Management Of Liabilities

Introduction

It often has been said that the management, or planning and control, of the assets (excepting cash and temporary investments) of an enterprise rests largely in the hands of the operating executives but that management, or planning and control, of the liabilities and equity of the company is primarily the responsibility of the financial executives. In a certain sense this is true up to a point and the financial officers must exercise control over the liabilities of the entity to preserve its economic health.

The comments in this chapter relate to the practical or pragmatic considerations regarding liability planning and control, of which the controller must be intimately familiar. Remarks will relate to the traditional types of liabilities as well as new developments and concerns in this field of management.

Liabilities Defined

Although it is not the purpose of the chapter to deal at length with the accounting niceties regarding the recording of the liabilities of a company, the subject is defined for our purposes as :

Liabilities are the economic obligations of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Liabilities also include certain deferred credits that are not obligations (such as, for example, deferred credits from income tax allocations) but that are recognized and measured in conformity with generally accepted accounting principles.

Liabilities are measured at amounts established in the exchanges involved, usually the amounts to be paid but sometimes at discounted rates.

Objectives Of Liability Management

In the basic sense, the purpose of liability management is to assure that the enterprise has “cash adequacy” the ability to meet cash requirements for any purpose significant to the short or long term financial health of the company. It is not merely to avoid insolvency or bankruptcy. From the standpoint of the controller, the more specific objectives of liability management might include :

-	The recording and disclosure in accordance with generally accepted accounting principles of the financial obligations of the company.
-	The reporting in proper form, as required by indentures or credit agreements, of the corporate liabilities.
-	Through effective planning and control, the maintenance of a sound financial structure, including the proper relationship of debt to equity capital.
-	Continuance of the ability to secure necessary borrowed funds in a timely manner and at a cost that is competitive.
-	To institute and maintain controls that restrict commitments within well defined limits so that they do not result ultimately in excessive and burdensome liabilities.
-	To enable the company to be so well regarded in the financial marketplace that its common (and preferred) stock will command respect far into the future with an acceptable Price earnings ratio, and that the stock will reflect a gradual increase in earnings per share and consequent long-term appreciation for the benefit of the owners.
-	To permit the company to maintain a prudent dividend policy.

All of these objectives of liability management are interrelated.

Direct Liabilities

In an attempt to categorize the types of liabilities and to indicate some of the matters to be considered by the controller, a brief commentary follows.

Current Liabilities

Generally, liabilities classified as current are those due to be paid within the operating Cycle that ordinarily is within a period of one year. The importance of the proper segregation of current liabilities from other liabilities rests in the role played by various financial ratios, such as the current ratio, when funds are borrowed.           

By another related definition, current liabilities include those obligations whose liquidation reasonably is expected to require the use of existing current assets or the creation of new current liabilities. Included in current liabilities are :

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Notes payable. Represent the obligations of the company under legal instruments in which there exists an explicit promise to pay a specified amount at a specified time

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Accounts payable. Accounts payable usually are largely trade accounts payable and represent the obligations of the firm to its suppliers. Since these liabilities are recorded at the time the title passes to the goods or the services are received, the financial officers should be satisfied that clean cutoffs on the obligations exist. This is especially true in those instances where the working capital or current ratio requirement is critical in a credit agreement or the company is nearing the limits specified.

Additionally, credit balances in various asset accounts, such as accounts receivable, usually are reclassified to the accounts payable category especially at year end or when financial statements are published.

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Accrued expenses. When an obligation exists by reason of the benefits having been received but is not yet due and payable, it normally would be recorded as an accrued expense. Included would be such items as accruals for wages, salaries, commissions, rents, royalties, pension costs, and income and other taxes.

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Accrued income taxes. Special mention is made of this liability, since often it is composed of two segments. The normal tax due within a year would be recorded under current liabilities as “currently payable.” However, using the principle of matching costs with related revenues, yet recognizing that the tax laws permit the reporting of income in a different fiscal period than generally accepted accounting principles would either permit or require, there may be includable under current liabilities a “deferred” income tax obligation.

There are rather continuously numerous official releases by the Financial Accounting  Standards Board (FASB), which provide new standards concerning income tax accounting. For example, in May 1992, the body issued Statement of Financial Accounting Standards No. 109 Accounting for Income Taxes. It supersedes FASB Statement No. 96, Accounting for Income Taxes and amends or supersedes a number of other accounting pronouncements. Statement No. 109 established financial accounting and reporting standards for the effects of income taxes that result from an enterprise’s activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting for income taxes. As the Standard says, “The objectives of accounting for income taxes are to recognize (a) the amount of taxes payable or refundable for the current year, and (b) deferred tax liabilities and assets for future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns.”

