CH 03

Chapter 03 - Analyzing Financing Activities
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 financingcredit and equityand
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.
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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
Appendix 3B: Accounting Specifics for Postretirement Benefits
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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.
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QUESTIONS
1. The two major source of liabilities, for both current and noncurrent liabilities, are
operating and financing activities. Current liabilities of an operating naturesuch as
accounts payable and operating expense accrualsrepresent 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 monthend 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.
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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.
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Thus, as the margin of safety decreases, the relative level of company risk
increases.
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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.
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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.
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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
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terminal, or port facilities from governmental units or authorities are to be classified

as operating leases.
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13. In the books of the lessee, the primary consideration regarding leases is the
appropriate classification of operating leases. When leases are classified as
operating leases, the lease payment is recorded as rent expense. However, lease
assets and liabilities are kept off the balance sheet. Because of this, many companies
avail themselves of operating lease treatment even when the underlying economics
justify capitalizing the leases. If this is done, the asset and liabilities of a company are
underreported and its debt-to-equity ratios are biased downward. Often such leases
are a form of off balance sheet financing. Therefore, an analyst must carefully
examine the classification of operating leases and capitalize the leases when the
underlying economic justify.
14. 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.
15. 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.
16. a. Rent expense
b. Interest expense and depreciation expense
17. a. Leasing revenue
b. Interest revenue (and possibly gain on sale in the initial year of the lease)
18.
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.
19.
In a defined contribution plan, the employer promises to currently contribute a

fixed sum of money to the employees retirement fund, so it is the contribution
that is defined. In a defined benefit plan, the employer promises to pay a periodic
pension benefit to the employee after retirement (typically until death), so it is the
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benefit that is defined. The risk (or reward) of the investment performance in the
former case is borne by the employee and in the latter by the employer.
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20.
Accounting for defined contribution plans is simple: whenever a contribution is
made it is recorded as an expense. Defined benefit plans accounting is complex
and involves currently recording a liability based on future expected benefit
payments and an asset to the extent the plan is funded. Pension expense in this
case depends on the changes in pension obligation and the return on plan assets.
21.
(a) Pension obligation: This is the present value of expected benefit payments to
the employee based on current service.
(b) Pension asset: this is the fair market value of the plan assets on the date of the
balance sheet.
(c) Net economic position of the plan: This is the difference between the fair
market value of the pension assets and the pension obligation. When this
difference is positive the plan is referred to as overfunded and when negative the
plan is termed underfunded.
(d) Economic pension cost: Economically, pension cost is equal to the change
(increase) in pension obligation minus return on plan assets. This is called the
funded status. Typically, pension obligation changes because of additional
employee service (service cost) and present value effects (interest cost).
22.
The common non-recurring components are: (a) Actuarial Gain/Loss: This arises
because of changes in actuarial assumptions such as discount rates and
compensation growth rates. (b) Prior Service Cost: This arises because of
changes in pension formulas, usually because of renegotiation of pension
contracts. In addition, the return on plan assets can have a recurring or expected
component and an unexpected component that is not expected to persist into the
future.
SFAS 158 has a complex method by which the non-recurring amounts are first
deferred, i.e., excluded from current income, and then the opening net deferrals
are amortized over the remaining employee service. For this purpose, the excess
of actual plan asset return over expected return is netted against actuarial gains
or losses and then deferred/amortized using something called the corridor
method. Prior service cost is deferred and amortized separately on its own.
23.
The net periodic pension cost is a smoothed version of the economic pension
cost. For determining net periodic pension cost, all non-recurring or unusual
components of economic pension cost (e.g., actuarial gain/loss, prior service
cost, excess of actual plan return over expected return) are deferred and
amortized using a complex corridor method. The rationale for this smoothing
mechanism is that the economic pension cost is very volatile. Including this in
income would cause income to be very volatile and also hide the true operating
profitability of the firm.
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24.
Under the current standard (SFAS 158), the balance sheet recognizes the funded
status of the plan. The income statement, however, does not recognize the net
economic cost, but a net periodic pension cost in which unusual or non-recurring
pension cost components are deferred and amortized. The cumulative net
deferrals are included in accumulated other comprehensive income. Under the
older standard, SFAS 87, the net periodic pension cost is recognized on the
income statement. The balance sheet however, merely recognized the accrued (or
prepaid) pension cost, which was simply the cumulative net periodic pension cost.
The accrued (or prepaid) pension cost was equal to the funded status minus
cumulative net deferrals.
25.
Under SFAS 158, the difference between the economic pension cost (which
articulates with the change in the funded status which is recorded in the balance
sheet) and the smoothed net periodic pension cost (which is essentially the net
deferral for the period) is included in other comprehensive income for the period,
which is transferred to accumulated other comprehensive income on the balance
sheet.
26.
Other post employment benefits (OPEBs) are retirement benefits other than
pensions, such as post retirement health care benefits. OPEBs differ from pension
on two dimensions: (1) most of them are non-monetary and therefore create
difficulties in estimation and (2) because of tax laws, companies rarely fund these
benefits.
27.
The pension note consists of five main parts: (1) an explanation of the reported
position in the balance sheet, (2) details of net periodic benefit costs, (3)
information regarding actuarial and other assumptions, (4) information regarding
asset allocation and funding policies, and (5) expected future contributions and
benefit payments.
28.
Since the funded status of the plan is reported on the balance sheet under SFAS
158, there is no adjustment to the balance sheet that is required. However, some
analysts note that netting pension assets and obligations tends to mask the
underlying pension risk exposure and thus recommend showing pension assets
and liabilities separately without netting them out.
Adjustments to the income statement depend on the purpose of the analysis. The
net periodic benefit cost that is reported under SFAS 158 is appropriate if the
objective of the analysis is identifying the permanent or core component of
income. However, to estimate a periods economic income it is advisable to use
the economic pension cost which includes all non-recurring items.
29.
The major actuarial assumptions underlying pension accounting are: (a) discount
rate (b) compensation growth rate and (c) expected rate of return on pension
assets. Less important assumptions include life expectancy and employee
turnover. In addition OPEBs also make assumptions about healthcare cost trends.
Managers can affect both the post-retirement benefit economic position (or
economic cost) and the reported cost. For example, choosing a higher discount
rate can reduce the pension obligation and thus improve economic position
(funded status). Also, increasing the expected rate of return on plan assets can
reduce the reported pension cost (net periodic pension cost).
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30.
31.
Pension risk exposure is the risk that a company is exposed to from its pension
plans. This risk arises because of a mismatch of the risk profiles of pension
assets and liabilities, primarily because companies invest pension assets whose
returns are not correlated with those of long-term bonds which form the basis for
the discount rate assumption affecting the measurement of the pension
obligation.
The pensions crisis in the early 2000s in the U.S. was precipitated by an unusual
combination of declining equity values (which lowered the value of pension
assets) and declining long-term interest rates, which increased the pension
obligations. The net effect was a steep reduction in pension funded status which
even resulted in some companies filing for bankruptcy.
The three factors that an analyst needs to consider when evaluating pension
exposure are: (1) the plans funded status relative to the companys assets (2) the
pension intensity, i.e., the size of the pension obligation and assets (without
netting) relative to total assets and (3) the extent to which the assets and
obligation is mismatched, which can be determined by the proportion of pension
assets invested in non-debt securities or assets.
32.
Current cash flows for pensions (or OPEBs) measure the extent of company
contributions into the plan during the year. For pensions, this is obviously not a
good indicator of future cash contributions since contributions are affected by
complex factors which eventually affect the funded status of the plan. For OPEBs,
current contributions are a somewhat better indicator of future contributions
since contributions in a period typically equal benefits paid (since most OPEB
plans are unfunded), and benefits are more predictable over time.
33.
Accumulated benefit obligation (ABO): This is the present value of estimated

