General Accounting questions

[WneverLOSE]

Hi,

I think that since accounting is the language of business, we all can benefit from having a place we can ask questions about it.

I hope that most of you will use this thread to ask questions and answer them.

In order to keep it organized and searchable, if you ask a new question please start it by writing its number at the beginning, and if you answer, please write the question number at the beginning of your answer.

 

Let me start by asking my first question.

 

#1 When company XYZ balance sheet says it has 100m in long term debt, does that amount takes into consideration the amount that will be paid in interest or is it only the principal that should be paid ?

 

[randomep]

I have so many, a lot of them I think I know but I just need conformation:

 

a company like SENVEST Capital (the traded stock) is a inc, but it invests in the senvest international hedge fund which is a LLC, there is no tax on capital gains at the hedge fund level but there is at the inc level? And of course any capital gains on the stock is taxable to the stockholder? So there is double taxation? why did they setup such a structure?

 

[doughishere]

Check out this spreadsheet I did for my accounting 101 course. Theres a number of conventions that accounting follows that are not terribly difficult but do require some time to explain...unfortunately i cant get super in depth at the moment but take a look at the "Example - Effective Interest Method - Above Par" and "Example - Effective Interest Method - Below Par" tabs.

 

 

Most of its taken from Financial Accounting 14e. Weil, Schipper and Francis.

 

https://docs.google.com/spreadsheets/d/16X83T6458CQSGwalodTw6psz_tm7V5goZ_k52DxDhsc/edit?usp=sharing

 

 

I was thinking of doing a like Accounting 101 workshop with the above mentioned book. I've done like 99% of the problems in the chapters but didn't think there was any interest.

[randomep]

I have so many, a lot of them I think I know but I just need conformation:

 

a company like SENVEST Capital (the traded stock) is a inc, but it invests in the senvest international hedge fund which is a LLC, there is no tax on capital gains at the hedge fund level but there is at the inc level? And of course any capital gains on the stock is taxable to the stockholder? So there is double taxation? why did they setup such a structure?

 

Gonna try to answer this as best I can, I use to work in the industry - I believe any capital gains in the LLC flows through to the inc like you said.  The inc pays the tax on 50% of the capital gain at the corporate level.  That non-taxable capital gain (the other 50%) is placed in a separate non-taxable pool.  If the inc pays out a dividend to shareholders it designates the non-taxable portion as a return of capital so the shareholder who receives this dividend does not pay tax on it.  The other 50% is paid out as a regular dividend and a shareholder would get taxed on this portion.

 

If this was a private inc, I am pretty confident that would be the tax treatment.  The only reason I am having doubts is because this is a public inc and the rules might be slightly different - although i don't think it should be because the tax laws/logic should be the same in both cases.

 

dyow, so I assume you worked in a Canadian firm.

 

Based on what you said then senvest pays 1/2 corporate tax rate, that makes sense, I remember seeing rates about 12% some years.

 

 

[Patmo]

Hi,

I think that since accounting is the language of business, we all can benefit from having a place we can ask questions about it.

I hope that most of you will use this thread to ask questions and answer them.

In order to keep it organized and searchable, if you ask a new question please start it by writing its number at the beginning, and if you answer, please write the question number at the beginning of your answer.

 

Let me start by asking my first question.

 

#1 When company XYZ balance sheet says it has 100m in long term debt, does that amount takes into consideration the amount that will be paid in interest or is it only the principal that should be paid ?

 

That's the principal only, you record the interest expense as it is incurred, not upfront. The interest liability is going to be recorded in a separate account as a current liab, eg.:

 

Yr1

Dr.Cash 10000

Cr.LT Debt 10000

 

Yr2

Dr.Int Exp  1000

Cr.Int Payable 1000

 

Dr. Int Payable 1000

Dr. LT Debt      1000

Cr.Cash            2000

 

 

 

 

 

 

[Aman1]

Hi,

I think that since accounting is the language of business, we all can benefit from having a place we can ask questions about it.

I hope that most of you will use this thread to ask questions and answer them.

In order to keep it organized and searchable, if you ask a new question please start it by writing its number at the beginning, and if you answer, please write the question number at the beginning of your answer.

 

Let me start by asking my first question.

