Module 5: Liabilities Flashcards
I have employees work for me and I don’t pay them in cash, I record?
DR salary expense XX / CR accrued liabilities (or salaries payable or accrued liabilities) XX
3 flavors of contingent liabilities
- remote
- reasonably possible
- probable and estimable
when a contingent liability falls under the remote category, a company _______
ignores it (no accounting implications)
when a contingent liability falls under the reasonably possible category, a company _______
discloses it in footnotes (but doesn’t record it)
when a contingent liability falls under the probable and estimable category, a company _______
records the liability: DR expense XX / CR liability (or reserve) XX
and will probably also disclose it in footnotes
examples of permanent book/tax differences
municipal interest income, fines and penalties, meals and entertainment, federal income tax expense itself
these are included in GAAP income but not taxable income (except for meals and expenses, which are only 50% deductible against tax income)
working capital
current assets - current liabilities
current ratio
current assets / current liabilities
quick ratio
current (cash + market securities + A/R) / current liabilities
If a company earns interest on a municipal bond, is it included in GAAP (“book”) net income?
But, is such income in taxable income
Yes
No - because federal government doesn’t tax income on state/local regulations
PBITWSBT
pretax book income that will someday be taxed
mortgage bonds
bonds that are secured by specific property
in the case of default on the bond, the bondholders have the first right to proceeds from the sale of that property
debentures
bonds with only a general claim against total assets, like other general creditors (as opposed to a claim against specific assets, which is what mortgage bonds have)
subordinated debentures
these are debentures with only a general claim against the company’s total assets, but with lower priority than other general creditors
I buy inventory and I don’t pay in cash. I record:
DR inventory XX / CR A/P XX
I have employees work for me and I don’t pay in cash. I record:
DR salary expense XX / CR accrued liabilities
Who do you deal with when borrowing via private placements vs. from the general public (bonds)?
borrow private placements: negotiate terms directly with the lender
borrow from general public: arrange terms through underwriter (i.e. intermediary like ibank) and then the underwriter sells the bonds to the investor
Examples of private placements?
Promissory notes payable (notes payable): arise from borrowing $, more formal than A/P, usually borrowed from banks
Credit facilities: provide companies with lines of credit where they can borrow up to a specific limit without having to go through loan approval process, company pays a fee for this arrangement and pays interest on any borrowings
Commercial paper: short-term (60-90 days), borrowed from banks and other institutions (like money market funds)
issue 10 mill in promissory notes payable, JE?
DR cash 10 mill / CR promissory notes payable 10 mill
3 flavors of bonds?
- Mortgage bonds: bonds secured by specific property, if defaulted on they have the 1st right to proceeds from sale of that property, then put on same level for the rest of the property as debentures
- Debentures: bonds with only a general claim against total assets, like other general creditors
- Subordinated debentures: debentures with only a general claim against total assets, but with lower priority than other general creditors
Separate all of As and Ls into current vs. concurrent on __________
Separate all of As and Ls into current vs. concurrent on classified B/S
solvency
measure of a company’s ability to pay debt as they come due, tied to CA vs CL
What does the debt in the debt:equity ratio include?
debt only includes interest-bearing debt like bank debt, but not A/P
interest coverage ratio
(aka times interest earned) = (NI + tax expense + interest expense) / interest expense
Does a change in the risk of a bond affect the price in the secondary market even if it’s not reflected in a change in the bond ratings?
A change in the risk of a bond whether or not it’s reflected in a change in the bond ratings (usually a change in bond rating doesn’t change coupon) affects the price in the secondary market
Increase risk → ______ discount rate → ______ the price
Increase risk → increases discount rate → decreases the price
Decrease risk → ______ discount rate → ______ the price
Decrease risk → decreases discount rate → increases the price
Does FASB allow companies to mark-to-market their bonds?
Yes
How to reduce the risk of a bond?
Debt covenants: restrictions a creditor puts on the borrower (ex. maintenance of a specific level of RE, prohibition against paying dividends, maintain certain working capital levels, current ratios, or debt:equity ratio)
What usually happens if a borrower failed to comply with a provision of a debt covenant?
the borrower defaults on the loan (the loan is immediately due)
pending lawsuits, product warranty liabilities, tax disputes with IRS, and potential liabilities associated with restructuring are all _____________
contingent liabilities
3 flavors of contingent liabilities based on likelihood of an unfavorable outcome:
- Remote: company ignores it
- Reasonably possible: discloses it in footnotes, including a description of the contingency and a range of estimated losses, if possible
- Probable AND estimable: company records the liability (DR expense XX / CR liability (or “reserve”) XX) and will probably also disclose relevant info in the footnotes
___________ gives auditors info on likelihood of losing asserted claims, amount of the loss on asserted claims, existence of unasserted claims
Legal counsel gives auditors info on likelihood of losing asserted claims, amount of the loss on asserted claims, existence of unasserted claims
Attorneys have issues about confidentiality, leading to conflict between auditors who want maximum disclosure and attorneys who want minimum disclosure. Who manages this conflict and how do they do it?