future pension benefit payments assuming current compensation. Projected
benefit obligations (PBO): This is the present value of estimated future pension
benefit payments assuming future compensation on the date of retirement. ABO is
closer to the legal obligation.
34.
The corridor method is used for determining the amount of amortization for net
gain or loss. Net gain or loss for the period is determined by netting the actuarial
gain/loss for the period with the difference between actual and expected return on
plan assets. Then the net gain or loss for the period is added to the cumulative net
gain or loss at the start of the period. Next a corridor for cumulative net
gain/loss is determined as the greater of 10% of PBO or 10% of plan assets
(whichever is greater). Only the amount of cumulative net gain/loss beyond this
corridor (in either direction) is amortized.
35.
Like the pension obligation, the OPEB obligation is the present value of expected
future benefits attributable to employee service to-date. The present value of the
expected future benefits is termed EPBO and that portion which is attributable to
service to-date is termed the APBO. The APBO is the obligation that is used to
estimate the funded status or the economic position of the plan reported on the
balance sheet.
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36.
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.
34. 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 companys 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.
35.
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 resultsthe 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).
36. Commitments are potential claims against a companys 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.
37. 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.
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38.
39. 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.
39. 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.
40. 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.
41. 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.
42. Some equity securities have mandatory redemption provisions that make them more
akin to debt than they are to equitya 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.
3-17
43.
43. 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 soldthe 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.
3-18
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.
44. 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.
3-19
The reason why over-provisions 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.
45. 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.
46. 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.
3-20
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.
47. 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 fixedalthough 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 purposethese
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.
48. 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.
49. 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
3-21
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.
3-22
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.
50. Accounting standards require 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.
51. 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.
3-23
EXERCISES
Exercise 3-1 (20 minutes)
a.
Long-term debt [46]
A
B
159.7
0.3
G
H
24.3
250.3
805.8
beg
0.1
99.8
100.0
199.6
C
D
E
F
1.9
772.6
I
end
A = Retirement of 13.99% Zero Coupon Notes.

B = Repayment of 9.125% Note.
C = Additional borrowing on 7.5% Note.
D = Borrowing on 9% Note
E = Borrowing on Medium-Term Notes.
F = Borrowing on 8.875% Debentures
G = Repayment of Other Notes
H = Reclassification of Note
I = Increase in capital lease obligation
b. Campbell Soups debt footnote indicates maturities of (in $millions) $227.7 in

Year 12, $118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year
16. The remaining long-term debt matures in excess of 5 years. Given
Campbells operating cash flow of $805.2 million, solvency does not appear to
be a problem. Further, Campbell reports net income of $401.5, well in excess
of its interest expense of $116.2 in Year 11, an interest coverage ratio of 6.7
[$667.4 + $116.2]/ $116.2). The company should also be able to meet its
interest obligations.
Campbell reports total liabilities of $2,355.6 million ($1278+$772.6+$305)
against stockholders equity of $1,793.4 million, a 1.3 times multiple. The
amount of debt does not appear to be excessive. Nor does the company
appear to be underutilizing its equity.
Given present debt levels that are not excessive and adequate cash flow, the
company should be able to finance additional investments with debt if desired
by management.
3-24

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.
3-25

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.
3-26
Exercise 3-5continued
Off-balance-sheet debtsuch as industrial revenue bonds or pollution control
financing where a municipality sells tax-free bonds guaranteed for paymentare
cases where a supposedly debt-free balance sheet could look much worse if
these obligations were recorded.
Finally, the practice of deferred taxessuch as taking some expenses for tax, but
not book purposes, or through differences in timing for recognition of salesis
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.
3-27
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 Campbells financial statements.]
a. The causes of the $101.6 million increase are identified in the table below (see
Campbells Consol. Statement of Owners Equity and Changes in Number of
Shares):
Millions
10
Net Income............................................................
Cash Dividends.....................................................
Treasury Stock Purchase.....................................
Treasury Stock Issued
Capital Surplus................................................
Treasury Stock................................................
Translation Adjustment........................................
Sale of foreign operations...................................
Increase in Stockholders' Equity........................
a
1,793.4
- 1,691.8
101.6
[54]
11
$401.5
(142.2) (89)
(175.6)
$ 4.4 (28)
(126.9) (87)
(41.1) (87)
45.4 (91)
12.4 (91)
(29.9) (92)
(10.0) (93)
11.1 (87)
4.6 (87)
61.4 (87)
101.6a
(86.5)b
1,691.8 [54]
1,778.3 [87]
(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.)
3-28
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 companys
stock.

