ues prior to the actual restructuring. However, management has considerable
opportunity to bias this information by delaying reporting losses for asset impairments,
or by misestimating the fair values of assets at a debt restructuring.
Key Analysis Questions
As noted above, both debt and equity investors are interested in changes in the fair
value of liabilities. Current reporting rules require U.S. ´¬ürms to report these values
and to estimate the consequences of changes in value for restructured debt instru-
ments. However, these rules create opportunities for management to use judgment
in reporting these effects. This raises several opportunities for analysts:
ÔÇó Has the fair value of debt declined? If so, what factors prompted this decline?
Have interest rates in the economy increased since the debt was issued at a
fixed rate? Or have the firmÔÇ™s assets and future cash flows become riskier, in-
creasing the risk faced by creditors? If the latter, has the firm written down
the value of impaired assets?
ÔÇó Has the fair value of debt increased? If so, is the change due to decreases in
interest rates or to a change in the firmÔÇ™s business?
ÔÇó If debt has become riskier, how reliable are the management estimates of the
ÔÇó If the firmÔÇ™s debt value has increased, does it appear to be in financial difficulty?
Liability and Equity Analysis
5-13 Part 2 Business Analysis and Valuation Tools
ABOUT LIABILITY ACCOUNTING
The above discussion of accounting for liabilities reveals a number of popular miscon-
ceptions about the nature of accounting for liabilities.
1. ItÔÇ™s prudent to provide for a rainy day.
Some ´¬ürms take the approach that it pays to be conservative in ´¬ünancial reporting and
to set aside as much as possible for contingencies. This logic is commonly used to justify
large loss reserves for insurance companies, for merger expenses, and for restructuring
charges. This argument presumes that investors are not able to see through current over-
estimates and will give the ´¬ürm credit for its performance when it reverses these charges.
From the standpoint of a ´¬ünancial statement user, it is important to recognize that con-
servative accounting is not the same as ÔÇťgoodÔÇŁ accounting. Financial statement users
want to evaluate how well a ´¬ürmÔÇ™s accounting captures business reality in an unbiased
manner, and conservative accounting can be as misleading as aggressive accounting in
this respect. Further, conservative accounting often provides managers with opportunities
for ÔÇťincome smoothing,ÔÇŁ which may prevent analysts from recognizing poor performance
in a timely fashion. Finally, over time, investors are likely to ´¬ügure out which ´¬ürms are
conservative and may discount their managementÔÇ™s disclosures and communications.
2. Off-balance-sheet financing is preferable to on-balance-sheet financing.
Some managers appear to believe that off-balance-sheet ´¬ünancing is preferable to ´¬ü-
nancing on the balance sheet because unsophisticated ´¬ünancial statement users are then
likely to underestimate the ´¬ürmÔÇ™s true leverage. Once again, this view is predicated on
investors being ´¬ünancially na├»ve. There may be good reasons for using types of debt ar-
rangements that are off-balance-sheet. For example, operating leases tend to reduce the
risks of ownership of assets, which may be important for ´¬ürms that want to be able to
quickly upgrade to the latest technology. However, it seems unlikely that investors will
continuously be fooled by off-balance-sheet liabilities, particularly given the increased
importance of well-trained institutional investors in the market. Further, there is a risk
that once they have discovered the ´¬ürmÔÇ™s attempts to mislead them, investors will be
wary of subsequent management reports.
EQUITY DEFINITION AND REPORTING CHALLENGES
As noted earlier, it is dif´¬ücult to specify the payoffs attributable to stockholders, which
in turn makes it dif´¬ücult to value equity. Accountants therefore treat equity as a residual
claim, whose value is de´¬üned exclusively by the values assigned to assets and liabilities.
180 Liability and Equity Analysis
Liability and Equity Analysis
Consequently, the challenges discussed for valuing assets and liabilities also apply to eq-
uity valuation. In addition, there are two reporting challenges that are speci´¬üc to equity:
the reporting for hybrid securities, and the allocation of equity values between reserves,
capital, and retained earnings.
Challenge One: Hybrid Securities
On August 11, 1998, Helix Hearing Care of America Corp., a Montreal-based hearing
aid chain, sold $2 million of convertible debentures. The debentures had a ´¬üve-year term
and a 13 percent coupon rate and were convertible into Helix common shares at
CA$1.70. Is this security a debt instrument or an equity claim? This question is further
complicated by the fact that the likelihood that the claim will be converted to equity
changes over time as HelixÔÇ™s stock price increases and decreases.
