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

Bonds

• 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

Leases

• 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