BUSN 7008
FINANCIAL STATEMENTS & REPORTING
Lecturer: Dr. Lijuan (Lily) Zhang
Week 6: Accounting for non-current liabilities &
Financial Statement Analysis (Textbook Chapter12 &18)
1
NON-CURRENT LIABILITIES AND
DEBENTURES PAYABLE (Chapter 12)
LEARNING OBJECTIVES
1. Unsecured notes payable & mortgages payable
2. Describe debentures payable: their different types, prices and interest
rates
3. Measure interest expense, and account for premiums and discounts on
debentures, using the straight-line amortisation method
UNSECURED NOTES PAYABLE AND MORTGAGES
PAYABLE

Unsecured notes are borrowings that are not secured by any legal
charge over the assets of the borrower
 They are often repayable in instalments

Mortgages payable are long-term debts that are backed with a legal
charge (a mortgage) over land (real estate or real property in legal
language)
 The mortgage will state that the borrower promises to transfer the
legal title to the property if the mortgage is not paid on schedule
 Like long-term notes payable, the total mortgage payable amount will
have a portion due within one year (current) and a portion that is
due more than one year from a specific date
UNSECURED NOTES PAYABLE
AND MORTGAGES PAYABLE



The principal portion of the total mortgage payable that is due within
one year is current.
To calculate the amount of each payment to apply to the mortgage
payable and how much is interest expense, we create an amortisation
schedule
An amortisation schedule details each loan payment’s allocation
between principal and interest
Example: Assume on 31 December 2020 , Smart Touch Purchases land and a building for
$150000, paying $49925 in cash and signing a $100075, 6%, 30-year mortgage payable
that requires $600 monthly payments, which include principal and interest, beginning on 31
January 2021. Smart Touch determined that $40000 of the purchase price of $150 000 was
allocated to the land and $110000 was allocated to the building.
Dec 31 Dr. Building 110 000
Land
40 000
Cr. Mortgage payable
Cash
100075
49925
Journal entries to record the first mortgage payment
Jan 31,
2021
Dr. Interest expense
($100 075 × 0.06 × 1/12) (E+)
Mortgage payable
($600.00 – $500.38) (L–)
Cr. Cash (A–)
500.38
99.62
600.00
DEBENTURES: AN INTRODUCTION
• Debentures (sometimes called bonds payable) are borrowings from
multiple lenders, called debenture holders
• Under the Australian Corporations Act 2001, the term ‘debenture’ may
be used only to describe loans secured by a legal charge over assets of
the borrower
– If the loan is secured by a mortgage over land, the description
–
mortgage debenture can be used
If the loan is not secured by a legal charge (or mortgage), it is an
unsecured loan
• There are two main types of debenture
– Term debentures (the most common type) all mature at the same
–
specified time
Serial debentures mature in instalments at regular intervals
DEBENTURES: AN INTRODUCTION

Each debenture holder receives a debenture certificate that shows the
name of the company that borrowed the money

The certificate states the principal, which is the amount borrowed (also
called maturity value, face value or par value)

The company must then pay each debenture holder the principal amount
at a specific future date, called the maturity date

The debenture certificate states the interest rate (stated interest rate or
nominal interest rate) that the company will pay and the dates the interest
is due
8
DEBENTURE PRICES

A debenture can be issued at any price agreed upon by the issuer and
the debenture holders

There are three basic categories of debenture prices



Maturity (or par or face) value
A discount, a price below maturity (par) value
A premium, a price above maturity (par) value

The issue price of a debenture does not affect the required payment at
maturity

As a debenture approaches maturity, its market price moves towards
maturity value
PRESENT VALUE



Money earns income over time, a fact called the time value of money
The amount that a person would invest at the present time is called the
present value.
The present value is the debenture’s market price
DEBENTURE INTEREST RATES

Debentures are sold at their market price, which is the present value
of the interest payments the debenture holder will receive while
holding the debenture plus the debenture principal paid at the end of
the debenture’s life
Market price (present value)= PV(of interest payments ) + PV of the principal amount.
Two interest rates work together to set the price of a debenture
The stated interest rate determines the amount of cash interest the
borrower pays each year, and does not change
The market interest rate (effective interest rate) is the rate that investors
demand to earn for lending their money, and varies constantly
DEBENTURE INTEREST RATES
Interaction of the stated interest rate and the market
interest rate to determine the price of a debenture
ISSUING DEBENTURES AT MATURITY (PAR) VALUE
Smart Touch issues $1 00, 000 of 9%, five-year debentures that pay interest halfyear at maturity (par) value on 1 Jan. 2021.
To record the issue (one-time Journal entry)
Date
Account title
Dr
2021
Jan 1
Cash (A+)
100 000
Debentures payable (L+)
Cr
100 000
Issued debentures.
To record payments of half-yearly interest at 9%
2021
Jun 30
Interest expense ($100 000 × 0.09 × 6⁄12) (E+)
Cash (A–)
Paid half-yearly interest.
4 500
4 500
ISSUING DEBENTURES AT MATURITY (PAR) VALUE
To record payments of the debentures at maturity ( in 5 years’ time)
Date
Account title
Dr
Debentures payable (L–)
100,000
Cr
2026
Jan 1
Cash (A–)
Repaid debentures at maturity.
100,000
ISSUING DEBENTURES AT A DISCOUNT
Smart Touch issues $100, 000 of its 9%, five-year debentures that pay interest halfyear when the market interest rate is 10% on Jan 1, 2021. The market price of the
debenture drops to 96.149, which means 96.149% of par value.
Date
Account title
Dr
2021
Jan 1
Cash ($100 000 × 0.96149) (A+)
96 149
Discount on debentures (CL+)
3 851
Debentures payable (L+)
100 000
Issued debentures at a discount.
Note: CL = contra liability account
Carrying amount of the debentures
Non-current liabilities:
Debenture payable
Less: Discount on debenture
$100 000
(3 851)
Cr
$96 149
ISSUING DEBENTURES AT A DISCOUNT
Smart Touch issues $100, 000 of its 9%, five-year debentures that pay interest halfyear when the market interest rate is 10% on Jan 1, 2021. The market price of the
debenture drops to 96.149, which means 96.149% of par value.
Date
Account title
Dr
2021
Jan 1
Cash ($100 000 × 0.96149) (A+)
96 149
Discount on debentures (CL+)
Debentures payable (L+)
Cr
3 851
100 000
Issued debentures at a discount.
 The company borrowed $96,149 but must pay $100,000 when the debentures
mature 5 years later
 The discount is additional interest expense for the company, and raises its true interest
expense on the debentures to the market interest rate
ISSUING DEBENTURES AT A DISCOUNT
 A debenture discount can be amortised by dividing it into equal amounts
for each interest period (in this case, half-yearly payments for 5 years =
10 interest periods)
 To record interest and straight-line amortisation of the debenture discount:
Date
Account title
Dr
Cr
2021
Jun 30
Interest expense (E+)
Cash ($100 000 × 0.09 × 6/12) (A–)
Discount on debentures
(3,851 × 1/5 years × 6/12) (CL–)
Paid half-yearly interest and amortised discount.
4,885
4,500
385
ISSUING DEBENTURES AT A DISCOUNT
The Discount on debentures account has a debit balance, and is credited to
amortise (reduce) its balance
 Ten amortisation entries will reduce the account’s balance to zero and the carrying amount of
the debentures will be $100,000 at maturity
To redeem the debenture at maturity,
Date
Account title
Dr
Cr
2026
Jan 1
Debentures payable (L–)
Cash (A–)
Repaid debentures at maturity.
100,000
100,000
ISSUING DEBENTURES AT A PREMIUM
Smart Touch issues $100 000 of its 9%, five-year debentures that pay interest halfyear when the market interest rate is 8% on Jan 1, 2021 The debentures are priced
at 104.1 (104.1% of maturity value).
To record the issue of the debentures:
Date
Account title
Dr
Cash ($100,000 × 1.041) (A+)
104,100
Cr
2021
Jan 1
Debentures payable (L+)
Premium on debentures (AL+)
Issued debentures at a premium.
Note: AL = Adjunct liability account
Adjunct accounts are related accounts that have the same
normal balance and which are reported together on the balance
sheet.
100,000
4,100
Issuing debentures at a premium
Carry amount of debenture payable
Non –current liabilities:
Debentures payable
$100 000
Plus: Premium on debentures
4 100
$104 100
The premium cuts the cost of borrowing and reduces the company’s interest
expense to the market rate
The company has borrowed $104,100 but must only pay back $100,000
at maturity
20
ISSUING DEBENTURES AT A PREMIUM
Smart Touch issues $100 000 of its 9%, five-year debentures that pay interest halfyear when the market interest rate is 8% on Jan 1, 2021 The debentures are priced
at 104.1 (104.1% of maturity value).
Date
Account title
Dr
Cr
Jan 1,2021
Cash ($100,000 × 1.041) (A+)
104,100
Debentures payable (L+)
100,000
Premium on debentures (AL+)
4,100
Issued debentures at a premium.
To record interest and straight-line amortisation of the premium:
Jun 30,2021 Interest expense (E+)
Premium on debentures
($4,100 × 1/5 years × 6/12) (AL–)
Cash ($100 000 × 0.09 × 6⁄12) (A–)
4,090
410
4,500
Paid interest and amortised premium.
At maturity, the debenture premium has been fully amortised and the debenture’s
carrying amount (which the company must repay) will again be $100,000
SUMMARY: CHAPTER 12




