1. Understanding Financial Statements NINTH EDITION
Lyn M. Fraser
Aileen Ormiston
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

2. Analyzing Financing Activities
Liabilities and shareholders’ equity
Friday, November 16, 2018

3. The Balance Sheet Assets = Liabilities + Stockholders’ equity
Also called the statement of condition or statement of financial position
Liabilities + Stockholders’ equity
Assets =
Assets = What the firm owns
Liabilities = What the firm owes to outsiders
Stockholders’ equity = What the firm owes to Internal owners
The Balance Sheet
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4. Current (short-term) Liabilities Noncurrent (Long-Term) Liabilities
Classification
Current (short-term) Liabilities
Noncurrent (Long-Term) Liabilities
must be satisfied in one year or one operating cycle and include
Accounts payable
Notes payable
Current portion of long-term debt
Accrued liabilities
Unearned revenue
Deferred taxes
Obligations not payable within one year or the operating cycle, whichever is longer. 2 2

5. Alternative Classification Operating Liabilities Financing Liabilities
Obligations that arise from operating activities--examples are accounts payable, unearned revenue, advance payments, taxes payable, postretirement liabilities, and other accruals of operating expenses
Operating Liabilities
Obligations that arise from financing activities--examples are short- and long-term debt, bonds, notes, leases, and the current portion of long-term debt
Financing Liabilities 73 5

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7. Current Liabilities
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8. Turkcell note 24
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9. Current Liabilities Trade Payables Notes Payable
Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services
Account is eliminated when the bill is satisfied
Significant changes from period to period often result from changes in sales volume, economic conditions or credit policies available to firm from its suppliers
Notes Payable
Short-term obligations in the form of promissory notes
Lines of credit to suppliers or financial institutions
Current Portion of Long-term Debt
the portion of the principal that will be repaid during the upcoming year
Current Liabilities
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10. Current Liabilities Accrued Liabilities
Result from recognition of an expense prior to actual payment of cash
Under accrual accounting, expenses are recognized when INCURRED and thus ACCRUED, not when paid in cash
In this case, cash flow succeeds expense recognition
Recorded as reserve accounts
Reserve accounts are
set up to estimate obligations for certain items
identified in the notes
Unearned Revenue or Deferred Credits
Result from payments received in advance for services or products
Transferred to a revenue account when service is performed or product is delivered
Under accrual accounting, revenue is recognized when EARNED, not when cash is received
In this case, cash flow precedes revenue recognition
Current Liabilities
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11. Current Liabilities Deferred Income Taxes
Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income
Intended to take advantage of all available tax deferrals to reduce actual tax payments, while showing the highest possible amount of reported net income
Classified as current or noncurrent on the balance sheet
Can appear on the balance sheet as a current asset, current liability, noncurrent asset, or noncurrent liability
Current Liabilities Deferred Income Taxes
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

12. Current Liabilities Deferred Income Taxes
Temporary differences can be caused by choice of accounting method for
Depreciation
Installment sales
Long-term contracts and leases
Warranties and service contracts
Pensions and other employee benefits
Subsidiary investment earnings
Current Liabilities Deferred Income Taxes
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

13. Deferred Taxation
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14. (C) 2007 Prentice Hall, Inc.

15. Turkcell note 17
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16. Noncurrent Liabilities
Obligations with maturities beyond one year
Long-term debt (financial liabilities)
Capital lease obligations
Postretirement benefits other than pensions
Provisions
Commitments and contingencies
Hybrid securities
Noncurrent Liabilities
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

17. Noncurrent Liabilities Long-term debt
Bonds
Long-Term Notes Payable
Mortgages
Obligations under leases
Long-Term Warranties
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

18. Noncurrent Liabilities Capital lease obligations
Are, in substance, a “purchase” rather than a “lease”
Affect both balance sheet and income statement
Disclosures found in the notes, often under both the property, plant, and equipment note and the commitments and contingencies note
Noncurrent Liabilities Capital lease obligations
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

