Module 7Module 7

Reporting and Reporting and Analyzing Analyzing Nonowner Nonowner Financing Financing ActivitiesActivities

Accounting Equation: Accounting Equation: Another LookAnother Look

What is a Liability?What is a Liability? ““Probable future sacrifices of economic Probable future sacrifices of economic

benefits arising from present benefits arising from present obligations of a particular entity to obligations of a particular entity to transfer assets or provide services to transfer assets or provide services to other entities in the future as a result other entities in the future as a result of past transactions or events.”of past transactions or events.”

Present obligations.Present obligations. Unavoidable obligations.Unavoidable obligations. Transaction or event must have Transaction or event must have

already happened.already happened.

The stigma of debtThe stigma of debt

Is debt bad?Is debt bad? Problems with having debtProblems with having debt Advantages of debtAdvantages of debt

FinancialFinancial ControlControl

Business FinancingBusiness Financing

Current liabilities (accounts payable Current liabilities (accounts payable & accrued expenses) are generally & accrued expenses) are generally non-interest bearing. Thus, firms try non-interest bearing. Thus, firms try to maximize the use of such to maximize the use of such liabilities to finance assets.liabilities to finance assets.

Companies generally finance long-Companies generally finance long-term assets with a combination of term assets with a combination of long-term liabilities and equity.long-term liabilities and equity.

Long-term financing is usually in the Long-term financing is usually in the form of bonds, and stock issuances. form of bonds, and stock issuances.

Debt, Leverage, and RiskDebt, Leverage, and Risk Magnitude of required debt payments Magnitude of required debt payments

increases proportionally with the level increases proportionally with the level of debt financing, and more required of debt financing, and more required debt payments implies a higher debt payments implies a higher probability of default should a probability of default should a downturn in business occur. downturn in business occur.

Increasing levels of debt, then, makes Increasing levels of debt, then, makes the firm look riskier to investors who, the firm look riskier to investors who, consequently, demand a higher return consequently, demand a higher return on the capital they provide to the on the capital they provide to the company. company.

Current LiabilitiesCurrent Liabilities Current operating liabilitiesCurrent operating liabilities

Accounts payableAccounts payable - obligations to other - obligations to other companies for amounts owed on purchases of companies for amounts owed on purchases of goods and services. These are usually non-goods and services. These are usually non-interest-bearing.interest-bearing.

Accrued liabilities - Accrued liabilities - obligations for which there obligations for which there is no related external transaction in the current is no related external transaction in the current period. These include, for example, accruals for period. These include, for example, accruals for wages payable which have been earned by wages payable which have been earned by employees but not yet paid, and accruals for other employees but not yet paid, and accruals for other business-related liabilities such as rent, utilities, business-related liabilities such as rent, utilities, and insurance. These accruals are made to and insurance. These accruals are made to properly reflect the liabilities owed and expenses properly reflect the liabilities owed and expenses incurred by the company as of the statement date.incurred by the company as of the statement date.

Current Liabilities Current Liabilities (cont’d)(cont’d)

Current non-operating liabilitiesCurrent non-operating liabilities Short-term interest-bearing loans: Short-term interest-bearing loans:

short-term bank borrowings expected to short-term bank borrowings expected to mature in whole or in part during the mature in whole or in part during the upcoming year, together with accrued upcoming year, together with accrued interest.interest.

Current maturities of long-term Current maturities of long-term debt: debt: long-term liabilities that are long-term liabilities that are scheduled to mature in whole or in part scheduled to mature in whole or in part during the upcoming year.during the upcoming year.

Accounts PayableAccounts Payable Accounts payable are usually non-interest Accounts payable are usually non-interest

bearing and, thus, represent an inexpensive bearing and, thus, represent an inexpensive source of financing. source of financing.

Recall that accounts payable often carry credit Recall that accounts payable often carry credit terms such as 2/10, net 30. These terms give terms such as 2/10, net 30. These terms give the buyer, for example, 2% off the invoice price the buyer, for example, 2% off the invoice price of goods purchased if paid within 10 days. of goods purchased if paid within 10 days. Otherwise the invoice is payable in its entirely Otherwise the invoice is payable in its entirely within 30 days.within 30 days.

Despite the incentive for early payment, is not Despite the incentive for early payment, is not uncommon for payables to remain outstanding uncommon for payables to remain outstanding for 45-90 days before payment is made. for 45-90 days before payment is made.

Accounts Payable Accounts Payable ExampleExample

Accrued ExpensesAccrued Expenses Accrued liabilities are identified at the end of an Accrued liabilities are identified at the end of an

accounting period to recognize liabilities and accounting period to recognize liabilities and expenses that have been incurred during the period expenses that have been incurred during the period but are not yet recognized in financial statements. but are not yet recognized in financial statements.

They are recorded into the books of the company, They are recorded into the books of the company, but there is no external transaction in the current but there is no external transaction in the current period. period.

Companies experience many different types of Companies experience many different types of accruals: accruals: accruals for wages payable which have been accruals for wages payable which have been

earned by employees but are not yet paid earned by employees but are not yet paid accruals of other business-related liabilities such accruals of other business-related liabilities such

as for rent, utilities, taxes, and insurance. as for rent, utilities, taxes, and insurance. When the liability is established, liabilities increase, When the liability is established, liabilities increase,

current income decreases, and equity is reduced. current income decreases, and equity is reduced. When the liability is ultimately paid, there are When the liability is ultimately paid, there are

decreases in both cash and the liability. decreases in both cash and the liability.

Wages Accrual ExampleWages Accrual Example

Employees have worked during the period and have not yet been paid. Failure to recognize this liability and associated expense would understate liabilities on the balance sheet and overstate income.

Employees are paid in the following period, resulting in a cash decrease and a reduction in wages payable. This payment does not result in expense because the expense was recognized in the prior period when incurred.

Unearned RevenueUnearned Revenue

Remember revenue recognition Remember revenue recognition criteriacriteria EARNEDEARNED RealizableRealizable

If not yet earned, but payment If not yet earned, but payment received, then it is a liability.received, then it is a liability.

Converted from a liability to revenue Converted from a liability to revenue when earned.when earned.

Uncertain AccrualsUncertain Accruals Some accruals are more uncertain. Some accruals are more uncertain.

Consider a company facing a lawsuit. Consider a company facing a lawsuit. Should it record the possible liability Should it record the possible liability and related expense? The answer and related expense? The answer depends on the likelihood of depends on the likelihood of occurrence and the ability to estimate occurrence and the ability to estimate the obligation. the obligation.

Specifically, if the obligation is Specifically, if the obligation is probableprobable and the amount and the amount estimableestimable, , then a company will recognize this then a company will recognize this obligation, called a obligation, called a contingent liabilitycontingent liability. .

If only one of the criteria is met, the If only one of the criteria is met, the contingent liability is disclosed in the contingent liability is disclosed in the footnotes.footnotes.

Accounting for Accounting for ContingenciesContingencies

Contingent loss

Probability ofOccurrence

Accounting Treatment

High Reasonable Remote

NoYes

DiscloseAccrue IgnoreDisclose

Estimable?

Misreporting of AccrualsMisreporting of Accruals The latitude in determining the amount and The latitude in determining the amount and

timing for recognition of accruals can lead timing for recognition of accruals can lead to misreporting of income and liabilities. to misreporting of income and liabilities.

If accruals are over (under) estimated, then If accruals are over (under) estimated, then liabilities are over (under) estimated, liabilities are over (under) estimated, income is under (over) estimated, and income is under (over) estimated, and equity (retained earnings) is under (over) equity (retained earnings) is under (over) estimated. estimated.

Further, in subsequent periods when an Further, in subsequent periods when an overstated accrued liability is reversed, overstated accrued liability is reversed, reported income is higher than it should be reported income is higher than it should be (because prior period income was lower (because prior period income was lower than it should have been).than it should have been).

Misreporting of AccrualsMisreporting of Accruals Experience tells us that accrued liabilities Experience tells us that accrued liabilities

that are linked to restructuring programs that are linked to restructuring programs (including severance accruals and accruals (including severance accruals and accruals for the write-down of assets), to legal and for the write-down of assets), to legal and environmental liabilities, and to business environmental liabilities, and to business combinations are sometimes problematic. combinations are sometimes problematic.

