Accounting Quality in the Liability Recognition and Measurement Area
A high-quality balance sheet is extremely important in assessing financial flexibility (i.e., the debt capacity of the firm for funding new projects) and financial risk. Given that financial flexibility and risk are closely tied to proper recognition, measurement, and classification of liabilities, we begin our discussion with a consideration of what balance sheet liabilities should capture. Financial reporting recognizes a liability if it satisfies the following criteria:
A high-quality balance sheet is extremely important in assessing financial flexibility (i.e., the debt capacity of the firm for funding new projects) and financial risk. Given that financial flexibility and risk are closely tied to proper recognition, measurement, and classification of liabilities, we begin our discussion with a consideration of what balance sheet liabilities should capture. Financial reporting recognizes a liability if it satisfies the following criteria:
- The obligation involves a probable future sacrifice of economic benefits—a future transfer of cash, goods, or services; the forgoing of a future cash receipt; or the transfer of equity shares—at a specified or determinable date. The firm can measure with reasonable precision the cash-equivalent value of the resources needed to satisfy the obligation.
- The firm has a present obligation (not a possible future obligation) and little or no discretion to avoid the transfer.
- The transaction or event that gave rise to the obligation has already occurred. While the criteria for liability recognition may appear straightforward and subject to unambiguous interpretation, unfortunately, this is often not the case. Various obligations of an enterprise fall along a continuum with respect to how well they satisfy these criteria. Exhibit 6.1 classifies obligations into six groups.
Obligations with Fixed Payment Dates and Amounts
The obligations that most clearly satisfy the liability recognition criteria are those with fixed payment dates and amounts (typically set by contract). Most obligations arising from borrowing arrangements (classified as financing activities) fall into this category. The borrowing agreement specifies the timing and amount of interest and principal payments. However, even with payment dates and amounts set by contract, long-term liabilities require the choice of an interest rate. At the date of the original transaction, the the lender. However, revaluations of long-term liabilities (i.e., fair value measurements) are required for the notes to the financial statements, and managers may choose to use fair value as a basis for reporting in the balance sheet (with changes in fair value affecting the income statement). To the extent possible, you should ascertain how those fair value measurements were determined by thoroughly reading the long-term debt note and the note describing accounting policy. If fair value is determined by reference to market prices or based on market prices of similar instruments (which implies a market-determined interest rate), then management discretion is minimized, and accounting quality is likely higher. If interest rates are firm-estimated, then material changes in long-term liability fair values require greater scrutiny because using too high of an assumed discount rate reduces liability fair values In Note 10, PepsiCo reports that debt obligations in its December 29, 2012 Consolidated Balance Sheet with a book value of $28.359 billion ($23,544 million long-term รพ $4,815 million short-term) had a fair value of $30.5 billion on the same date. PepsiCo bases the fair values on prices of similar instruments in the marketplace.
Obligations with Fixed Payment Amounts but Estimated Payment Dates
Most current operating liabilities fall into this category. Oral agreements, written agreements, or legal statutes fix the amounts payable to suppliers, employees, and government agencies. Firms normally settle these obligations within a few months after incurring them. The firm can estimate the settlement date with sufficient accuracy to warrant recognizing a liability. Aside from concerns over outright fraudulent attempts to hide liabilities, the lack of an interest rate assumption in measuring these liabilities, their short-run nature, and the tendency for amounts to be fixed by contract causes few quality concerns. For example, PepsiCo reports that it has $838 million Dividends payable at December 29, 2012, in its Note 14 to the Consolidated Financial Statements.
Obligations with Estimated Payment Dates and Amounts
Obligations in this group require estimation because the firm cannot identify the specific future recipients of cash, goods, or services at the time the obligation becomes a liability. In addition, the firm cannot precisely compute what amount of resources it will transfer in the future or when the transfers will occur. For example, when a firm sells products under a warranty agreement, it promises to replace defective parts or perform certain repair services for a specified period of time. At the time of sale, the firm can neither identify the specific customers who will receive warranty benefits nor ascertain the timing or amounts of customers’ claims. Past experience, however, often provides the necessary information for estimating the likely proportion of customers who will make claims and the probable average amount of their claims. As long as the firm can reasonably estimate the probable amount of the obligation, it satisfies the first criterion for liability recognition. Both balance sheet and earnings quality are similarly affected by this category of liability. Managers must judge if and when future resource outflows will occur. They must also estimate the cost of satisfying the obligations
Obligations Arising from Advances from Customers on Unexecuted Contracts and Agreements
A firm sometimes receives cash from customers in advance for goods or services it will provide at a future time. Many types of revenues involve prepayments from customers, such as airfares, subscriptions, insurance premiums, membership dues, and license fees, among others, which create service obligations for firms. Revenue recognition usually requires that the firm deliver the goods or provide the services before recognizing revenue.12 The important balance sheet and earnings quality issue is whether revenue has been recognized too early, in which case balance sheet quality is impaired by an understatement of liabilities and earnings quality is impaired by an overstatement of revenue. Therefore, you should study the accounting policy on revenue recognition and decide whether the policy makes sense in light of the economics of the industry and corporate operating strategy
Best Buy describes revenue recognition relating to its gift cards in its 2012, 10-K