Convertible debt is a hybrid security. Typically it commands a lower rate of interest
than a straight debenture, since the seller also receives the option to convert the debt into
common shares. The value of the conversion right depends on the conversion price, the
´¬ürmÔÇ™s current stock price, the government bond rate, and the estimated variance of the
´¬ürmÔÇ™s stock returns. A good case can be made for separating the debt and equity com-
ponents of a convertible issue, since the value of each can be separately estimated. The
value of the debt claim will vary over time with interest rates. The value of the option
will vary with the ´¬ürmÔÇ™s stock price.
However, accounting rules do not recognize any value attached to the conversion right.
The convertible debenture is therefore reported as if it were nonconvertible debt (see APB
14). If the debt converts, it can be recorded using either the book value or market value
methods. The book value approach records the exchange at the book value of the convert-
ible debt. No gain or loss is recorded on conversion. The market value method values the
equity issued at its market value and records any difference between the market value of
the equity and the book value of the convertible debt as an ordinary gain or loss.
The accounting rules for hybrid securities are simpli´¬ücations of the underlying eco-
nomics. This raises questions about how to compare two ´¬ürms that use the same effective
capital structure, but where one uses hybrid securities and the other does not. Simply
looking at the ´¬ünancial statements of the two will not give an accurate re´¬‚ection of the
leverage of each. The ´¬ürm with the hybrid securities will appear to be more highly le-
veraged, using book values of debt and equity, because the conversion right is not re-
corded. Ideally, an analyst would attempt to separate the debt and equity components of
hybrid securities to make a more valid comparison of capital structures.
Challenge Two: Classification of Unrealized Gains and Losses
The second challenge for equity valuation relates to how to allocate certain unrealized
gains and losses within the equity segment of the balance sheet. Should these items be
included in the income statement and then in retained earnings? Alternatively, should
Liability and Equity Analysis
5-15 Part 2 Business Analysis and Valuation Tools
they be treated as separate non-operating items that can only go through income when
they have been realized?
As discussed in other chapters on accounting, current accounting rules require some
unrealized gains and losses to be charged to a reserve rather than going through the in-
come statement. These include gains and losses on
ÔÇó financial instruments that are available for sale (see Chapter 7),
ÔÇó financial instruments used to hedge uncertain future cash flows (see Chapter 7), and
ÔÇó foreign currency translations for foreign operations whose transactions occur in the
local currency rather than in the parentÔÇ™s currency (see Chapter 4).
These types of gains and losses are sometimes referred to as ÔÇťdirty surplusÔÇŁ charges,
since they are not recorded in the income statement. A system where all accounting
charges are re´¬‚ected in income is called ÔÇťclean surplusÔÇŁ accounting. We will see that this
concept is important in subsequent chapters, where we discuss earnings-based valuation
It is worth noting that changes in equity book values from many of the ÔÇťdirty surplusÔÇŁ
gains and losses are dif´¬ücult to predict from year to year, since they depend on changes
in ´¬ünancial instrument and foreign currency prices, which are themselves dif´¬ücult to
forecast. Consequently, their expected impact in any given year is likely to be zero.
How should analysts and users of ´¬ünancial statements view equity changes that are
not reported in income? Conceptually, there is no strong economic justi´¬ücation for treat-
ing them differently from gains and losses that are included in the income statement. For
example, from an analystÔÇ™s point of view they are no different from gains and losses on
asset sales, realized gains and losses on sales of ´¬ünancial instruments, and unrealized
gains and losses on ´¬ünancial instruments intended to be traded, all of which are included
in income. The justi´¬ücation for treating all gains and losses comparably is reinforced by
the potential concern that management might use reporting judgment to exclude certain
types of gains and losses from earnings. Perhaps in response to these concerns, the FASB
now requires ´¬ürms to prepare a statement of comprehensive income, showing all
changes in equity, other than capital transactions, in one place (see SFAS 130).
Key Analysis Questions
Analysis of equity values is largely covered in the earlier discussion of asset and
liability analysis. The following questions are unique to equity analysis:
ÔÇó What charges are included in earnings, and what are excluded? How should
these charges be viewed?
ÔÇó Does the firm have hybrid securities? If so, is it worthwhile separating their
debt and equity components? How has the conversion value changed since
their issue? Is it likely that the debt will be converted, making it closer to eq-
uity than debt?
