A basic understanding of accounting for liabilities is necessary to assess the viability of any company. Companies are required to follow certain accounting rules; however, the rules allow considerable flexibility in how a company accounts for liabilities. Unfortunately, the flexibility also gives a company's management the opportunity to manipulate reports. In addition, different accounting procedures may make it hard to compare the financial statements of different companies in a specific industry or to monitor the performance of a single company over time.
A lender or credit analyst examining the financial statements of a firm needs to be aware of the different accounting methods available and the choices made by the company. Otherwise, a sound decision on whether to lend to the company is impossible.
Long-term liabilities can be analyzed with even a limited comprehension of the many accounting rules governing their reporting. Understanding liability accounting will allow the discovery of unreported liabilities (or off-balance-sheet obligations) and make a valid lending decision possible.
This article examines the flexibility allowed for reporting long-term liabilities with complex accounting rules. The following four types of long-term liabilities are discussed:
1. Leases. 2. Pensions. 3. Postretirement benefits. 4. Deferred taxes.
While the Financial Accounting Standards Board Statement of Financial Accounting Standards (SFAS) No. 13, "Accounting for Leases," has been revised several times since its inception in 1976, it still contains the basic rules for lease accounting. Of primary importance is the distinction between capital and operating leases.
Capital leases are reported on the balance sheet as both an asset (the present value of the future use of the leased property) and a liability (the present value of the future lease payments). A capital lease is treated much like a purchase of property when the selling company provides financing.
Operating leases, on the other hand, are not reported on the balance sheet. However, operating leases may be a significant portion of the long-term financial commitments of a company. For example, Delta Airlines in its 1993 annual report showed minimum operating lease commitments totaling $18 billion. This is more than three times its total noncurrent liabilities.
SFAS No. 13 provides a clear, if complex, definition of leases that are required to be reported as capital leases. A lease is considered a capital lease if it meets one of the following four criteria:
* Title is transferred at the end of the lease period.
* The lessees can purchase the asset at the end of the lease period for less than the estimated fair market value (a bargain-purchase option).
* The lease period (noncancelable) is for more than 75% of the useful life of the asset.
* The present value of the minimum future lease payments is more than 90% of the fair market value of the asset.
What this means for an unwary lender is that the company can structure a lease so that it does not meet the definition of a capital lease and, therefore, does not need to be included in the financial statement as a liability. A lease of real estate for 20 years (a period that is less than 75% of its useful life) may not meet the definition of a capital lease, despite the fact that it may be one of the most significant future obligations of a company.
Financial statement footnotes provide a way to assess a company's exposure to operating leases. A company is required to project operating lease obligations individually for five years and to provide a total amount for subsequent years. With this information, the future payments for operating leases can be determined. Although it is not an easy task, the amount of future payments should be expressed at present value (no estimate of an appropriate discount rate is provided in SFAS No. …