Basics of Contingencies

Contingencies -- potential losses and gains whose resolution depends on one or more future events.
Contingent liabilities -- contingencies with potential claims on resources
         -- to record a contingent liability (and loss) two conditions must be met:
(i) probable i.e. an asset  will be impaired or a
         liability incurred, and 
(ii) the amount of loss is reasonably estimable;
         -- to disclose a contingent liability (and loss) there must be at least a reasonable possibility of incurrence
 
Contingent assets -- contingencies with potential additions to resources
      -- a contingent asset (and gain) is not recorded until
                 the contingency is resolved
         -- a contingent asset (and gain) can be disclosed if
            probability of realization is very high 

Analyzing Contingencies 

Sources of useful information:
Notes, MD&A, and Deferred Tax Disclosures
 
Useful analyses:
• Scrutinize management estimates
• Analyze notes regarding contingencies, including
   Description of contingency and its degree of risk
   Amount at risk and how treated in assessing risk exposure
   Charges, if any, against income
• Recognize a bias to not record or underestimate contingent liabilities
• Beware of big baths — loss reserves are contingencies
• Review SEC filings for details of loss reserves
• Analyze deferred tax notes for undisclosed provisions for future losses
 
Note: Loss reserves do not alter risk exposure, have no cash flow consequences, and do not provide insurance 

Basics of Commitments -- potential claims against a company’s resources due to future performance under contract 

Analyzing Commitments 

Sources of useful information:
Notes and MD&A and SEC Filings
 
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
Review SEC filings for details of commitments 

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
Certain joint ventures and limited partnerships
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 

Analysis of Off-Balance-Sheet Financing  

Sources of useful information:
Notes and MD&A and SEC Filings
 
Companies disclose the following info about financial instruments with off-balance-sheet risk of loss:
 • Face, contract, or principal amount
 • Terms of the instrument and info on its credit and market risk, cash requirements, and accounting Loss incurred if a party to the contract fails to perform 
 • Collateral or other security, if any, for the amount at risk
 • Info about concentrations of credit risk from a counterparty or groups of counterparties
 
Useful analyses:
 • Scrutinize management communications and press releases
 • Analyze notes about financing arrangements
 • Recognize a bias to not disclose financing obligations
 • Review SEC filings for details of financing arrangements 

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.
Illustration of SPE Transaction to Sell Accounts Receivable 
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.

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

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
Reverse stock splits 

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

Classification of Capital Stock 

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

Basics of Retained Earnings  

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 

Spin-Offs and Split-Offs 

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.

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