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As a result of the dif¬culty in estimating the costs of cleanups, it is unclear when a
company responsible for waste cleanup should record a liability for its cost. Should it be
when the party is suspected of being responsible for hazardous waste? Should it be when
it is named as a responsible party for a particular site cleanup? Should it occur when a
study has been conducted to estimate the cleanup costs? Or, should it be when a settle-
ment has been reached with other liable parties for the cost of the cleanup?
The dif¬culties in assessing legal liability for cleanup are illustrated by the case of
Hanson Plc, a U.K. building materials ¬rm that was formed from the breakup of the Han-
son conglomerate. In 1991 Hanson acquired the U.S. ¬rm Beazer, a homebuilding ¬rm.
Prior to its acquisition by Hanson, Beazer had owned and then sold a chemical company,
Koppers, which had been prosecuted by the Environmental Protection Agency (EPA) for
leaking dangerous chemicals at 119 sites in the U.S. Under U.S. law, Hanson was con-
sidered liable for some of the environmental cleanup costs for Koppers™ sites. The
cleanup costs were initially thought to be in excess of $2 billion. Hanson, however, dis-
puted the cost effectiveness of the cleanup procedures required by the EPA and its share
of these costs relative to its own insurers. In its 1996 annual report, Hanson noted that it
had set aside £938 million as a liability to cover the cleanup costs. However, in 1997 the
company reported that, based on a third-party appraisal, its estimate could be reduced
by £430.3 million. The liability was consequently reduced and an exceptional credit re-
corded in the pro¬t and loss account. In 1998 Hanson agreed to pay further costs of £168
million, and two insurance companies guaranteed to cover any remaining costs to settle
the dispute, up to £488 million. After the agreement, £67 million of the estimated liabil-
ity was no longer required and was recorded as an unusual credit.
Given the challenges in measuring cleanup costs, accounting rules permit ¬rms to de-
lay recording a liability for environmental costs until much of the uncertainty over the cost
of cleanup and the ¬rm™s responsibility have been resolved. SFAS 5 and Statement of
Position 96-1 require that an obligation be reported when the following conditions hold:
1. A firm has been identified as a potentially responsible party.
2. The firm is participating in a remedial feasibility study.
3. A remedial feasibility study has been completed.
4. A decision has been made as to the method of cleanup and an estimate made of
the cleanup cost.
5. The firm has been ordered to clean up a site.
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Research ¬ndings indicate that there is considerable variation in the quality of ¬nan-
cial statement disclosures on estimated environmental cleanup liabilities for affected
¬rms. Factors in¬‚uencing ¬rms™ disclosures include regulatory enforcement, manage-
ment™s information on allocation uncertainty, litigation and negotiation concerns, and
capital market concerns.3

EXAMPLE: PENSION AND OTHER POSTEMPLOYMENT BENEFIT LIABILITIES.
Many ¬rms make commitments to employees under de¬ned bene¬t plans for prespeci-
¬ed pension or retirement bene¬ts at some point in the future. The challenge that arises
in reporting on these commitments comes from the dif¬culty in measuring the bene¬ts
provided. For example, consider the September 1996 agreement reached between the
Big Three U.S. auto manufacturers and the United Auto Workers union. The agreement
provided the following incremental bene¬ts for hourly employees:
a. Basic pension benefits were increased by $4.55 ($1.15) a month for every year
worked for new (current) retirees. New retirees are employees who retired after
September 1996, and current retirees are those who retired before this date.
b. New retirees who retired prior to age 62 but had 30 years of service received an
$80-a-month increase in pension benefits in 1997, a $160-per-month increase in
1998, and a $265-per-month increase thereafter. Current retirees who had retired
prior to 62 but had 30 years of service received an $80-a-month increase in pen-
sion benefits.
c. Current retirees received two cost-of-living lump sum payments in 1997 and
1998. The amount of the payment depended on the retiree™s years of service and
inflation rates for those years.
d. Retired employees (new and current) were eligible for up to $1,000 a year in tu-
ition assistance for approved courses through the Retiree Tuition Assistance Plan.
What are the economic obligations that GM, Ford, and Chrysler incurred under this
pension plan? To estimate the timing and expected pension bene¬ts for current and past
employees, the ¬rms have to forecast the life expectancies of current and past employ-
ees, as well as the future working lives with the ¬rm and retirement ages of current em-
ployees. The present value of these future commitments, net of pension plan assets,
represents the economic obligation under the pension plan. The obligation increases
over time to re¬‚ect the incremental pension earned with years of service, and interest ac-
cruing on the liability. The obligation also changes if the ¬rm retroactively changes the
bene¬ts to be paid to employees for past service. Finally, the pension obligation de-
creases as the ¬rm funds its obligation, as plan assets increase in value, and as the ¬rm
pays out bene¬ts to retired employees.
How does accounting re¬‚ect this obligation, given the challenge of making actuarial
assumptions about employees™ working lives and retirement decisions? The current
rules, discussed in SFAS 87, recognize most of the above effects, but they require ¬rms
to amortize changes in the obligations that arise from retroactive changes in pension
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bene¬ts (called prior service costs) and from changes in pension asset values over time,
rather than recognizing them immediately. As a result, the reported pension liability is
likely to be understated. However, current rules also require ¬rms to disclose in the foot-
notes the full liability, termed the projected bene¬t obligation, and the fair value of plan
assets.4 For example, in its 1996 annual report, Ford reported the projected benefit obli-
gation for U.S. plans at $28.2 billion, and the fair value of the plan s assets at $30.9 bil-
lion. In contrast, GM™s projected benefit obligation was reported at $44.5 billion, and its
plan assets had fair values of $40.2 billion. Ford thus had surplus assets in its pension
plan, whereas GM showed a shortfall for which the company is ultimately liable.
The range of actuarial assumptions, discount rate assumptions, and amortization
periods for prior period service costs and gains or losses on plan assets all provide man-
agement with an opportunity to exercise discretion in the reporting of pension and
postemployment bene¬t liabilities.5 In addition, accounting rules for these liabilities do
not always re¬‚ect the full effect of changes in plan obligations and fair values. Both these
factors create opportunities for analysis.