182 Liability and Equity Analysis
Liability and Equity Analysis
To recognize a liability, a ´¬ürm has to have incurred an obligation to provide a future ben-
e´¬üt to another entity, and to be able to estimate the value of that obligation with reason-
able certainty. Liabilities continue to be recorded at their historical cost on the balance
sheet. However, in footnote disclosures, ´¬ürms are required to report fair value estimates
for interest-bearing debt. In future years we may even see balance sheet values based on
fair values as accountants become more con´¬üdent that fair values of liabilities can be es-
However, valuation of certain types of liabilities can be challenging if there is uncer-
1. whether an obligation has been incurred, as is the case for restructuring reserves,
frequent flyer programs, and litigation;
2. the value of the obligation, as in the case of environmental liabilities, warranty
reserves, insurance loss reserves, and pensions; and
3. changes in values of liabilities, as in the case of a troubled debt restructuring.
Managers are likely to have the best information about the extent of the ´¬ürmÔÇ™s liabil-
ities. However, they also have incentives to understate the ´¬ürmÔÇ™s ´¬ünancial risks, creating
opportunities for liability analysis.
The other major claimant on the ´¬ürmÔÇ™s assetsÔÇ”equityÔÇ”can be viewed as the residual
owner of the ´¬ürm. Because it represents that portion of the claims on the ´¬ürm that are
most dif´¬ücult to specify, it cannot be valued as precisely as liabilities. Consequently,
´¬ünancial reporting treats equity as the difference between asset and liability values. The
challenges in measuring and reporting for assets and liabilities are therefore also relevant
to the valuation of equity. In addition, there are several challenges that are speci´¬üc to
equity reporting, such as the valuation of hybrid securities (e.g., convertible debt) and
the classi´¬ücation of certain gains and losses.
1. As discussed in the chapter, the following restructuring events were reported by
a. In October 1994, the company announced plans to lay off 7 percent of its 8,600-
person staff, close two spice plants, and sell off a money-losing onion-ring op-
eration. A $70.5 million restructuring liability was created for the costs of the re-
b. In February 1995, the company reduced the amount of the charge by $3.9 mil-
lion, which it added to earnings in the first quarter of 1995.
c. In 1996 McCormick announced a second restructuring. Most of the costs of the
restructuring ($58.1 million) were recognized immediately as a restructuring li-
ability. However, the firm noted that some charges related to costs of moving
Liability and Equity Analysis
5-17 Part 2 Business Analysis and Valuation Tools
equipment and personnel from a closed U.S. packaging plant could not be ac-
crued. These charges (for $1.9 million) were eventually recognized in the fourth
quarter of 1998.
d. In the third quarter of 1997, McCormick reevaluated its restructuring plans and
recorded a restructuring credit of $9.5 million because plans to sell an overseas
food brokerage and distribution business were not completed.
e. The 1996 restructuring was concluded in the fourth quarter of 1998 and a further
restructuring credit of $3.1 million was reported.
What are the financial statement effects of these events? As a corporate manager,
what forecasts do you have to make to record these events? As a financial analyst,
what questions would you raise with the firmÔÇ™s CFO about the restructuring events?
2. What are the economic costs and benefits to airlines from frequent flyer programs?
What information would you need to measure these costs and benefits? As a financial
analyst, what questions would you raise with the firmÔÇ™s CFO about its frequent flyer
3. The cigarette industry is subject to litigation for health hazards posed by its products.
The industry has been negotiating a settlement of these claims with state and federal
governments. As the CFO for Philip Morris, one of the larger firms in the industry,
what information would you report to investors in the annual report on the firmÔÇ™s lit-
igation risks? How would you assess whether the firm should record a liability for
this risk, and if so, how would you assess the value of this liability? As a financial
analyst following Philip Morris, what questions would you raise with the CEO over
the firmÔÇ™s litigation liability?
4. As discussed in the chapter, Hanson Plc incurred an environmental liability from its
1991 acquisition of the U.S. firm Beazer. In 1997 the company reported that, based
on third party appraisal, its estimate could be reduced by ┬ú430.3 million. In 1998
Hanson agreed to pay further costs of ┬ú168 million, and two insurance companies
guaranteed to cover any remaining costs up to ┬ú488 million. After the agreement,
┬ú67 million of the estimated liability was no longer required and was recorded as an
unusual credit. What are the financial statement effects of these events?
5. Hewlett Packard reported the following information on its U.S. retiree medical plan: