Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Analyzing Financing Activities Liabilities and shareholders’ equity Friday, November 16, 2018

The Balance Sheet Assets = Liabilities + Stockholders’ equity Also called the statement of condition or statement of financial position Liabilities + Stockholders’ equity Assets = Assets = What the firm owns Liabilities = What the firm owes to outsiders Stockholders’ equity = What the firm owes to Internal owners The Balance Sheet (C) 2007 Prentice Hall, Inc.

Current (short-term) Liabilities Noncurrent (Long-Term) Liabilities Classification Current (short-term) Liabilities Noncurrent (Long-Term) Liabilities must be satisfied in one year or one operating cycle and include Accounts payable Notes payable Current portion of long-term debt Accrued liabilities Unearned revenue Deferred taxes Obligations not payable within one year or the operating cycle, whichever is longer. 2 2

Alternative Classification Operating Liabilities Financing Liabilities Obligations that arise from operating activities--examples are accounts payable, unearned revenue, advance payments, taxes payable, postretirement liabilities, and other accruals of operating expenses Operating Liabilities Obligations that arise from financing activities--examples are short- and long-term debt, bonds, notes, leases, and the current portion of long-term debt Financing Liabilities 73 5

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Current Liabilities Friday, November 16, 2018

Turkcell note 24 Friday, November 16, 2018

Current Liabilities Trade Payables Notes Payable Short-term obligations that arise from credit extended by suppliers for the purchase of goods and services Account is eliminated when the bill is satisfied Significant changes from period to period often result from changes in sales volume, economic conditions or credit policies available to firm from its suppliers Notes Payable Short-term obligations in the form of promissory notes Lines of credit to suppliers or financial institutions Current Portion of Long-term Debt the portion of the principal that will be repaid during the upcoming year Current Liabilities Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Accrued Liabilities Result from recognition of an expense prior to actual payment of cash Under accrual accounting, expenses are recognized when INCURRED and thus ACCRUED, not when paid in cash In this case, cash flow succeeds expense recognition Recorded as reserve accounts Reserve accounts are set up to estimate obligations for certain items identified in the notes Unearned Revenue or Deferred Credits Result from payments received in advance for services or products Transferred to a revenue account when service is performed or product is delivered Under accrual accounting, revenue is recognized when EARNED, not when cash is received In this case, cash flow precedes revenue recognition Current Liabilities Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Deferred Income Taxes Result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income Intended to take advantage of all available tax deferrals to reduce actual tax payments, while showing the highest possible amount of reported net income Classified as current or noncurrent on the balance sheet Can appear on the balance sheet as a current asset, current liability, noncurrent asset, or noncurrent liability Current Liabilities Deferred Income Taxes Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Current Liabilities Deferred Income Taxes Temporary differences can be caused by choice of accounting method for Depreciation Installment sales Long-term contracts and leases Warranties and service contracts Pensions and other employee benefits Subsidiary investment earnings Current Liabilities Deferred Income Taxes Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Deferred Taxation (C) 2007 Prentice Hall, Inc.

(C) 2007 Prentice Hall, Inc.

Turkcell note 17 Friday, November 16, 2018

Noncurrent Liabilities Obligations with maturities beyond one year Long-term debt (financial liabilities) Capital lease obligations Postretirement benefits other than pensions Provisions Commitments and contingencies Hybrid securities Noncurrent Liabilities Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Long-term debt Bonds Long-Term Notes Payable Mortgages Obligations under leases Long-Term Warranties Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Capital lease obligations Are, in substance, a “purchase” rather than a “lease” Affect both balance sheet and income statement Disclosures found in the notes, often under both the property, plant, and equipment note and the commitments and contingencies note Noncurrent Liabilities Capital lease obligations Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Leases Leasing Facts Lease – contractual agreement between a lessor (owner) and a lessee (user or renter) that gives the lessee the right to use an asset owned by the lessor for the lease term. MLP – minimum lease payments (MLP) of the lessee to the lessor according to the lease contract

