mitsutaka goto's List: Accounting

• for the most part, it is not captured on the balance sheet.
• here we review only a certain type: the defined  benefit pension plan.
• the company bears the investment risk
• Funded Status = Plan Assets - Projected Benefit Obligation  (PBO)
• During the year, wise investments will hopefully increase the size of the fund.  This is the return on plan assets. Also, employer contributions, cash the  company simply gives from its own bank account, will increase the fund. Finally,  benefits paid (or disbursements) to current retirees will reduce the plan  assets.
  
  On the right, we show the basic calculation of the projected  benefit obligation (PBO), which is an estimate of the future stream of benefit  obligations discounted to the present value into a single number.
• On the left, we show the fair value of the  plan assets.
• the vested benefit obligation (VBO) and the accumulated benefit obligation  (ABO). You do not need either of these for the purposes we discuss here, but ABO  is less than PBO because it assumes that salaries will not rise into the future,  while PBO assumes salary increases. VBO is less than ABO because it counts only  service already performed, but PBO counts the future service (minus turnover  assumptions).
• Whereas the fair value of plan assets (how much the fund was worth) is a  somewhat objective measure, the PBO requires several assumptions which make it  more subjective:
• Service cost is the additional liability created because another year has  elapsed, for which all current employees get another year's credit for their  service.
• Interest cost is the additional liability created because these employees are  one year nearer to their benefit payouts.
• The reason for and effect of the additional interest cost is easier to  understand with an example. Let's assume that today is 2005 and the company owes  $100 in five years, the year 2010. If the discount rate is 10%, then the present  value of this obligation is $62 ($100 ÷ 1.1^5 = $62). (For a review of this  calculation, see Understanding the Time  Value of Money.) Now let one year elapse. At the start of 2006 the  funds now have four years instead of five years to earn interest before 2010,  the present value of the obligation as of 2006 increases to $68.3 ($100 ÷ 1.1^4  = $68.3).
• Experience loss is more commonly labeled actuarial loss/gain, and it too can be  positive or negative. It refers to additional costs created because the changes  in actuarial estimates changes made during the year. For example, we don't know  the cause in PepsiCo's case, but perhaps it increased its estimate of the  average rate of future salary increases or the average age of retirement
• The fair value of the plan assets ($4,245) subtracted by the PBO ($5,214)  results in the funded status at the end of 2003 of -$969 million.
• Now remember we said that pension plans are off-balance-sheet financing, and in  PepsiCo's case, the $4.245 billion in assets and $5.214 billion in liabilities  are not recognized on the balance sheet.
• Therefore, typical debt ratios like long-term debt to equity probably do not  count the pension liability of $5+ billion. But it's even worse than that. You  might think the net deficit of -$969 million would be carried as a liability,  but it is not. Again, from the footnotes:
• Due to the smoothing rules of pension plan accounting, PepsiCo carried $1,288 in  pension plan assets on the balance sheet, at the end of 2003. You can see how  the two "unrecognized" lines on the footnote above boost the negative into a  positive: the losses for the current year, and prior years, for that matter, are  not recognized in full; they are amortized or deferred into the future.  Although the current position is negative almost one billion, smoothing captures  only part of the loss in the current year--it's not hard to see why smoothing is  controversial.
• Cash Contributed to the Pension Is Not Pension Cost
• We can find actual cash contributed in the statement of cash flows:
  
• Now compare these cash contributions to the pension expense. In each of the  three years reported, cash spent was significantly higher than pension expense:
• Critical Questions
• • What is the economic status of the liability? A dramatically under-funded  plan will require increased cash contributions in the future and foreshadows  future increases in income statement expenses.
     
  • How aggressive/conservative is the pension expense? An aggressive accounting  policy is a red flag because it will usually have to be unraveled by the company  in future periods. Conservative policies contribute to earnings that are higher  in quality.
• In regard to our first concern - the economic status of the liability - we want  to look at the funded status that equals the fair value of plan assets minus the  PBO. The two key assumptions that impact the PBO are the discount rate and  projected rate of salary increases. A company can decrease its PBO (and  therefore, increase its funded status) by either increasing the discount rate or  lowering the projected rate of salary increases. You can see that PepsiCo's rate  of salary increase is fairly stable at 4.4% but the discount rate dropped to  6.1%. This steady drop in the discount rate contributes significantly to the  increased PBO and the resultant under-funded status.
  
• In regard to our second concern - the quality of the pension expense - there are  three key assumptions:

21 more annotations...

• When a bank makes 1,000 loans during the quarter, it knows from experience  that, say, 1% of those loans will go bad. It doesn't know which ones will go bad  -- it just knows from statistical experience that 10 of those loans will not be  repaid, or will become slow-paying loans.

   

  Rather than waiting for the credit loss to occur, a bank uses its best  judgment to account for those losses through the provision for loan  losses
• loan loss provision is not a cash expense
• Instead, that $150 million charge builds the loan loss reserve on the  balance  sheet
• Every charge-off causes the reserve to shrink
• the provision for loan losses builds the reserve

3 more annotations...

• Generally, a higher inventory turnover ratio is considered a positive  indicator of operating efficiency, since inventory that remains in place  produces no revenue and increases the cost associated with maintaining those  inventories. However, a higher inventory turnover ratio does not always mean  better performance. You need to analyze it in conjunction with other trends  within the financial statements to ensure that operations are truly business  beneficial.
• Offering large discounts may also generate a boost in sales. Such discounts  erode the company’s profit margins, but will boost revenue and rate of inventory  turnover.
• Watch the gross margins reported by the business. Gross margin is the difference  between the dollar value of sales and cost of goods sold (also termed cost of  sales). If inventory turnover is increasing, but gross margins as a percentage  of sales are decreasing, then this may indicate a problem.

