CORPORATE FINANCIAL REPORTING

Long-Lived Assets 10 – Liabilities: Notes, Bonds & Leases CORPORATE FINANCIAL REPORTING

UNITED CONTINENTAL HOLDINGS, INC. CONSOLIDATED BALANCE SHEETS(In millions) At December 31, 20102009 Long-term debt 11,434 6,378 Long-term obligations under capital leases 1,036 1,194 Other liabilities and deferred credits: Frequent flyer deferred revenue 3,491 2,720 Postretirement benefit liability 2,344 1,928 Pension liability 1,473 93 Advanced purchase of miles 1,159 1,157 Deferred income taxes 1,585 551 Other 2,7041,094 12,7567,450

REMEMBER THE THREE FINANCIAL REPORTING ISSUES Recognition Classification Valuation

RECOGNITION A liability is an obligation to give an asset to, or perform a service for, another entity in the future. Remember, liabilities have four characteristics:

LIABILITY CHARACTERISTICS: 1. it is a present obligation for which 2. the future sacrifice is measurable 3. probable, and $ 4. is the result of a past transaction.(economic exchange)

CLASSIFICATION Some companies do not make a distinction, but most distinguish between current and non-current liabilities. A current liability is one management expects will be paid within the longer of one year or operating cycle.

WINDOW DRESSING Current assets $200 Current liabilities $150 Noncurrent liabilities 350 Noncurrent assets 800 Owners’ equity 500 $1,000 $1,000

VALUATION TODAY is October 1, 2011 I promise to pay you $1,000 on Sept. 30, 2013 and to pay you 10% per year, semiannually; interest will be paid each March 31 and Sept. 30 until Sept. 30, 2013. Signed tb But you want to earn 12% interest compounded semi-annually. How much money will you loan me? • .

PRESENT VALUE OF FUTURE CASH FLOWS 6 mo. 6 mo. 6 mo. 6 mo. |________|________|________|_______| 50 50 50 50 1,000 Using either Excel PV or NPV function will tell you: $ 965.35

PRESENT VALUE OF FUTURE CASH FLOWS You loan me $965 and I repay you a total of $1,200 What is the difference?

WHAT WILL APPEAR IN MY FINANCIAL STATEMENTS ON THESE DATES? (on these dates I prepare financial statements) October 1, 2011 March 31, 2012 September 30, 2012 March 31, 2013 September 30, 2013

FAIR VALUE OPTION Fairly new accounting rule: companies have a choice – do what we did when I borrowed money or show the “fair value” of the debt on their balance sheet. For example, suppose on Mar. 31, 2012, market interest rates are 16%/year for my company, what is the fair value of my liability and what would appear in my financial statements?

REPORTING, IN THE NOTES, OF FINANCIAL INSTRUMENTS GAAP requires note disclosure of the fair value of financial instruments, like notes payable, bonds payable, etc., even if the company does not elect to show fair values on the balance sheet. {keep this in mind when doing the fsa}

LEASES: AFINANCIAL REPORTING NIGHTMARE You fly to San Diego after the fall term is over.

LEASES: AFINANCIAL REPORTING NIGHTMARE Is the car your asset?

Equipment costs $30,000 new, LESSEE leases the equipment for 3 years, payments start one year after signing the lease. Lessee estimates a residual value of $20,000 at the end of the 3 years and wants to earn 10%/year. The equipment has a 7 year life. To T1 T2 T3 | | | | 30,000 20,000 SIMPLE LEASE EXAMPLE

Equipment costs $30,000 new, LESSEE leases the equipment for 3 years, payments start one year after signing the lease. Lessee estimates a residual value of $20,000 at the end of the 3 years and wants to earn 10%/year. The equipment has a 7 year life. To T1 T2 T3 | | | | 30,000 20,000 HOW MUCH ARE THE ANNUAL LEASE PAYMENTS? SIMPLE LEASE EXAMPLE

HOW MUCH ARE THE ANNUAL LEASE PAYMENTS? To T1 T2 T3 | | | | $ 30,000 20,000 ( 15,026)pv $14,974 SIMPLE LEASE EXAMPLE

HOW MUCH ARE THE ANNUAL LEASE PAYMENTS? To T1 T2 T3 | | | | $ 30,000 20,000 ( 15,026)pv $14,974 What future annuity gives a pv of $14,974? SIMPLE LEASE EXAMPLE

HOW MUCH ARE THE ANNUAL LEASE PAYMENTS? To T1 T2 T3 | | | | $ 30,000 20,000 ( 15,026)pv $14,974 What future annuity gives a pv of $14,974? Answer: RENT (or payment) = $6,021. SIMPLE LEASE EXAMPLE

If you were the CEO of a publicly traded company leasing this equipment, would you like to record this equipment as your asset and liability? SIMPLE LEASE EXAMPLE

Suppose you believed the equipment was not your asset and so you did not record the asset or liability – in financial reporting terminology you would be saying the lease was an “operating lease.” SIMPLE LEASE EXAMPLE

To T1 T2 T3 | | | | $6,021 $6,021 $6,021 When rent is paid: cash decreases $6,021 and there is rent expense of $6,021 on the income statement. SIMPLE LEASE EXAMPLEif it is an Operating Lease

Now, suppose you believed the equipment was your asset - you would show the equipment as an asset and also a liability – in reporting terminology you would be saying the lease were a “capital” (or finance) lease. SIMPLE LEASE EXAMPLEif it is a Capital Lease

To T1 T2 T3 | | | | $ 30,000 20,000 At To: When lease is signed: show an asset and liability for the present value of future payments of ($6,021) which would be $14,974. (Assume for now, the residual value was not guaranteed by the lessee.) SIMPLE LEASE EXAMPLEif it is a Capital Lease

ses Lessee is making 3 payments of $6,021- a total of $18,063; the liability is recorded at $14,974. The difference of $3,089 represents what? SIMPLE LEASE EXAMPLEif it is a Capital Lease

