Reporting and Analyzing Nonowner Financing Activities Module 7 Reporting and Analyzing Nonowner Financing Activities

Accounting Equation: Another Look

What is a Liability? “Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” Present obligations. Unavoidable obligations. Transaction or event must have already happened.

The stigma of debt Is debt bad? Problems with having debt Advantages of debt Financial Control

Business Financing Current liabilities (accounts payable & accrued expenses) are generally non-interest bearing. Thus, firms try to maximize the use of such liabilities to finance assets. Companies generally finance long-term assets with a combination of long-term liabilities and equity. Long-term financing is usually in the form of bonds, and stock issuances.

Debt, Leverage, and Risk Magnitude of required debt payments increases proportionally with the level of debt financing, and more required debt payments implies a higher probability of default should a downturn in business occur. Increasing levels of debt, then, makes the firm look riskier to investors who, consequently, demand a higher return on the capital they provide to the company.

Current Liabilities Current operating liabilities Accounts payable - obligations to other companies for amounts owed on purchases of goods and services. These are usually non-interest-bearing. Accrued liabilities - obligations for which there is no related external transaction in the current period. These include, for example, accruals for wages payable which have been earned by employees but not yet paid, and accruals for other business-related liabilities such as rent, utilities, and insurance. These accruals are made to properly reflect the liabilities owed and expenses incurred by the company as of the statement date.

Current Liabilities (cont’d) Current non-operating liabilities Short-term interest-bearing loans: short-term bank borrowings expected to mature in whole or in part during the upcoming year, together with accrued interest. Current maturities of long-term debt: long-term liabilities that are scheduled to mature in whole or in part during the upcoming year.

Accounts Payable Accounts payable are usually non-interest bearing and, thus, represent an inexpensive source of financing. Recall that accounts payable often carry credit terms such as 2/10, net 30. These terms give the buyer, for example, 2% off the invoice price of goods purchased if paid within 10 days. Otherwise the invoice is payable in its entirely within 30 days. Despite the incentive for early payment, is not uncommon for payables to remain outstanding for 45-90 days before payment is made.

Accounts Payable Example

Accrued Expenses Accrued liabilities are identified at the end of an accounting period to recognize liabilities and expenses that have been incurred during the period but are not yet recognized in financial statements. They are recorded into the books of the company, but there is no external transaction in the current period. Companies experience many different types of accruals: accruals for wages payable which have been earned by employees but are not yet paid accruals of other business-related liabilities such as for rent, utilities, taxes, and insurance. When the liability is established, liabilities increase, current income decreases, and equity is reduced. When the liability is ultimately paid, there are decreases in both cash and the liability.

Wages 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 Revenue Remember revenue recognition criteria Realizable If not yet earned, but payment received, then it is a liability. Converted from a liability to revenue when earned.

Uncertain Accruals Some accruals are more uncertain. Consider a company facing a lawsuit. Should it record the possible liability and related expense? The answer depends on the likelihood of occurrence and the ability to estimate the obligation. Specifically, if the obligation is probable and the amount estimable, then a company will recognize this obligation, called a contingent liability. If only one of the criteria is met, the contingent liability is disclosed in the footnotes.

Accounting for Contingencies Contingent loss Probability of Occurrence High Reasonable Remote Estimable? Yes No Accounting Treatment Accrue Disclose Disclose Ignore

Misreporting of Accruals The latitude in determining the amount and timing for recognition of accruals can lead to misreporting of income and liabilities. If accruals are over (under) estimated, then liabilities are over (under) estimated, income is under (over) estimated, and equity (retained earnings) is under (over) estimated. Further, in subsequent periods when an overstated accrued liability is reversed, reported income is higher than it should be (because prior period income was lower than it should have been).

Misreporting of Accruals Experience tells us that accrued liabilities that are linked to restructuring programs (including severance accruals and accruals for the write-down of assets), to legal and environmental liabilities, and to business combinations are sometimes problematic. Namely, these accruals too often represent early (aggressive) recognition of expenses, some as part of a ‘big bath,’ in a desire to relieve future periods of these expenses. Accordingly, we must monitor any change or unusual activity with accrued liabilities.

Current Non-Operating Liabilities Short-term bank loans (including the accrual of interest) Current maturities of long-term debt – long-term liabilities that are scheduled to mature on whole or in part during the upcoming 12 months are reported as a current liability. Current assets are usually financed with current liabilities

Accounting for Interest-Bearing Note Bank line of credit is a commitment to lend up to a given level with the understanding that the line is be repaid in full sometime during the year. An interest-bearing note evidences such borrowings. Accounting for notes is clear - cash received is reported on the balance sheet together with an increase in liabilities (notes payable); and interest payments are recorded as expenses.