 

#1 When company XYZ balance sheet says it has 100m in long term debt, does that amount takes into consideration the amount that will be paid in interest or is it only the principal that should be paid ?

 

That's the principal only, you record the interest expense as it is incurred, not upfront. The interest liability is going to be recorded in a separate account as a current liab, eg.:

 

Yr1

Dr.Cash 10000

Cr.LT Debt 10000

 

Yr2

Dr.Int Exp  1000

Cr.Int Payable 1000

 

Dr. Int Payable 1000

Dr. LT Debt      1000

Cr.Cash            2000

 

Pretty harsh going straight for Debits & Credits!!!  :o

 

For corporates, the total debt is the principal only. Don't forget to include short term portions of long term debt (current liabilities) in this number and potentially any significant operating lease liabilities and the net pension liability if the pension is material.

 

A simple rule of thumb for operating leases is to take the current year operating lease payment (rent) and multiply by 5. Finance leases are already included as debt so no need to worry about those.

 

For pensions, remember to use the actual economic deficit - which means taking the "projected benefit obligation (PBO)" from the notes to the account as the liability and taking the fair value of plan assets. This net liability should be added to the debt if it's a material number, particularly in UK / European companies where the pension can rank senior to bondholders. Would be interesting to know where pension deficits rank in US Chapter 11 bankruptcy.

 

I think banks, perversely, are allowed to record discounts on their debt as a gain (which means I assume they drop the principal amount to face value) but I don't really look at the big banks so someone with better expertise could clarify that.

 

I am a qualified IFRS accountant and did some US GAAP when doing the CFA. I can help on financial reporting questions but will be of no use on tax related stuff (I've never looked at US tax but mainly because tax laws pretty much change every other year, I qualified 10 years ago and have not kept up to date on it).

 

[bookie71]

Actually all debit means is "left" and credit means "right".  Pacioli (sp?)in the 1700's (he was the first bean counter)used these terms based on the Latin debere and credere.

It probably makes more sense if you take the basic accounting equation:

Assets = Debts + Equity (equity is broken down by retained investment (stock and retained earnings) + (current income - current expenses)

debit = left thus a debit on the left side of the equation Increases

when you go to the other side of the equation a debit decreases (the signs change)

a credit decreases on the left side of the "=" and increases on the left side of the "="

More than you ever wanted to know

 

[Guest bksimon]

Question 3. At an investor group I recall hearing that Operating Cash Flow incorporates CapEx, but I thought CapEx would go under Cash Flow from Investing Activities. Does anyone know what this might have meant? It's possible I misheard/misunderstood.

[doughishere]

Buffett on accounting https://youtu.be/X5MqqU-sz6o?t=1723

[Guest Schwab711]

Question 3. At an investor group I recall hearing that Operating Cash Flow incorporates CapEx, but I thought CapEx would go under Cash Flow from Investing Activities. Does anyone know what this might have meant? It's possible I misheard/misunderstood.

 

Maybe the company they were talking about primarily used operating leases?

[Drake]

For corporates, the total debt is the principal only. Don't forget to include short term portions of long term debt (current liabilities) in this number and potentially any significant operating lease liabilities and the net pension liability if the pension is material.

[...]

I think banks, perversely, are allowed to record discounts on their debt as a gain (which means I assume they drop the principal amount to face value) but I don't really look at the big banks so someone with better expertise could clarify that.

 

First: I am no accounting expert, but I would like to add some questions for my own understanding...

 

On the question whether principal shown or whether interest is included: Wouldn't that depends less on whether a company is a corporate or a bank, but on the form of the debt? To my understanding, loans taken by a company would be accounted for at amortized cost and hence be shown as principal, only. Debt issued via marketable securities (bonds) would be accounted for at fair value.

 

Fair value is the value of all future payments, discounted by expected interest rates plus credit spreads of the issuer. Thus, debt accounted at fair value would be discounted for by the market's estimate of the issuer's creditworthiness: if the issuer's creditworthiness degrades, liabilities are reduced and a gain is shown. I don't like this effect either, but if you want fair value to reflect market price, then there is no easy way out of this - after all, the market will indeed pay less for your bonds if your creditworthiness degrades.

