On Balance Sheet Debt Short and long-term Introduction: Important issue in analysis of debt is to realize that not all

items classified as debt are debt. Some items represent equity (raised from shareholders); others are equity by virtue of being unrecognized income (revenue). At the same time, (certain) items classified as equity are perhaps better treated as debt. Most importantly there exist numerous items not reported anywhere on the financial statements which should be reported as debt (off balance sheet debt). Current liabilities: three classifications that should be treated differently: 1. Trade debt (A/P, accrued liabilities etc) normal operating debt within firms operating cycle 2. Short-term debt (& current portion of Long-term debt) loans , commercial paper outside financing care should be taken to ensure that firm is not shifting from trade to bank financing 3. Advance from customers not a liability! (at least not in the amount listed). Unrecognized revenue as advance from customer goes up, it is good sign--future income increases. Long-term debt and equity Nature of debt should be analyzed: Convertible bonds Debt or equity? portion debt and portion equity; one should examine strike price to assess this question (option pricing models may be appropriate. Redeemable preferred shares: Equity or debt? Given its provisions, more than likely its debt and should be so treated. [SEC requires that it be reported above (but not as part of) equity.] Market or Cost: (Carrying Value) Difference between two affected by a function of three factors: 1. Terms of debt fixed or variable (swaps) 2. Horizon long or short 3. Imbedded rate versus change in interest rates Debt denominated in foreign currency is adjusted for changes in exchange rates (not changes in interest rate)

Debt - 1

Effect on Cash Flow Statement: Per GAAP, coupon payments (interest) are treated as CFO; whereas Face Value (principal) is treated as CFF. Distortion/Inconsistency When bonds issued at premium coupon payments include principal payment but reported as CFO When bonds issued at discount face value payments include interest but reported as CFF Consider Zero Coupon Bond: all payments are CFF, no CFO!

Bond Covenants

Debt - 2

10-5
Selected Balance Sheet Data, December 31, 1987 to 1988 ($ in millions) American Airlines 1987 1988 $1,012.4 $1,286.6 729.2 833.6 299.4 375.1 105.3 119.7 $2,146.3 $2,615.0 560.4 728.5 577.0 205.1 $2,071.0 $7,198.0 710.4 1,072.0 800.0 213.2 $2,795.6 $8,824.3 Eastern Airlines 1987 1988 $ 332.9 $ 402.3 396.5 463.1 182.1 163.7 44.3 37.4 $ 999.9 $1,022.4 267.2 344.9 390.5 190.1 $1,192.7 $4,447.5 242.7 455.7 302.4 153.0 $1,153.8 $3,806.1

Cash and short-term investments Net receivables Inventories Other current assets Current assets Accounts payable Accrued liabilities Air traffic liability* Notes payable and current portion long-term debt Current liabilities Net revenues

*For Eastern Air Lines includes $7.8 million and 19.2 million in frequent flier miles for 1987 and 1988, respectively. Source: American Airlines and Eastern Airlines, 1988 Annual Reports.

American Airlines 1987 Current assets Current Liabilities Net working Capital $2,146.3 2,071.0 $ 75.3 1988 $2,615.0 2,795.6 $ (180.6)

Eastern Airlines 1987 $1,022.4 1,192.7 $ (170.3) 1988 $ 999.9 1,153.8 $ (153.9)

Current ratio Quick ratio Cash ratio Adjusted Computations: Current liabilities Air traffic liability Current liabilities Net working capital Current ratio Quick ratio Cash ratio

1.03X 0.84 0.49

0.94X 0.76 0.46

0.86X 0.67 0.28

0.87X 0.69 0.35

$2,071.0 (577.0) $1,494.0 652.3 1.44X 1.17 0.68

$2,795.6 (800.0) $1,995.6 619.4 1.31X 1.06 0.64

$1,192.7 (390.5) $ 802.2 220.2 1.27X 0.99 0.41

$1,153.8 (302.4) $ 851.4 148.5 1.17X 0.94 0.47

Debt - 3

MICROSOFT

Balance Sheet (In millions)

June30 Assets Current assets: Cash and short-term investments Accounts receivable Other Total current assets Property and equipment Equity and other investments Other assets Total assets Liabilities and stockholders equity Current liabilities: Accounts payable Accrued compensation Income taxes payable Unearned revenue Other Total current liabilities Commitments and contingencies Stockholders equity: Convertible preferred stock shares authorized 100; shares issued and outstanding 13 Common stock and paid-in capital shares authorized 12,000; shares issued and outstanding 4,940 and 5,109 Retained earnings, including other comprehensive income of $666 and $1,787 Total stockholders equity Total liabilities and stockholders equity 1998 1999

