So, we have learned to treat commitments as debt. Although we should somehow factor these obligations in our analysis, they are just future operating costs… Lets take McDonald’s (MCD), lets say that the CFO decides to commit to a certain number of tomato forwards but decides not to commit to beef forwards. As an analyst I cannot see myself treating one food group as debt. In anycase, its a “soft” operating cost, I cannot understand why I would treat it as debt. Leases are close to this, and my understanding is that we treat them as debt, just to normalize balance sheets and help compare companies, plus, conceptually, they really do look like debt as you receive something today and make payments in the future… But this is where it falls apart for commitments, you don’t receive anything today… Thoughts?
Forward contracts are derivatives and are treated according to FAS 133. In this case, it would be a cash flow hedge because McDonald’s doesn’t own tomatoes (I guess). That means that P/L from the forward is going to flow through to other comprehensive income until they offset it with tomato sales.
Fair point. Lets forget the word forward, and just call them commitments (which are essentially the same). The book dictates that we should treat the commitments as debt, while perhaps we should treat them according to something like FAS 133 in order to create a comparable set of financial statements… My question still stands: why would I want to treat commitments as debt?
johnnyblazini Wrote: > My question still stands: why would I want to > treat commitments as debt? i think that might be a semantics question. do you agree that a commitment should create a liability?
I think in most cases they represent unlikely liabilities. I don’t think we should consider commitments on the financial statements. We are essentially talking about a form of risk, so perhaps it’s something we should consider in our discount rate… But if business goes on as usual, once the commitments expire, we end in the same place as we would have if we hadn’t had commitments. I just cant see the debt profile here…? Its risk…! Not debt! (I am refering to short/medium term commitments here)
So, to make it clear, no, I don’t consider a commitment a form of liability…
notice both definitions include a reference to a financial OBLIGATION Webster Dictionary Online ***Liability*** Inflected Form(s): plural li·a·bil·i·ties Date: 1705 1 a: the quality or state of being liable b: probability 2: something for which one is liable; especially : pecuniary obligation : debt —usually used in plural 3: one that acts as a disadvantage : drawback *** commitment**** Pronunciation: \kə-ˈmit-mənt\ Function: noun Date: 1603 1 a: an act of committing to a charge or trust: as (1): a consignment to a penal or mental institution (2): an act of referring a matter to a legislative committee b: mittimus 2 a: an agreement or pledge to do something in the future; especially : an engagement to assume a financial obligation at a future date b: something pledged c: the state or an instance of being obligated or emotionally impelled
I don’t think a semantic argument here is very helpful. One way to think about it is that if McD’s enters into a forward contract for tomatoes (btw- BK Whoppers have tomatoes; Big Mac’s don’t) you could decompose that into inventory, debt, and storage costs if tomatoes were storable. I think that would be completely appropriate with gasoline forwards for McD’s delivery trucks (btw - McD’s doesn’t deliver either). It’s a little different with tomatoes. In any event, MTM vs hedge accounting for derivatives is a place where reasonable people can disagree. In the end, I think the way derivatives are treated comes down to the certainty with which they represent a hedge. If the company goes bankrupt, their commitments under forward contracts, leases, unsecured bank loans, etc. are all approximately the same (i.e., unsecured claims in bankruptcy court).
JoeyDVivre Wrote: ------------------------------------------------------- One way to think about it is that if > McD’s enters into a forward contract for tomatoes > (btw- BK Whoppers have tomatoes; Big Mac’s don’t) > you could decompose that into inventory, debt, and > storage costs if tomatoes were storable. I think > that would be completely appropriate with gasoline > forwards for McD’s delivery trucks. I woulden’t decompose the gasoline forward. Lets say that you enter into a 3 year forward, do you think some Saudi investor is storing oil in a shed? My guess is that he’s making a bet on future oil coming out of the ground in 2.75 years. And you’re making a bet. Probably close to an even money bet. I think it may be interesting to analyse all transaction fees to place the bet including poor odds in certain cases. And to possibly account for those fees today and the cost of the gasoline in 3 years. Although I imagine the cost of all this to outweight the benefits… Even from a purely analytical point of view… In other words, if you’re making a bet today, you should probably account for the cost of placing such bet, but probably not for the principle you may or may not win in the future, especially on something like a future, since we have no idea how the payoff will look like.
