Ch. 9: Reporting & Analysing Liabilities

Question 1

Current (short-term) liabilities

Answer 1

Require payment generally within a year.

Usually non-interest- bearing so companies seek to maximise the use of these as a source of financing

Question 2

Long-term liabilities

Answer 2

Require payments over several years.

Usually interest-bearing so companies seek to match repayment with the cash inflows of the assets to which they relate

Question 3

Categories of current obligations

Answer 3

Current operating liabilities

• Accounts payable
• Accrued liabilities

Current non-operating liabilities

• Short-term interest-bearing debt
• Current maturities of long-term debt

Question 4

Accrued liabilities

Answer 4

Reflect liabilities and expenses incurred during the period but not yet paid

Often referred to as ‘accrued expenses’ given the debit side of the accrual is reflected as
an expense in the income statement

E.g. Wages, Taxes, Rent, Utilities…

Question 5

Underestimated accruals create…

Answer 5

Underestimated liabilities

Overestimated income

Overestimated ret. earnings

Question 6

Warranties

Answer 6

Commitments made by manufacturers to their customers to repair or replace defective products within a specified time period

Question 7

Financial liabilities

Answer 7

Do not relate to operations

Include
▪ Bank loans
▪ Accrual of interest of those loans
▪ Current maturities of long-term debt

Question 8

Interest expense

Answer 8

Cost of borrowing money

Interest expense = Principal x Annual rate x Portion of year outstanding

Question 9

Current maturities of long-term debt

Answer 9

Consist of payments that must be made during the upcoming 12 months on long-term debt

Often relate to mortgages, bonds, or long- term notes payable

Question 10

Debt ratings

Answer 10

Often referred to as credit quality and creditworthiness

Related to default risk-> Default is when interest and principal are not paid or the covenants of bond indentures are violated

Rating agencies assign ratings to debt issues to inform investors
Agencies include:
▪ Moody’s Investors Service 
▪ Standard & Poor’s
▪ Fitch

AAA -> top rating
D -> Most risk

Question 11

Two interests crucial in pricing debt

Answer 11

Coupon rate:

• The rate stated in the bond contract
• Used to compute the amount of interest paid to bondholders
• Also known as the contract or stated rate.

Market rate:

• The rate that investors expect to earn on a debt
• Used to price a bond issue
• Also known as the yield rate

Question 12

Two cash flows associated with most bonds

Answer 12

1. Periodic interest payments during the bond’s life
   ▪ Usually semiannual
   ▪ Referred to as an interest annuity
   ▪ Rate is printed on the bond certificate
2. Single payment of the principal amount of the bonds at maturity
   ▪ Often called face value
   ▪ Amount is printed on the bond certificate

Question 13

Issuing bonds at par

Answer 13

Market rate = Coupon rate

Equal to FV

Question 14

Issuing bonds at a discount

Answer 14

Market rate > coupon rate

Less than FV

Question 15

Issuing bonds at premium

Answer 15

Market rate < coupon rate

More than FV

Question 16

PVs of principal and annuity

Answer 16

PV principal = P x ((1-r)^n / r)

PV annuity = P x ((1 - (1-r)^n) / r)

Question 17

Debt-to-equity (D/E)

Answer 17

A measure of solvency.

Measures the corporation’s financial leverage

D/E = Total liabilities / Total stockholders equity

Question 18

Times interest earned (TIE)

Answer 18

Measures how many times interest expense is covered by a company’s earnings.

TIE = Earnings bef. interest & taxes / Interest exp.

Question 19

Lease

Answer 19

A lease is a contract between an owner of an asset and a party desiring to use the asset.

Question 20

Lessor

Answer 20

Owner of an asset

Question 21

Lessee

Answer 21

Party desiring to use the asset

Question 22

Advantages of leasing over bank financing

Answer 22

Often requires less equity investment.

Asset may be used for only part of its life.

Payments may be structured to meet lessee’s needs.

Lessor retains tax benefit of depreciation.

With proper lease structure,
lessee will report neither the lease asset nor the liability.

Question 23

Two approaches GAAP allows for lessee reporting of leases

Answer 23

1. Operating Lease Method

2. Capital Lease Method

Question 24

Operating Lease Method

Answer 24

No balance sheet reporting of leased asset nor the lease liability

Lease payments are recorded as rent expense when paid

Question 25

Capital Lease Method

Answer 25

Leased asset and lease liability reported on the lessee’s balance sheet

Asset is depreciated

Lease liability is amortised like debt

Lease payments are divided between interest and principal payments

Question 26

For capital lease accounting under GAAP, the lease agreement must meet one or more of the following conditions:

Answer 26

1. Title to the leased asset automatically transfers to the lessee at the end of the lease term.
2. The lease contains a bargain purchase option.
3. The lease term is at least 75% of the economic life of the asset.
4. The present value of the lease payments is at least 90% of the asset’s fair market value.

Question 27

Benefits of operating leases for the lessee

Answer 27

No leased asset is reported -> Asset turnover ratios are higher

No lease liability is reported on the balance sheet -> Improves financial leverage ratios

In early years of lease term, expenses are less than reported under capital leases -> Higher net income reported