Example: Notes Payable

Current Maturities of Long-Term Debt Payments that must be made during the upcoming 12 months on long-term debt (such as a mortgage) or the maturity of a bond or note are reported as current liabilities called ‘current maturities of long-term debt.’ All companies are required to provide a schedule of the maturities of its long-term debt in the footnotes to financial statements.

Long-Term Financing Companies typically require long-term liabilities in their capital structure to support long-term asset acquisitions and maintenance. Issuing bonds and notes is a cost-efficient way to raise significant amounts of capital. Bonds and notes are structured like any other borrowing - the borrower receives cash and agrees to pay it back along with interest. Commonly, the principal amount of the bond or note (face amount) is repaid at maturity, and interest payments are made (semi-annually) until the liability matures.

Bonds Payable Terminology and terms of bond contracts Life Maturity date Face value, principal, par value, maturity value Interest payment Proceeds at issuance Effective interest rate Other provisions Restrictions Security Call provision

Bond Pricing There are two different interest rates you must understand before we can discuss the mechanics of bond pricing: Coupon (contract or stated) rate – the stated rate in the bond contract. It is used to compute the dollar amount of (semiannual) interest payments that are paid to bondholders during the life of the bond issue. Market (yield) rate – the interest rate that investors expect to earn on the investment in the debt security. This rate is used to price the bond issue.

Cash Flows from Bonds Bondholders normally expect to receive two different cash flows: Periodic (usually semiannual) payments of interest during the bond life. These payments are often in the form of equal cash flows at periodic intervals, called an annuity. Single payment of the face (principal) amount of the bond at maturity.

When a company issues a bond, what is it selling? Assume a company issues a $1,000, 5%, 10 year bond, payments are semi-annual. What is the company selling? Interest payments of $25 at the end of each of 20 six month periods. (An ordinary annuity.) A lump-sum payment of $1,000 at the end of 10 years.

Cash Flows from Bonds To illustrate, assume that investors wish to price a bond with a face amount of $10 million, an annual coupon rate of 6% payable semiannually (3% semiannual rate), and a maturity of 10 years. Investors purchasing this issue will receive the following cash flows:

Bond Pricing: Coupon Rate = Market Rate (Par) Company promises to pay 20 semiannual payments of $10 million  (6%/2) = $300,000 each, plus the $10 million face amount of the bond at maturity, for a total of $16 million. Assuming that investors desire a 6% annual market rate of interest (yield), the bond sells for $10 million:

Bond Pricing: Coupon Rate < Market Rate (Discount) Assume that the company is not viewed as an acceptable credit risk and, to compensate for accepting a higher level of risk, investors expect an 8% annual yield (4% semi-annual yield). Given this new discount rate, the bond will sell for $8,640,999:

Bond Pricing: Coupon Rate > Market Rate (Premium) Assume that investors expect only a 4% annual yield (2% semiannual yield). Given this new discount rate, the bond sells for $11,635,129 – see below:

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

Coupon Rate vs. Market Rate

Bond Interest Expense 2 components: Cash interest payments (usually semi-annual). Amortization of bond premium or discount. GAAP requires the effective interest rate method of amortization. SL method allowed only if it does not differ materially from effective interest rate method.

Effective Interest Rate Actual rate paid by issuer May or may not be same as the stated rate Determined by discount rate that sets the present value of the future cash outflows equal to the fair market value of that which is received in the exchange.

Effective Interest Rate Method Bond Disc. Amortization Table Beginning book value. Bonds payable – unamort. Disc. (or + Prem.). Interest expense. Beginning book value * effective interest rate. Interest paid. Face amount * stated interest rate. Discount amortization. Interest expense - interest paid. Ending book value. B. payable - new unamort. Disc. (or + Prem.).

Accounting for Long-Term Obligations Record the asset acquired in the exchange at its fair market value. Record the obligation at its face value. Record a discount or premium if the obligation is different than the fair market value of the asset acquired. Record interest expense for each period: effective interest rate x balance sheet value of the obligation at the beginning of the period.

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

Bonds Sold at a Discount

Bonds Sold at a Premium

Accounting for Bonds: Income Statement Interest expense in the income statement is the sum of two components: Amortization of a discount adds to the cash interest paid to compute interest expense. Amortization of a discount reflects additional cost the company incurs upon sale of the bonds; and, recognition of this cost through its amortization yields increased interest expense. Conversely, a premium is a benefit the company receives at issuance of a bond; and, amortization of a premium yields reduced interest expense.

Effective Interest Method (Discount Example) Companies amortize the discount and premium using the effective interest method

Effective Interest Method (Premium Example)

Gain (Loss) on Repurchase of Bonds Purchase of a bond is like the sale of a long-term asset A gain or loss can result from a repurchase. Book value of the bond is the net amount that appears on the balance sheet. If the company pays more to retire the bonds than they carry on the balance sheet, this is a cost that is reflected in the income statement as a loss on retirement of bonds. Conversely, a company reports a gain on retirement of bonds if the purchase price is less than its book value.