1 more annotation...

• So what happens when a bank buys a portfolio of loans from another bank at a  discount? That’s when banks can apply the accretable yield methodology. Back to  our example, the bank buys a loan portfolio with $100 MM face for $60 MM (60  cents on the dollar). Let’s say the bank believes that 85% of those loans will  be repaid and the average maturity for that portfolio is 10 years. The bank  expects to make $25 MM (expected repayment of $85 MM less the cost of $60 MM) of  profits over 10 years and will therefore accrete $2.5MM per year. In addition it  will accrue 7% x $100 MM x 85% (since only 85% of loans pay interest) = $5.95 MM  of accrued interest. So the accretable yield on the portfolio is the total  annual income over the purchase price = ($2.5MM + $5.95 MM)/ $60 MM = 14%.

  • Original mortgage :$100 MM at an average rate of 7%
    ↓
    Distressed and bought @ $60 MM
    Assuming: 85% is recovrable and avg maturity of 10yr
    ↓
    Total Profitは$85M(since 85% recoverable out of 100M)-$60M=$25M. $2.5M/year
    +
    Annual Interest of 100M*85%*7%=5.95M/yr
    ↓
    So Accretable Yield is ($2.5MM + $5.95 MM)/ $60 MM =14%

• CVA is the market value of counterparty credit risk.

  • nullthey have to mark their liabilities to fair value, and in the case of their own debt (or in this case liabilities on derivative positions), they have to consider their own default potential as a component of fair value. So the more likely it becomes that Citi will default on their debt/swaps, the less those instruments are worth to the investors that hold them. Therefore the accounting guidance says that Citi should reduce the value of the liabilities on their books, and they book this reduction as a gain through the income statement. As an auditor I find the guidance to be ridiculous, but its the rule so companies are following it ... -- 2011-01-18
    (ex)
    
    C default risk ↑　
    
    C bonds less attractive for investores
    
    Liability for C will be less
    
    CはISで、"ゲイン"として計上する -- 2011-01-18
    

• TDR Accounting
  Let’s assume a real estate loan has a  balance of $200,000 with an interest rate of 6% and a remaining term of 28  years. The borrower is in trouble, and the best estimate of property value is  $150,000. The borrower requests a rate modification for two years at 2% to  enable their continued payments on the loan. Let’s also assume the credit union  believes the borrower will make the reduced payments in good faith and will be  able to return to full payments at the end of the concession period.

   

  The first point to recognize is if the credit union simply recognizes the  reduced rate of interest over the course of the next two years, earnings will be  prospectively reduced by the amount of the rate concession (6% versus 2%).  Accounting standards don’t generally allow for delayed loss recognition and  specifically require immediate loss recognition in the context of TDRs.

   

  So how do we calculate the loss in interest income which results from the  rate concession? In this simple example, the amount of loss recognition would be  the present value, discounted at the loans original interest rate of 6%, of the  difference in cash flows that result from the rate concession. Assume the  present value in the difference in payments, discounted at 6%, amounts to  $10,000. This amount would need to be specifically provided for in the Allowance  for Loan Losses for the loan in question. To reiterate, if this entry is not  made at the time of restructure, this amount of loss would be deferred over the  next two years, which is NOT in accordance with GAAP.

   

  The longer the period of the rate concession or the greater the amount  of the rate reduction, the greater the TDR loss to recognize. TDRs can also  result from the forgiveness of part of the outstanding loan balance.

• When Is a Restructure a Troubled-Debt Restructure?  
  Understanding the difference between a restructure versus a  troubled-debt restructure (TDR) is critical. A TDR is one in which the creditor,  for economic or legal reasons related to the debtor's financial difficulties,  grants a concession to the debtor that it would not otherwise consider. A TDR is  the result of an agreement between parties or terms imposed by a court  of law.

• a deferred tax asset (DTA) is a future tax benefit. We like those. A DTA is  created when shareholder income (what the company tells you) is less than  taxable income (what Uncle Sam sees). A DTA is kind of like a prepaid tax
• , if a company doesn't think it will receive the full benefit of a DTA, it can  offset this with a valuation allowance in order to be more conservative. For  example, a company losing tons of money will have lots of NOLs (net operating  losses) as DTAs. These NOLs can be used to offset future income, which lowers  taxes, a good thing. However, if the company can't reasonably expect to make a  future profit, then it will never reap the benefit of those NOLs, and a  valuation allowance must be set up to reflect this

  • Sometimes, a company expects it will not be able to realize the benefits of its deferred tax assets. For example, If a company loses $10 million, it would record a deferred tax asset representing the decrease in taxes on its next $10 million in earnings. However, if the company doesn't expect profits for the next several years, and doesn't expect to earn $10 million in the seven-year time horizon before these deferred tax assets expire, it can't record them at full value - because the company won't be able to take advantage of this tax benefit.
    
    If a company expects there is more than 50% chance it will not be able to realize some of its deferred tax assets (because its future income won't be large enough to take full advantage of these tax breaks), it must report a valuation allowance to account for this

• When a company owns more than 50% of another company, U.S. accounting rules state that the parent company has to consolidate its books.  In other words, the parent company reflects 100% of the assets and liabilities and 100% of financial performance (revenue, costs, profits, etc.) of the majority-owned subsidiary (the “sub”) on its own financial statements. 
• sales or EBITDA from the parent company’s financial statements, these figures due to the accounting consolidation, will contain 100% of the sub’s sales or EBITDA, even though the parent does not own 100%.  In order to counteract this, we must add to Enterprise Value, the value of the sub that the parent company does not own (the minority interest).