19. Leases
Leasing Facts
Lease – contractual agreement between a lessor (owner) and a lessee (user or renter) that gives the lessee the right to use an asset owned by the lessor for the lease term.
MLP – minimum lease payments
(MLP) of the lessee to the lessor
according to the lease contract

20. Lease Accounting and Reporting
Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that transfer substantially all benefits and risks of ownership—accounted for as an asset acquisition and a liability incurrence by the lessee, and as a sale and financing transaction by the lessor
A lessee classifies and accounts for a lease as a capital lease if,
at its inception, the lease meets any of four criteria:
(i) lease transfers ownership of property to lessee by end of the lease term
(ii) lease contains an option to purchase the property at a bargain price
(iii) lease term is 75% or more of estimated economic life of the property
(iv) present value of rentals and other minimum lease payments at beginning of lease term is 90% or more of the fair value of leased property
(2) Operating Lease Accounting For leases other than capital leases—the lessee (lessor) accounts for the minimum lease payment as a rental expense (income)

21. Leases Lease Disclosure and Off-Balance-Sheet Financing
Lessee must disclose: (1) future MLPs separately for capital leases and operating leases — for each of five succeeding years and the total amount thereafter, and (2) rental expense for each period on income statement is reported
Off-Balance-Sheet Financing
Off-Balance-Sheet financing is when a lessee structures a lease so it is accounted for as an operating lease when the economic characteristics of the lease are more in line with a capital lease—neither the leased asset nor its corresponding liability are recorded on the balance sheet

22. Effects of Lease Accounting
Leases
Effects of Lease Accounting
Impact of Operating Lease versus Capital Lease:
• Operating lease understates liabilities—improves solvency ratios such as debt to equity
• Operating lease understates assets—can improve return on investment ratios
• Operating lease delays expense recognition—overstates income in early term of the lease and understates income later in lease term
• Operating lease understates current liabilities by ignoring current portion of lease principal payment—inflates current ratio & other liquidity measures
• Operating lease includes interest with lease rental (an operating expense)—understates both operating income and interest expense, inflates interest coverage ratios,
understates operating cash flow, & overstates
financing cash flow

23. Turkcell note 24
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24. Turkcell note 30
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25. Converting Operating Leases to Capital Leases
Determining the Present Value of Projected Operating Lease
2010
Non cancellable leases:
less than one year
$ ,00
between one and five year
16107
more than five years
7221
$ ,00
payment
discount factor 5%
present value
interest
lease obligation
lease balance
35225,32
2011
18024
0,952381
17165,71
1761,27
16262,73
18962,58
2012
3221,4
0,907029
2921,90
948,13
2273,27
16689,31
2013
0,863838
2782,77
834,47
2386,93
14302,38
2014
0,822702
2650,25
715,12
2506,28
11796,10
2015
0,783526
2524,05
589,80
2631,60
9164,50
2016
0,746215
2403,86
458,23
2763,17
6401,33
2017
1805,25
0,710681
1282,96
320,07
1485,18
4916,14
2018
0,676839
1221,86
245,81
1559,44
3356,70
2019
0,644609
1163,68
167,84
1637,41
1719,29
2020
0,613913
1108,27
85,96
0,00
41352
Leases

26. Noncurrent Liabilities Postretirement benefits other than pensions
Can appear under the liability section of the balance sheet Can have a significant impact on corporate balance sheets Can also impact profitability by substantially increasing the recognition of annual postretirement benefit expense
Noncurrent Liabilities Postretirement benefits other than pensions
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27. Noncurrent Liabilities Commitments and contingencies
Commitments refer to contractual agreements that will have a significant financial impact on the company in the future.
Contingencies refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits.
Intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements
Noncurrent Liabilities Commitments and contingencies
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