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.
3-29
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:
3-30
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.
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).
3-31

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 companys 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.
3-32

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.
3-33
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 interestit 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 notesNote 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.)
3-34

a. 1/1/Year 1
Enter into Lease Contract
Leased Property under Capital Leases ................................
Lease Obligation under Capital Leases..........................
39,930
12/31/Year 1
Payment of Rental
Interest on Leases ..................................................................
Lease Obligations under Capital Leases .............................
Cash ...................................................................................
10,000
Amortization of Property Rights
Amor. of Leased Property under Capital Leases ................
Leased Property under Capital Leases ..........................
39,930
3,194.40 (1)
6,805.60
7,986 (2)
7,986
(1) $39,930 x .08 = $3,194.40

(2) $39,930 5 = $7,986
b.
ASSETS
Leased property under
capital leases
(2)
Balance Sheet
December 31, Year 1
LIABILITIES
Lease Obligations under
$31,944 (1) capital leases.
$33,124.40
Income Statement
For Year Ended December 31, Year 1
Amortization of leased property ..................................................
Interest on leases...........................................................................
Total lease-related cost for Year 1 ...............................................
$ 7,986.00
3,194.40
$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.
3-35
Problem 3-2continued
c.
Payments of Interest and Principal
Total
Interest
Payment of
Payment
at 8%
Principal
Year
1
2
3
4
5
10,000
10,000
10,000
10,000
10,000
$50,000
$3,194.40
2,649.95
2,061.95
1,426.90
736.80
$10,070.00
$6,805.60
7,350.05
7,938.05
8,573.10
9,263.20
$39,930.00
Principal
Balance
$39,930.00
33,124.40
25,774.35
17,836.30
9,263.20
d.
Year
1
2
3
4
5
Expenses to Be Charged to Income Statement

Lease
Total
Expense
Amortization
Interest
Expenses
$10,000
$ 7,986.00
$ 3,194.40
$11,180.40
10,000
7,986.00
2,649.95
10,635.95
10,000
7,986.00
2,061.95
10,047.95
10,000
7,986.00
1,426.90
9,412.90
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.
3-36

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.
3-37

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. These gains (losses)
are no longer treated as extraordinary items, net of related income taxes,
unless they meet the text of both unusual and infrequent.
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 firms bonds, the analyst must examine the note disclosures and make
appropriate adjustments to market.
(AICPA Adapted)
3-38

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

= $24.00
= $7,500 / 400 shares

= $18.75
Price/book value
= $51.50 / $24.00
= 2.15
= $49.50 / $18.75
= 2.64
2. Total debt to equity ratio:

Ratio
JDS
MLS
Total debt to equity

[Total debt = (S-T debt
+ L-T debt)] / Equity
= $0 + 2,700 / $6,000
=$1,000 + $2,500 / $7,500
= $2,700 / $6,000
= 45.00%
= $3,500 / $7,500
= 46.67%
3. Fixed-asset utilization (turnover):

Ratio
JDS
MLS
Sales / fixed assets
= $21,250 / $5,700
= 3.73
= $18,500 / $5,500
= 3.36
b. Investment Choice and Justification Based on Part A

Based on Westfields 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.
45%
47%
JDS: lower debt or

ratios are very similar
iii.
Asset turnover
3.73
3.36
JDS: higher turnover
3-39
c.
Investment Choice and Justification Based on Note Information

Note: Details underlying the Balance Sheet Adjustments ($ millions):
JDS:
i.
Leases recognition of MDSs present value lease payments will add $1,000 to
JDSs property, plant, and equipment (PP&E) and is offset by a $1,000 addition
to JDSs long-term debt.
ii.
Receivables recognition of JDSs 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
(PP&E)
+$1,000
(Accounts receivable)
+$800
i.
ii.
Liabilities
(Long-term debt [LTD])
+$1,000
(Short-term debt [STD])
+$800
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
Adjusted total debt-to-equity ratio:
$2,700
+1,000
+ 800
$4,500
Adjusted debt-to-equity ration = $4,500 / $6,000 = 75%
iii.
Historical LTD
LTD
STD
Adjusted total debt
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
(Pension) +$1,600
i.
Owners Equity
+$1,600
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:

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
3-40
Part c continued:
Summary of Adjustments
Ratio
Adjusted book value
Adjusted debt to equity
Fixed-asset utilization
JDS
$24.00
75%
3.17
MLS
$22.75
38%
3.36
Final Results of Analysis:

Based on Westfields 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
i.
JDS
Price to adjusted book
MLS
2.15a
Company favored
2.18b
approximately equal
ii.
Adjusted debt to equity
equity
75%
36%
MLS lower adjusted debt to
iii.
3.17
3.36
MLS higher asset utilization
Fixed-asset utilization
$51.50 / $24.00 = 2.15.

$49.50 / $22.75 = 2.18.
3-41

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 doesnt 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 doesnt 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.
3-42

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 marketand, 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 $172.5 million in Year 11
[120].
Periodic pension cost computation ($ millions)
Service Cost ($586 x 1.10)................................................................................
Interest Cost (PBO x Discount Rate = $2,212 x 0.085)..................................
Return on plan assets ($3,238 x 0.115)...........................................................
Amortization of deferred loss ($48 / 30 years)...............................................
Periodic pension cost ......................................................................................
3-43
$645
188
(372)
2
$463
CASES
Case 3-1 (60 minutes)
a. Colgate administers defined benefit plans for substantial majority of its
employees. The primary OPEBs provided by Colgate and health care and
life insurance benefits.
b.
1. The economic positions are follows (in $ millions):
Pensions
OPEB
Total
Domestic
International
2005
(225.6)
(303.0)
(400.8)
(929.4)
2006
(188.3)
(315.9)
(437.4)
(941.6)
Negative numbers indicate underfunded status. Colgates plans are

underfunded and so are net liabilities.
2. The position reported in the balance sheet is as follows ($ million):
Pensions
OPEB
Total
Domestic
International
2005
254.9
(142.2)
(200.5)
(87.8)
2006
(188.3)
(315.9)
(437.4)
(941.6)
Negative/positive numbers indicate liability/asset. Colgates

postretirement benefit plans are net liabilities on the balance sheet.
3. The amounts are primarily reported as noncurrent liabilities, but also
included in noncurrent assets and current liabilities.
4. In 2005, Colgate reported postretirement benefits under SFAS 87.
This standard reports only accumulated (or prepaid) pension cost on
the balance sheet instead of the net economic position (funded
status). This causes the divergence.
5. The projected benefit obligation (PBO) and accumulated benefit
obligation (PBO) are as follows ($ million):
3-44
Projected Benefit Obligation