It is assumed the controller will keep abreast of tax reporting requirements and will see that the tax liability is properly recognized.

This distinction becomes important in calculating cash flows and when considering acceptable terms in indentures or credit agreements.

Long Term Liabilities

Long term liabilities, by definition, represent those obligations due in more than one year or those to be paid out of noncurrent assets. Only three limited comments need be made.

1.	Long term leases. If at its inception a lease meets one or more of the following criteria, it shall be classified as a capital lease by the lessee and placed on the balance sheet. Otherwise, it would be treated as an operating lease, with appropriate disclosure. The criteria for capitalization include :
	a.	The lease transfers ownership of the property to the lessee by the end of the lease term.
	b	The lease contains a bargain purchase option.
	c	The lease term is equal to 75% or more of the estimated economic life of the leased property (with certain exceptions).
	d	The present value at the beginning of the lease term of the minimum lease payments excluding certain costs—equals or exceeds 90% of the fair market value of the property over the related investment tax credit retained or expected to be used by the lessor
	For the specific criteria and the exceptions, reference should be made to the literature of the American Institute of Certified Public Accountants (AICPA).
2.	Bonds. Bonds are essentially long-term corporate notes issued under a formal legal procedure and secured either by the pledge of specific properties, or revenues, or the general credit of the issuer. Bonds differ from individual notes in that each represents a fractional interest of participation in a group contract, usually with a trustee acting as intermediary. The terms of the contract are set forth in the trust indenture.
3.	Other long term obligations, etc. Depending on circumstances, there may exist other obligations and like items that are classified either as long term obligations or items carried in the long-term section of the balance sheet above the shareholders’ equity. These may include such items as :
	-	Deferred income taxes
	-	Deferred compensation
	-	Accrued product warranty
	-	Employees pension, indemnity, retirement, and related provision
	-	Negative goodwill
	-	Minority interests

The reader is referred to the various publications of the AICPA about the generally accepted principles that govern the recording of the item.

Illustrative Provisions Of Credit Agreements

To be sure, within limits, indentures or credit agreements will be tailored to fit the desires of both the lender and the borrower. However, a great number of standard provisions apply to many loan agreements. Before further discussing the recording of the liabilities and, indeed, before considering the planning of indebtedness, it may be helpful to be aware of some of these usual provisions that relate to indebtedness limits and certain uses of cash. Excerpts from the note agreement for a ten-year private placement loan from an insurance company to a manufacturing concern include :

6A. Current Ratio Requirement. 

The Company covenants that it will not permit Consolidated Current Assets at any time to be less than an amount equal to 150 % of Consolidated Current Liabilities.

6B. Dividend Limitation. 

The Company covenants that it will not pay or declare any dividend on any class of its stock or make any other distribution on account of any class of its stock, or redeem, purchase or otherwise acquire, directly or indirectly, any shares of its stock (all of the foregoing being herein called “Restricted Payments”) except out of Consolidated Net Earnings Available For Restricted Payments ; provided, however, that notwithstanding the foregoing limitations, the Company may make sinking fund and dividend payments on its outstanding preferred stock not in excess of $3,300,000 in the aggregate in any year, but provided further, that the amount of any such sinking fund payments and the amount of any such dividends paid or declared shall be included in any subsequent computation pursuant to this paragraph 6B. “Consolidated Net Earnings” shall mean consolidated gross revenues of the Company and its Subsidiaries less all operating and non operating expenses of the Company and its Subsidiaries including all charges of a proper character (including current and deferred taxes on income, provision for taxes on unremitted foreign earnings which are included in gross revenues and current additions to reserves), but not including in gross revenues any gains (net of expenses and taxes applicable thereto) in excess of losses resulting from the sale, conversion or other disposition of capital assets (i.e., assets other than current assets), any gains resulting from the write-up of assets, any equity of the Company or any Subsidiary in the undistributed earnings of any corporation which is not a Subsidiary, any earnings of any corporation acquired by the Company or any Subsidiary through purchase, merger or consolidation or otherwise for any year prior to the year of acquisition, or any deferred credits representing the excess of the equity in any Subsidiary at the date of acquisition over the cost of the investment in such Subsidiary; all determined in accordance with generally accepted accounting principles including the making of appropriate deductions for minority interests in Subsidiaries. “Consolidated Net Earnings Available For Restricted Payments” shall mean an amount equal to (1) the sum of $10,000,000 plus 90% (or minus 100% in case of a deficit) of Consolidated Net Earnings for the period (taken as one accounting period) commencing on August 1, 20XX, and terminating at the end of the last fiscal quarter preceding the date of any proposed Restricted Payment, less (2) the sum of (a) the aggregate amount of all dividends and other distributions paid or declared by the Company on any class of its stock after July 31, 20XX, and (b) the excess of the aggregate amount expended, directly or indirectly, after July 31, 20XX, for the redemption, purchase or other acquisition of any shares of its stock, over the aggregate amount received after July 31, 20XX as the net cash proceeds of the sale of any shares of its stock. In the event that any shares of stock of the Company are issued upon conversion of convertible notes, bonds or debentures of the Company, the proceeds of the shares of stock so issued shall be deemed to be an amount equal to the principal amount of the obligations so converted. There shall not be included in Restricted Payments or in any computation of Consolidated Net Earnings Available For Restricted Payments: (x) dividends paid, or distributions made, in stock of the Company; or (y) exchanges of stock of one or more classes of the Company, except to the extent that cash or other value is involved in such exchange. The term “stock” as used in this paragraph 6B shall include warrants or options to purchase stock.

