Balance Sheet Analysis
- INTRODUCTION
For the balance sheet to be in equilibrium, the assets which a company shows must also be shown with the corresponding “claims” against those assets. The claims against those assets are either liabilities or shareholder’s equity. In this article, I examine liabilities, which are the financial or operational obligations which a company has with company “outsiders” (i.e., non-owners).
- CURRENT LIABILITIES
Current liabilities are those obligations of the company which must be satisfied within one year or the company’s operating period, whichever is shorter. Consistent with the “order of liquidity” presentation of the balance sheet, the company’s current liabilities are presented before its non-current liabilities.
Operating current liabilities are the current obligations which the company incurs as part of normal business operations. Examples of operating current liabilities are accounts payable and customer deposits.
Financing current liabilities are those current obligations which are related to the company’s borrowings. Companies must recognise in current liabilities borrowings with maturities of less than one year and the portion of longer-term borrowings (such as discussed below) which are due within one year from the balance sheet date.
- LONG-TERM LIABILITIES
3.1. Bonds Payable
A bond is a debt instrument issued by a company. The bond obligates the company to make periodic interest payments and a payment for the bond’s face value at maturity. The terms of the bond are outlined in a contract known as the bond indenture.
The bond’s par value is the amount which the company will pay the bond holder at the maturity date specified in the indenture. This amount is $1,000 for most U.S. dollar-denominated corporate bonds issued in the U.S. The interest payment is determined by multiplying the bond’s par value by the rate stated in the bond’s indenture (the bond’s coupon rate).
These payments are usually paid in instalments, such as semiannually or annually. A bond could be issued at a discount or a premium to the bond’s par value. When a bond is issued at a discount or a premium, the bond’s effective rate (also called effective yield) – the rate which equates the interest payments with the bond’s price at issuance – will differ from the bond’s stated rate.
3.1.1. Bonds Issued at Par
For a bond issued at par, the effective yield to investors will equal the bond’s stated rate. The company would record the bond issuance by debiting cash and crediting bonds payable. The company would recognise periodic interest expense by debiting interest expense and crediting accrued interest payable.
For example, a bond of $1,000,000 at par at a stated 10% annual rate would have an annual interest payment of $100,000. The company would record their monthly interest expense and offsetting payable as $100,000 x 1/12 = $8,333.33. When the company makes the interest payment, the company would debit accrued interest payable and credit cash.
3.1.2. Bonds Issued at a Discount
If at the time of a bond’s issuance, market rates are greater than the stated interest rate on a bond, the bond will be issued at a discount from par. This discount compensates investors for the bond’s below-market coupon rate.
The company would account for the bond discount using a contra-liability account called bond discount, which reduces bonds payable by the amount of the discount. The company would amortise the discount over the life of the bond by periodically allocating a portion of the discount to interest expense (debiting interest expense and crediting bond discount).
The credit to bond discount reduces this account and thus increases the net carrying amount of the bond. Thus, through this process of “amortizing the bond discount”, the bond’s carrying amount will equal the bond’s par value at maturity.
3.1.3. Bonds Issued at a Premium
If at the time of issuance market rates are less than the stated rate on a bond, the bond will be issued at a premium to par value. The company would recognise the bond premium using a liability valuation account called bond premium. This account increases the carrying value of the bond over par.
The company would recognise interest expense at the effective interest rate, i.e., the rate which equates the bond’s cash flows with the bond’s price. This rate will be lower than the bond’s stated rate. However, the actual interest payment will be based on the bond’s stated rate.
Thus, for a bond issued at a premium, the recorded interest expense will always be less than the cash interest payment. The difference is the amortisation premium. To record periodic interest expense, the company would debit interest expense (the effective rate multiplied by the beginning period’s carrying value of the bond), debit bond premium, and credit accrued interest payable. By debiting bond premium, the premium would be periodically decreased, thus reducing the carrying amount of the bond.
3.1.4. Market Value of Bonds after Issuance
Companies can issue floating rate debt, in which the company’s interest payments fluctuate based on a benchmark interest rates. When rates fall, companies benefit from a reduction in their interest expense. When rates rise, companies recognise higher interest expense. The company recognises interest expense and accrued interest payable using the contractual interest rate in effect during the period.