Namely, these accruals too often represent Namely, these accruals too often represent early (aggressive) recognition of expenses, early (aggressive) recognition of expenses, some as part of a ‘big bath,’ in a desire to some as part of a ‘big bath,’ in a desire to relieve future periods of these expenses. relieve future periods of these expenses.

Accordingly, we must monitor any change Accordingly, we must monitor any change or unusual activity with accrued liabilities.or unusual activity with accrued liabilities.

Current Non-Operating Current Non-Operating LiabilitiesLiabilities

Short-term bank loans (including Short-term bank loans (including the accrual of interest) the accrual of interest)

Current maturities of long-term Current maturities of long-term debt – long-term liabilities that debt – long-term liabilities that are scheduled to mature on are scheduled to mature on whole or in part during the whole or in part during the upcoming 12 months are upcoming 12 months are reported as a current liability. reported as a current liability.

Current assets are usually Current assets are usually financed with current liabilities financed with current liabilities

Accounting for Interest-Accounting for Interest-Bearing NoteBearing Note

Bank line of credit is a commitment to Bank line of credit is a commitment to lend up to a given level with the lend up to a given level with the understanding that the line is be repaid understanding that the line is be repaid in full sometime during the year.in full sometime during the year.

An interest-bearing note evidences such An interest-bearing note evidences such borrowings.borrowings.

Accounting for notes is clear - cash Accounting for notes is clear - cash received is reported on the balance received is reported on the balance sheet together with an increase in sheet together with an increase in liabilities (notes payable); and interest liabilities (notes payable); and interest payments are recorded as expenses.payments are recorded as expenses.

Example: Notes PayableExample: Notes Payable

Current Maturities of Current Maturities of Long-Term DebtLong-Term Debt

Payments that must be made during Payments that must be made during the upcoming 12 months on long-the upcoming 12 months on long-term debt (such as a mortgage) or term debt (such as a mortgage) or the maturity of a bond or note are the maturity of a bond or note are reported as current liabilities called reported as current liabilities called ‘current maturities of long-term ‘current maturities of long-term debt.’ debt.’

All companies are required to All companies are required to provide a schedule of the maturities provide a schedule of the maturities of its long-term debt in the footnotes of its long-term debt in the footnotes to financial statements.to financial statements.

Long-Term FinancingLong-Term Financing Companies typically require long-term Companies typically require long-term

liabilities in their capital structure to liabilities in their capital structure to support long-term asset acquisitions and support long-term asset acquisitions and maintenance. maintenance.

Issuing bonds and notes is a cost-efficient Issuing bonds and notes is a cost-efficient way to raise significant amounts of capital.way to raise significant amounts of capital.

Bonds and notes are structured like any Bonds and notes are structured like any other borrowing - the borrower receives other borrowing - the borrower receives cash and agrees to pay it back along with cash and agrees to pay it back along with interest. interest.

Commonly, the principal amount of the Commonly, the principal amount of the bond or note (face amount) is repaid at bond or note (face amount) is repaid at maturity, and interest payments are made maturity, and interest payments are made (semi-annually) until the liability matures. (semi-annually) until the liability matures.

Bonds PayableBonds Payable Terminology and terms of bond contractsTerminology and terms of bond contracts

LifeLife Maturity dateMaturity date Face value, principal, par value, maturity valueFace value, principal, par value, maturity value Interest paymentInterest payment Proceeds at issuanceProceeds at issuance Effective interest rateEffective interest rate

Other provisionsOther provisions RestrictionsRestrictions SecuritySecurity Call provisionCall provision

Bond PricingBond Pricing

There are two different interest rates you There are two different interest rates you must understand before we can discuss the must understand before we can discuss the mechanics of bond pricing:mechanics of bond pricing:

1.1. Coupon (contract or stated) rateCoupon (contract or stated) rate – the – the stated rate in the bond contract. It is used to stated rate in the bond contract. It is used to compute the dollar amount of (semiannual) compute the dollar amount of (semiannual) interest payments that are paid to interest payments that are paid to bondholders during the life of the bond issue. bondholders during the life of the bond issue.