To manage this conflict, client’s management acts as a go-between by coming up with a list of pending litigation and other asserted or unasserted claims, sends the list to the attorneys for comments about the status of each item (e.g., legal action client intends to take, likelihood of an unfavorable outcome, estimate of the potential loss), requests the attorney to identify any unlisted contingencies or include a statement that the list is complete, informs the attorney of the attorney’s responsibility to inform management of legal matter requiring disclosure in the financial statements under ASC 450
Examples of restructuring liabilities?
severance pay for laid off employees, costs of closing down factories, costs of getting rid of excess inventory
FASB rule:
FASB: Before a company can record a restructuring reserve it must: ?
In the years after the restructuring reserve is recorded the company must disclose: ?
FASB: Before a company can record a restructuring reserve it must:
o Have a formal restructuring plan that’s approved by the Board of Directors
o Identify and notify the affected employees
In the years after the restructuring reserve is recorded the company must disclose:
o The original liability
o How much of the liability was paid off in the current period
o How much of the liability was reversed bc of overestimations
o New accruals for unanticipated costs
o Ending balance of the liability
Any reversal of a restructuring liability must be reported to _________
Any reversal must be reported to the same I/S account to which the expense was recorded when the liability was first established
Company has 1 mill of income, corp tax rate of 40% that it pays in cash, record: ?
If the company doesn’t pay tax at the same time it records the tax journal entry (which it probably won’t), record: ?
DR tax expense (“provision”) 400k / CR cash 400k
DR tax provision 400k / CR CTL 400k
Does GAAP NI = taxable income?
Nope - permanent book/tax differences affect book (GAAP) income, but never taxable income
Interest income on a municipal bond, fines and penalties, and federal income tax expense itself are examples of ____________
Interest income on a municipal bond, fines and penalties, and federal income tax expense itself are examples of permanent book/tax differences, which affect book income, but never taxable income
How is meals and entertainment recorded against GAAP NI? Tax income?
recorded as expense against GAAP NI but only 50% deductible against tax income
Are temporary book/tax differences in book income or taxable income?
Temporary book/tax differences are in both book income and taxable income, but in different years
When are DTAs recorded? DTLs?
DTAs (pay less tax later):
- income is recorded now for tax, later for GAAP (prepaid rental income)
- expenses are recorded now for GAAP, later for tax (contingent liabilities)
DTLs (pay more tax later):
- income is recorded now for GAAP, later for tax (like-kind exchanges)
- expenses are recorded now for tax, later for GAAP (depreciation)
What gives rise to DTLs?
- Report GAAP I/S in year 1 but don’t have to actually pay the tax in year 1
- Like-kind exchange
When do we report liabilities for income taxes for tax purposes?
when fixed and determinable: the contingent liability isn’t actually reported until paid in cash
NOL (net operating loss)?
a tax loss, used as tax deductions against taxable income earned in other years
How far back and forward can a NOL be carried?
2 years back and 20 years forward
NOL: carryback is recorded as _________
tax refund receivable
NOL: carryforward is recorded as _________
DTA
If it’s more likely than not that the DTA won’t be realized, ___________ in required against the DTA account
Valuation allowance against the DTA account is req’d if it’s more likely than not that the DTA will not be realized (e.g., bc we don’t think we’ll have enough income in the future to use up an NOL)
off B/S financing
games people play to keep debt off of the B/S to make leverage ratios look good
How is off B/S financing done?
Done by keeping ownership of highly-leveraged subsidiaries just under 50% by obtaining the use of assets by leasing, not purchasing
Difference in buying vs. leasing
Difference is that leasing results in:
- less debt on B/S: when you lease, you have an executory K under which both parties have only promised to perform in the future, not usually recorded for accounting purposes
- less assets on B/S
Through buying, you end up owning an asset—but if the lease is long enough at the end the asset is worthless either way
Similarities between buying and leasing?