The company will not :

6C (2) Debt 

Create, incur, assume, guarantee or in any way become liable for any Funded Debt in addition to the Funded Debt referred to in paragraph 8D, or create, incur, assume or suffer to exist any Current Debt, except.

(i) Funded Debt of the Company or any Subsidiary provided that, after giving effect thereto and to the concurrent repayment of any other Funded Debt, Consolidated Net Tangible Assets shall be not less than an amount equal to (a) 250% of Consolidated Senior Funded Debt, and (b) 150% of Consolidated Funded Debt, and further provided that no Subsidiary shall create, incur, assume, guarantee or in any way become liable for any Funded Debt permitted by this clause (i) unless such Funded Debt shall be secured by a Lien on its property permitted by clauses (v), (vii) or (viii) of paragraph 6C(1), shall be of the type referred to in clause (iii) of paragraph 10G or shall constitute Funded Debt payable to the Company or another Subsidiary, and.

(ii) Current Debt of the Company or any Subsidiary, provided that the aggregate Current Debt of the Company and its Subsidiaries permitted by this clause (ii) shall not be in excess of the Permitted Amount on any day after December 31, 20XX unless, during the fifteen months’ period immediately preceding such day, the aggregate Current Debt of the Company and its Subsidiaries permitted by this clause (ii) shall not have been in excess of the Permitted Amount for at least 60 consecutive days, and further provided that no Subsidiary shall create, incur, assume or suffer to exist any Current Debt permitted by this clause (ii) unless such Current Debt shall be secured by a Lien on its property permitted by clauses (v), (vii) or (viii) of paragraph 6C (1) or shall constitute Current Debt payable to the Company or another Subsidiary :

6E. Subordinated Debt. 

The Company covenants that it will not (i) pay, prepay, redeem, purchase or otherwise acquire for value any Subordinated Debt except as required by the original provisions of the instruments evidencing Subordinated Debt or pursuant to which Subordinated Debt shall have been issued, (ii) amend the instruments evidencing Subordinated Debt or pursuant to which Subordinated Debt may have been issued in such manner as to terminate, impair or have adverse effect upon the subordination of the Subordinated Debt, or any part thereof, to the indebtedness evidenced by the Notes; or (iii) take or attempt to take any action whereby the subordination of the Subordinated Debt, or any part thereof, to the indebtedness evidenced by the Notes might be terminated, impaired or adversely affected. The term “Subordinated Debt” as used in this paragraph 6E shall mean any Funded Debt of the Company or any Subsidiary which does not constitute Senior Funded Debt.

Thus, it can be seen that overall debt constraints are included in this agreement and usually are a part of most credit agreements.

With respect to securing short-term credit, certain other types of restrictions may apply. Excerpts from a loan and credit agreement for short-term borrowing under a revolving line of credit between a manufacturer and a group of commercial banks contain clauses that, under specified conditions, do :

-	Restrict certain payments (such as cash dividends or purchases of company stock).
-	Restrict the sale or lease of assets.
-	Require the maintenance of a given ratio of shareholders’ equity to senior indebtedness and a minimum amount of shareholders’ equity.
-	Place restraints on specific contingent liabilities
-	Place limitations on acquisitions of other companies.
-	Place limitations both on certain specific debts and on overall consolidated indebtedness

The specific wording of some of the clauses relating to covenants or restrictions may be of interest :

Minimum Working Capital.