EXAMPLE: INSURANCE LOSS RESERVES. Insurance companies typically recog-
nize revenues before the amount and timing of claims for the period have been fully re-
solved. As a result, insurance managers have to estimate the expected costs of
unreported claims and reported claims where the claim amount has not been settled.
Management bases its estimates on data on reported claims and estimates of the costs of
settlement, as well as historical data and experience in estimating unreported losses. For
example, in its 1995 ¬nancial statements, Travelers Property Casualty Corp. estimated
that its gross loss reserve was $13.9 billion. The company also reported details on dif-
ferences between its estimated losses on a yearly basis and subsequent loss realizations
for those years. It estimated loss reserves for 1985 claims at $5.5 billion in 1985. In sub-
sequent years, Travelers management steadily revised this estimate upward. In 1986 the
estimate was increased to $5.9 billion, in 1990 to $6.9 billion, and in 1995 to $8.5 bil-
lion. A similar pattern of under-reserving arose for each of the years 1986 to 1992. The
de¬ciencies amounted to $2.6 billion, $2.3 billion, $2.0 billion, $1.7 billion, $1.2 billion,
$0.7 billion, and $0.3 billion for these years.
The data for Travelers illustrate how dif¬cult it can be to forecast future claims. The
data also show that there are potentially signi¬cant opportunities for management to
make mistakes in forecasting, and to bias its estimates either for regulatory purposes or
for stock market valuation purposes.6 The disclosures of estimates and subsequent revi-
sions of estimates provide analysts with extensive information to evaluate management™s
reporting for reserves. However, even with these data, it can be challenging to assess
whether systematic under- or overestimates arose from poor management forecasting,
unforeseen events, or management bias in reporting.

EXAMPLE: WARRANTIES. Many manufacturers provide implicit or explicit product
warranties on their products. How should these be reported in the ¬nancial statements?
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Should a liability be created when sales are recognized to re¬‚ect an estimate of the costs
of returns or repairs? Alternatively, should ¬rms wait until returns actually occur before
recognizing the ¬nancial implications of the warranty commitment?
Accounting rules require that ¬rms that offer warranties establish a liability for prob-
able losses that have been incurred at the ¬nancial statement date. Thus, in its 1998 an-
nual report, General Motors reported that it had a $14.6 billion liability for “warranties,
dealer and customer allowances, claims and discounts.”
Of course, estimating the potential commitment for warranty costs is not an easy task.
It should come as no surprise that there are sometimes sizable errors in management™s
estimates. For example, on December 21, 1994, Intel, the world™s largest silicon chip
manufacturer, bowed to consumer pressure and agreed to replace millions of Pentium
chips that contained a ¬‚aw in long-division calculations requiring maximum precision.
The recall was the largest in computer history. Intel announced that it would replace all
the chips without question, and gave users the option of requesting a replacement chip
to ¬t into their own computers or having the work done by a dealer. Since no prior lia-
bility had been created to allow for any such possibility, Intel created a $475 million li-
ability at the end of the fourth quarter. This liability covered replacement costs,
replacement material, and inventory write-down related to the division problem. It is in-
teresting to note that Intel still has not created a liability for other possible losses from
explicit or implicit warranties on their products.


