Module 5: Liabilities

Question 1

I have employees work for me and I don’t pay them in cash, I record?

Answer 1

DR salary expense XX / CR accrued liabilities (or salaries payable or accrued liabilities) XX

Question 2

3 flavors of contingent liabilities

Answer 2

1. remote
2. reasonably possible
3. probable and estimable

Question 3

when a contingent liability falls under the remote category, a company _______

Answer 3

ignores it (no accounting implications)

Question 4

when a contingent liability falls under the reasonably possible category, a company _______

Answer 4

discloses it in footnotes (but doesn’t record it)

Question 5

when a contingent liability falls under the probable and estimable category, a company _______

Answer 5

records the liability: DR expense XX / CR liability (or reserve) XX

and will probably also disclose it in footnotes

Question 6

examples of permanent book/tax differences

Answer 6

municipal interest income, fines and penalties, meals and entertainment, federal income tax expense itself

these are included in GAAP income but not taxable income (except for meals and expenses, which are only 50% deductible against tax income)

Question 7

working capital

Answer 7

current assets - current liabilities

Question 8

current ratio

Answer 8

current assets / current liabilities

Question 9

quick ratio

Answer 9

current (cash + market securities + A/R) / current liabilities

Question 10

If a company earns interest on a municipal bond, is it included in GAAP (“book”) net income?

But, is such income in taxable income

Answer 10

Yes

No - because federal government doesn’t tax income on state/local regulations

Question 11

PBITWSBT

Answer 11

pretax book income that will someday be taxed

Question 12

mortgage bonds

Answer 12

bonds that are secured by specific property

in the case of default on the bond, the bondholders have the first right to proceeds from the sale of that property

Question 13

debentures

Answer 13

bonds with only a general claim against total assets, like other general creditors (as opposed to a claim against specific assets, which is what mortgage bonds have)

Question 14

subordinated debentures

Answer 14

these are debentures with only a general claim against the company’s total assets, but with lower priority than other general creditors

Question 15

I buy inventory and I don’t pay in cash. I record:

Answer 15

DR inventory XX / CR A/P XX

Question 16

I have employees work for me and I don’t pay in cash. I record:

Answer 16

DR salary expense XX / CR accrued liabilities

Question 17

Who do you deal with when borrowing via private placements vs. from the general public (bonds)?

Answer 17

borrow private placements: negotiate terms directly with the lender

borrow from general public: arrange terms through underwriter (i.e. intermediary like ibank) and then the underwriter sells the bonds to the investor

Question 18

Examples of private placements?

Answer 18

Promissory notes payable (notes payable): arise from borrowing $, more formal than A/P, usually borrowed from banks

Credit facilities: provide companies with lines of credit where they can borrow up to a specific limit without having to go through loan approval process, company pays a fee for this arrangement and pays interest on any borrowings

Commercial paper: short-term (60-90 days), borrowed from banks and other institutions (like money market funds)

Question 19

issue 10 mill in promissory notes payable, JE?

Answer 19

DR cash 10 mill / CR promissory notes payable 10 mill

Question 20

3 flavors of bonds?

Answer 20

1. Mortgage bonds: bonds secured by specific property, if defaulted on they have the 1st right to proceeds from sale of that property, then put on same level for the rest of the property as debentures
2. Debentures: bonds with only a general claim against total assets, like other general creditors
3. Subordinated debentures: debentures with only a general claim against total assets, but with lower priority than other general creditors

Question 21

Separate all of As and Ls into current vs. concurrent on __________

Answer 21

Separate all of As and Ls into current vs. concurrent on classified B/S

Question 22

solvency

Answer 22

measure of a company’s ability to pay debt as they come due, tied to CA vs CL

Question 23

What does the debt in the debt:equity ratio include?

Answer 23

debt only includes interest-bearing debt like bank debt, but not A/P

Question 24

interest coverage ratio

Answer 24

(aka times interest earned) = (NI + tax expense + interest expense) / interest expense

Question 25

Does a change in the risk of a bond affect the price in the secondary market even if it’s not reflected in a change in the bond ratings?

Answer 25

A change in the risk of a bond whether or not it’s reflected in a change in the bond ratings (usually a change in bond rating doesn’t change coupon) affects the price in the secondary market

Question 26

Increase risk → ______ discount rate → ______ the price

Answer 26

Increase risk → increases discount rate → decreases the price

Question 27

Decrease risk → ______ discount rate → ______ the price

Answer 27

Decrease risk → decreases discount rate → increases the price

Question 28

Does FASB allow companies to mark-to-market their bonds?

Answer 28

Yes

Question 29

How to reduce the risk of a bond?

Answer 29

Debt covenants: restrictions a creditor puts on the borrower (ex. maintenance of a specific level of RE, prohibition against paying dividends, maintain certain working capital levels, current ratios, or debt:equity ratio)

Question 30

What usually happens if a borrower failed to comply with a provision of a debt covenant?