- Total expenses on I/S: over the term of the lease, the total of the interest expense and the depreciation expense equals the total expense recorded under a lease
- Cash outflow
Rule: if a lease is too much like borrowing/buying the lease is a ________ lease and has to be accounted for as a borrowing/buying
capital lease
Under GAAP, a lease is like a purchase (and will be capitalized) if:
- the lease transfers ownership to the lessee at the end of the lease or
- lease contains a bargain purchase option at the end of the lease or
- lease term is ≥ 75% of asset’s useful life or
- PV of minimum lease payments to be made under the lease is ≥ 90% of the asset’s FMV
How can corps turn A/R into $$$ now?
- borrow against the receivables (ex. take out a loan and pledge the receivables as collateral), resulting as debt on the I/S
- sell the receivables
What does borrowing against the receivables result in?
debt on the I/S, making debt: equity ratio look worse
borrowing against the receivables is a way to turn A/R into $$$ now
2 ways to sell the receivables
selling the receivables is a way of turning A/R into $$$ now, 2 ways to sell receivables: factor the receivables and securitization
factoring the receivables?
sell the receivables (usually to the bank), must often sell at a discount
Securitization?
company creates a securitization trust (SPE or specific purpose entity), SPE buys the receivables using $$ it raises from selling securities to investors
2 ways the securitization process adds value to the receivables?
- bankruptcy remote (safer): owners of SPE’s securities have the only possible claim against the receivables, no longer owned by the company and no longer subject to lawsuits brought against the company
- more customized to investors’ specific needs: SPE collects the receivables and create a whole new distinct set of cash flows that it pays out in the form of tranches
tranches?
layers, pieces, portions, or shares; creation of different tranches with different attributes allows investors to buy securities that meet their specific needs
each tranche provides a different mix of risk and return (can also vary based on maturity date):
- senior tranche: little risk
- mezzanine tranche: some risk
- equity tranche: most risk
Tranches are 1 of 2 ways the securitization process adds value to the receivables
What does it mean if the securitization process has added value to the A/R?
the investors in the SPE are using a lower discount rate (than the interest being received on the underlying A/R) to value the SPE securities
What do securitizations result in?
- I/S looks better: company records gain from selling the receivables to the trust
- B/S looks better: bc the company avoids the debt it would’ve incurred if it simply borrowed against the receivables
- SCF looks better: cash flows from selling the receivables to the trust are reported in the operating section
What does FASB require to be treated as a true sale of the receivables to the SPE?
FASB now requires the SPE to be truly independent of the company. The company can’t have the power to direct the most significant activities of the trust, and the company cannot have the right to receive benefits and/or absorb losses from the trust that potentially could be significant.
Since many companies retain servicing rights on the receivables (i.e., the process of collecting on the receivables) that means they have the powers to direct.
Likewise, many companies retain equity tranches, meaning they have the right to receive significant benefits and/or absorb significant losses from the trust. As a result, their securitizations are accounted for as if the company borrowed $ (using the A/R as collateral) instead of as if the company sold the receivables
asset-backed securitizations
securities issued by securitization trusts, can be backed by lots of different kinds of receivables (e.g., car loans, credit cards, home mortgages, commercial mortgages)
mortgage-backed securities: what happened when the homeowners quit paying their mortgage payments?
when the homeowners quit paying their mortgage payment → homes went down in value → mortgage-backed securities lost value
CDs (credit default swaps)
bets on whether a bonds will default
- Buyer of a CD pays $$ upfront and gets paid if the bond defaults
- Seller of a CD gets $$ upfront and pays out if the bond defaults
Do asset-back securities and CDs have to be marked to market?
Yes!
Issue: these instruments are often thinly traded so it’s difficult to determine true market valuations
Mortgage-backed securities have been given high debt ratings that may’ve been unjustified so rating agencies must now…
- Provide more detail about how they determine each rating
- Bar their sales people from participating in ratings processes
- Review and potentially revise their ratings in cases where an employee was later hired by a company she rated
- Litigation against ibanks that sold the securities and against the ratings agencies that rated the securities
promissory notes payable (notes payable)
type of private placement that arises from borrowing $, more formal than A/P (documented and charge interest), usually borrowed from banks
credit facilities
type of private placement that provides companies with lines of credit where they can borrow up to a specific limit without having to go through loan approval process, company pays a fee for this arrangement and pays interest on any borrowings
commercial paper
type of private placement that is short-term (60-90 days), borrowed from banks and other institutions (like money market funds)