Lease Accounting and Reporting Leases Lease Accounting and Reporting (1) Capital Lease Accounting For leases that transfer substantially all benefits and risks of ownership—accounted for as an asset acquisition and a liability incurrence by the lessee, and as a sale and financing transaction by the lessor A lessee classifies and accounts for a lease as a capital lease if, at its inception, the lease meets any of four criteria: (i) lease transfers ownership of property to lessee by end of the lease term (ii) lease contains an option to purchase the property at a bargain price (iii) lease term is 75% or more of estimated economic life of the property (iv) present value of rentals and other minimum lease payments at beginning of lease term is 90% or more of the fair value of leased property   (2) Operating Lease Accounting For leases other than capital leases—the lessee (lessor) accounts for the minimum lease payment as a rental expense (income)

Leases Lease Disclosure and Off-Balance-Sheet Financing Lessee must disclose: (1) future MLPs separately for capital leases and operating leases — for each of five succeeding years and the total amount thereafter, and (2) rental expense for each period on income statement is reported   Off-Balance-Sheet Financing Off-Balance-Sheet financing is when a lessee structures a lease so it is accounted for as an operating lease when the economic characteristics of the lease are more in line with a capital lease—neither the leased asset nor its corresponding liability are recorded on the balance sheet

Effects of Lease Accounting Leases Effects of Lease Accounting Impact of Operating Lease versus Capital Lease: • Operating lease understates liabilities—improves solvency ratios such as debt to equity • Operating lease understates assets—can improve return on investment ratios • Operating lease delays expense recognition—overstates income in early term of the lease and understates income later in lease term • Operating lease understates current liabilities by ignoring current portion of lease principal payment—inflates current ratio & other liquidity measures • Operating lease includes interest with lease rental (an operating expense)—understates both operating income and interest expense, inflates interest coverage ratios, understates operating cash flow, & overstates financing cash flow

Turkcell note 24 Friday, November 16, 2018

Turkcell note 30 Friday, November 16, 2018

Converting Operating Leases to Capital Leases Determining the Present Value of Projected Operating Lease 2010 Non cancellable leases: less than one year $ 18.024,00 between one and five year 16107 more than five years 7221 $ 41.352,00 payment discount factor 5% present value interest lease obligation lease balance 35225,32 2011 18024 0,952381 17165,71 1761,27 16262,73 18962,58 2012 3221,4 0,907029 2921,90 948,13 2273,27 16689,31 2013 0,863838 2782,77 834,47 2386,93 14302,38 2014 0,822702 2650,25 715,12 2506,28 11796,10 2015 0,783526 2524,05 589,80 2631,60 9164,50 2016 0,746215 2403,86 458,23 2763,17 6401,33 2017 1805,25 0,710681 1282,96 320,07 1485,18 4916,14 2018 0,676839 1221,86 245,81 1559,44 3356,70 2019 0,644609 1163,68 167,84 1637,41 1719,29 2020 0,613913 1108,27 85,96 0,00 41352 Leases  

Noncurrent Liabilities Postretirement benefits other than pensions Can appear under the liability section of the balance sheet Can have a significant impact on corporate balance sheets Can also impact profitability by substantially increasing the recognition of annual postretirement benefit expense Noncurrent Liabilities Postretirement benefits other than pensions Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Noncurrent Liabilities Commitments and contingencies Commitments refer to contractual agreements that will have a significant financial impact on the company in the future. Contingencies refer to potential liabilities of the firm such as possible damage awards assessed in lawsuits. Intended to draw attention to the fact that required disclosures can be found in the notes to the financial statements Noncurrent Liabilities Commitments and contingencies Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Provisions and Contingent Liabilities a potential liability arising from a past transaction and that depends on a future event could be disclosed in the body of the balance sheet with the liabilities could be disclosed within notes to financial statements certainty of the amount and the payment will be disclosed Provisions and Contingent Liabilities (C) 2007 Prentice Hall, Inc.

(CONTINGENT LIABILITY) Is the amount of the liability known? Recognize liability on the balance sheet YES YES NO Can the amount of Liability be reasonably Estimated? Is the liability likely to occur? (Probable) YES NO Disclose in the notes To the financial Statements (CONTINGENT LIABILITY) (C) 2007 Prentice Hall, Inc.