(PBO)
Domestic
International
Accumulated Benefit Obligation

(ABO)
Total
Domestic
International
Total
2005
1462.4
658.8
2121.2
1381.1
572.5
1953.6
2006
1582.0
720.4
2302.4
1502.0
625.2
2127.2
The accumulated benefit obligation is closer to the legal liability

related to pensions. The PBO is used to determine the net funded
status on the balance sheet under SFAS 158.
6. If the plans were terminated, Colgate will be liable to pay the ABO
amounts to the employees for domestic plans. While it is unclear if
such liability exists in other countries, we assume this is the case.
Therefore, assuming that the assets can be sold at their reported fair
value, the net economic position of the pensions plans if terminated
are the difference between the fair value of plan assets and the ABO
($ million):
Pensions
Total
Domestic
International
2005
(144.3)
(216.7)
(361.0)
2006
(108.3)
(220.7)
(329.0)
There is no clear basis for determining the companys legal liability

regarding OPEBs. There is no legal requirement to provide OPEBs to
employees.
3-45
7. The closing value of plan assets is as follows ($ million):

Pensions
OPEB
Total
Domestic
International
2005
1236.8
355.8
12.2
1604.8
2006
1393.7
404.5
22.6
1820.8
Colgate invests its plan assets primarily in equity securities, with a

lower proportion in debt securities and a much small proportion in
real estate.
8. For 2006, Colgate net periodic benefit cost (reported cost) is $ 58.2
million ($ 37.6 million, $ 37.8 million) for its domestic pension
(international pension, OPEB) plans. Therefore a total postretirement
benefit expense of $ 133.6 million was charged to income. Its
components are the service cost, interest cost, expected return on
plan assets and amortization of actuarial gain/loss and prior service
cost. In addition, it should be noted that Colgate also charged
unusual items (largely termination benefits) termed other
postretirement charges totaling 115.3 million.
9. The two non-recurring items are actuarial gain/loss and prior service
cost/plan amendments. The movement in these two items is given
below ($ million):
3-46
Pensions
Domestic
OPEB
Total
Internation
Movement in Actuarial (Gain)/Loss

Opening Balance (unrecognized)
470.8
150.8
198.8
820.4
Acturial Gain for the year
(36.7)
(7.1)
30.9
(12.9)
Actual less Expected Return
(54.3)
(0.1)
(1.5)
(55.9)
Amortization
(24.4)
(7.9)
(12.3)
(44.6)
9.8
0.5
10.3
355.4
145.5
216.4
717.3
9.7
10.0
1.5
21.2
36.7
(2.3)
0.0
34.4
Adjustments
=
Closing Balance (Accumulated Other Compr Inc)
Movement in Prior Service Cost (Plan Ammendments)

Opening Balance (unrecognized)
Plan ammendments during the year
Amortization
(4.1)
Adjustments
0.8
Closing Balance (Accumulated Other Compr Inc)
41.5
(1.5)
0.0
(5.6)
(2.6)
0.2
(1.6)
8.8
1.3
Note: Because of foreign exchange translation effects on

international plans and the effects of first-time adoption of SFAS 158,
the numbers do not articulate exactly and so there is a need to
introduce adjustments.
Also note that, while the cumulative net deferral was unrecognized,
i.e., kept off the balance sheet, in 2005 (under SFAS 87), in 2006 the
cumulative net deferrals are recorded as part of accumulated other
comprehensive income.
10. Colgates actual return on plan assets and expected returnthat is
included in incomeis given below ($ million):
Pensions
Domesti
c
Actual plan return
OPEB
Total
International
153.2
25.1
2.8
181.1
Expected return
98.9
25.0
1.3
125.2
Difference
54.3
0.1
1.5
55.9
11. The economic benefit cost (excluding unusual items such as

termination benefits, curtailments and settlements) and the reported
benefit cost are compared below:
3-47
51.6
2006
Pensions
Domestic
OPEB
Total
Internation
Service cost
45.2
21.1
11.9
78.2
Interest cost
83.4
32.1
28.7
144.2
(153.2)
(25.1)
(2.8)
(181.1)
(36.7)
(7.1)
30.9
(12.9)
Actual return on plan assets

Actuarial gain
Plan amendments (prior service cost)
Economic benefit cost/(income)
Net periodic benefit cost (reported cost)
Difference
36.7
(2.3)
0.0
34.4
(24.6)
18.7
68.7
62.8
58.2
37.6
37.8
133.6
(82.8)
(18.9)
30.9
(70.8)
The differences between the reported and economic benefit costs

arise primarily because of the treatment of the non-recurring items,
actuarial gain/loss (also called net gain/loss) and prior service cost.
See answer for (9) above for a detailed reconciliation of the balance
sheet and income statement effects for these items.
12. The primary actuarial assumptions used by Colgate are: (a) discount
rate (2) long-term rate of return on plan assets (3) long-term rate of
compensation growth and (4) ESOP growth rate.
In 2006, Colgate has changed only one assumption for domestic
plans: it has reduced the discount rate to 5.5% from 5.75%. This
reduction is expected to increase the pension obligation and create
an actuarial loss (note Colgate reports an actuarial gain for domestic
pension plans in 2006, probably because of changes in certain other
unreported actuarial assumptions).
For international plans, Colgate decreased discount rate and
compensation growth rate. The decrease in discount rate will
increase the pension obligation but the decrease in compensation
growth rate will decrease the pension obligation. Colgate also
reduced its expected return on plan assets for international plans
which would have reduced the expected return recognized in the net
periodic pension cost.
13. Colgates cash flows related to benefit plans are the contributions it
makes to the plans. In 2006, Colgate contributed $ 173.9 million to its
benefit plans ($ 113.6 million, $ 36.4 million and $ 23.9 million
respectively for its domestic pension, international pension and
OPEB plans). This contribution is a cash outflow.
3-48
Case 3.2 (45 minutes)

a.
The schedule below provides details of Colgates benefit plans economic

position (funded status) and the net amount recognized in the balance sheet
for 2006 and 2005 ($ million):
2006
Pensions
Domestic
OPEB
Total
Internation
Plan Assets
1393.7
404.5
22.6
1820.8
Benefit Obligation
1582.0
720.4
460.0
2762.4
Net Economic Position (Funded Status)
(188.3)
(315.9)
(437.4)
(941.6)
Reported Position on Balance Sheet
(188.3)
(315.9)
(437.4)
(941.6)
OPEB
Total
12.2
1604.8
NO ADJUSTMENTS
2005
Pensions
Domestic
Internation
Plan Assets
1236.8
Benefit Obligation
1462.4
658.8
413.0
2534.2
Net Economic Position (Funded Status)
(225.6)
(303.0)
(400.8)
(929.4)
254.9
(142.2)
(200.5)
(87.8)
(480.5)
(160.8)
(200.3)
(841.6)