2.2. Market (yield) rateMarket (yield) rate – the interest rate that – the interest rate that investors expect to earn on the investment in investors expect to earn on the investment in the debt security. This rate is used to price the debt security. This rate is used to price the bond issue. the bond issue.

Cash Flows from BondsCash Flows from Bonds

Bondholders normally expect to Bondholders normally expect to receive two different cash flows:receive two different cash flows:

Periodic (usually semiannual) Periodic (usually semiannual) payments of interest during the payments of interest during the bond life. These payments are often bond life. These payments are often in the form of equal cash flows at in the form of equal cash flows at periodic intervals, called an periodic intervals, called an annuityannuity..

Single payment of the face Single payment of the face (principal) amount of the bond at (principal) amount of the bond at maturity.maturity.

When a company issues a When a company issues a bond, what is it selling?bond, what is it selling?

Assume a company issues a $1,000, Assume a company issues a $1,000, 5%, 10 year bond, payments are 5%, 10 year bond, payments are semi-annual. What is the company semi-annual. What is the company selling?selling? Interest payments of $25 at the end of Interest payments of $25 at the end of

each of 20 six month periods. (An each of 20 six month periods. (An ordinary annuity.)ordinary annuity.)

A lump-sum payment of $1,000 at the A lump-sum payment of $1,000 at the end of 10 years.end of 10 years.

Cash Flows from BondsCash Flows from Bonds To illustrate, assume that investors wish to price To illustrate, assume that investors wish to price

a bond with a face amount of $10 million, an a bond with a face amount of $10 million, an annual coupon rate of 6% payable semiannually annual coupon rate of 6% payable semiannually (3% semiannual rate), and a maturity of 10 (3% semiannual rate), and a maturity of 10 years. years.

Investors purchasing this issue will receive the Investors purchasing this issue will receive the following cash flows:following cash flows:

Bond Pricing:Bond Pricing:Coupon Rate = Market Rate Coupon Rate = Market Rate

((Par)Par) Company promises to pay 20 semiannual payments of Company promises to pay 20 semiannual payments of

$10 million $10 million (6%/2) = $300,000 each, plus the $10 (6%/2) = $300,000 each, plus the $10 million face amount of the bond at maturity, for a million face amount of the bond at maturity, for a total of $16 million. total of $16 million.

Assuming that investors desire a 6% annual market Assuming that investors desire a 6% annual market rate of interest (yield), the bond sells for $10 million:rate of interest (yield), the bond sells for $10 million:

Bond Pricing:Bond Pricing:Coupon Rate < Market Rate Coupon Rate < Market Rate

((Discount)Discount) Assume that the company is not viewed as an Assume that the company is not viewed as an

acceptable credit risk and, to compensate for acceptable credit risk and, to compensate for accepting a higher level of risk, investors expect accepting a higher level of risk, investors expect an 8% annual yield (4% semi-annual yield). an 8% annual yield (4% semi-annual yield).

Given this new discount rate, the bond will sell Given this new discount rate, the bond will sell for $8,640,999: for $8,640,999:

Bond Pricing:Bond Pricing:Coupon Rate > Market Rate Coupon Rate > Market Rate

((Premium)Premium) Assume that investors expect only a Assume that investors expect only a

4% annual yield (2% semiannual 4% annual yield (2% semiannual yield). Given this new discount rate, yield). Given this new discount rate, the bond sells for $11,635,129 – see the bond sells for $11,635,129 – see below: below:

Book ValueBook Value

Net book value = principal plus Net book value = principal plus unamortized premium or less unamortized premium or less unamortized discount.unamortized discount.

Coupon Rate vs. Market Coupon Rate vs. Market RateRate

Bond Interest ExpenseBond Interest Expense

2 components:2 components: Cash interest payments (usually semi-Cash interest payments (usually semi-

annual).annual). Amortization of bond premium or Amortization of bond premium or

discount.discount. GAAP requires the effective interest GAAP requires the effective interest

rate method of amortization.rate method of amortization. SL method allowed only if it does not SL method allowed only if it does not

differ materially from effective interest differ materially from effective interest rate method.rate method.