 

If I remember correctly (and again, I am no expert on this, so I might remember wrongly), this discount is treated differently in U.S? IFRS and  European IFRS: IIRC in Europe, the best approximation of market price, including discounts for creditworthiness, will be used for fair valued liabilities while in the U.S. the market price has to be corrected by changes from own creditworthiness so that deteriorating creditworthiness will not reduce the liabilities (which I think to be more intelligent than the European treatment because a company always will have to repay its debt fully) Can anyone confirm this? I am really not certain about this difference, but I think that the upcoming IFRS 9 will have rules that forbid to show gains on the balance sheet caused by deteriorating creditworthiness...

[Simple Investor]

I have been doing some work on Wabtec.  They have done about 34 acquisitions since 2005.  This has added around 800mm in goodwill.  The interesting thing is parts of the goodwill are allocated to “deductible goodwill”. 

 

Not sure what number question we are on so I will use letters. 

 

A. Has anyone seen or heard of deductible goodwill?  I have not seen this amortized or deducted on the WAB 10-k. So far investor relations says “some goodwill is amortized’.  Not sure if that is true.

B. How about adjusting goodwill for currency fluctuations.  Is this normal?  The past two years they have lowered goodwill value by $80mm due to currency fluctuations. 

 

from 10-k

On February 4, 2015, the Company acquired Railroad Controls L.P. (“RCL”), a U.S. based provider of railway signal construction services for a purchase price of approximately $78.0 million, net of cash acquired, resulting in preliminary goodwill of $14.9 million, all of which will be deductible for tax purposes.

 

and

 

Goodwill

                                                      Freight       Transit   Total Goodwill

previous year (2014)                               515,067     347,217     862,284

Adjustment to purchase                       (1,210)     (4,056)           (5,266)

Acquisitions Goodwill                               28,964     12,140   41,104

Impairment -

foreign currency impact                       (10,856)     (28,788)   (39,644)

year end (2015)                                       531,965     326,513     858,478

 

 

[WneverLOSE]

Question :

When a company issues stock options they expense the cost of the options to arrive at the net income figure.

but the cost is only a forecast, they calculate the cost using the black scholes model.

lets say the options are for 3 years, and were given at the first year.

during that year the net income figure took into account the value of the options at the time, but by year 3 the stock did so well the options are worth much more.

so during the first year the net income figure shown to investors was too high.

What happens on year 3 ?

The company get the value of the options it issued and in exchange buys the appropriate amount of stock on the market and flips it to the employees (buying it at a premium) so net the company cash outflow was bigger than the inflow from the options.

(employees got paid much more that what initially thought, thus leaving less for shareholders)

by my best understanding the income statement doesn't recognize that shareholders wealth was lost by that.

How does one calculate the true earnings if a company stock keeps rising by so diverting income from shareholders to employees ?

[Cigarbutt]

Question :

When a company issues stock options they expense the cost of the options to arrive at the net income figure.

but the cost is only a forecast, they calculate the cost using the black scholes model.

lets say the options are for 3 years, and were given at the first year.

during that year the net income figure took into account the value of the options at the time, but by year 3 the stock did so well the options are worth much more.

so during the first year the net income figure shown to investors was too high.

What happens on year 3 ?

The company get the value of the options it issued and in exchange buys the appropriate amount of stock on the market and flips it to the employees (buying it at a premium) so net the company cash outflow was bigger than the inflow from the options.

(employees got paid much more that what initially thought, thus leaving less for shareholders)

by my best understanding the income statement doesn't recognize that shareholders wealth was lost by that.

How does one calculate the true earnings if a company stock keeps rising by so diverting income from shareholders to employees ?

That's a good question.

Accounting rules for stock options measure and reporting is a form of compromise.

The convention now requires to bring no adjustments to the allocated expenses after the grant date but the principle of incentive alignment between you, the shareholder, and the manager is maintained. Remember that when the stock is down, the same logic works in reverse unless the Board grants large numbers of options at low prices to "compensate" for the expiring stock options previously granted.

Stock options are truly an expense and the "true" expense (in the form of foregone opportunity to issue shares at market price), even if unrecognized, will be larger if the company does well. That seems fair.

Another mitigating aspect is that the relevant accounts (compensation expense and paid-in capital) will gradually incorporate the new market information over time.

BTW, nice avatar.