Contingencies and Commitments Basics of Commitments Commitments -- potential claims against a company’s resources due to future performance under contract Analyzing Commitments Sources of useful information: Notes and MD&A   Useful analyses: Scrutinize management communications and press releases Analyze notes regarding commitments, including Description of commitment and its degree of risk Amount at risk and how treated in assessing risk exposure Contractual conditions and timing Recognize a bias to not disclose commitments Contingencies and Commitments

Turkcell Note 32 Friday, November 16, 2018

Product Warranty Liabilities When goods and services are sold under warranty coverage A good example of provision matching principle - warranty expenses of sales in a period should be recorded in the same period Subsequent expenditures of warranties are charged against warranty liability (C) 2007 Prentice Hall, Inc.

Noncurrent Liabilities Hybrid Securities Have the characteristics of both debt and equity Also called mandatorily redeemable preferred stock Financial instrument is preferred stock, but the issuing company must retire the shares at a future date. Noncurrent Liabilities Hybrid Securities Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Important Features in Analyzing Liabilities Terms of indebtedness (such as maturity, interest rate, payment pattern, and amount). Restrictions on deploying resources and pursuing business activities. Ability and flexibility in pursuing further financing. Obligations for working capital, debt to equity, and other financial figures. Dilutive conversion features that liabilities are subject to. Prohibitions on disbursements such as dividends Liabilities Important Features in Analyzing Liabilities

Off-Balance-Sheet Financing Basics of Off-Balance-Sheet Financing Off-Balance-Sheet Financing is the non-recording of financing obligations   Motivation To keep debt off the balance sheet—part of ever-changing landscape, where as one accounting requirement is brought in to better reflect obligations from a specific off-balance-sheet financing transaction, new and innovative means are devised to take its place Transactions sometimes used as off-balance-sheet financing: • Operating leases that are indistinguishable from capital leases • Through-put agreements, where a company agrees to run goods through a processing facility • Take-or-pay arrangements, where a company guarantees to pay for goods whether needed or not • Product financing arrangements, where a company sells and agrees to either repurchase inventory or guarantee a selling price • Sell receivables with recourse and record them as sales rather than liabilities • Sell receivables as backing for debt sold to the public • Outstanding loan commitments

Off-Balance-Sheet Financing Illustration of SPE Transaction to Sell Accounts Receivable A special purpose entity is formed by the sponsoring company and is capitalized with equity investment, some of which must be from independent third parties. The SPE leverages this equity investment with borrowings from the credit markets and purchases earning assets from or for the sponsoring company. The cash flow from the earning assets is used to repay the debt and provide a return to the equity investors.

Off-Balance-Sheet Financing Illustration of SPE Transaction to Sell Accounts Receivable Off-Balance-Sheet Financing

Off-Balance-Sheet Financing Benefits of SPEs: SPEs may provide a lower-cost financing alternative than borrowing from the credit markets directly. Under present GAAP, so long as the SPE is properly structured, the SPE is accounted for as a separate entity, unconsolidated with the sponsoring company. Off-Balance-Sheet Financing

Related party transactions Friday, November 16, 2018

Ownership equity is the residual interest in assets that remains after deducting liabilities Shareholders’ Equity (C) 2007 Prentice Hall, Inc.

Shareholders’ Equity-Basics of Equity Financing Equity — refers to owner (shareholder) financing; its usual characteristics include: Reflects claims of owners (shareholders) on net assets Equity holders usually subordinate to creditors Variation across equity holders on seniority Exposed to maximum risk and return Equity Analysis — involves analyzing equity characteristics, including: Classifying and distinguishing different equity sources Examining rights for equity classes and priorities in liquidation Evaluating legal restrictions for equity distribution Reviewing restrictions on retained earnings distribution Assessing terms and provisions of potential equity issuances Equity Classes — two basic components: Capital Stock Retained Earnings Shareholders’ Equity-Basics of Equity Financing

