Financial Statement Analysis & Valuation Third Edition

1. Financial Statement Analysis & Valuation Third Edition Peter D. Mary Lea Gregory A. Xiao-Jun Easton McAnally Sommers Zhang

2. Module 7: Liability Recognition and Nonowner Financing

3. Verizon’s Current Liabilities

4. Current Liabilities - Operating Accounts payable - Obligations to others for amounts owed on purchases of goods and services; these are usually non-interest-bearing. Accrued liabilities - Obligations for which there is no related external transaction in the current period. These include, for example, accruals for employee wages and taxes, as well as accruals for other liabilities such as rent, utilities, and insurance.

5. Current Liabilities - Nonoperating Short-term interest-bearing loans - Short-term bank borrowings and notes expected to mature in whole or in part during the upcoming year; this item can include any accrued interest payable. Current maturities of long-term debt - Long-term liabilities that are scheduled to mature in whole or in part during the upcoming year.

6. Accounts Payable Example

7. Accounts Payable Turnover and Days Payable Outstanding

8. Verizon’s Accrued Liabilities

9. Wages Accrual Example Failure to recognize this liability and associated expense would understate liabilities on the balance sheet and overstate income. Payment does not result in expense because the expense was recognized in the prior period when incurred.

10. Uncertain Accruals A contingent liability is a potential liability whose occurrence and/or ultimate amount is dependent upon a future event. If the obligation is probable and the amount estimable, then a company will recognize this obligation. If only one of the criteria is met, the contingent liability is disclosed in the footnotes.

11. Warranty Accrual

12. Harley Davidson’s Warranty Liability

13. Current Non-Operating Liabilities Short-term bank loans (including the accrual of interest) Current maturities of long-term debt – long-term liabilities that are scheduled to mature on whole or in part during the upcoming 12 months are reported as a current liability.

14. Short-term Interest-Bearing Loans Companies generally finance seasonal swings in working capital with a bank line of credit.

15. Example: Notes Payable

16. Bond Pricing – 2 Important Rates Coupon (contract or stated) rate - the coupon rate of interest is stated in the bond contract; it is used to compute the dollar amount of (semiannual) interest payments that are paid to bondholders during the life of the bond issue. Market (yield or effective) rate - this is the interest rate that investors expect to earn on the investment for this debt security; this rate is used to price the bond.

17. Cash Flows from Bonds Assume that investors wish to price a bond with a face amount of $10 million, an annual coupon rate of 6% payable semiannually (3% semiannual rate), and a maturity of 10 years. Investors purchasing this issue will receive the following cash flows:

18. Bond Pricing:Coupon Rate = Market Rate (Par) • Assuming that investors desire a 6% annual market rate of interest (yield), the bond sells for $10 million:

19. Bond Pricing:Coupon Rate < Market Rate (Discount) • Assume that investors expect an 8% annual yield (4% semi-annual yield). • Given this new discount rate, the bond will sell for $8,640,999:

20. Bond Pricing:Coupon Rate > Market Rate (Premium) • Assume that investors expect only a 4% annual yield (2% semiannual yield). • Given this new discount rate, the bond sells for $11,635,129:

21. Coupon Rate vs. Market Rate

22. Union Pacific’s $500MM4% Notes

23. Effective Cost of Debt Sale at par - the effective cost to the company is the cash interest paid. Sale at a discount - the effective cost to the company includes both the cash interest paid and the discount. Sale at a premium - the effective cost to the company, then, is the cash interest paid less the premium amortization.

24. Accounting for Bonds: Balance Sheet • Sale at par:

25. Bonds Sold at a Discount

26. Bonds Sold at a Premium

27. Accounting for Bonds: Income Statement Interest expense in the income statement is the sum of two components:

28. Effective Interest Method (Discount Example)

29. Effective Interest Method (Premium Example)

30. Gain (Loss) on Repurchase of Bonds Gains and losses on the repurchase of bonds are treated as part of ordinary income unless the transaction satisfies the criteria for treatment as an extraordinary item (i.e., both unusual and infrequent).

31. Verizon’s L-T Debt Footnote

32. Verizon’s L-T Debt Footnote Companies are required to present a schedule of debt maturities for each of the next 5 years:

33. Comcast’s L-T Debt Footnote

34. Debt Ratings

35. Bond Interest Rates

36. Factors Affecting Bond Ratings Business Risk Financial Risk • Industry characteristics • Competitive position (marketing, technology, efficiency, regulation) • Management • Financial characteristics • Financial policy • Profitability • Capital structure • Cash flow protection • Financial flexibility

37. Selected Financial Ratios for Various Bond Rating Classes

38. Moody’s Ratings Distributions

39. Financial Ratios Over Time

40. Ratings Changes Over Time

41. EBITA/Average Assets Across Industries

42. EBITA Margin Across Industries

43. What Financial Ratios Matter?

44. Global Accounting Under IFRS, companies can limit disclosure of contingent liabilities if doing so would severely prejudice the entity’s competitive or legal position. For accruals, U.S. GAAP requires the company to accrue the lowest number in the range whereas IFRS requires the company to accrue the expected amount. IFRS offers more disclosure of liabilities and accruals. Under IFRS, convertible debt is split into two parts: debt and equity (reflecting the option to convert).

45. End Module 7