johnnyblazini Wrote: ------------------------------------------------------- > JoeyDVivre Wrote: > -------------------------------------------------- > ----- > One way to think about it is that if > > McD’s enters into a forward contract for > tomatoes > > (btw- BK Whoppers have tomatoes; Big Mac’s > don’t) > > you could decompose that into inventory, debt, > and > > storage costs if tomatoes were storable. I > think > > that would be completely appropriate with > gasoline > > forwards for McD’s delivery trucks. > > > I woulden’t decompose the gasoline forward. > > Lets say that you enter into a 3 year forward, do > you think some Saudi investor is storing oil in a > shed? Irrelevant to me as long as it’s not a credit issue. >My guess is that he’s making a bet on future > oil coming out of the ground in 2.75 years. And > you’re making a bet. Probably close to an even > money bet. > I am making a bet, but if I am going to consume a predictable amount of gasoline, it’s a hedging bet. And it’s only a bet to the extent that storing gasoline is pretty expensive. > > I think it may be interesting to analyse all > transaction fees to place the bet including poor > odds in certain cases. And to possibly account for > those fees today and the cost of the gasoline in 3 > years. Although I imagine the cost of all this to > outweight the benefits… Even from a purely > analytical point of view… > I don’t understand this. Buying a 3-yr gasoline forward might be a perfectly reasonable thing to do (a little too far in the future for the futures market). The problem with 3-yr forward contracts is that you need to do something to mitigate credit risk (like MTM periodically) and the hassle of that outweighs the benefits. > In other words, if you’re making a bet today, you > should probably account for the cost of placing > such bet, but probably not for the principle you > may or may not win in the future, especially on > something like a future, since we have no idea how > the payoff will look like. Well, the corporate America that wants to expense stock options would like that kind of treatment but it’s particularly unrealistic in forwards contracts for traded commodities. NYMEX gives a Sept 2011 settle of 2.9427 so if you had a forward contract to buy gas @ 3.20, standard MTM accounting would give you a sizable loss. If the forward contract was MTM’d you would realize that loss. The argument that says you don’t have a loss because you don’t know what the gasoline will be worth in 2011 is Enron-esque and probably fraudulent in most situations.
Due to some time constraints, I’m going to refrain from replying to every point here. Lets see if we agree on the following; However we account for it, booking the complete value of a commitment as a liability is not representative of the underlying financial situation and makes it difficult to compare companies.
If you mean the complete notional value of the commitment, of course that’s right.
Good… I actually think that (from a theoretical point of view) we shouldn’t account for any of it and raise the discount rate of the company… I say this understanding that the benefits of this strategy would likely not overweight the costs…
You would simply be wrong about that…
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JoeyDVivre Wrote: ------------------------------------------------------- > You would simply be wrong about that… You don’t think that committing to something (that you would have bought regardless) is more a question of raising the company’s risk profile than recognising some possible numbers (that would probably have occured) on your financial statements…?
I think there is a huge difference in unrecognized paper P/L and “what you will do, regardless” because the future is just never known with certainty. For example, a) I’ve seen gold miners go bankrupt selling futures contracts because they can’t pull gold out of the ground fast enough to meet commitments on futures contracts. b) McD’s might change its business plan to not include tomatoes in any of its products c) The quality requirements of the forwards contracts may not match McD’s future needs d) In bankruptcy, McD’s no longer cares about its future tomato needs but providers of capital need to know about other creditors including the counterparty of the forwards contract. e) MTM requirements of the derivatives could eat into operating cash f) The accounting effects of excessive derivative exposure even for hedging can cause companies to buyout contracts in “big bath” kinds of ways to enhance future earnings. etc, etc, etc…
On a, b, d, e and f: I like to think about liabilities (as well as equity) as how you fund a company. Taking on a commitment is not helping you fund your venture, it’s a mere bet on the future which could have positive or negative impacts on your business. In other words you are simply raising the risk profile for your business (greater expected earnings variance). I would use a higher discount rate for a company with holding many bets, and of course I would take account of bets that clearly look like losers (or winners). But I wouldn’t discount the whole value of the commitment to the present and use that number as a liability. Perhaps I’m wrong, but I believe that is how the CFA books prescribe we deal with this…?!? On c: Lets assume that MCD purchases the right tools… Btw, is this your first time writing level II?
johnnyblazini Wrote: ------------------------------------------------------- > Btw, is this your first time writing level II? ummmm johnnyblazini… is this your first time on this site?
Yes. Yes it is…