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Chapter 5

Liability and Equity Analysis

Concepts of Liabilities
Liabilities: Liabilities are defined as economic obligations
that arise from benefits received in the past. These are
external claims on assets of the firm. These arise from
contractual obligations and have reasonable certainty of
amount and timing. Liabilities include:
Cash received from customers against future sales of
product and services;
Credit purchases of goods and services in the current
year of the operating cycle (e.g., accounts payable)
commitments to public and private providers of debt
obligations to tax authority,
commitment to employees for unpaid wages, pensions
and other retirement benefits; and
obligations from court or government fines and
environmental cleanup orders.

Criteria for Recognizing Liabilities and

Implementation challenges
First Criterion:
An obligation
has incurred

Second Criterion: The amount and

timing of the obligation is measurable
with reasonable certainty

Record a liability
Challenges of Liability reporting

It is uncertain whether a firm has incurred an obligation

The amount and timing of obligation is difficult to measure

Liability values have changed


Reporting Challenges for Liabilities



Has an obligation been incurred? Example: Cash flows from a note receivables
sold to a bank and bank has recourse against the firm should the receivable
default. Is there any liability incurred?
How to measure the obligation? Examples:

Obligations to laid off employees in case of restructuring.

Frequent flyer obligation of airlines (Case study: next slide).

Obligation for environmental pollution. European Union regulation of

disposal management cost to be borne by the producers is a potential
cost not properly accounted.

Pension and other post-employment benefit liabilities.

Product warranties. Is liability created at the time of sales reflected by

estimated cost of returns? Or, should the firm wait for the expiry of
warranty period? Accounting suggests for a liability recognition on the
basis of probable losses. Accordingly, GM reported in 1998 that it had a
$14.6 billion liability for warranties, dealers, and customer allowances,
claims and discounts. Intel had to make a huge replacement of chips in
1994 and suddenly created a $475 million liability for that.
Changes in the value of liabilities. Example: Fixed rate liabilities are sometimes
sensitive to changes in interest rate. Liabilities are reported at their historical
costs, although fair value of interest bearing debt instrument is reported in the
footnote. Fair value becomes imprecise when a firm is in financial distress. It is
difficult to report the restructuring of troubled debt.

Case: Frequent Flyer Obligations

Since 1980s, many airlines have frequent flyer programs for their
passengers which offers bonus award miles every time the passenger flies
with the same airline.
Has the firm incurred liability?
The argument of no is based on the fact that the airlines have discretion to
modify and even abandon their mileage program. For example, in 1987,
United Airlines (UAL) made it difficult for passengers to earn free flights.
Airlines can also regulate the commitment by limiting the number of seats
available to frequent flyers.
The amount of liability is questionable as well.
Given normal load factors and the incremental costs of an additional
passenger, the opportunity and out-of-pocket costs of frequent flyer awards
could be minimal. Of course, changing the requirements for mileage
awards can be costly as UAL was sued over its plan changes.
Current accounting rules provide no definite guidance on how to report
these obligations, potentially providing an opportunity for management to
exercise judgment.
In its 1999 annual report, United Airlines noted that approximately 6.1
million frequent flyer awards were outstanding. Based on historical data,
the firm estimated that 4.6 million of these awards would ultimately be
redeemed, and recorded a liability for $195 million.

Common Misconceptions
About Liability Accounting


Its prudent to provide for a rainy day. Conservative accounting is

not always good accounting. Because:
(i) It assumes that the investor can not see through the
(ii) The basic purpose of B/S to reflect the firms true
standing is violated.
(iii) The purpose is not served as the investors over time
recognizes which firm are conservative and which are not.
Off-B/S financing is better than on B/S financing because
unsophisticated financial statement users are then likely to
underestimate the firms true leverage. It seems unlikely that
investors are continuously be fooled by off balance sheet
liabilities. Of course, operating lease financing may be necessary
to reduce the risk of ownership and technological obsolescence.