Answer 30

the borrower defaults on the loan (the loan is immediately due)

Question 31

pending lawsuits, product warranty liabilities, tax disputes with IRS, and potential liabilities associated with restructuring are all _____________

Answer 31

contingent liabilities

Question 32

3 flavors of contingent liabilities based on likelihood of an unfavorable outcome:

Answer 32

1. Remote: company ignores it
2. Reasonably possible: discloses it in footnotes, including a description of the contingency and a range of estimated losses, if possible
3. Probable AND estimable: company records the liability (DR expense XX / CR liability (or “reserve”) XX) and will probably also disclose relevant info in the footnotes

Question 33

___________ gives auditors info on likelihood of losing asserted claims, amount of the loss on asserted claims, existence of unasserted claims

Answer 33

Legal counsel gives auditors info on likelihood of losing asserted claims, amount of the loss on asserted claims, existence of unasserted claims

Question 34

Attorneys have issues about confidentiality, leading to conflict between auditors who want maximum disclosure and attorneys who want minimum disclosure. Who manages this conflict and how do they do it?

Answer 34

To manage this conflict, client’s management acts as a go-between by coming up with a list of pending litigation and other asserted or unasserted claims, sends the list to the attorneys for comments about the status of each item (e.g., legal action client intends to take, likelihood of an unfavorable outcome, estimate of the potential loss), requests the attorney to identify any unlisted contingencies or include a statement that the list is complete, informs the attorney of the attorney’s responsibility to inform management of legal matter requiring disclosure in the financial statements under ASC 450

Question 35

Examples of restructuring liabilities?

Answer 35

severance pay for laid off employees, costs of closing down factories, costs of getting rid of excess inventory

Question 36

FASB rule:
FASB: Before a company can record a restructuring reserve it must: ?

In the years after the restructuring reserve is recorded the company must disclose: ?

Answer 36

FASB: Before a company can record a restructuring reserve it must:
o Have a formal restructuring plan that’s approved by the Board of Directors
o Identify and notify the affected employees

In the years after the restructuring reserve is recorded the company must disclose:
o The original liability
o How much of the liability was paid off in the current period
o How much of the liability was reversed bc of overestimations
o New accruals for unanticipated costs
o Ending balance of the liability

Question 37

Any reversal of a restructuring liability must be reported to _________

Answer 37

Any reversal must be reported to the same I/S account to which the expense was recorded when the liability was first established

Question 38

Company has 1 mill of income, corp tax rate of 40% that it pays in cash, record: ?

If the company doesn’t pay tax at the same time it records the tax journal entry (which it probably won’t), record: ?

Answer 38

DR tax expense (“provision”) 400k / CR cash 400k

DR tax provision 400k / CR CTL 400k

Question 39

Does GAAP NI = taxable income?

Answer 39

Nope - permanent book/tax differences affect book (GAAP) income, but never taxable income

Question 40

Interest income on a municipal bond, fines and penalties, and federal income tax expense itself are examples of ____________

Answer 40

Interest income on a municipal bond, fines and penalties, and federal income tax expense itself are examples of permanent book/tax differences, which affect book income, but never taxable income

Question 41

How is meals and entertainment recorded against GAAP NI? Tax income?

Answer 41

recorded as expense against GAAP NI but only 50% deductible against tax income

Question 42

Are temporary book/tax differences in book income or taxable income?

Answer 42

Temporary book/tax differences are in both book income and taxable income, but in different years

Question 43

When are DTAs recorded? DTLs?

Answer 43

DTAs (pay less tax later):

• income is recorded now for tax, later for GAAP (prepaid rental income)
• expenses are recorded now for GAAP, later for tax (contingent liabilities)

DTLs (pay more tax later):

• income is recorded now for GAAP, later for tax (like-kind exchanges)
• expenses are recorded now for tax, later for GAAP (depreciation)

Question 44

What gives rise to DTLs?

Answer 44

• Report GAAP I/S in year 1 but don’t have to actually pay the tax in year 1
• Like-kind exchange

Question 45

When do we report liabilities for income taxes for tax purposes?

Answer 45

when fixed and determinable: the contingent liability isn’t actually reported until paid in cash

Question 46

NOL (net operating loss)?

Answer 46

a tax loss, used as tax deductions against taxable income earned in other years

Question 47

How far back and forward can a NOL be carried?

Answer 47

2 years back and 20 years forward

Question 48

NOL: carryback is recorded as _________

Answer 48

tax refund receivable

Question 49

NOL: carryforward is recorded as _________

Answer 49

DTA

Question 50

If it’s more likely than not that the DTA won’t be realized, ___________ in required against the DTA account

Answer 50

Valuation allowance against the DTA account is req’d if it’s more likely than not that the DTA will not be realized (e.g., bc we don’t think we’ll have enough income in the future to use up an NOL)

Question 51

off B/S financing

Answer 51

games people play to keep debt off of the B/S to make leverage ratios look good

Question 52

How is off B/S financing done?

Answer 52

Done by keeping ownership of highly-leveraged subsidiaries just under 50% by obtaining the use of assets by leasing, not purchasing

Question 53

Difference in buying vs. leasing

Answer 53

Difference is that leasing results in:

• less debt on B/S: when you lease, you have an executory K under which both parties have only promised to perform in the future, not usually recorded for accounting purposes
• less assets on B/S

Through buying, you end up owning an asset—but if the lease is long enough at the end the asset is worthless either way

Question 54

Similarities between buying and leasing?