Note 1 (Critical Accounting Policies) as follows (amounts in millions of dollars):
We recognize revenue from gift cards when: (i) the gift card is redeemed by the customer, or (ii) the likelihood of the gift card being redeemed by the customer is remote (‘‘gift card breakage’’), and we determine that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions. We determine our gift card breakage rate based upon historical redemption patterns. Based on our historical information, the likelihood of a gift card remaining unredeemed can be determined 24 months after the gift card is issued. At that time, we recognize breakage income for those cards for which the likelihood of redemption is deemed remote and we do not have a legal obligation to remit the value of such unredeemed gift cards to the relevant jurisdictions. Gift card breakage income is included in revenue in our Consolidated Statements of Earnings. Gift card breakage income was as follows in fiscal 2012, 2011, and 2010
The obligations that most clearly satisfy the liability recognition criteria are those with fixed payment dates and amounts (typically set by contract). Most obligations arising from borrowing arrangements (classified as financing activities) fall into this category. The borrowing agreement specifies the timing and amount of interest and principal payments. However, even with payment dates and amounts set by contract, long-term liabilities require the choice of an interest rate. At the date of the original transaction, the the lender. However, revaluations of long-term liabilities (i.e., fair value measurements) are required for the notes to the financial statements, and managers may choose to use fair value as a basis for reporting in the balance sheet (with changes in fair value affecting the income statement). To the extent possible, you should ascertain how those fair value measurements were determined by thoroughly reading the long-term debt note and the note describing accounting policy. If fair value is determined by reference to market prices or based on market prices of similar instruments (which implies a market-determined interest rate), then management discretion is minimized, and accounting quality is likely higher. If interest rates are firm-estimated, then material changes in long-term liability fair values require greater scrutiny because using too high of an assumed discount rate reduces liability fair values In Note 10, PepsiCo reports that debt obligations in its December 29, 2012 Consolidated Balance Sheet with a book value of $28.359 billion ($23,544 million long-term รพ $4,815 million short-term) had a fair value of $30.5 billion on the same date. PepsiCo bases the fair values on prices of similar instruments in the marketplace.
Obligations with Fixed Payment Amounts but Estimated Payment Dates
Most current operating liabilities fall into this category. Oral agreements, written agreements, or legal statutes fix the amounts payable to suppliers, employees, and government agencies. Firms normally settle these obligations within a few months after incurring them. The firm can estimate the settlement date with sufficient accuracy to warrant recognizing a liability. Aside from concerns over outright fraudulent attempts to hide liabilities, the lack of an interest rate assumption in measuring these liabilities, their short-run nature, and the tendency for amounts to be fixed by contract causes few quality concerns. For example, PepsiCo reports that it has $838 million Dividends payable at December 29, 2012, in its Note 14 to the Consolidated Financial Statements.
Obligations with Estimated Payment Dates and Amounts
Obligations in this group require estimation because the firm cannot identify the specific future recipients of cash, goods, or services at the time the obligation becomes a liability. In addition, the firm cannot precisely compute what amount of resources it will transfer in the future or when the transfers will occur. For example, when a firm sells products under a warranty agreement, it promises to replace defective parts or perform certain repair services for a specified period of time. At the time of sale, the firm can neither identify the specific customers who will receive warranty benefits nor ascertain the timing or amounts of customers’ claims. Past experience, however, often provides the necessary information for estimating the likely proportion of customers who will make claims and the probable average amount of their claims. As long as the firm can reasonably estimate the probable amount of the obligation, it satisfies the first criterion for liability recognition. Both balance sheet and earnings quality are similarly affected by this category of liability. Managers must judge if and when future resource outflows will occur. They must also estimate the cost of satisfying the obligations
Obligations Arising from Advances from Customers on Unexecuted Contracts and Agreements
A firm sometimes receives cash from customers in advance for goods or services it will provide at a future time. Many types of revenues involve prepayments from customers, such as airfares, subscriptions, insurance premiums, membership dues, and license fees, among others, which create service obligations for firms. Revenue recognition usually requires that the firm deliver the goods or provide the services before recognizing revenue.12 The important balance sheet and earnings quality issue is whether revenue has been recognized too early, in which case balance sheet quality is impaired by an understatement of liabilities and earnings quality is impaired by an overstatement of revenue. Therefore, you should study the accounting policy on revenue recognition and decide whether the policy makes sense in light of the economics of the industry and corporate operating strategy
Best Buy describes revenue recognition relating to its gift cards in its 2012, 10-K
Note 1 (Critical Accounting Policies) as follows (amounts in millions of dollars):
We recognize revenue from gift cards when: (i) the gift card is redeemed by the customer, or (ii) the likelihood of the gift card being redeemed by the customer is remote (‘‘gift card breakage’’), and we determine that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions. We determine our gift card breakage rate based upon historical redemption patterns. Based on our historical information, the likelihood of a gift card remaining unredeemed can be determined 24 months after the gift card is issued. At that time, we recognize breakage income for those cards for which the likelihood of redemption is deemed remote and we do not have a legal obligation to remit the value of such unredeemed gift cards to the relevant jurisdictions. Gift card breakage income is included in revenue in our Consolidated Statements of Earnings. Gift card breakage income was as follows in fiscal 2012, 2011, and 2010
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