Shareholders’ Equity- Reporting Capital Stock Sources of increases in capital stock outstanding: Issuances of stock Conversion of debentures and preferred stock Issuances pursuant to stock dividends and splits Issuances of stock in acquisitions and mergers Issuances pursuant to stock options and warrants exercised Sources of decreases in capital stock outstanding: Purchases and retirements of stock Stock buybacks Shareholders’ Equity- Reporting Capital Stock

Shareholders’ Equity – Components of Capital Stock Contributed (or Paid-In) Capital — total financing received from shareholders for capital shares; usually divided into two parts:   Common (or Preferred) Stock — financing equal to par or stated value; if stock is no-par, then equal to total financing Contributed (or Paid-In) Capital in Excess of Par or Stated Value — financing in excess of any par or stated value Treasury Stock (or buybacks) - shares of a company’s stock reacquired after having been previously issued and fully paid for. Reduces both assets and shareholders’ equity contra-equity account (negative equity). typically recorded at cost Shareholders’ Equity – Components of Capital Stock

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Preferred Stock —. stock with features not possessed by Preferred Stock — stock with features not possessed by common stock; typical preferred stock features include: • Dividend distribution preferences • Liquidation priorities • Convertibility (redemption) into common stock • Call provisions • Non-voting rights Common Stock — stock with ownership interest and bearing ultimate risks and rewards (residual interests) of company performance Shareholders’ Equity

Stockholders’ Equity Common Stock Shareholders Do not ordinarily receive a fixed return Have voting privileges in proportion to ownership interest Dividends are declared at the discretion of a company’s board of directors Stockholders’ Equity Common Stock Shareholders (C) 2007 Prentice Hall, Inc.

Stockholders’ Equity Additional Paid-In Capital Reflects the amount by which the original sales price of the stock shares exceeded par value Stockholders’ Equity Additional Paid-In Capital (C) 2007 Prentice Hall, Inc.

Stockholders’ Equity Retained Earnings Is the sum of every dollar a company has earned since its inception, less any payments made to shareholders in the form of cash or stock dividends Beginning retained earnings ± Net income (loss) – Dividends = Ending retained earnings Stockholders’ Equity Retained Earnings (C) 2007 Prentice Hall, Inc.

Retained Earnings — earned capital of a company; reflects accumulation of undistributed earnings or losses since inception; retained earnings is the main source of dividend distributions   Cash and Stock Dividends Cash dividend — distribution of cash (or assets) to shareholders Stock dividend — distribution of capital stock to shareholders Prior Period Adjustments — mainly error corrections of prior periods’ statements Appropriations of Retained Earnings — reclassifications of retained earnings for specific purposes Restrictions (or Covenants) on Retained Earnings — constraints or requirements on retention of retained earnings Shareholders’ Equity

Spin-off, the distribution of subsidiary stock to shareholders as a dividend; assets (investment in subsidiary) are reduced as is retained earnings. Split-off, the exchange of subsidiary stock owned by the company for shares in the company owned by the shareholders; assets (investment in subsidiary) are reduced and the stock received from the shareholders is treated as treasury stock. Shareholders’ Equity

Stockholders’ Equity Other Equity Accounts Other accounts that can appear in the equity section include: Preferred stock Accumulated other comprehensive income Treasury stock Revaluation Fund Stockholders’ Equity Other Equity Accounts (C) 2007 Prentice Hall, Inc.

Nonowner changes to equity Other comprehensive income (GAAP) Adjustments to fair value for available-for-sale securities Foreign currency translation adjustment Gains/losses on cash flow hedge derivatives Gains/losses on investment hedge instruments Adjustments related to underfunding a defined benefit pension plan Nonowner changes to equity Other comprehensive income (GAAP) (C) 2007 Prentice Hall, Inc.

Statement of Shareholders’ Equity Provides details of changes in Equity Stock Other comprehensive income Retained earnings Includes beginning and ending balances in accounts Statement of Shareholders’ Equity (C) 2007 Prentice Hall, Inc.

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