Adjustment
355.8
No adjustments are required in 2006, since the net economic position is

reported on the balance sheet under SFAS 158. In 2005, under the older
standard (SFAS 87) the balance sheet reported a net deficit of only $ 87.8
million compared to Colgates net underfunded status of $ 929.4 million. This
necessitates an adjustment of $ 841.6 million, which will involve increasing
noncurrent liabilities and reducing shareholders equity (retained earnings) by
that amount. This adjustment needs to be made irrespective of the analysis
objective.
If the purpose of the analysis is to determine the liquidation value of Colgate,
then it is appropriate to determine the funded status using the ABO, rather
than the PBO. Using the ABO will improve the funded status by $ 167.6 million
($ 175.2 million) in 2005 (2006).
Since we are proposing no adjustments in 2006 to the balance sheet, there
will be no change to the debt-equity ratios. For 2005, Colgates total debt to
equity ratio before and after adjustment is 5.3 and 5.9. Long-term debt to
equity ratio will not be affected since postretirement benefits are not included
in long-term debt.
3-49
The schedule below gives details of Colgates economic and reported benefit
costs for 2006 and 2005 ($ million):
2006
Pensions
Domestic
Service cost
Actuarial (gain)/loss
Plan ammendments (prior service cost)
Difference
2005
Total
21.1
11.9
78.2
Internation
45.2
Interest cost
OPEB
83.4
32.1
28.7
144.2
(153.2)
(25.1)
(2.8)
(181.1)
(36.7)
(7.1)
30.9
(12.9)
36.7
(2.3)
0.0
34.4
(24.6)
18.7
68.7
62.8
58.2
37.6
37.8
133.6
(82.8)
(18.9)
30.9
(70.8)
OPEB
Total
20.0
10.3
77.7
Pensions
Domestic
Service cost
47.4
Interest cost
Actuarial (gain)/loss
Plan ammendments (prior service cost)
Internation
76.1
33.3
26.4
135.8
(92.4)
(41.8)
(1.1)
(135.3)
83.4
49.4
63.7
196.5
2.6
0.0
10.2
12.8
117.1
60.9
109.5
287.5
64.9
37.5
31.1
133.5
Difference
52.2
23.4
78.4
154.0
On an economic basis, Colgate costs pertaining to its postretirement benefit

plans are $ 62.8 million and $ 287.5 million in 2006 and 2005 respectively.
However, it recognized net periodic benefit cost of $ 133.6 million and $ 133.5
million during these years. If the analysis objective is to ascertain economic
income, then pre-tax income increasing (decreasing) adjustments of $ 70.8
million ($ 154 million) should be made in 2006 (2005). No adjustments need to
be made when the analysis objective is measuring permanent (or core)
income.
3-50
b. Overall, there is little to suggest that Colgates key actuarial assumptions are
unusual or unreasonable. It also appears that Colgate is somewhat
conservative in its assumptions choices. For example, the US discount rate is
5.5% which for 2006 is slightly below the yield on high yield bonds and closer
to the treasury yield. (One reason for the lower discount rates could be that
Colgate is benchmarking itself to shorter term bonds; being an old company,
it has a mature work force that is expected to retire sooner than that of
average companies). Colgates assumptions on expected rates of return are
also conservative given the high proportion of equity in its plan assets and
also given the actual returns in the recent past. Colgate has marginally
lowered its discount rate in 2006, which would have increased the value of the
PBO and lowered its funded status.
Colgate uses somewhat lower discount rates and expected rates of return for
its international plans. This could reflect the different economic environments
that it operates in internationally. Colgate has also lowered both these rates in
2006, which would have had adverse effects both on the balance sheet and
income statement, by increasing the pension obligation and decreasing
expected return from plan assets respectively.
Overall, there is little to suggest that Colgate is being aggressive in its choice
of actuarial assumptions or that it is using changes in these assumptions to
manage earnings.
c. An analyst needs to examine three dimensions with respect to pension risk
exposures:
The extent of underfunding: Colgates pension plans are
underfunded, but not seriously. In 2006, the underfunding for
pension plans is around $ 500 million, which translates to about 6%
of total assets.
Pension intensity: In 2006, Colgates pension obligation (assets) are
15% (17%) of total assets, which is not very high. However, in light of
Colgates high leverage, the pension risk is much higher. For
example, the above percentages are around 100% of equity, which is
very high.
Colgate also invests fairly heavily in equity securities: about 2/3 for
domestic and for international plans. This does create some
pension risk exposure.
Overall, Colgate has moderate risk exposure from its pension plans.
3-51
d. In 2006, Colgate contributed $ 173.9 million to its benefit plans ($ 113.6

million, $ 36.4 million and $ 23.9 million respectively for its domestic pension,
international pension and OPEB plans). The level of these contributions are
somewhat higher than the reported postretirement benefit cost, which is
something that an analyst needs to note. However, given Colgates copious
operating cash flows, these contributions need not be cause for concern.
Generally, it is difficult to use current contributions to predict future
contributions. However, Colgate appears to follow a policy of slightly
underfunding its plans and contributing amounts that are not very different
from benefits paid. One can use the estimated benefits payable (which
Colgate forecasts all the way up to 2016 in the footnote) to reasonably
forecast future contributions.
e. Campbell Soup reports the following categories of liabilities
Interest bearing (short-term and long-term)
Non-interest-bearing short-term operating obligations (payables and
accruals)
Other primarily deferred taxes (non-interest-bearing)
b.
Long-term debt [46]
A
B
159.7
0.3
G
H
24.3
250.3
805.8
beg
0.1
99.8
100.0
199.6
C
D
E
F
1.9
772.6
I
end
A = Retirement of 13.99% Zero Coupon Notes.

B = Repayment of 9.125% Note.
C = Additional borrowing on 7.5% Note.
D = Borrowing on 9% Note
E = Borrowing on Medium-Term Notes.
F = Borrowing on 8.875% Debentures
G = Repayment of Other Notes
H = Reclassification of Note
I = Increase in capital lease obligation
3-52
f. Campbell Soup has issued a number of long-term Notes and Debentures, all
of which appear to be fixed rate. Thus, the company does not require
derivatives in order to manage interest rate risk. Further, Campbell Soups
debt footnote indicates maturities of (in $millions) $227.7 in Year 12, $118.9 in
Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The
remaining long-term debt matures in excess of 5 years. Given Campbells
operating cash flow of $805.2 million, solvency does not appear to be a
problem.
a. Book value of common stock is equal to total assets less liabilities and claims
of securities senior to the common stock (e.g., preferred stock) at amounts
reported on the balance sheet.
Book value can also be reduced by
unrecorded claims of senior securities.
Year 11 Analysis:
Book value ($ millions) = ($1,793.4 - 0) = $1,793.4
Number of shares outstanding = 135,622,676-8,618,911=127,003,765
Book value per share = $14.12
b. The par value of Campbells common shares is $0.15. Its details follow:
(in millions)
Year 11
Authorized
Issued
Outstanding
140,000,000
135,622,676
127,003,765 (part a)
Common shares purchased (mil)

