Topic 11: Non-current liabilities Flashcards
Reporting liabilities on the balance sheet:
Economic consequences
Shareholders are affected by liabilities through:
① Seniority of interest payments over dividend payments.
② Debt covenants that influence investing, financing, and operating
activities that a company may undertake.
③ Seniority of creditors’ claims on assets over shareholders’ claims in the event of liquidation.
Creditors are concerned with:
① The seniority of liabilities.
② The presence of sufficient assets to cover liabilities.
③ The protection of their investments through debt covenants.
Managers:
① Liabilities are an important source of capital for operating, investing, and financing activities.
② Debt covenants may restrict investing, financing, and operating decisions that the managers may make.
③ Credit raitng is affected by the amount of debt a company has and the ability to manage this debt. Improved credit ratings can lead to lower borrowing costs.
④ Management has strong incentive to manage the balance sheet by using “off-balance-sheet financing”
Auditors are concerned with ascertaining that liabilities are not materially understated.
-Materially understated liabili7es could result in the auditor being sued.
Loan conventants specify mutual expectatinos of the borrowe and lender by speciying actions the borrower will and will not take.
① Require certain action
② Preclude certain action
③ Require maintenance of certain financial ratios
Types of collaterals
- Receivables: Trade receivable are the most desirable form of security because they are the msot liquid
- Inventory: The desirability of inventory as security varies widely. Bank typically lend up to 60% on raw materials, 50% on finished goods and 20% on work in process.
- Machinery and equipment: Less desirable as collateral (used, stored, insured and marketed). Banks typically will lend up to 50% of the estimated value.
- Real estate: The value of real estate as collateral varies considerably. Banks will often lend up to 80% of the appraised value readily saleable real estate.
How Long-Term Notes Payable differs and are similar to Bonds?
Similar to bonds: valued at the present value of its future interest and principal cash flows. Fixed maturity
Differ from bonds: Not traded in public security markets
Mortgage Payable and how they differ from notes payable
Most common form of long-term notes payable
Payable in full at maturity or in installments
Differs from notes payable:
- Secure with specific assets = Backed with a security interest in specific property
- Legal title of assets will be transferred if the mortgage isn’t paid on schedule.
Bonds Payable
Large companies need large amounts of money to finance operations:
- borrow long-term from banks
- issue bonds payable to multiple lenders to raise the money
What show the bond certificate?
- the name of the company that borrowed the money
- the principal of face value
- the maturity date
- stated interest rate
Types of bonds
§ Term bonds: Mature on a single date
§ Serial bonds: Mature in installments at regular intervals
§ Callable bonds: Issuer has the right to call and rezire the bonds prior to maturity
§ Secured bonds: Backed by assets if company fails to pay
§ Debenture: Unsecured; not backed by company’s assets
§ Convertible: Bonds convertible into other securities of the company
§ Income bonds: pay no interest unless the issuing company is profitable
§ Revenue bonds: the interest is paid from specific revenue sources
Steps for issuance of bonds
company must:
- Arrange for underwritters
- Obtain regulatory approval of the bond issue, undergo audits, and issue prospectus
- Have bond certificates
A company can sell the bond to:
i) An investment bank that act as selling agent
1) Firm underwritting: Investment bank underwrites the entires issu and guarantees a certain sum to the company
2) Best-Effort underwritting: Investment bank sells the bond issue taking a commission on the proceeds of the sale.
ii) Financial institution ( private placement)
Categories of bond prices
Face value: price = face value
Discount price: price < face value => contra account: discount on bond payable
Premium price: price > face value => contra account: premium on bond payable
Difference between Stated interest rate and Market interest rate
Stated Interest rate:
-Rate used to calculate interest the borrower pays each year
Market interest rate:
-Rate that provides an acceptable retur commensurate with the issuer’s risk
Steps for Journal entry of bonds
① Issue of bonds
② Payment of semiannual interest and amortized discount/premium
③ Payoff of bonds at maturity
Bonds Payable at Face Value
Smart Touch has $100,000 of 9% bonds payable that mature in 5 years. Smart Touch issues these bonds at maturity (par) value on January 1, 2013.
① Issue of bonds
② Interest payments: semi-annually (every 6 months)
③ Maturity date: the principal is paid back
What causes a bond to priced:
• At maturity (face or par) value?
• A discount
• A premium
- At maturity: The stated interest rate on the bond = the market interest rate
- A discount : The stated interest rate on the bond < interest rate
- A premium : The stated interest rate on the bond > interest rate
Characteristic of discount on bond payable
- Contra account to bond payable
=> decreases carrying amount (book value) of bonds
=> is additional interest expense (added to interest expense over the life of bonds)
Interest expense = stated interest + amortization of discount
Characteristic of premium on bond payable
-Adjunct account to Bonds Payable
=> increases carrying amount (book value) of Bonds
=> reduces interest expense over the life of bonds
Interest expense = stated interest - amortization of discount
What happens to the bonds’ carrying amount when bonds payable are issued at
• At maturity (face or par) value?
• A discount
• A premium
- At maturity: Carrying amount stays at maturity (face or par) value
- A discount : Carrying amount decreases gradually to maturity value
- A premium : Carrying amount increases gradually to maturity value
What is off-balance-sheet financing?
Arrangements to finance assest and create obligation that do not appear on the balance sheet.
Forms of off-balance-sheet financing
• Non-Consolidated Subsidiary
=> IFRS: a parent company does no have to consolidate subsidiary that is less than 50% owned.
• Special Purpose Entity (SPE)
• Operating Leases:
=>Instead of buying the assets, companies lease them
Benefits of Leasing
Flexibility Avoid obsolescence Improves Cash flow Tax advantages Off-balance-sheet financing Used equipment
Situations that normally lead to a lease being classified as a finance lease
- Transfer of ownership of the asset to the lessee by the end of the lease term
- The lesses has the option to purchase the asset at a price that is lower than the fair value at the date the option becomes exercisable (bargain purchase option)
- The lease term is for the major part of the economic life of the asset even if title is not transferred
- Asset is specialized to lesses’s needs, costly to modify for other use
-At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all the fair value of the leased asset
Other factors influencing leasing decisons?
Off balancing financing
Tax advantages
Flexible payment option
How shall lesses recognise finance leases
As assets and liabilities in their balance sheet at amounts equal to :
- The fair value of the leased property
- If it is lower, the present value of the minimum lease payments
Disclosure fo Lease
- Future minimum lease payments in the aggragate and for period to 1 year, from over 1 up to 5 years and over 5 years.
- Total of future minimum sublease paymenst expected to be received
- Lease and sublease payments recognised as an expense in the period
- General description of the lesses’s lease arrangements