For a bond with fixed-rate payments, market fluctuations in interest rates will lead to changes in the bonds market price ii. A company may purchase its debt in the market when it is advantageous for the company (i.e., when bond prices are depressed). Because market prices are likely to differ from the bond’s amortised book value, the company will record a gain or loss on the purchase.
The accounting gain or loss is the difference between the cash paid to extinguish the bond and the bond’s book value: when the bond is purchased for less than the bond’s carrying value, the company records a gain; when the bond is purchased for more than the bond’s carrying value, the company records a loss. These gains or losses are accounted for as a component of operating income, and investors should remove these gains or losses when calculating sustainable earnings iiiiii.
3.1.5. Use of Fair Value Accounting
U.S. GAAP allows firms the option of using fair value accounting for debt instrumentsi. The choice to use fair value accounting, however, is irrevocable for the life of the instrument. A company need not, however, use fair value accounting for all debt instruments; the company may elect to use fair value accounting for select assets or liabilities.
The major benefit is that fair value accounting could dampen earnings volatility by matching the accounting method of an asset with that of the corresponding liability – a holding gain or loss on one instrument would be offset by a holding loss or gain on the other instrument. Investors should realise that fair value accounting could lead to a perverse outcome for companies in distress.
Particularly, a company which is in distress would record an unrealised holding gain (recognised in operating income) on the depressed price of the outstanding debt. Likewise, companies that are in distress would also show a lower debt-to-equity ratio because of the lower carrying amount of debt.
The criteria for using fair value accounting under IFRS (IAS 39) is more restrictive than that under U.S. GAAP. Specifically, IFRS allows firms to use fair value accounting for liabilities only when (a) fair value accounting is part of an overall risk management strategy or (b) fair value accounting is used to eliminate the mismatch on related financial instruments.
3.2. Contingent Liabilities
Contingent liabilities are those liabilities whose existence and amount is dependent on the outcome of some future event (examples: litigation, industrial accidents, etc.). Under U.S. GAAP, losses from contingent liabilities are only recognised as a charge against income with an offsetting reserve liability if the loss has a high probability of occurring and the amount of loss can be reasonably estimated.
Footnote disclosures are required if the liability is reasonably possible and can be estimated. The reliance on managerial estimates makes enforcement of accounting guidelines for contingencies difficult. Investors should be aware of the potential for companies to understate contingent liabilities. The accounting for gain contingencies, however, is more conservative: the company cannot recognise a contingent gain until the event actually occurs and the payment obligation is confirmed.
IFRS differs from U.S. GAAP in accounting for contingent events in two material respects. First, IFRS requires recognition of a contingent loss when the loss is “more likely than not” to occur. Thus, IFRS has a higher recognition threshold for contingent losses than U.S. GAAP. Second, IFRS requires the company to recognise the contingent liability as the midpoint of managerial estimates, whereas U.S. GAAP allows firms to use the low-end of managerial estimates.
- PENSION AND OTHER POST-RETIREMENT LIABILITIES
4.1. Pensions
Companies may provide employees with benefits upon retirement. The two most common arrangements for these retirement benefits are defined contribution plans and defined benefit plans. With a defined contribution plan, the company merely agrees to a set contribution to an employee’s retirement account (such as a 401(K)).
The future value of the account, and thus the future benefits to the employee, is based on whatever returns the investments in the plan produce. Thus, the employee bears the risk on investing in the plan. Since the company accepts no future liability for the plan, the company would simply record the contributions to pension expense.
Defined benefit plans, however, entitle the employee to a specified future retirement payments based on some formula established by the company (for example, annual payments in retirement of x% of the employee’s final-year salary). With defined benefit plans, the company accepts the full liability of providing the future benefits.
4.1.1. Overview of Accounting for Defined Benefit Plans under U.S. GAAP
The accounting for defined benefit plans is necessarily complicated due to companies having to determine the current financial statement impact of future pension benefits.