Concepts of Equity
Equity: Internal claims on assets that represent the gap
between assets and liabilities. It is the residual claims. Equity
funds can come from issues of common and preferred stock,
from profits that are reinvested, and from any reserve set
aside from profits. Valuation of equity plays the most important
role in the valuation of the firm. Equity=assets-liability?
(i) Valuation of assets,
(ii) hybrid securities, and
(iii) allocation of equity values between reserves, capital,
and retained earnings.
Since equity is the residual claim so the valuation depends on
the valuation of assets and liabilities. Consequently, the
challenges of valuation of assets and liabilities also apply to
equity valuation. In addition to that following challenges are
specific to equity.

Reporting Challenges of Equity

1. Hybrid securities: Convertible debt is a hybrid security that
commands a lower interest rate than straight debenture since
the holder also receives the option to convert the debt into
common stock. Accounting rules do not recognize the value
attached to the conversion right. So, the convertible bond is
just like ordinary bond until converted. If the debt converts, it
can be recorded using either the book value or market value
methods. The book value method does not recognize any gain
or loss on conversion. The market value approach records the
difference between book value and market value as operating
gain or loss. This raises question about how to compare two
firms that use same effective capital structure, but where one
uses hybrid securities and other does not. The firm with hybrid
securities will appear to be highly leveraged, using book
values of debt and equity, because conversion right is not
recorded. As a result, valuation of equity becomes

Reporting Challenges of Equity(Contd.)

2. Classification of unrealized gains and looses. One
method is to take it in income statement and then to
retained earnings as soon as it accrues. This is called
Clean surplus. Another method is to take as income only
when it is realized called Dirty Surplus.
These gains include:
i. Financial instruments that are available for sale.
ii. Financial instruments used to hedge uncertain future
cash flows including insurance policies, forward contract,
options, swap, etc.
iii. Foreign currency translations of foreign operations
whose transactions occur in the local currency rather
than parent currency.

Foreign exchange risk exposure

The degree to which the value of future cash transactions can be

affected by exchange rate fluctuations is referred to as transaction
exposure. If an exporter denominates its export in foreign currency,
a 10% decline in the value of that currency (dollar) will reduce the
taka value of its receivable by 10%. Transaction exposure includes
export denominated in foreign currency, interest received from
overseas investment, import denominated in foreign currency,
interest owed on foreign loan.
Economic exposure refers to the degree to which a firms present
value of future cash flows can be influenced by exchange rate
fluctuations. Cash flows that do not require conversion of currencies
do not reflect transaction exposure. Yet, these cash flows may also
be influenced significantly by exchange rate movements, which is
included in economic exposure.
The exposure of the MNCs consolidated financial statements to
exchange rate fluctuations is known as translation exposure. In
particular, subsidiary earnings translated into the reporting currency
on the consolidated income statement are subject to changing
exchange rates.


Managing Madison Inc.s Economic Exposure

(Figures in Millions)
(1) U.S.
(2) Canadian (C$4)
(3) Total
Cost of gods sold:
(4) U.S.
$ 50.00
$ 50.00
(5) Canadian
C$200= 150.00
C$200= 160.00
(6) Total
(7) Gross profit
$ 97.20
Operating expenses:
(8) U.S. - Fixed
$ 30.00
$ 30.00
(9) U.S. Variable (ex., sales com) 30.30
(10) Total
$ 60.30
$ 60.72
(11) EBIT
$ 42.70
$ 36.48
Interest expense:
(12) U.S.
$ 3.00
$ 3.00
(13) Canadian
(14) Total
$ 10.50
$ 11.00
(15) EBT
$ 32.20
$ 25.48
*Non-transactional economic exposure
*Transactional Economic Exposure
*Translation Exposure

$ 50.00
C$200= 170.00
$ 90.40
$ 30.00
$ 61.04
$ 29.36

$ 11.50
$ 17.86