28. Provisions and Contingent Liabilities
a potential liability arising from a past transaction and that depends on a future event
could be disclosed in the body of the balance sheet with the liabilities
could be disclosed within notes to financial statements
certainty of the amount and the payment will be disclosed
Provisions and Contingent Liabilities
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29. (CONTINGENT LIABILITY)
Is the amount of the
liability known?
Recognize liability
on the balance
sheet
YES
YES NO
Can the amount of
Liability be reasonably
Estimated?
Is the liability likely to
occur? (Probable)
YES NO
Disclose in the notes
To the financial
Statements
(CONTINGENT LIABILITY)
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30. Contingencies and Commitments
Basics of Commitments
Commitments -- potential claims against a company’s resources due to future performance under contract
Analyzing Commitments
Sources of useful information:
Notes and MD&A  
Useful analyses:
Scrutinize management communications and press releases
Analyze notes regarding commitments, including
Description of commitment and its degree of risk
Amount at risk and how treated in assessing risk exposure
Contractual conditions and timing
Recognize a bias to not disclose commitments
Contingencies and Commitments

31. Turkcell Note 32
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32. Product Warranty Liabilities
When goods and services are sold under warranty coverage
A good example of provision
matching principle - warranty expenses of sales in a period should be recorded in the same period
Subsequent expenditures of warranties are charged against warranty liability
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33. Noncurrent Liabilities Hybrid Securities
Have the characteristics of both debt and equity
Also called mandatorily redeemable preferred stock
Financial instrument is preferred stock, but the issuing company must retire the shares at a future date.
Noncurrent Liabilities Hybrid Securities
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34. Important Features in Analyzing Liabilities
Terms of indebtedness (such as maturity, interest rate, payment pattern, and amount).
Restrictions on deploying resources and pursuing business activities.
Ability and flexibility in pursuing further financing.
Obligations for working capital, debt to equity, and other financial figures.
Dilutive conversion features that liabilities are subject to.
Prohibitions on disbursements such as dividends
Liabilities
Important Features in Analyzing Liabilities

35. Off-Balance-Sheet Financing
Basics of Off-Balance-Sheet Financing
Off-Balance-Sheet Financing is the non-recording of financing obligations
Motivation
To keep debt off the balance sheet—part of ever-changing landscape, where as one accounting requirement is brought in to better reflect obligations from a specific off-balance-sheet financing transaction, new and innovative means are devised to take its place
Transactions sometimes used as off-balance-sheet financing:
• Operating leases that are indistinguishable from capital leases
• Through-put agreements, where a company agrees to run
goods through a processing facility
• Take-or-pay arrangements, where a company guarantees to pay
for goods whether needed or not
• Product financing arrangements, where a company sells and agrees to either repurchase inventory or guarantee a selling price
• Sell receivables with recourse and record them as sales rather than liabilities
• Sell receivables as backing for debt sold to the public
• Outstanding loan commitments

36. Off-Balance-Sheet Financing
Illustration of SPE Transaction to Sell Accounts Receivable
A special purpose entity is formed by the sponsoring company and is capitalized with equity investment, some of which must be from independent third parties.
The SPE leverages this equity investment with borrowings from the credit markets and purchases earning assets from or for the sponsoring company.
The cash flow from the earning assets is used to repay the debt and provide a return to the equity investors.

37. Off-Balance-Sheet Financing
Illustration of SPE Transaction to Sell Accounts Receivable
Off-Balance-Sheet Financing

38. Off-Balance-Sheet Financing
Benefits of SPEs:
SPEs may provide a lower-cost financing alternative than borrowing from the credit markets directly.
Under present GAAP, so long as the SPE is properly structured, the SPE is accounted for as a separate entity, unconsolidated with the sponsoring company.
Off-Balance-Sheet Financing

39. Related party transactions
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40. Ownership equity is the residual interest in assets that remains after deducting liabilities
Shareholders’ Equity
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41. Shareholders’ Equity-Basics of Equity Financing
Equity — refers to owner (shareholder) financing; its usual characteristics include:
Reflects claims of owners (shareholders) on net assets
Equity holders usually subordinate to creditors
Variation across equity holders on seniority
Exposed to maximum risk and return
Equity Analysis — involves analyzing equity characteristics, including:
Classifying and distinguishing different equity sources
Examining rights for equity classes and priorities in liquidation
Evaluating legal restrictions for equity distribution
Reviewing restrictions on retained earnings distribution
Assessing terms and provisions of potential equity issuances
Equity Classes — two basic components:
Capital Stock
Retained Earnings
Shareholders’ Equity-Basics of Equity Financing