Average share repurchase price
Year 11
175.6 million
$175.6 million / $3.3954 million
shares = $51.72
c.
3-53

a. Ratio Analysis
Liquidity
Current ratio
Solvency
Long-term debt to equity
Times interest earned
Return on Investment
Return on total assets
Return on equity
1998
AMR
1997
1998
Delta
1997
1998
UAL
1997
0.865
0.895
0.735
0.702
0.513
0.562
2.330
1.488
6.817
2.356
1.459
4.867
2.630
1.492
9.310
3.237
1.879
7.509
4.657
2.929
4.463
5.617
3.371
6.220
7.17%
8.18%
6.21%
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. UALs 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 goodROE 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 during 1998.
We assume that 25% of operating expenses are variable (75% are fixed). We
also assume a 35% tax rate for the changes to income. Recast income
statements appear below:
AMR
Drop in Revenue
5%
10%
5%
Delta
10%
UAL
5%
10%
Revised Income Statement for Yr

8
Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision (35% tax rate)
Continuing Income
% drop in Continuing Income
18,245
17,285
(16,656) (16,445)
1,589
840
198
198
(372)
(372)
1,415
666
(596)
(333)
819
332
37%
75%
3-54
13,431
12,724
(12,289) (12,134)
1142
590
141
141
(197)
(197)
1,086
534
(454)
(261)
632
273
36%
72%
16,683
15,805
(15,882) (15,681)
801
124
133
133
(361)
(361)
573
(104)
(192)
45
381
(59)
54%
107%
Case 3-5continued
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 1998 ratios:
AMR
Drop in Revenue
Liquidity
Current Ratio
Solvency
Total Debt to Equity
Long Term Debt to Equity
Times Interest Earned
Return on Total Assets
Return on Equity
5%
10%
5%
Delta
10%
UAL
5%
10%
0.865
0.865
0.735
0.735
0.513
0.513
2.330
1.488
4.803
2.330
1.488
2.788
2.630
1.492
6.511
2.630
1.492
3.712
4.657
2.929
2.587
4.657
2.929
0.712
4.91%
12.68%
2.66%
5.14%
5.56%
17.97%
2.94%
7.77%
3.62%
13.56%
1.03%
-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.
3-55
Case 3-5continued
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
Capital
UAL
Capital
Operating
12480
919
14
5
19
71
48
1
5
6
10360
960
11
5
16
1759
242
7
5
12
17266
1305
13
5
18
13,366
887
15
5
20
118
57
2
5
7
9,780
850
12
5
17
1,321
277
5
5
10
19,562
1,357
14
5
19
1998
AMR
1997
1998
Delta
1997
1998
UAL
1997
273
154
119
1,918
6.20%
255
135
120
1,764
6.80%
100
63
37
312
11.86%
101
62
39
384
10.16%
317
176
141
2,289
6.16%
288
171
117
1,850
6.32%
Estimate Average Remaining Lease

Term (1998)
1 MLP in Later Years
1261
2 MLP in Last Reported Year
191
3 # of later years (1)/(2)
7
4 Add # of reported years
5
5 Average Remaining Lease
12
(3)+(4)
Estimate Average Remaining Lease
Term (1997)
1 MLP in Later Years
1,206
2 MLP in Last Reported Year
247
3 # of later years (1)/(2)
5
4 Add # of reported years
5
10
(3)+(4)
Estimate Interest Rate on

Capital Leases
6 MLP During Next Year
7 Less Principal Component
8 Interest (6) - (7)
9 PV of Capital Leases
10 Interest Rate (8)/(9)
Delta
Operating
Capital
Operating
Note: The principal component is shown as a current liability on the balance sheet.
3-56
Case 3-5continued
AMR
1997
1998
Delta
1997
1998
UAL
1997
Estimate Average MLP per year on

Operating Leases
11 Total MLP
17,215
19
Term
13 Average MLP (11) / (12)
927
18,115
20
15,120
16
14,020
17
23,798
18
26,515
19
903
957
849
1,305
1,366
Estimate Present Value of Operating

Leases
10.8505
14 Present Value Factor
15 Average MLP (13)
927
16 Present Value (14)X(15)
10,053
10.7762
6.9958
7.8515
10.7746
11.0047
903
9,727
957
6,698
849
6,669
1,305
14,065
1,366
15,029
1998
Note: Present value factor represents the present value of an annuity of $ 1 at a given interest
rate and lease term from the annuity tables. We use the interest rate on capital leases (estimated
in (10) above) as a surrogate interest rate for operating leases. The lease term for operating
leases was estimated in (5) above.
AMR
1998
Delta
1998
UAL
1998
E. Estimate Interest and Depreciation on Operating Lease

17 Present Value of Operating Leases
9,727
6,669
18 Interest Rate
7%
10%
19 Interest Expense (17) X (18)
662
677
15,029
6%
950
20
21
22
Value of Operating Lease Assets

Average Remaining Lease
Term (Lease Life)
Depreciation Expense
9,727
6,669
15,029
20
485
17
404
19
774
F. Estimate Efect of Operating Lease Conversion on Income Statement

23 Increase in Depreciation Expense
(485)
(404)
Decrease in Lease Rental
24 Expense
1,011
860
25 Effect on Operating Income
526
456
(774)
1,419
645
26
27
Increase in Interest Expense

Effect on Income before Tax
(662)
(135)
(677)
(221)
(950)
(306)
28
29
Decrease in Tax Provision

(35%)
Effect on Continuing Income
47
(88)
77
(144)
107
(199)
Note: For computing interest and depreciation for 1998, we use the lease asset/obligation we
estimated at the end of 1997.
3-57
Case 3-5continued
AMR
Delta
UAL
G. Determine Principal and Interest Component of Next Year's MLP

30 Next Year MLP (1999)
1,012
950
31 Estimated Interest Component
624
794
32 Estimated Principal Component
388
156
1,320
866
454
H. Decompose Operating Lease Liability into Current and Non-Current Components