Effective Interest RateEffective Interest Rate

Actual rate paid by issuerActual rate paid by issuer May or may not be same as the May or may not be same as the

stated ratestated rate Determined by discount rate that Determined by discount rate that

sets the present value of the future sets the present value of the future cash outflows equal to the fair cash outflows equal to the fair market value of that which is market value of that which is received in the exchange.received in the exchange.

Effective Interest Rate Effective Interest Rate MethodMethod

Bond Disc. Bond Disc. Amortization TableAmortization Table Beginning book value.Beginning book value.

Bonds payable – unamort. Disc. (or + Prem.).Bonds payable – unamort. Disc. (or + Prem.). Interest expense.Interest expense.

Beginning book value * effective interest rate.Beginning book value * effective interest rate. Interest paid.Interest paid.

Face amount * stated interest rate.Face amount * stated interest rate. Discount amortization.Discount amortization.

Interest expense - interest paid.Interest expense - interest paid. Ending book value.Ending book value.

B. payable - new unamort. Disc. (or + Prem.).B. payable - new unamort. Disc. (or + Prem.).

Accounting for Accounting for Long-Term ObligationsLong-Term Obligations

Record the asset acquired in the Record the asset acquired in the exchange at its fair market value.exchange at its fair market value.

Record the obligation at its face value.Record the obligation at its face value. Record a discount or premium if the Record a discount or premium if the

obligation is different than the fair obligation is different than the fair market value of the asset acquired.market value of the asset acquired.

Record interest expense for each Record interest expense for each period: effective interest rate x balance period: effective interest rate x balance sheet value of the obligation at the sheet value of the obligation at the beginning of the period.beginning of the period.

Accounting for Bonds: Accounting for Bonds: Balance SheetBalance Sheet

When a bond is sold, the company When a bond is sold, the company receives cash proceeds and has an receives cash proceeds and has an obligation to make payments per the obligation to make payments per the bond indenture (contract). A bond sale bond indenture (contract). A bond sale has the following financial effects:has the following financial effects:

Bonds Sold at a DiscountBonds Sold at a Discount

Bonds Sold at a PremiumBonds Sold at a Premium

Accounting for Bonds: Income Accounting for Bonds: Income StatementStatement

Amortization of a discount adds to the cash Amortization of a discount adds to the cash interest paid to compute interest expense. interest paid to compute interest expense.

Amortization of a discount reflects additional cost Amortization of a discount reflects additional cost the company incurs upon sale of the bonds; and, the company incurs upon sale of the bonds; and, recognition of this cost through its amortization recognition of this cost through its amortization yields increased interest expense. yields increased interest expense.

Conversely, a premium is a benefit the company Conversely, a premium is a benefit the company receives at issuance of a bond; and, amortization receives at issuance of a bond; and, amortization of a premium yields reduced interest expense. of a premium yields reduced interest expense.

Interest expense in the income statement is the sum of two components:

Effective Interest Method Effective Interest Method (Discount Example)(Discount Example)

Companies amortize the discount and Companies amortize the discount and premium using the premium using the effective interest effective interest methodmethod

Effective Interest Method Effective Interest Method (Premium Example)(Premium Example)

Gain (Loss) on Repurchase Gain (Loss) on Repurchase of Bondsof Bonds

Purchase of a bond is like the sale of a long-term assetPurchase of a bond is like the sale of a long-term asset A gain or loss can result from a repurchase. A gain or loss can result from a repurchase. Book value of the bond is the net amount that appears Book value of the bond is the net amount that appears

on the balance sheet. on the balance sheet. If the company pays more to retire the bonds than If the company pays more to retire the bonds than

they carry on the balance sheet, this is a cost that is they carry on the balance sheet, this is a cost that is reflected in the income statement as a loss on reflected in the income statement as a loss on retirement of bonds. retirement of bonds.

Conversely, a company reports a gain on retirement of Conversely, a company reports a gain on retirement of bonds if the purchase price is less than its book value.bonds if the purchase price is less than its book value.