Answer 54

• Total expenses on I/S: over the term of the lease, the total of the interest expense and the depreciation expense equals the total expense recorded under a lease
• Cash outflow

Question 55

Rule: if a lease is too much like borrowing/buying the lease is a ________ lease and has to be accounted for as a borrowing/buying

Answer 55

capital lease

Question 56

Under GAAP, a lease is like a purchase (and will be capitalized) if:

Answer 56

• the lease transfers ownership to the lessee at the end of the lease or
• lease contains a bargain purchase option at the end of the lease or
• lease term is ≥ 75% of asset’s useful life or
• PV of minimum lease payments to be made under the lease is ≥ 90% of the asset’s FMV

Question 57

How can corps turn A/R into $$$ now?

Answer 57

• borrow against the receivables (ex. take out a loan and pledge the receivables as collateral), resulting as debt on the I/S
• sell the receivables

Question 58

What does borrowing against the receivables result in?

Answer 58

debt on the I/S, making debt: equity ratio look worse

borrowing against the receivables is a way to turn A/R into $$$ now

Question 59

2 ways to sell the receivables

Answer 59

selling the receivables is a way of turning A/R into $$$ now, 2 ways to sell receivables: factor the receivables and securitization

Question 60

factoring the receivables?

Answer 60

sell the receivables (usually to the bank), must often sell at a discount

Question 61

Securitization?

Answer 61

company creates a securitization trust (SPE or specific purpose entity), SPE buys the receivables using $$ it raises from selling securities to investors

Question 62

2 ways the securitization process adds value to the receivables?

Answer 62

1. bankruptcy remote (safer): owners of SPE’s securities have the only possible claim against the receivables, no longer owned by the company and no longer subject to lawsuits brought against the company
2. more customized to investors’ specific needs: SPE collects the receivables and create a whole new distinct set of cash flows that it pays out in the form of tranches

Question 63

tranches?

Answer 63

layers, pieces, portions, or shares; creation of different tranches with different attributes allows investors to buy securities that meet their specific needs

each tranche provides a different mix of risk and return (can also vary based on maturity date):

• senior tranche: little risk
• mezzanine tranche: some risk
• equity tranche: most risk

Tranches are 1 of 2 ways the securitization process adds value to the receivables

Question 64

What does it mean if the securitization process has added value to the A/R?

Answer 64

the investors in the SPE are using a lower discount rate (than the interest being received on the underlying A/R) to value the SPE securities

Question 65

What do securitizations result in?

Answer 65

• I/S looks better: company records gain from selling the receivables to the trust
• B/S looks better: bc the company avoids the debt it would’ve incurred if it simply borrowed against the receivables
• SCF looks better: cash flows from selling the receivables to the trust are reported in the operating section

Question 66

What does FASB require to be treated as a true sale of the receivables to the SPE?

Answer 66

FASB now requires the SPE to be truly independent of the company. The company can’t have the power to direct the most significant activities of the trust, and the company cannot have the right to receive benefits and/or absorb losses from the trust that potentially could be significant.

Since many companies retain servicing rights on the receivables (i.e., the process of collecting on the receivables) that means they have the powers to direct.

Likewise, many companies retain equity tranches, meaning they have the right to receive significant benefits and/or absorb significant losses from the trust. As a result, their securitizations are accounted for as if the company borrowed $ (using the A/R as collateral) instead of as if the company sold the receivables

Question 67

asset-backed securitizations

Answer 67

securities issued by securitization trusts, can be backed by lots of different kinds of receivables (e.g., car loans, credit cards, home mortgages, commercial mortgages)

Question 68

mortgage-backed securities: what happened when the homeowners quit paying their mortgage payments?

Answer 68

when the homeowners quit paying their mortgage payment → homes went down in value → mortgage-backed securities lost value

Question 69

CDs (credit default swaps)

Answer 69

bets on whether a bonds will default

• Buyer of a CD pays $$ upfront and gets paid if the bond defaults
• Seller of a CD gets $$ upfront and pays out if the bond defaults

Question 70

Do asset-back securities and CDs have to be marked to market?

Answer 70

Yes!

Issue: these instruments are often thinly traded so it’s difficult to determine true market valuations

Question 71

Mortgage-backed securities have been given high debt ratings that may’ve been unjustified so rating agencies must now…

Answer 71

• Provide more detail about how they determine each rating
• Bar their sales people from participating in ratings processes
• Review and potentially revise their ratings in cases where an employee was later hired by a company she rated
• Litigation against ibanks that sold the securities and against the ratings agencies that rated the securities

Question 72

promissory notes payable (notes payable)

Answer 72

type of private placement that arises from borrowing $, more formal than A/P (documented and charge interest), usually borrowed from banks

Question 73

credit facilities

Answer 73

type of private placement that provides companies with lines of credit where they can borrow up to a specific limit without having to go through loan approval process, company pays a fee for this arrangement and pays interest on any borrowings

Question 74

commercial paper

Answer 74

type of private placement that is short-term (60-90 days), borrowed from banks and other institutions (like money market funds)