33 Total Operating Lease Liability
10,053
6,698
14,065
34 Estimated Current Portion
388
156
454
35 Estimated Non-Current Portion
9,665
6,543
13,611
Restated Balance Sheet
$ Millions
Assets
Current Assets
Freehold Assets (Net)
Leased Assets (Net)
Intangibles & Other
Total
Liabilities
Current Liabilities:
Current Portion of Capital Lease
Other Current Liabilities
Long Term Liabilities:
Lease Liability
Long Term Debt
Other Long Term Liabilities
Preferred Stock
Shareholder's Equity
Contributed Capital
Retained Earnings
Treasury Stock
Total
Restated Income Statement
$ Millions
Operating Revenue
Operating Expenses
Operating Income
Other Income & Adjustments
Interest Expense*
Income before Tax
Tax Provision
Continuing Income
* Includes preference dividends.
AMR
1998
Delta
1998
UAL
1998
4,875
12,239
12,200
3,042
32,356
3,362
9,022
6,997
1,920
21,301
2,908
10,951
16,168
2,597
32,624
542
5,485
219
4,514
630
5,492
11,429
2,436
5,766
6,792
1,533
4,046
175
15,724
2,858
3,848
791
3,257
4,729
(1,288)
32,356
3,299
1,776
(1,052)
21,301
3,518
1,024
(1,261)
32,624
AMR
1998
Delta
1998
UAL
1998
19205
(16396)
2809
198
(996)
2011
(805)
1207
14138
(11919)
2219
141
(991)
1369
(553)
815
17561
(15535)
2026
133
(1227)
932
(318)
614
3-58
Case 3-5continued
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 Deltas 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 Deltas 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 Deltas capital leases, on
average, were contracted 4-5 years before AMR or UAL, which is consistent
with the higher interest rate on Deltas capital leases. To some extent, this
problem is alleviated (at least on a comparative basis) because Deltas
operating leases also appear to have been contracted around three years
earlier to AMRs or UALs. 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.
3-59
Case 3-5continued
g. Ratio Analysis on Restated Financial Statements
AMR
Delta
1998
Liquidity
Current Ratio
0.809
Solvency
3.831
Long Term Debt to Equity 2.931
3.020
Return on Investment*
5.89%
18.69%
Return on Equity
*computed on adjusted yearend asset and equity
balances
UAL
1998
1998
0.710
0.475
4.295
3.118
2.380
8.943
7.078
1.759
7.17%
4.47%
23.20%
21.87%
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 UALs
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. UALs 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 twothirds. In particular, UALs 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.
3-60
Case 3-5continued
Sensitivity Analysis after lease capitalization

AMR
Drop in demand
5%
UAL
5%
10%
5%
10%
17285
(15986)
1298
13431
(11770)
1661
12724
(11621)
1103
16683
(15340)
1343
15805
(15146)
659
198
(996)
501
(276)
225
141
(991)
811
(358)
453
141
(991)
253
(162)
90
133
(1227)
248
(78)
170
133
(1227)
(436)
161
(275)
81%
44%
89%
72%
145%
0.809
0.809
0.710
0.710
0.475
0.475
3.831
2.931
2.261
3.831
2.931
1.503
4.295
3.118
1.818
4.295
3.118
1.255
8.943
7.078
1.202
8.943
7.078
0.645
4.33%
10.69%
2.77%
3.36%
5.39%
11.26%
3.61%
2.24%
3.07%
5.18%
1.66%
-8.37%
Revised Income Statement for 1998

Operating Revenue
18245
Operating Expenses
(16191)
Operating Income
2054
Other Income &
Adjustments
198
Interest Expense*
(996)
Income before Tax
1256
Tax Provision
(540)
Continuing Income
716
% drop in Continuing
Income
41%
Revised Ratios (1998)
Liquidity
Current Ratio
Solvency
Long Term Debt to Equity
Return on Equity
Delta
10%
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.
3-61
Case 3-5continued
h. 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 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 tacticsfor
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.
3-62

a.
Pension Benefits
1998
1997
Health and Life Benefits

1998
1997
Net Economic Position

Fair Market Value of Plan Assets
PBO
Net Economic Position
Difference
Balance Sheets
Assets
Current Assets
PP&E
Intangible Assets
Other
Total
Liabilities & Equity
Current Liabilities
Long Term Borrowing
Other Liabilities
Minority Interest
Equity Share Capital
Retained Earnings
Total
Relevant Ratios
Debt to Equity
Long-Term Debt to Equity
Return on Equity
43,447
27,572
15,875
7,752
8,123
38,742
25,874
12,868
6,574
6,294
Original
1998
1997
2,121
5,007
(2,886)
(2,420)
(466)
243,662
212,755
243,662
32,316
19,121
39,820
35,730 32,316
23,635 19,121
52,908 39,820
355,935
304,012
355,935
304,012
120,668
141,579
120,668
141,579
46,603
59,663 46,603
4,275
7,402
31,478
3,682
5,028
29,410
4,275
3,682
7,402
5,028
39,135 35,292
355,935
304,012
355,935
7.25
3.97
21.54%
6.98
3.81
6.00
3.22
21.52%
45,568
32,579
12,989
40,659
5,332
7,657
4,128
5,882
30,649
10,010
212,755
59,663
98,621
1997
Restated
1998
1997
35,730
23,635
52,908
111,538
1,917
4,775
(2,858)
(2,446)
(412)
Totals
1998
103,881
92,739
304,012
5.91
3.17
18.29% 18.64%
Inference: Net assets (other liabilities) are understated (overstated) by $7.66

billion in 1998 ($5.89 billion in 1997). Both the debt to equity and the return on
equity ratios decrease when the true economic position is depicted in the
balance sheet.
3-63
Case 3-6continued
b.
Pension Benefits Retiree Health and Life Benefits Total
Change
Change 1998
1997
1998
1997
1997
Post Retirement Expense Restatement
1998
Permanent Income
Reported Expense
One-time charge
Permanent Income
1,016
0
1,016
331
412
743
685
(412)
273
(313)
0
(313)
(455)
165
(290)
6,363
(625)
(1,749)
(1,050)
0
2,939
6,587
(596)
(224)
(29)
(63)
338
412
434
316
(96)
(319)
(268)
0
(367)
343
(107)
(299)
(301)
(165)
(529)
(367)
Economic Income
Actual Return on Assets
Service Cost
Interest Cost
Actuarial Changes
Early Retirement Costs
Economic Income or Expense
(1,686)
(1,388)
(412)
2,505
Reconciliation of Economic and Reported Expense