$13,927 1,460 502 15,889 1,505 4,703 260 $22,357

$17,236 2,245 752 20,233 1,611 14,372 940 $37,156

$ 759 359 915 2,888 809 5,730

$ 874 396 1,607 4,239 1,602 8,718

980 8,025 7,622 16,627 $22,357

980 13,844 13,614 28,438 $37,156

Income Statement (In millions)

Year Ended June30 Revenue Operating expenses: Cost of revenue Research and development Acquired in-process technology Sales and marketing General and administrative Other expenses Total operating expenses Operating income Investment income Gain on sale of Softimage, Inc. Income before income taxes Provision for income taxes Net income 1997 $ 11,936 2,170 1,863 2,411 362 259 7,065 4,871 443 5,314 1,860 $ 3,454 1998 $ 15,262 2,460 2,601 296 2,828 433 230 8,848 6,414 703 7,117 2,627 $ 4,490 1999 $ 19,747 2,814 2,970 3,231 689 115 9,819 9,928 1,803 160 11,891 4,106 $ 7,785

Debt - 4

MICROSOFT Notes To Financial Statements UNEARNED REVENUE

A portion of Microsofts revenue is eamed ratably over the product life cycle or, in the case of subscriptions, over the period of the license agreement. End users receive certain elements of the Companys products over a period of time. These elements include browser technologies and technical support. Consequently, Microsofts earned revenue reflects the recognition of the fair value of these elements over the products life cycle. Upon adoption of SOP 98-9 during the fourth quarter of fiscal 1999, the Company was required to change the methodology of attributing the fair value to undelivered elements. The percentages of undelivered elements in relation to the total arrangement decreased, reducing the amount of Windows and Office revenue treated as uneamed, and increasing the amount of revenue recognized upon shipment. The percentage of revenue recognized ratably decreased from a range of 20% to 35% to a range of approximately 15% to 25% of Windows desktop operating systems. For desktop applications, the percentage decreased from approximately 20% to a range of approximately 10% to 20%. The ranges depend on the terms and conditions of the license and prices of the elements. The impact on fiscal 1999 was to increase reported revenue $170 million. In addition, the Company extended the life cycle of Windows from two to three years based upon managements review of product shipment cycles. The impact on fiscal 1999 was to decrease reported revenue $90 million. Product life cycles are currently estimated at 18 months for desktop applications. The Company also sells subscriptions to certain products via maintenance and certain organizational license agreements. At June 30, 1999, Windows platforms products unearned revenue was $2.17 billion and unearned revenue associated with productivity applications and developer products totaled $1.96 billion. Uneamed revenue for other miscellaneous programs totaled $116 million at June 30, 1999. Contingencies The Securities and Exchange Commission is conducting a non-public investigation into the Companys accounting reserve practices. Microsoft is also subject to various legal proceedings and claims that arise in the ordinary course of business.

Debt - 5

Face Value Coupon Mkt rate Opening 1 2 3 4

$100,000 10% 10% Issued at Par Interest Change in Payment Principal $ 10,000 $ $ 10,000 $ $ 10,000 $ $ 10,000 $ $ 40,000 $ Closing Balance $ 100,000 $ 100,000 $ 100,000 $ 100,000 Balance Expense $100,000 $ 10,000 $100,000 $ 10,000 $100,000 $ 10,000 $100,000 $ 10,000 $ 40,000

Face Value Coupon Mkt rate

$100,000 10% 8% Issued at Premium Opening Interest Balance Expense $106,624 $ 8,530 $105,154 $ 8,412 $103,567 $ 8,285 $101,852 $ 8,148 $ 33,376 Payment $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 40,000 Change in Principal $ (1,470) $ (1,588) $ (1,715) $ (1,852) $ (6,624)

$106,624 Closing Balance $ 105,154 $ 103,567 $ 101,852 $ 100,000

1 2 3 4

Face Value Coupon Mkt rate

$100,000 10% 12% Issued at Discount Opening Interest Balance Expense $ 93,925 $ 11,271 $ 95,196 $ 11,424 $ 96,620 $ 11,594 $ 98,214 $ 11,786 $ 46,075 Change in Payment Principal $ 10,000 $ 1,271 $ 10,000 $ 1,424 $ 10,000 $ 1,594 $ 10,000 $ 1,786 $ 40,000 $ 6,075