To T1 T2 T3 | | | | $ 30,000 20,000 At T1 - T3 : When each payment is made, part of the payment is interest and part a payment toward the lease liability. Also, the asset has been used for a year and should be depreciated. SIMPLE LEASE EXAMPLEif it is a Capital Lease

Which has more expense over the life of the lease: OPERATINGCAPITAL COMPARISON OF INCOME STATEMENTS

Balance sheet: a capital lease increases liabilities (and the “worst ones” at that) and increases non-current assets. Income statement: a capital lease reduces income more in the early years of the lease. Cash flow statement: Opposite effect! capital lease payments are divided between operating activity and financing activity, while operating leases are operating activities. LEASES – REPORTING SUMMARY

Can the lessee cancel the lease? no yes BOO ! CAPITAL LEASE HURRAY ! OPERATING LEASE LEASES – WHICH IS IT?(OR WHAT TO DO TO AVOID capital LEASES)

Can the lessee cancel the lease? no yes Does title transfer at the lease end? yes BOO ! no CAPITAL LEASE HURRAY ! OPERATING LEASE LEASES – WHICH IS IT?(OR WHAT TO DO TO AVOID capital LEASES)

Can the lessee cancel the lease? no yes Does title transfer at the lease end? yes BOO ! no CAPITAL Is there a bargain purchase option? yes LEASE no HURRAY ! OPERATING LEASE LEASES – WHICH IS IT?(OR WHAT TO DO TO AVOID capital LEASES)

Can the lessee cancel the lease? no yes Does title transfer at the lease end? yes BOO ! no CAPITAL Is there a bargain purchase option? yes LEASE no Is the lease for ≥ ¾ of the asset’s useful life? yes no HURRAY ! OPERATING LEASE LEASES – WHICH IS IT?(OR WHAT TO DO TO AVOID capital LEASES)

Can the lessee cancel the lease? no yes Does title transfer at the lease end? yes BOO ! no CAPITAL Is there a bargain purchase option? yes LEASE no Is the lease for ≥ ¾ of the asset’s useful life? yes no Is the PVMLP ≥90% assets fair value? yes no HURRAY ! OPERATING LEASE LEASES – WHICH IS IT?(OR WHAT TO DO TO AVOID capital LEASES)

LEASESINTERNATIONAL VIEW Risks include: • possibility of losses from idle capacity or technological obsolescence • variations in return because of changing economic conditions Rewards are: • the expectation of profitable operation over the asset’s life • gain from appreciation in value of residual value.

IAS 17 stipulates that if any one of these criteria are met, substantially all of the risks or rewards of ownership are deemed to have been transferred: 1. the lease transfers ownership of the asset to the lessee by the end of the lease term; 2. the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised; 3. the lease term is for the major part of the economic life of the asset, even if title is not transferred; 4. at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and 5. leased assets are of a specialized nature such that only the lessee can use them without major modifications being made.

Further indicators suggesting that a lease might be properly considered to be a finance lease are: 6. in the lessee can cancel the lease, the lessor’s losses associated with the lease are to be borne by the lessee, 7. gains or losses resulting from fluctuations in the fair value of the residual will accrue to the lessee, and 8. the lessee has the ability to continue the lease for a supplementary term at a rent that is substantially lower than market rent (i.e., there is a bargain rental option).

So, lessee must decide if the asset has been “purchased” or not; and the lessor must decide if the asset has been “sold” or not. LESSOR

At least one of the 4 criteria must be met: title transfer,bargain purchase option,lease ≥ 75% of economic life,PVMLP ≥ 90% assets fair value AND lessor must believe lessee will make payments & lessor must not have any material uncertain costs related to the lease. LESSORTo treat the lease as a “sale”

IAS and American GAAP differ in detail, but both do give you a method to “undo” management “maneuvers” to avoid capital leases. LEASES – WHAT TO DO WHEN READING FINANCIAL STATEMENTS:

Using Sony Corporation as an example. http://www.sony.net/SonyInfo/IR/financial/ar/2006/index.html LEASES – WHAT TO DO WHEN READING FINANCIAL STATEMENTS:

Sony Corporation Balance Sheet (in $ million) {original} Current assets 3,218 Current liabilities 27,352 PP&E 11,868 Long-term liabilities 35,613 Other assets 75,579 Owners’ equity 27,700 Total assets 90,665 Total L. & OE 90,665 LEASES – WHAT TO DO WHEN READING FINANCIAL STATEMENTS:

es Sony Corporation Balance Sheet (in $ million) Current assets 3,218 Current liabilities ?? PP&E ?? Long-term liabilities ?? Other assets 75,579 Owners’ equity 27,700 Total assets Total L. & OE LEASES – WHAT TO DO WHEN READING FINANCIAL STATEMENTS:

LEASES – WHAT TO DO WHEN READING FINANCIAL STATEMENTS:

s in $ million Year ending CAPITAL OPERATING March 31: LEASESLEASE 2007 157 406 2008 82 297 2009 46 227 2010 26 139 2011 18 98 Later years 40504 Total 369 1,671 less interest (42) Present value 327 less current portion (145) Long-term portion 182 LEASES – WHAT TO DO WHEN READING FINANCIAL STATEMENTS:

Sony Corporation Balance Sheet (in $ million) {revised} Current assets 3,218 Current liabilities ?? PP&E ?? Long-term liabilities ?? Other assets 75,579 Owners’ equity 27,700 Total assets Total L. & OE LEASES – WHAT TO DO WHEN READING FINANCIAL STATEMENTS:

QUESTIONS? LEASES

CORPORATE FINANCIAL REPORTING