Authoritative U.S. GAAP for defined benefit plans is likewise complex, requiring companies to make numerous assumptions. A defining feature of current accounting guidelines is the use of smoothing mechanisms to mitigate fluctuations in plan assets and obligations due to changes in interest rates, asset returns, actuarial assumptions, and benefit plan changes.
The increases or decreases plan assets or obligations are recognised in accumulated other comprehensive income (a component of shareholder’s equity), with a corresponding amount recognised in the balance sheet pension asset or liability. These accumulated amounts are then amortised into pension expense on a straight-line basis.
4.1.2. Pension Expense
Under current U.S. GAAP, pension expense consists of five components: (1) service cost, (2) interest cost, (3) expected return on plan assets, (4) recognised gains or losses, and (5) recognised prior service cost.
4.1.2.1. Service Cost
Most plans increase the future benefits an employee is entitled for each year of service. The increase in the present value of these benefits is referred to as the plan’s service cost. For example, suppose an employee is entitled to a lifetime annuity of 5% of her final salary at retirement multiplied by the number of years of service.
Suppose also that the employee has 10 years until retirement, an estimated life expectancy of 20 years after retirement, and an estimated final year salary of $200,000. The employee has just begun employment with the employer, and thus has no accrued benefits until the end of the first year. The company calculates the present value of future benefits using a discount rate of 6%.
At the end of the first year, the employee is entitled to a 20-year annuity equal to $10,000 (.05 x $200,000 x 1). The present value of this obligation (at the time of the employee’s retirement) is $114,699.21. The employee has 9 years until retirement at the end of this first period, so this amount must be further discounted by 9 years. The employer’s obligation is thus $67,890.29 at the reporting periodvi. Because no obligation existed at the beginning of the period, the period’s service cost is the full $67,890.29.
At the end of the second year, the employee is entitled to an annuity payment of $20,000 ($200,000 x .05 x 2). Thus, the employee is now entitled to an additional $10,000 per year. The present value of this incremental increase at the time of the employee’s retirement is $114,699.21.
The present value of this increase as of the reporting period is $71,963.70. This amount is the period’s service cost, as it is the discounted value of the increase in the employee’s benefits resulting from an additional year of employment.
4.1.2.2. Interest Expense
Interest expense is the increase in the pension obligation due to the passage of time. As each year passes, the future obligation is discounted over a shorter-period. Thus, the present value of the obligation increases each yearvii.
In the above example, the pension obligation at the end of the first reporting period was $67,890.29. In the second year, the obligation was increased by the period’s service cost $71,963.70. However, at the end of the second reporting period, the obligation at the end of the first period was no longer the discounted amount of the annuity due in 9 years, but was rather the present value of the annuity discounted by 8 years.
Thus, the same obligation at the end of period 1 has increased to $71,963.70 by the end of the second period viii. The obligation increased by $4,073.41 ($71,963.70 – $67,890.29) in the second period. This amount is the period’s interest expense.
4.1.2.3. Expected Return on Plan Assets
For calculating pension expense, U.S. GAAP allows firms to recognise a decrease in pension expense based on an expected rate of return on the plan assets. Suppose the company in the above example contributed $50,000 to the pension plan at the beginning of the first period.
Further suppose that the company has a target allocation for the plan of 60% stocks and 40% bonds. The company assumes a long-term rate of return for stocks of 9% and a long-term rate of return for bonds of 4%. The total expected rate of return on the plan would thus be 7% ((.6 x .09) + (.4 x .04)). For the first year, the expected return on plan assets would be $3,500 ($50,000 x .07).
4.1.2.4. Recognised Gains or Losses
Of course, actual gains or losses will differ from the expected returns on the respective asset classes. Asset returns, especially for stocks, would introduce volatility into a company’s pension expense. Over long periods of time, however, asset price returns are likely to be more predictable. In recognition of this, U.S. GAAP contains a feature to smooth the actual gains or losses in the pension plan.
This smoothing feature of actual return is accomplished in two stages. First, the company uses an expected rate of return (described above) on plan assets in pension expense. Second, the company recognises any difference between the actual return on plan assets and the expected return on plan asset in other comprehensive income (a component of shareholder’s equity). These gains or losses are aggregated into accumulated other comprehensive income (AOCI) and then amortised into pension expense on a straight-line method.