42. Shareholders’ Equity- Reporting Capital Stock
Sources of increases in capital stock outstanding:
Issuances of stock
Conversion of debentures and preferred stock
Issuances pursuant to stock dividends and splits
Issuances of stock in acquisitions and mergers
Issuances pursuant to stock options and warrants exercised
Sources of decreases in capital stock outstanding:
Purchases and retirements of stock
Stock buybacks
Shareholders’ Equity- Reporting Capital Stock

43. Shareholders’ Equity – Components of Capital Stock
Contributed (or Paid-In) Capital — total financing received from shareholders for capital shares; usually divided into two parts:
Common (or Preferred) Stock — financing equal to par or stated value; if stock is no-par, then equal to total financing
Contributed (or Paid-In) Capital in Excess of Par or Stated Value — financing in excess of any par or stated value
Treasury Stock (or buybacks) - shares of a company’s stock
reacquired after having been previously issued and fully paid for.
Reduces both assets and shareholders’ equity
contra-equity account (negative equity).
typically recorded at cost
Shareholders’ Equity – Components of Capital Stock

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45. Preferred Stock —. stock with features not possessed by
Preferred Stock — stock with features not possessed by common stock; typical preferred stock features include:
• Dividend distribution preferences
• Liquidation priorities
• Convertibility (redemption) into common stock
• Call provisions
• Non-voting rights
Common Stock — stock with ownership interest and bearing ultimate risks and rewards (residual interests) of company performance
Shareholders’ Equity

46. Stockholders’ Equity Common Stock Shareholders
Do not ordinarily receive a fixed return
Have voting privileges in proportion to ownership interest
Dividends are declared at the discretion of a company’s board of directors
Stockholders’ Equity Common Stock Shareholders
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47. Stockholders’ Equity Additional Paid-In Capital
Reflects the amount by which the original sales price of the stock shares exceeded par value
Stockholders’ Equity Additional Paid-In Capital
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48. Stockholders’ Equity Retained Earnings
Is the sum of every dollar a company has earned since its inception, less any payments made to shareholders in the form of cash or stock dividends
Beginning retained earnings
± Net income (loss) – Dividends
= Ending retained earnings
Stockholders’ Equity Retained Earnings
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49. Retained Earnings — earned capital of a company; reflects accumulation of undistributed earnings or losses since inception; retained earnings is the main source of dividend distributions
Cash and Stock Dividends
Cash dividend — distribution of cash (or assets) to shareholders
Stock dividend — distribution of capital stock to shareholders
Prior Period Adjustments — mainly error corrections of prior periods’ statements
Appropriations of Retained Earnings — reclassifications of retained earnings for specific purposes
Restrictions (or Covenants) on Retained Earnings — constraints or requirements on retention of retained earnings
Shareholders’ Equity

50. Spin-off, the distribution of subsidiary stock to shareholders as a dividend; assets (investment in subsidiary) are reduced as is retained earnings.
Split-off, the exchange of subsidiary stock owned by the company for shares in the company owned by the shareholders; assets (investment in subsidiary) are reduced and the stock received from the shareholders is treated as treasury stock.
Shareholders’ Equity

51. Stockholders’ Equity Other Equity Accounts
Other accounts that can appear in the equity section include:
Preferred stock
Accumulated other comprehensive income
Treasury stock
Revaluation Fund
Stockholders’ Equity Other Equity Accounts
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52. Nonowner changes to equity Other comprehensive income (GAAP)
Adjustments to fair value for available-for-sale securities
Foreign currency translation adjustment
Gains/losses on cash flow hedge derivatives
Gains/losses on investment hedge instruments
Adjustments related to underfunding a defined benefit pension plan
Nonowner changes to equity Other comprehensive income (GAAP)
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53. Statement of Shareholders’ Equity
Provides details of changes in Equity
Stock
Other comprehensive income
Retained earnings
Includes beginning and ending balances in accounts
Statement of Shareholders’ Equity
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54. Friday, November 16, 2018