[SharperDingaan]

The company will report on its Statement Changes Financial Position the debt due on maturity date. There will also be a note disclosure that outlines the relevant details, terms, and conditions. The only time an entity can report a 'gain' on its issued debt, is if they've bought it back from the market at less than the maturity value; then either extinguished or defeased it.

 

A company can only MTM assets and liabilties available for sale, and must record the MTM adjustment in Other Comprehensive Income. It cannot record a MTM adjustment on debt that it has issued, just because it has become less credit worthy. A company does not get a positive MTM on debt they cannot repay as a result of restructuring or bankruptcy.

 

Under IFRS goodwill is means tested every year, and the deteriation in value recorded as a goodwill expense in the income statement. Under US GAAP, goodwill is simply amortized forward over up to a 40 year period.

 

Obviously it is possible to 'engineer' transactions.

Parents will often defease a portion of a subs debt to execute a restructuring. Goodwill will often move to a US GAAP reporter to minimize the annual goodwill charge. To avoid a note disclosure it must only be non-material, at the time it occurrs.

 

SD

 

 

For corporates, the total debt is the principal only. Don't forget to include short term portions of long term debt (current liabilities) in this number and potentially any significant operating lease liabilities and the net pension liability if the pension is material.

[...]

I think banks, perversely, are allowed to record discounts on their debt as a gain (which means I assume they drop the principal amount to face value) but I don't really look at the big banks so someone with better expertise could clarify that.

 

First: I am no accounting expert, but I would like to add some questions for my own understanding...

 

On the question whether principal shown or whether interest is included: Wouldn't that depends less on whether a company is a corporate or a bank, but on the form of the debt? To my understanding, loans taken by a company would be accounted for at amortized cost and hence be shown as principal, only. Debt issued via marketable securities (bonds) would be accounted for at fair value.

 

Fair value is the value of all future payments, discounted by expected interest rates plus credit spreads of the issuer. Thus, debt accounted at fair value would be discounted for by the market's estimate of the issuer's creditworthiness: if the issuer's creditworthiness degrades, liabilities are reduced and a gain is shown. I don't like this effect either, but if you want fair value to reflect market price, then there is no easy way out of this - after all, the market will indeed pay less for your bonds if your creditworthiness degrades.

 

If I remember correctly (and again, I am no expert on this, so I might remember wrongly), this discount is treated differently in U.S? IFRS and  European IFRS: IIRC in Europe, the best approximation of market price, including discounts for creditworthiness, will be used for fair valued liabilities while in the U.S. the market price has to be corrected by changes from own creditworthiness so that deteriorating creditworthiness will not reduce the liabilities (which I think to be more intelligent than the European treatment because a company always will have to repay its debt fully) Can anyone confirm this? I am really not certain about this difference, but I think that the upcoming IFRS 9 will have rules that forbid to show gains on the balance sheet caused by deteriorating creditworthiness...

[AdjustedEarnings]

Some goodwill is deductible for tax purposes based on how the transaction was structured. This will reduce your goodwill at the time of the initial recording of the transaction, with the corresponding change to the net deferred tax assets or liabilities. Financial statement goodwill is not deductible. But, when deductible for tax purposes, it improves cash flows in the years deducted. Foreign currency impact here might just be translation differences at reporting dates of goodwill of the foreign subs.

 

I have been doing some work on Wabtec.  They have done about 34 acquisitions since 2005.  This has added around 800mm in goodwill.  The interesting thing is parts of the goodwill are allocated to “deductible goodwill”. 

 

Not sure what number question we are on so I will use letters. 

 

A. Has anyone seen or heard of deductible goodwill?  I have not seen this amortized or deducted on the WAB 10-k. So far investor relations says “some goodwill is amortized’.  Not sure if that is true.

B. How about adjusting goodwill for currency fluctuations.  Is this normal?  The past two years they have lowered goodwill value by $80mm due to currency fluctuations. 

 

from 10-k

On February 4, 2015, the Company acquired Railroad Controls L.P. (“RCL”), a U.S. based provider of railway signal construction services for a purchase price of approximately $78.0 million, net of cash acquired, resulting in preliminary goodwill of $14.9 million, all of which will be deductible for tax purposes.