Maintain Consolidated Working Capital at a level whereby consolidated current assets are at least 175% of consolidated current liabilities of the Company and all Consolidated Subsidiaries and, in any event, of at least $ 200,000,000. In any calculation of Consolidated Working Capital, an amount equal to Covered Customer Advances shall be excluded from both consolidated current assets and consolidated current liabilities and deferred income taxes reported by the Company as a current liability in its consolidated balance sheet shall be excluded from consolidated current liabilities.

Negative Covenants.

So long as credit shall remain available to the Company hereunder and until the payment in full of all Notes outstanding hereunder and the performance of all other obligations of the Company hereunder, the Company will not, and will not permit any Consolidated Subsidiary to, without the prior written consent of Banks holding at least 66 2/3% in aggregate unpaid principal amount of the Notes, or, if no Notes are then outstanding, Banks having at least 66 2/3% of the aggregate commitments to make loans hereunder :

Restrictive P ayments.

Declare, pay or authorize any Restricted Payment if (a) any such Restricted Payment is not paid out of Consolidated Net Earnings Available For Restricted Payments and (b) at the time of, and immediately after, the making of any such Restricted Payment (or the declaration of any such dividend except a stock dividend) no Event of Default specified in § 8 and no event which with notice or lapse of time or both would become such an Event of Default has occurred and (c) the making of any such Restricted Payment would reduce Consolidated Tangible Shareholders’ Equity below $ 225,000,000.

Sale, Lease, etc.

Sell, lease, assign, transfer or otherwise dispose of any of its assets, tangible and intangible (other than investments permitted by § 7B(7) and obsolete or worn-out property or real estate not used or useful in its business), whether now owned or hereafter acquired, excluding from the operation of this clause sales, leases, assignments, transfers and other dispositions (a) in the ordinary and normal operation of its business and for a full and adequate consideration, (b) between the Company and any Consolidated Subsidiary, and between Consolidated Subsidiaries and (c) by the Company not in the ordinary and normal operation of its business provided the value on the Company’s books of assets so transferred shall not exceed 10% of Consolidated Tangible Shareholders’ Equity in the aggregate in any calendar year.

Maintenance of Shareholder’s Equity.

Permit the amount of Consolidated Tangible Shareholders’ Equity at any time to be less than 100 % of the then aggregate outstanding amount of Consolidated Senior Indebtedness or less than $ 225,000,000.

Contingent Liabilities.

Assume, guarantee (which for purposes of this clause (4) shall include agreements to purchase or to provide funds for the payment of obligations of, to maintain the net worth or working capital or other financial test of, or otherwise become liable upon the obligations of, any person, firm or corporation) or endorse any obligation of any other person, firm or corporation (except the Company or a Consolidated Subsidiary, or any captive insurance subsidiary, as the case may be, as permitted by this clause (4)) or permit to exist any assumption, guarantee or endorsement, excluding from the operation of this clause, (a) assumptions, guaranties and endorsements in the ordinary and normal operation of its business as presently conducted, it being understood that performance guaranty bonds, bank guaranties for foreign work, advance payment bonds, direct guarantees for performance, or other surety bonds will be so considered; (b) guarantees by the Company or any Consolidated Subsidiary or direct obligations of the Company or any Consolidated Subsidiary for the payment of money, whether domestic or foreign, so long as an amount equal to the aggregate amount of such guaranteed obligations is deemed to be (without duplication). Indebtedness and/or Consolidated Senior Indebtedness, as the case may be, for purposes of §§ 7b (8) and 7B (9) ; (c) guarantees of the Company or any Consolidated Subsidiary issued, or obligations assumed, in connection with acquisitions of assets permitted under § 7B (5), provided that obligations for borrowed money (whether guaranteed or assumed) shall be treated as provided in the next preceding clause (b); and (d) guaranties by the Company or any Consolidated Subsidiary of direct obligations of third parties for the payment of money, provided that if the then aggregate amount of such obligations shall exceed an amount equal to 15% of Consolidated Tangible Shareholders’ Equity, the amount of such excess shall be deemed Consolidated Senior Indebtedness for purposes of this Agreement.