Economic Income
2,939 2,505
Less One-Time Charges
Actuarial Changes
1,050 1,388
Diff. in expected & actual return (3,339) (3,866)
Add Amortization
Prior Service Cost
(153)
(145)
SFAS 87
154
154
Net Actuarial Gain
365
295
Reported Pension Income
1,016
331
142
(165)
(23)
703
0
703
Change
(124)
577
453
827
(577)
250
(27) 6,679
11
(721)
(20) (2,068)
33 (1,318)
165
0
162 2,572
6,930
(703)
(251)
(18)
(83)
371
577
596
(529)
2,572
1,976
268
(167)
301
(206)
1,318
1,689
(3,506)
(4,072)
(8)
0
(39)
(313)
11
0
(32)
(455)
(161)
154
326
703
(134)
154
263
(124)
(1,985)
(1,689)
(577)
1,976
c. Under SFAS 158, the net economic position (funded status) of $ 12.99 ($ 10.01)
billion in 1998 (1997) will be reported on the balance sheet (pension + OPEB).
Therefore, the balance sheet will correctly depict the economic position of the
plan.
In contrast, the income statement under SFAS 158 will continue to reflect the
smoothed net periodic benefit cost. For example, in 1998 $ 703 million will
shown as net periodic benefit income under SFAS 158 instead of economic
income $ 2.572 billion.
The articulation of the income statement and balance sheet effects under
SFAS 158 are done through movement in accumulated other comprehensive.
For example in 1998 the following reconciliation will occur:
Opening Accumulated Comprehensive Income
(Difference between economic and SFAS 87 reported position in Balance sheet)
Other Comprehensive Income for 1998
1,869
(Difference between economic and smoothed benefit income)
Change in pension liability
=
Closing Accumulated Comprehensive Income
* This is an unusual item that General Electric kept off the balance sheet.
3-64
$ 5,882
(94)*
$ 7,657
d. 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 1998, 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 ($58 million) in 1998
(1997), when compared to previous year. Overall, there appears to be no
evidence of earnings management using actuarial assumptions.
e. To suggest that any change in the reported net pension income (or expense)
must be excluded when determining the legitimate earnings growth rate
implies either that pension plans are not an integral part of the company or
that pension expense (or income) should be constant over time. Both
assumptions are not necessarily correct. As explained in the textbook, while
pension plans are administered by separate trustees, the net assets (or
liabilities) of the plans are the employers responsibility. Moreover, while
reported pension expense is generally not volatile, there is no reason why it
must remain the same each year. Therefore, to determine whether the change
in the pension income is warranted we need to examine the changes in the
components of reported pension costs:
Pension Benefits
1998
1997
Change
($ Millions)
Effect on Operations
Expected Return on Plan Assets
Service Cost for Benefits Earned
Interest Cost on Benefit Obligation
Prior Service Cost
SFAS 87 Transition Gain
Net Actuarial Gain Recognized
Special Early Retirement Cost
Post Retirement Benefit Income(Cost)
3,024
(625)
(1,749)
(153)
154
365
1,016
2,721
(596)
(1,686)
(145)
154
295
(412)
331
303
(29)
(63)
(8)
0
70
412
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, 1997 to $38.742 billion on January 1, 1998).
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 over-reported pension
income for 1998, but rather
3-65
because GE underreported pension income for 1997, by taking a one-time

charge of $412 million. GE did reduce its discount rate by 0.25% in 1998,
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 1998. Overall, Barrons 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
Pension Income
Net Earnings
Earnings Growth Rate
1998
1,016
9,296
13.32%
1997
331
8,203
12.68%
Excluding One-Time
Charge
1998
1,016
9,296
7.90%
1997
743
8,615
18.34%
When we examine the timing of the large one-time charge, it appears that
there is a kernel of truth to the Barrons complaint, although not in the sense
that was implied. If GE had not taken the $412 million charge in 1997, its
earnings growth would have been an outstanding 18.34% in 1997, thereby
creating an expectation of similar growth in 1998. The real growth rate in 1998,
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 Barrons
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 GEs earnings smoothing techniques, see
the Wall Street Journal article (WSJ, 11/3/94).
f. The pension related cash flows for GE are the employers contributions of $68
million ($64 million) in 1998 (1997). Evidently these cash flows have little to do
with the economics of the pension plans or their effects on either GEs
performance or financial position. GEs 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 attempt to capture the economic reality
3-66

a. The number of claims by categories are: (1) Smoking and health cases
alleging personal injury brought on behalf of individual plaintiffs510 cases;
(2) Smoking and health cases alleging personal injury and purporting to be
brought on behalf of a class of individual plaintiffs60 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 States95 cases, as well as cases in several
foreign countries27 cases plus 6 foreign class actions suits).
b.
The company recorded the following pre-tax charges related to tobacco

litigation: $3.081 billion and $1.457 billion during 1998 and 1997, 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 1998 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 1998 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.
3-67

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Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Contingencies and Commitments

Liabilities at the Edge of Equity

Appendix 3A: Lease Accounting Lessor

Appendix 3B: Accounting Specifics for Postretirement Benefits

Chapter 03 - Analyzing Financing Activities

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.

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

9. Analysis of the terms and conditions of recorded liabilities is an area deserving an

Chapter 03 - Analyzing Financing Activities

b. Summary of accounting for leases by lessees:

Chapter 03 - Analyzing Financing Activities

5. The estimated residual value is periodically reviewed. If it is determined to be

Chapter 03 - Analyzing Financing Activities

terminal, or port facilities from governmental units or authorities are to be classified

Chapter 03 - Analyzing Financing Activities

Property, plant, and equipment can be financed by having an outside party

In a defined contribution plan, the employer promises to currently contribute a

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Accumulated benefit obligation (ABO): This is the present value of estimated

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

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

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities

A = Retirement of 13.99% Zero Coupon Notes.

b. Campbell Soups debt footnote indicates maturities of (in $millions) $227.7 in

Chapter 03 - Analyzing Financing Activities

Exercise 3-2 (20 minutes)

Chapter 03 - Analyzing Financing Activities

Exercise 3-4 (18 minutes)

Chapter 03 - Analyzing Financing Activities

Exercise 3-6 (20 minutes)

Information available prior to issuance of the financial statements indicates

The amount of loss can be reasonably estimated.

Chapter 03 - Analyzing Financing Activities

b. The average price for treasury share purchases is computed as:

c. Book Value per Share of Common Stock is computed as:

Chapter 03 - Analyzing Financing Activities

Exercise 3-9 (30 minutes)

Chapter 03 - Analyzing Financing Activities

Chapter 03 - Analyzing Financing Activities