 

and

 

Goodwill

                                                      Freight       Transit   Total Goodwill

previous year (2014)                               515,067     347,217     862,284

Adjustment to purchase                       (1,210)     (4,056)           (5,266)

Acquisitions Goodwill                               28,964     12,140   41,104

Impairment -

foreign currency impact                       (10,856)     (28,788)   (39,644)

year end (2015)                                       531,965     326,513     858,478

 

 

[SharperDingaan]

Goodwill is a business expense no different to depreciation, and reflects use of the asset.

Tax deductibility depends on the tax code of the country the company is based in, in most places it will be a tax deductible expense.

 

Where goodwill was incurred in foreign currency, it is revalued the same as any other foreign currency asset at period end; typically at the end-of-period exchange rate. It's not that unusual a transaction; it's just not seen that often on most NA company books.

 

SD

 

 

Some goodwill is deductible for tax purposes based on how the transaction was structured. This will reduce your goodwill at the time of the initial recording of the transaction, with the corresponding change to the net deferred tax assets or liabilities. Financial statement goodwill is not deductible. But, when deductible for tax purposes, it improves cash flows in the years deducted. Foreign currency impact here might just be translation differences at reporting dates of goodwill of the foreign subs, though generally this is to be done at historical rates for that account.

 

I have been doing some work on Wabtec.  They have done about 34 acquisitions since 2005.  This has added around 800mm in goodwill.  The interesting thing is parts of the goodwill are allocated to “deductible goodwill”. 

 

Not sure what number question we are on so I will use letters. 

 

A. Has anyone seen or heard of deductible goodwill?  I have not seen this amortized or deducted on the WAB 10-k. So far investor relations says “some goodwill is amortized’.  Not sure if that is true.

B. How about adjusting goodwill for currency fluctuations.  Is this normal?  The past two years they have lowered goodwill value by $80mm due to currency fluctuations. 

 

from 10-k

On February 4, 2015, the Company acquired Railroad Controls L.P. (“RCL”), a U.S. based provider of railway signal construction services for a purchase price of approximately $78.0 million, net of cash acquired, resulting in preliminary goodwill of $14.9 million, all of which will be deductible for tax purposes.

 

and

 

Goodwill

                                                      Freight       Transit   Total Goodwill

previous year (2014)                               515,067     347,217     862,284

Adjustment to purchase                       (1,210)     (4,056)           (5,266)

Acquisitions Goodwill                               28,964     12,140   41,104

Impairment -

foreign currency impact                       (10,856)     (28,788)   (39,644)

year end (2015)                                       531,965     326,513     858,478

 

 

[meiroy]

Regarding goodwill:

 

http://www.berkshirehathaway.com/letters/1983.html

 

 

The part under "Corporate Performance" and then the Appendix.

 

If someone wakes you up in the middle of the night you should be able to recite the whole thing from memory.

 

 

 

 

 

[SharperDingaan]

Just to add to this ....

 

Accounting treatment is mandated by the accounting standard used. US GAAP allows amortization over 40 years, IFRS requires a means test every year, and an immediate expense of any decline in valuation. However, IFRS also allows a write-up of goodwill, to the total amount paid for goodwill at the time of acquisition; US GAAP does not.

 

The IFRS treatment is largely a response to the widespread abuse of goodwill accounting under GAAP; primarily by serial acquirers, technology, and drug companies. Create the goodwill by using overvalued company stock to pay for the acquisition; amortise the cost of the 'synergy premium' over 40 years to minimize the impact every year. And the bigger the goodwill asset, the better the  Balance Sheet ratios, and the easier to debt finance. If the promised 'synergies' subsequently did not appear, it did not matter; as there was no impact on the annual amortization.

 

The name may be the same, but economic and accounting goodwill are not the same thing.

Goodwill is not a substitute for reputation; it's just acquisition premium.

 

SD

 

[gfp]

I don't think US GAAP requires amortization of Goodwill since 2001 or so.

[AdjustedEarnings]

Under current US-GAAP, goodwill is NOT amortized. It has been that way for a LONG time. US Tax law allows deduction of goodwill, depending on how the deal is structure.

 

As to FX, foreign subs must first remeasure their financial statements (if needed) and then translate them (if needed). This is what produces the change to goodwill from quarter to quarter. The offset is in the cumulative adjustment in AOCI. It's not a big deal at all, unless all yours subs are in Venezuela. Both of these are minor things that generally don't affect your analysis of a company at all.