Continuing with the above example, assume the actual return on the pension plan in the first period was 15% on the beginning plan assets of $50,000 for a gain of $7,500. The assumed rate of return, however, was 7%, so only a $3,500 was recognised with pension expense.
The company would account for the $4,000 difference within other comprehensive income. The differences in each year are deferred into AOCI and this cumulative difference in amortised into pension expense. The recognised gains or losses component or pension expense are thus an amortisation component arising from this smoothing mechanism.
Changes in plan asset and liabilities can also arise due to changes in certain assumptions used to compute these amounts. These key assumptions are referred to as actuarial assumptions. In our example above, which is highly simplified, the present value of the pension obligation is based on two key assumptions: the life expectancy of the employee and the discount rate.
If there were a change in either of those assumptions, the pension obligation would change. In a real pension plan, a company must make numerous actuarial assumptions when calculating the pension obligations and expense 11. These assumptions change frequently and could introduce a high degree of volatility into pension expense. U.S.
GAAP also allows the smoothing of the gains or losses arising from changes in actuarial assumptions (known as actuarial gains or losses). This smoothing is also accomplished through recognition into other comprehensive income and subsequent amortisation into pension expense.
4.1.2.5. Recognised Prior Service Costs
The terms of pension plans may be amended at various points. These terms may also be changed retroactively; for example, a company may retroactively enhance benefits as a result of negotiations with labour unions. Likewise, a company may reduce pension benefits if the company is facing financial difficulty.
The monetary impact on the pension obligation due to these plan changes is called prior service cost. These costs are also smoothed through initial recognition in other comprehensive income and subsequent amortisation (on a straight-line basis) over the expected service lives of the employees affected by the plan changes.
4.1.2.6. The Corridor Method
The smoothing mechanism described above presumes that certain changes in plan assets and obligations are transitory and thus will reverse over time. Because the changes may be large, U.S. GAAP requires that excess gains over a materiality threshold (called the corridor) be recognised in pension expense.
Specifically, the corridor is the higher of 10% of the plan’s assets or 10% of the beginning period’s pension obligation. The excess of the net cumulative gains or losses over the corridor is amortised on a straight-line basis over the average remaining service period of plan employees. The corridor method thus assures that companies are recognising a minimum amount of amortisation in pension expense.
4.1.3. Pension Recognition on The Balance Sheet
Companies do not present pension assets and pension obligations directly on the balance sheet. Rather, the balance sheet presents the pension’s funded status. The pension’s funded status is the difference between the pension assets and the pension obligations.
When the pension assets exceed the pension obligations, the pension is over funded, and the over funding is presented on the balance sheet as an asset. When the pension assets are less than the pension obligations, the pension is underfunded, and the underfunding is presented on the balance sheet as a liability.
The pension obligation is formerly referred to as the projected benefit obligation (PBO). The PBO is the present value of the actuarial estimate of future pension benefits paid to employees. The PBO is based on employee’s estimated future compensation and service to date.
The pension plan itself is a separate entity, usually a trust, established to pay benefits to pensioners and invest the assets of the plan. The company makes contributions to the plan, which are then invested by the plan.x The pension assets are also impacted by actual investment gains or losses and benefits paid out of the plan.
Because of the use of deferrals (the smoothing mechanism described above), pension expense does not correspond to the funded status shown on the balance sheet.
4.1.4. Accounting for Defined Benefit Plans under IFRS
IFRS standards for pension accounting mostly parallel those of U.S. GAAPxi. However, there are a few significant differences.
Under IFRS, companies recognise past service costs directly in pension expense. Under U.S. GAAP, these costs are initially recognised in OCI and amortised into pension expense ( current service cost, however, is recognised directly in pension expense).
Under IFRS, companies use the discount rate as the expected return on plan assets. Recall that under U.S. GAAP, companies will use an expected return on plan assets which is likely to be higher than the discount rate. Thus, pension expense is likely to be lower under U.S. GAAP.
