I'm Larry Walther, this is principlesofaccounting.com, chapter 13.
And this is the final module in this chapter, and we're looking at analysis,
debt analysis, disclosures for commitments, lease transactions, and
some fair value measurement and considerations.
First of all looking at analysis.
There's two ratios I would have you look at.
One is the debt to total assets.
Here total debt is simply divided by total assets.
It shows what proportion of the company's total assets are underscored or
represented by financing.
A related ratio, really very much a spin of the first ratio, is debt to equity.
In this case total debt is divided by total equity.
Both these ratios were seen as indicating to the degree on which
the company is financed, or leveraged.
Leverage can be a positive thing or a negative thing,
depending on the relative operating performance of the company and
how much is available for common shareholders.
They're often seen as a sign of financial strength, but
you can't draw any general conclusions about whether small or large values for
these are necessarily good or bad.
One has to look at this on a industry basis.
For example, the financial services industries usually highly leveraged.
They may have 10% of their financing provided through equity and
90% through debt.
That may be perfectly acceptable.
Whereas a manufacturing company may be 50/50 would be a more appropriate mix.
Again, it is highly dependent upon the circumstances.
Another related ratio is times interest earned.
Here we're going to take income before interest and taxes and
divide it by the interest charges.
This is how many times a company is able to incur its interest cost.
Obviously, if it's not able to cover interest costs, it can go and
default on its debt and really lose the ability to continue to operate.
This number's relatively small, it could be a signal or
a sign that the company is on the verge of not generating sufficient
cash flows to coverage mandatory interest obligations.
Again, one needs to be very careful not to place undue reliance on
one particular indicator.
Even this indicator, for example, a cash rich company mail a bad year from
operations and look like they're having trouble covering interest but
it may be they have plenty cash available to cover that interest.
And it may be that their operating performance is gonna return to
a more normal, better state.
What one should also be very careful about is understanding the nature of commitments
that may not be reflected as liabilities on the books.
For example,
a company agrees to buy a certain quantity of supplies from another company.
Often these do not result in the recording or
presentation of an obligation on the balance sheet.
But they may give rise to significant obligations in the future.
Footnote disclosures are generally required for
the aggregate amount of future committed payments,
typically with a year-by-year breakdown at least for the next five years.
So financial statement user should pay close attention to the footnotes,
not only looking at the depth that's on the books, but
the other intrinsic commitments the company may face.
Finally, I would like to point out that in the case of commitments where someone's
locked themselves into a loss position, having to buy something in the future at
a below market value, that loss might be recognized, probably should be recognized
in the period it becomes apparent you're going to be incurring the loss.
So a portion of that loss may be recognized and
recorded as a liability on the books.
Moving on to capital leases.
You’ve already seen operating leases where a company pays periodic rent for periodic
use of an asset, but some transactions are more like the purchase of an asset,
even though they are legally styled as a lease.
Transactions enable the lessee to acquire the needed productive asset,
without an outright purchase.
But the contract for the lease may be so
strong that it's viewed as more like a note.
So in this case, assume we have a five-year lease that's leased on
January 1 of year 1 and the lease agreement provides for
five end-of-year lease payments of $23,739 each.
I've done some underlying mathematics,
assuming a 6% incremental borrowing rate here.
The present value of the five payments at 6% happens to come out to $100,000.
So, when we sign the contract for five years, that $23,000 a year,
we're gonna record the equipment and the capital lease at the present
value of those lease payments discounted back, it comes to $100,000.
The accounting for the lease asset and
obligation take divergent paths at this point.
The asset, the $100,000 asset, would be depreciated over the five year period.
The Obligation Under Capital Lease is accounted for like a mortgage note.
Here, I'm showing the first payment, credit,
cash $23,739, that's the first year.
I'm actually going to record interest expense,
it's interest expense, not rent for 6% liability.
And the difference reduces the liability.
If I were to carry this out for four additional years,
the last payment would exactly pay off the last amount of interest in the obligation.
I believe the mathematics there for
this lease illustration are exactly like mortgage note that was illustrated earlier
in the book so you could actually go back and look at that illustration and
review it to see how you account for a mortgage note.
Here, the Obligation Under Capital lease is viewed in that context.
To have a capital lease, one of several conditions needs to be present.
But essentially the risk and rewards of ownership are transferred to the lessee
and they're committed to pay for it and so we take this approach to accounting for
capital lease.
Importantly, the asset and liability both appear on the company's balance sheet when
a company enters into a capital lease.
Lastly, let's look at fair value accounting.
Okay. The fair value option
can be applied to debt.
Okay. We talked about fair value accounting for
investments in an earlier chapter.
But now I'm suggesting there is an option available to record debt at fair value,
if market rates of interest rise, the value of the debt may decline.
The company could recognize that decline and the corresponding gain.
Not many companies have yet elected to follow this option, but
it is something that is available and
it may be in the offing that it becomes more prevalent in time.
Companies are permitted, but not required,
to recognize changes in value of such liabilities.
Entities that opt for this approach,
report unrealized gains and losses on that debt in earnings at each reporting date.
And the balance sheet is revised to reflect the fair value to debt.
Once a company opt for fair value accounting for a particular debt
instrument, they need to continue to apply that indefinitely into the future.