee’s incremental borrowing rate.

17. Liabilities-Types • Pensions and OPEBs- • Companies today record pension obligations and OPEB obligations, to the extent that any accrued benefits exceed fundings. • In the case of pensions, these commitments are legally binding. With OPEBs they are not. Accordingly, OPEBs are usually unfunded. In both cases, however, they are booked.

18. Pensions • Pension accounting can be very complex depending on the type of pension plans involved, the uncertainties involved, and how the plans are funded. • Plan types- • Defined contribution- this is the easy one. Many employers today are switching to this. • Defined benefit- still popular, especially among older industrial-type firms.

19. Pensions • Defined contribution- employers pay a % of the employee’s income each year into a vested and dedicated fund. The employee is entitled at retirement to whatever is accumulated in the fund. • Expense is simply the amount contributed and no liability arises.

20. Pensions • Defined benefit- The employer agrees to give the employee a set amount per year, usually based on a formula, when the employee retires. The amount of expense will vary as a function of many uncertainties, including: • The length of service • The number of employees that actually retire • The extent to which any benefit is vested. • The amount agreed to. • How long the employee lives • The yield on investments made to pay the expense someday.

21. Pensions • Liabilities arise when the amount set aside to pay future expenses is less than the amount of expense that has accrued. • Determining pension expense and the liability involves numerous actuarial and financial assumptions (e.g., plan rate of return).

22. Pensions • A special note: when return on plan assets is a lot less than expected, the difference increases the cost companies incur in providing defined benefit plans. To smooth out the impact, this difference is only gradually charged to earnings. • As a result, because of the stock market crash, many companies experienced major shortfalls in pension funding from 2001-2003 that are only slowly being recognized. • A lot of important pension info is not booked but simply disclosed in footnotes.

23. Deferred Taxes • Taxable Income, based on GAAP, and taxable income, from the IRS’s point of view, often disagree. The differences are either: • Permanent- they never reconcile, or • Temporary – strictly a matter of the timing of when revenues/expenses are recognized.

24. Deferred Taxes • When differences are permanent, there is no problem- tax paid to the IRS is the ultimate tax, even though there may differences in taxable income. • When differences are temporary, however, reported income will/has generated tax effects arguably applicable to another period.

25. Deferred Taxes • To resolve the problem, deferred tax liabilities (assets) are created to better match tax effects with the income that precipitates them. • Deferred tax liabilities- occur when • the GAAP basis of an asset is greater than the IRS (e.g., PPE) or • The GAAP basis of a liability is less than that recognized by the IRS. (e.g., allowances for warranty expense).

26. A Point About Tax Rates • The effective tax rate is just GAAP tax expense/ GAAP pre-tax income. • The statutory, or marginal rate, is the tax owed on the next dollar of income. • The difference between the statutory and marginal rate is due to permanent tax differences. • The two rates are used for different puposes in financial statement analysis.

27. Bonds • Significant debt needs of a company are often filled by issuing bond securities. • Bonds, being a form of debt, offer several advantages compared to other financing options, including • Ownership and control preserved and not diluted. • Interest is tax-deductable. • Low interest rates can allow for positive leveraging effects.

28. Bonds • The mix of debt and equity used to finance a company is called the capital structure. • Bond securities can (and usually are) be traded on active exchanges. • Interest rates are impacted by capital structure. • The more liquid the firm is, the lower the cost of borrowing.

29. Bonds • Disadvantages of bonds: • Risk of bankruptcy- unlike dividends and equity capital, interest and debt must be paid. • Cash flows can be negatively impacted.

30. Bonds • Bonds are long-term securities that evidence a debt the firm owes bondholders. • Bonds are usually denominated in $ 1,000 increments of face value. • Bonds are issued by firms, often to the public directly, to raise funds. • Bonds require the firm to pay back regular amounts, usually semi-annually (coupons), and the face value at maturity.

31. Bonds • An unsecured bond is called a debenture. • Most bonds are debentures.

32. Bond Characteristics • Face value (often called par value)- this is the bond’s maturity value. • Maturity date • Stated interest rate • Interest payment dates • Bond date

33. Bond Features • Callable? • Redeemable? • Convertible? • Secured? • Serial?

34. Bonds • Bonds are often sold for amounts that differ from the face value. • The effective rate of interest is thus different from the stated rate of interest on the bond. • In essence, the terms (the amount really borrowed and the interest rate) of the exchange are different from what is stated on the bond certificate.

35. Bonds • When the stated rate = market rate, bonds trade at face value (par). • When the stated rate < market rate, bonds trade at a discount. • When the stated rate > market rate, bonds trade at a premium.

36. Bonds • Bonds are always quoted at a fraction of par. • e.g., “98” = 98% of par, or $ 980 per bond.

37. Bonds • To calculate the value of bonds using tables: • Divide the bond’s cash flow rights into two: • The coupon (an annuity) • The maturity value (a single payment at the end of the bond’s term).

38. Bonds • To calculate the value of bonds using tables: • Determine the interest rate per period (i) and the number of periods interest is compounded (n). • Then value each cash flow and add to get the value of the bond.

39. Bonds • Accounting for Bonds- • When bonds are sold, they are booked at the amount that was exchanged by investors in return for the paper. • Subsequently, any discount or premium is amortized, thus adjusting cash payments (the coupon) for differences between the face amount due at maturity and what investors actually received when they lent the firm money. • An important note: Amortization causes the interest recongized to be based on the effective rate at the time bonds were issued. • Interest rates change constantly. As they do, the value of bonds change. This is not recognized in financial reports.

40. Bond Amortization • Two types are possible • Effective interest- preferred under GAAP • Straight-line amortization (OK if not materially different from effective rate method).

41. Bond Retirements • Sometimes firms will call, or simply purchase on the open market, some, or all,of their bonds and then retire them. • When this happens the gain/loss (difference between the price to buy back the bonds and their book value) is recorded as an extraordinary item on the income statement.

42. Key points-Liabilities • Financial reporting liabilities reflect probable economic sacrifices of future resources. • Reported liabilities arise through exchange transactions. • Not all legal, or even economic, liabilities are reported in the balance sheet. • Liabilities are not reported at market value, but instead historical value, with adjustments.

43. Liabilities • Can a liability be a liability if it is never paid? • Example: deferred taxes. Timing differences create deferrals that delay tax payments into future years. • To better match tax expense with the revenues that create it, these deferrals are recognized when the associated income is recognized. They are booked as an expense, with an offsetting liability called “deferred tax”. • If a firm is constantly growing (at least nominally), the deferrals to the IRS also keep growing. Thus, the balance in deferred taxes keeps growing and never gets paid.