IFRS requires companies to recognise actuarial gains or losses and differences between the actual return on plan assets and the discount rate be recognised in OCI without subsequent amortisation. Thus, periodic pension expense under IFRS will generally consist of only current service cost, past service cost, and net interest on the plan’s funded status. This contrasts with the five components of pension expense under U.S. GAAP described in previous sections.
4.2. Analytical Insights for Pension Accounting
To a certain extent, pension obligations represent an analysable liability. This is because the company’s liability today is determined by estimated future events, such as investment returns and employee’s length of service and life expectancy. The liability could change dramatically with a change in key assumptions.
Investors should scrutinise all the actuarial assumptions (disclosed in the pension footnotes) used in the pension calculations. For example, the investor should ask if the projected rate of salary increases is consistent with expected wage inflation, and if the expected life expectancy of employees seems reasonable.
Some assumptions, however, may be more difficult to scrutinise. For example, the investor will likely have to trust management assumptions on the plan participant’s expected length of employment.
Investors should be particularly concerned with two key assumptions: the discount rate and the expected return on plan assets.
Because the obligation is reported as the present value of the future payouts, the obligation will be highly sensitive to the discount rate. Current accounting guidance provides that the discount rate used be based on current rates on high-grade corporate bonds with maturities approximating the future pension payments.
Although companies have limited discretion in the use of the discount rate, they do have discretion. Specifically, companies will have an incentive to use a higher-than-warranted discount rate, as a higher discount rate will result in a lower pension obligation. Investors should thus compare the assumed discount rate to the rates on high-quality credit instruments and to the rates used by peer companies.
Investors should also scrutinise the expected return on plan assets. This expected return lower the period pension expense. Therefore, companies are incentives to use a higher-than-realistic rate. Investors should compare the expected rate with the long-term average rates on the assets which the plan invests in.
The expected rate is a weighted-average of the rates on the various assets within the plan’s target asset allocation. This information is disclosed in the company’s pension footnote.
4.3. Other Post-Retirement Liabilities
Companies may offer additional future benefits to employees in addition to pensions. For example, companies may provide health care and life insurance to certain employees after retirement.
These additional benefits are collectively known as other post-retirement employment benefits (OPEB). These benefits are accounted for using the same methodologies for pensions described in the previous sections. However, a few significant differences exist.
Pensions are highly regulated. Particularly, the Employee Retirement Income Security Act (ERISA) establishes minimum funding requirements for pensions, among other requirements. In contrast, OPEB are not under ERISA funding requirements. In addition, pension contributions are tax-deductible, whereas OPEB contributions are generally not. Therefore, OPEB obligations are more likely to be significantly underfunded than pension obligations.
For most companies, the largest component of OPEB is health care benefits. Companies must estimate the future costs of these benefits. OPEB thus require additional actuarial assumptions.
- LEASE LIABILITIES
A lease is a contract which grants right of control of an asset to the lessee (the party in the contract who is paying to use the asset). Under current accounting standards, companies must recognise an asset and offsetting liability on a lease only when certain conditions are met. When such conditions are met, the lease is considered a form of financing in which the company is given effective ownership of the asset.
Such a lease is referred to as capital leases under U.S. GAAP and a financing lease under IFRS. When the lease does not meet the conditions for capitalisation, the lease is considered an operating lease.
With an operating lease, a company merely recognised the lease payments as an operating expense on a straight-line basis over the life of the lease xii. Thus, no asset or liability is recognised on an operating lease. Many investors considered operating leases to be a significant off-balance sheet liability, since the lease still represents a contractual obligation.
In 2016, the FASB and IFRS both issued updated guidance on accounting for leases xiiix. These new standards will substantially change how companies recognise lease obligations. Under U.S. GAAP, companies must comply with the new standards for all reporting periods after December 15, 2018. Under IFRS, companies must apply the new standards for reporting periods after January 1, 2019.
