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