Friday, January 17, 2014

Liabilities: Notes, Bonds & Leases Outline: Accounting for Lawyers

Liabilities: Notes, Bonds & Leases Outline: Accounting for Lawyers
  • Liability is an obligation of business:
    • Result of a past transaction
    • Requires an unavoidable future sacrifice
    • Amount can be quantified (estimated)
  • Valuation of LT liabilities
    • Many liabilities do not have to be paid until far in the future
    • Must consider the time value of money (interest)
      • Rewards lender for:
        • Giving up use of the money (rent)
        • Inflation
        • Risk
      • Expressed as an annual rate
  • Sources of LT financing
    • Notes: borrow from commercial banks, insurance co, and other institutions
    • Bonds: borrow from capital markets
Notes Payable – Term Loans
  • Bank lends a certain sum (principal) to business for a fixed time (term) at a set rate of interest and payment schedule
    • At end of term, loan is repaid or refinanced
    • May be short term (less than one year) or LT (greater than one year)
      • If long-term note has less than one year to be repaid, re-classified short term
  • Issuing Procedures:
    • Requires regulatory approval
    • Paper certificate, typically $1,000 face value
    • Interest payments usually are made semi-annually
    • Contract is called a “bond indenture
      • Represents a promise to pay a sum of money at designated maturity date plus periodic interest at a stated rate on the face value
  • Definitions:
    • Face value: maturity value, except for serial bonds
    • Principal: face value on coupon bonds and serial bonds but not zero coupon bonds
    • Maturity value: amount paid by the issuer at the maturity date of bond
    • Stated interest rate: rate stated in bond contract
    • Semiannual interest rate: half stated annual rate
  • Types of bonds:
    • Zero coupon bond: provides for no periodic payments of interest while the bond is outstanding, but repays all principal and interest at maturity
    • Term bond: pays interest periodically and repays principal at maturity
    • Serial bond: requires periodic payments of interest plus a portion of the principal throughout the life of the bond
    • Registered and Bearer bonds
    • Unsecured borrowing – Debenture bonds: lenders do not have rights to specific assets but must rely on assets not pledged as collateral for other loans in event of default
    • Senior Rights (Collateralized bonds): higher priority for payment in the event of bankruptcy than subordinated unsecured lenders
  • Bond Provisions:
    • Convertible bonds: permit the holder to exchange the bonds for shares of the firm’s common stock under certain conditions
    • Callable bonds: issuing firm has the right to repurchase the bonds prior to maturity at a specified price
    • Redeemable Bonds: put options allow bond investors to force the issuing company to repay the bonds prior to maturity under specified contractual conditions
  • Market Interest Rate at Issue (e.g., issued to yield 6%)
    • Rate used by market to discount future cash flows and determine the initial price of the bond, also called yield
    • To account for lag between filing registration papers and market issue
      • Rates fluctuate frequently- changes in overall economy, government policy, consumer demand, credit worthiness of the company
  • When the market-required yield to maturity exceeds the stated rate, then the bonds initially sell for less than or a discount to, face value
    • When market-required yield to maturity is less than the stated rate, the bonds will sell at a premium to face value
  • Fair Value Option:
    • Firms can choose between fair value measurement and the amortized cost approach based on historical market rates on a case-by-case basis
  • Lease = renting an asset instead of purchasing that asset.
  • Types of leases:
    • Capital lease: equivalent of purchases
      • Lessee recognizes both the leased asset and lease liability
      • Lease asset is depreciated over time and lease liability is amortized as payments are made
      • Non-cancelable
        • Transfers ownership at end of lease, or
        • Has a bargain purchase option, or
        • Lease life > 75% of asset, or
        • PV of contractual lease payments > 90% FMV (most restrictive)
    • Operating Lease (true lease) recognizes lease payments as rental expenses
      • No asset or long-term liability is recognized
  • Benefits to Lessee
    • Leases may not require down payment
    • May have less restrictive covenants than other types of lending arrangements
    • May be less costly way of financing
    • Operating leases do not add debt or assets on the balance sheet
    • Reduce risk of obsolescence to the lessee
  • Firms must disclose the cash flows associated with capital and operating leases for each of the succeeding five years and all years after 5 years in the aggregate
    • In the notes of financial statements
    • Must also indicate the present value of the cash flows for capital leases

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