5.1. Capital Lease Accounting Under Old Standard
Under current U.S. GAAP, a lease must be capitalised when it meets at least one of the four criteria: (1) the lease transfers ownership to the lessee at some point over the lease term, (2) the lease contains a bargain purchase option – i.e., a price low enough that purchase is assured, (3) the lease term represents 75% or more of the asset’s useful life, and (4) the present value of the lease payments is 90% or more of the asset’s fair valuexiv.
When one or more of the above criteria are met, the company must recognise an asset in the amount of the present value of the minimum lease payments. The company must discount these payments at the lower of either the company’s incremental borrowing rate or the interest rate implicit in the lease (the rate which equates the present value of the lease payments with the price of the asset).
The company would depreciate this asset in accordance with its depreciation policy. The company would also recognise a corresponding liability. The company would also build an amortisation schedule showing the interest and principle components of each payment throughout the lease. The company would account for each payment by debiting interest expense and crediting capital lease liability.
Executory costs, such as maintenance, taxes, insurance, etc., must be excluded from the minimum lease payments, and are thus not included in the lease capitalisation. The company would expense such costs as the lease payments are made. When a company provides a residual value guarantee, in which the company guarantees the asset’s value at the end of the lease, the company must add the present value of the guarantee to the capitalised leased asset.
IFRS contains similar, but less-prescriptive, criteria for lease capitalisationxv. The specific language used in the guidance follows the “principle-based” approach of IFRS, and provides for a lower threshold for capitalisation.
For example, IFRS requires capitalisation when the asset represents a “major part” of the asset, rather than the 75% threshold under U.S. GAAP. Another major difference is that IFRS requires the lease payments be discounted using implicit rate of the lease only, whereas U.S. GAAP requires the lower of the implicit rate or the firm’s borrowing rate.
5.2. New Lease Accounting Standards
In February of 2016, the FASB issued a new accounting standard affecting the treatment of operating leases xvi. The new standard will require lessee companies to recognise a capitalised lease liability for operating leases with an offsetting right-of-use asset.
Thus, the new standard will no longer allow lessees to structure leases so the obligation is “off-balance sheet”. The only exception to lease liability recognition will be for short-term leases (less than 12 months). This new standard, however, retains the distinction between operating and financing leases. Public companies must comply with the new standard for all reporting periods after December 15, 2018.
The IASB has issued a similar standard with IFRS 16. This standard differs from the U.S. GAAP standard in several ways, the most notable being that the new IFRS standard recognises no distinction between operating and financing leases. The new IFRS lease standard is required for all reporting periods on or after January 1, 2019.
- HEDGES
Companies are often exposed to significant fluctuations in financial and production inputs. Companies can engage in certain transactions designed to mitigate these fluctuations. These transactions are known as hedges.
Often such transactions involve the use of derivatives, financial instruments whose value is derived from the value of some underlying asset. The accounting for derivative instruments depends on whether the instruments are used for hedging or speculation.
Under U.S. GAAP, stringent criteria must be met before an instrument is considered as a hedge xviii. Particularly, the derivative must be designated as a hedge instrument, the hedging strategy must be clearly described, and the company must describe the derivative’s effectiveness in eliminating a specific risk.
Categorically, a hedging instrument can be a fair value hedge, a cash flow hedge, or a foreign currency exposure hedge. If a derivative instrument does not meet the hedge criteria, the company must account for the instrument by recording the asset at fair value and recognise unrealised gains or losses on the instruments as a component of operating income.
A fair value hedge is an instrument used to hedge the exposure to changes in the fair value of an existing asset or liability. For such a hedge, the company must recognise changes in the market prices of both the asset being hedged and the hedging instrument.
The company would recognise these fair value changes within the respective asset or liability accounts with corresponding gains or losses recognised in current income, regardless of how the asset being hedged would be accounted for with otherwise xix.
By matching fair value changes of the hedged asset or liability with the fair value changes in the hedged instrument, fair value hedge accounting helps smooth earnings volatility which would have been recognised from a speculative derivative.
A cash flow hedge is an instrument intended to mitigate the volatility of future cash inflows and outflows. For such a cash flow hedge, the company would recognise the changes in the fair value of the hedging instrument in Other Comprehensive Income (a component of shareholder’s equity), rather than in operating income.
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