The second set of questions that we would like to answer (and accounting statements to shed some light on) relates to the current value and subsequently the mixture of debt and equity used by the firm. The bulk of the information about these questions is provided on the liability side of the balance sheet and the footnotes.
Just as with the measurement of asset value, the accounting categorization of liabilities and equity is governed by a set of fairly rigid principles. The first is a strict categorization of financing into either a liability or equity based on the nature of the obligation. For an obligation to be recognized as a liability, it must meet three requirements:
Š It must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date.
Š The firm cannot avoid the obligation.
Š The transaction giving rise to the obligation has happened already.
In keeping with the earlier principle of conservatism in estimating asset value, accountants recognize as liabilities only cash flow obligations that cannot be avoided.
The second principle is that the value of both liabilities and equity in a firm are better estimated using historical costs with accounting adjustments, rather than with expected future cash flows or market value. The process by which accountants measure the value of liabilities and equities is inextricably linked to the way they value assets. Because assets are primarily valued at historical cost or at book value, both debt and equity also get measured primarily at book value. In what follows, we will examine the accounting measurement of both liabilities and equity.
Accountants categorize liabilities into current liabilities, long-term debt, and long-term liabilities that are neither debt nor equity; the last category includes leases, underfunded pension and heatlh care obligations and deferred taxes.
Š Current liabilities include all obligations that the firm has coming due in the next accounting period. These generally include accounts payable (representing credit received from suppliers and other vendors to the firm), short term borrowing (representing short-term loans taken to finance the operations or current asset needs of the business) and the short-term portion of long-term borrowing (representing the portion of the long-term debt or bonds that is coming due in the next year). As with current assets, these items are usually recorded at close to their current market value. Long-term debt for firms can take one of two forms: a long-term loan from a bank or other financial institution, or a long-term bond issued to financial markets, in which case the creditors are the investors in the bond. Accountants measure the value of long-term debt by looking at the present value of payments due on the loan or bond at the time of the borrowing. For bank loans, this will be equal to the nominal value of the loan. With bonds, however, there are three possibilities. When bonds are issued at par value, for instance, the value of the long-term debt is generally measured in terms of the nominal obligation created in terms of principal (face value) due on the borrowing. When bonds are issued at a premium or a discount on par value, the bonds are recorded at the issue price, but the premium or discount to the face value is amortized over the life of the bond. In all these cases, the book value of debt is unaffected by changes in interest rates during the life of the loan or bond..
Š Lease obligations include obligations to lessors on assets that firms have leased. There are two ways of accounting for leases. In an operating lease, the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Because the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement, and the lease does not affect the balance sheet. In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a liability (for the lease payments) on the balance sheet. The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year.
Š In a pension plan, the firm agrees to provide certain benefits to its employees, either by specifying a “defined contribution” (wherein a fixed contribution is made to the plan each year by the employer, without any promises as to the benefits to be delivered in the plan) or a “defined benefit” (wherein the employer promises to pay a certain benefit to the employee). In the latter case, the employer has to put sufficient money into the plan each period to meet the defined benefits. A pension fund whose assets exceed its liabilities is an overfunded plan, whereas one whose assets are less than its liabilities is an underfunded plan, and disclosures to that effect have to be included in financial statements, generally in the footnotes.
Š Firms often use different methods of accounting for tax and financial reporting purposes, leading to a question of how tax liabilities should be reported. Because accelerated depreciation and favorable inventory valuation methods for tax accounting purposes lead to a deferral of taxes, the taxes on the income reported in the financial statements will generally be much greater than the actual tax paid. The same principles of matching expenses to income that underlie accrual accounting require that the deferred income tax be recognized in the financial statements, as a liability (if the firm underpaid taxes) or as an asset (if the firm overpaid taxes).
The accounting measure of equity is a historical cost measure. The value of equity shown on the balance sheet reflects the original proceeds received by the firm when it issued the equity, augmented by any earnings made since then (or reduced by losses, if any) and reduced by any dividends paid out during the period. A sustained period of negative earnings can make the book value of equity negative. In addition, any unrealized gain or loss in marketable securities that are classified as available-for-sale is shown as an increase or decrease in the book value of equity in the balance sheet.
When companies buy back stock for short periods with the intent of reissuing the stock or using it to cover option exercises, they are allowed to show the repurchased stock as treasury stock, which reduces the book value of equity. Firms are not allowed to keep treasury stock on the books for extended periods and have to reduce their book value of equity by the value of repurchased stock in the case of actions such as stock buybacks. Because these buybacks occur at the current market price, they can result in significant reductions in the book value of equity.
Accounting rules still do not seem to have come to grips with the effect of warrants and equity options (such as those granted by many firms to management) on the book value of equity. If warrants are issued to financial markets, the proceeds from this issue will show up as part of the book value of equity. In the far more prevalent case, where options are given or granted to management, there is no effect on the book value of equity. When the options are exercised, the cash inflows do ultimately show up in the book value of equity, and there is a corresponding increase in the number of shares outstanding. The same point can be made about convertible bonds, which are treated as debt until conversion, at which point they become part of equity.
As a final point on equity, accounting rules still seem to consider preferred stock, with its fixed dividend, as equity or near equity, largely because of the fact that preferred dividends can be deferred or accumulated without the risk of default. Preferred stock is valued on the balance sheet at its original issue price, with any accumulated unpaid dividends added on. To the extent that there can still be a loss of control in the firm (as opposed to bankruptcy), we would argue that preferred stock shares almost as many characteristics with unsecured debt as it does with equity.