Key Analysis Questions
Given the role of management judgment in assessing whether a ¬rm has incurred
an obligation that can be measured with reasonable certainty, there is ample op-
portunity for analysts to question whether there are signi¬cant liabilities that are
not reported on the balance sheet. Speci¬c questions can include the following:
• What potential obligations are not included on the balance sheet? What fac-
tors explain these omissions? Does the firm adopt a business strategy that
gives rise to off-balance-sheet financing? Does management appear to be us-
ing off-balance-sheet financing to improve the balance sheet™s appearance?
If so, what factors underlie this decision?
• Are any off-balance-sheet liabilities likely to be significant in terms of eval-
uating the firm™s effective leverage and financing risks, either relative to its
own historical standard or relative to the norms of other firms in the industry?
If so, is it possible to make an estimate of their effect?
• Does the firm report liabilities where the amount and timing of the obliga-
tions are based largely on management judgment? If so, what are the key
management assumptions?
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• If liability values are dependent on management assumptions or forecasts, is
management likely to have information about these parameters that is supe-
rior to that of analysts? If so, what is management™s track record in prior
years™ forecasts? Has management systematically made optimistic or pessi-
mistic forecasts?
• If liability values are dependent on management assumptions or forecasts, are
analysts likely to be as informed on these parameters as management? For ex-
ample, management is unlikely to have any superior insight about market in-
terest rates. In such cases, are management™s estimates consistent with those
of experts in the market?



Challenge Three: Changes in the Value of Liabilities
Fixed-rate liabilities are subject to changes in fair values as interest rates change. Rates
can change, either because of market-wide ¬‚uctuations or because of ¬rm-speci¬c rate
¬‚uctuations attributable to changes in the market assessment of risks borne by debt own-
ers. How are such changes in value re¬‚ected in the ¬nancial statements? Does the ¬rm
report liabilities at their historical cost, or mark them up or down to fair values? We ex-
amine the reporting for troubled debt to illustrate the issues in reporting for changes in
liability values.

EXAMPLE: TROUBLED DEBT. On January 15, 1996, Muscocho Explorations Ltd.,
Flanagan McAdam Resources, and McNellen Resources Inc., three Canadian gold min-
ing companies, signed an agreement with their principal secured creditor, Canadian Im-
perial Bank, to restructure the CA$8.95 million secured debt the three companies owed
the bank. Under the agreement, Canadian Imperial received proceeds from the sale of
the Magnacon Mill as well as a $500,000 payment for the Magino Mill. The bank agreed
to convert its remaining debt to 10 percent of the equity in a new company created by
combining Muscocho, Flanagan, and McNellen. The companies™™ other major secured
creditor, Echo Bay Mines Ltd., also agreed on similar terms to convert the CA$4.46 mil-
lion owed by Flanagan and McNellen.
What are the economic effects of a debt restructuring? A troubled debt restructuring
arises when a ¬rm™s assets and cash ¬‚ow generation decline. Most of this decline in asset
values is borne by the shareholders. However, the creditors can also suffer a loss if there is
an increase in the likelihood that the ¬rm will be unable to meet debt principal and interest
obligations. The creditors then have to decide whether to make concessions to the ¬rm by
exchanging their current claims for new claims, or to force the ¬rm into bankruptcy.
How would the above events be reported in the ¬rm™s ¬nancial statements? Impair-
ments in asset values should have been recorded as asset write-downs, with accompany-
ing disclosures about the reasons for impairment and management™s future plans.
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Further, under SFAS 107, U.S. ¬rms would continue to show liabilities at their historical
cost, but would disclose the fair value of interest-bearing debt instruments in a footnote.
It is worth noting that fair value estimates of debt are likely to be imprecise when a ¬rm
is in ¬nancial distress. This occurs because the debt claim can be converted into equity
if the ¬rm defaults. As discussed below, equity claims are more complex to value since
they are residual claims on the ¬rm™s cash ¬‚ows, rather than ¬xed commitments.
How would the troubled debt restructuring itself be recorded? Under SFAS 15, there
would be no change in the valuation of the debt until a formal restructuring takes place.
If such an agreement provides for the debt to be retired in exchange for assets, as is the
case for Muscocho, Flanagan, and McNellen, an extraordinary gain is recognized to re-
¬‚ect the difference between the book value of the debt and the fair value of the assets.
This transaction may require the ¬rm to initially revalue the assets involved to their fair
values, recording a gain or loss as ordinary income. Alternatively, as discussed in SFAS
118, if the terms of the debt are modi¬ed (by changing the interest rate or principal, or
by extending the payment dates), no gain is recorded. Instead, the implied interest rate
on the modi¬ed debt is computed to equate the present value of the modi¬ed and original
payments. The debt continues to be reported at its book value, and the new interest rate
is used to compute the revised interest expense.
The above method of reporting for a troubled debt restructuring indicates that inves-

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