$93,925 Closing Balance $ 95,196 $ 96,620 $ 98,214 $ 100,000

1 2 3 4

Face Value Coupon Mkt rate

$100,000 0% 10% Issued at discount Opening Interest Balance Expense $ 68,301 $ 6,830 $ 75,131 $ 7,513 $ 82,645 $ 8,264 $ 90,909 $ 9,091 $ 31,699 Payment $ $ $ $ $ Change in Principal $ 6,830 $ 7,513 $ 8,264 $ 9,091 $ 31,699

$68,301 Closing Balance $ 75,131 $ 82,645 $ 90,909 $ 100,000

1 2 3 4

Debt - 6

EQK REALTY Zero Coupon Financing, Financial Statement Excerpts Balance Sheet
Year Ended December 31 Liabilities Mortgage note payable, net of debt discount of $392 Zero-coupon mortgage notes, net of unamortized discount of $9,574 1991 -----------$89,410 1992 $ 75,324 ---------

Statement of Cash Flows Year Ended December 31 Cash flows from operating activities Net loss Adjustments to reconcile net loss to net cash provided by operating activities Amortization of discount on zero-coupon mortgage notes Other adjustments Net cash provided by operating activities Cash flows from financing activities Prepayment of zero-coupon note Other adjustments Net cash provided by (used in) financing activities

1992 $ (8,850)

9,344 7,574 $ 8,068

$(23,038) 1,572 $(21,466)

Note 2: Debt Restructuring In December 1992, the Company refinanced $75,689,000 representing the balance of its zero-coupon mortgage note that remained after reducing this indebtedness with the proceeds from the sale of properties. . . . The new financing, which is collateralized by first mortgage liens . matures in December 1995.
Source: EQK Realty Investors, 1992 Annual Report.

EQK Realty Investors Adjustment of Operating Cash Flow (CFO), Years Ending December 31, 1989 to 1994 ($ in thousands) 1989 1990 1991 1992 Reported CFO Less: Zero-coupon interest Adjusted CFO $10,458 7,486 $2,972 $9,795 8,318 $1,477 $5,728 9,229 $(3,501) $8,068 9,344 $(1,276)

1993 $4,087 0 $4,087

1994 $2,184 0 $2,184

Debt - 7

EXHIBIT 10-13. NORAM ENERGY CORP. Stockholders Equity and Debt Covenants Condensed Shareholders Equity Capital Stock Preferred Common stock including paid-in capital 1994 $ 130,000 944,870 $1,074,870 1993 $ 130,000 944,118 $1,074,118

Retained Deficit Balance at beginning of year Net income (loss) Cash dividends Preferred stock, $3.00 per share Common stock, $0.28 per share in 1994 and $0.28 per share in 1993 Balance at end of year Unrealized gain on Itron investment, net of tax Total stockholders equity Note 5: Restrictions on Stockholders Equity and Debt

(366,080) 48,066 (7,800) (34,265) $ (360,079) 2,586 $ 717,377

(360,121) 36,087 (7,800) (34,246) $ (366,080) ____ $ 708,037

Under the provisions of the Companys revolving credit facility as described in Note 3, and under similar provisions in certain of the Companys other financial arrangements, the Companys total debt capacity is limited and it is required to maintain a minimum level of stockholders equity. The required minimum level of stockholders equity was initially set at $650 million at December 31, 1993, increasing annually thereafter by (1) 50% of positive consolidated net income and (2) 50% of the proceeds (in excess of the first $50 million) of any incremental equity offering made after June 30, 1994. The Companys total debt is limited to $2,055 million. Based on these restrictions, the Company had incremental debt issuance and dividend capacity of $321.2 million and $43.3 million, respectively, at December 31, 1994. The Companys revolving credit facility also contains a provision which limits the Companys ability to reacquire, retire or otherwise prepay its long-term debt prior to its maturity to a total of $100 million.
Source:NorAm Energy, 1994 Annual Report.

A.Current Income Level 1995 1996 1997 Estimated Stockholders' Equity Opening $717.3 $723.3 $729.3 Income 48.0 48.0 48.0 (42.0) Dividend (42.0) (42.0) Closing $723.3 $729.3 $735.3* Minimum Stockholders' Equity Opening $674.0 $698.0 $722.0 Addition (50% of 24.0 income) 24.0 24.0 Closing $698.0 $722.0 $746.0
*Below minimum stockholders' equity required. Debt - 8

B. Required Level 1997 1998 $729.3 69.4 (42.0) $756.7 $722.0 34.7 $756.7 $756.7 84.0 (42.0) $798.7 $756.7 42.0 $798.7