Mortgages payable are long-term debts that are backed by a
legal charge (a mortgage) over land
Debentures (sometimes called bonds payable) are borrowings
from multiple lenders
A debenture can be issued at any price agreed upon by the
issuer and the debenture holders
Investors are generally interested in the present value of their
investment
LECTURE 6 (CONTINUED)
Financial Statement Analysis
(Textbook Chapter 18)
23
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
Perform a horizontal analysis of financial statements
Perform a vertical analysis of financial statements
Prepare and use common-size financial statements
Calculate and evaluate the standard financial ratios
Analyse the non-financial elements of a company annual
report
FINANCIAL ANALYSIS
Financial analysis of companies covers at least two periods, and
typically examines trends over three to five years
Analytical tools allow:
 Small-business owners to measure performance
 Financial analysts to analyse share investments
 Auditors to assess a company’s financial health
 Creditors to determine credit risk
 Any other person to compare financial data in relevant terms
FINANCIAL ANALYSIS
• Comparisons can be made:
– from year to year
– with a competing company
– with the industry as a whole
• There are three main ways to analyse financial statements
--horizontal analysis
– vertical analysis
– financial ratio analysis
HORIZONTAL ANALYSIS

The study of percentage changes in comparative statements is called
horizontal analysis
 It provides a year-to-year comparison of a company’s performance in
different periods; it compares one year with the next
Two steps to calculate percentage change:
Step 1: Calculate the dollar amount of the change from the earlier
period to the later period
Step 2: Divide the dollar amount of change by the earlier period
(base period) amount
TREND ANALYSIS



Trend analysis is a form of horizontal analysis
Trend percentages indicate the direction a business is taking
Trend analysis percentages are calculated by:
-Selecting a base year, and setting the base year amounts
equal to 100%
-Expressing the amounts for each subsequent year as a percentage
of the base amount
(in $ millions)
Net sales
Trend percentages
2021
2020
2019
2018
2017
3,189
1,466
1,280
976
1,000
318.9%
146.6%
128%
97.6%
100%
VERTICAL ANALYSIS

Vertical analysis of a financial statement shows the relationship of each
item to its base amount, which is the 100% figure

Every other item on the statement is then reported as a percentage of
that base
Vertical
analysis %
Each income statement
item/Revenues (net sales)
100
VERTICAL ANALYSIS
30
How do we compare one
company with another?
31
HOW DO WE COMPARE ONE COMPANY WITH ANOTHER?




Common-size statements are used to compare one company with another,
regardless of company size
A common-size statement reports only percentages—the same percentage
that appear in a vertical analysis
By only reporting percentages, it removes dollar value bias when comparing
one company with another company
Dollar value bias is the bias one sees from comparing numbers in absolute
(dollars) rather than relative (percentage) terms
HOW DO WE COMPARE ONE COMPANY WITH
ANOTHER?



Benchmarking is the practice of comparing a company with other
leading companies
It often uses the common-size percentages in a graphical manner to
highlight differences
Benchmarking against a key competitor and benchmarking against the
industry average are the main types
Graphical analysis highlights differences
USING RATIOS TO MAKE DECISIONS

A ratio expresses the relationship of one number to another number

No single ratio tells the whole picture of any company’s performance

Ratios may be classified as follows
 Evaluating the ability to pay current liabilities
 Evaluating the ability to sell inventory and collect receivables
 Evaluating the ability to pay long-term debt
 Evaluating profitability
 Evaluating shares as an investment
Caroline wants you to write a report commenting on profitability,
liquidity and financial position of the business after this first month of
operations in comparison with the cleaning industry averages listed in
the table below.
ability to
pay current
liabilities
Ability to pay
Long-term debt
Profitability
Ratios
Current Ratio
Formula
Current Assets
Current Liabilities
Industry Average
1.80
Debt-to-equity Ratio
Total Liabilities
Total Equity
0.25
Debt-to-assets Ratio
Total Liabilities
Total assets
0.20
Profit margin
Net Profit
Total Revenue
0.35
Rate of return on total
assets
Net Profit
Total assets
0.3
Rate of return on total assets
= (Profit before tax+ Interest expense)
Average total assets
35
EVALUATING THE ABILITY TO PAY CURRENT
LIABILITIES
Working
capital
Current
assets
Current
liabilities
 Working capital measures the ability to meet short-term
obligations with current assets
 Two decision tools based on working capital data are the current
ratio and the acid-test ratio
EVALUATING THE ABILITY TO PAY CURRENT
LIABILITIES

The most widely used ratio is the current ratio, which is current assets
divided by current liabilities
Current ratio = Current assets / Current liabilities

The current ratio measures a company’s ability to pay current liabilities
with its current assets

A high current ratio indicates that the business has sufficient current
assets to maintain normal business operations

An acceptable ratio depends on the industry.
EVALUATING THE ABILITY TO PAY CURRENT LIABILITIES
 The acid-test ratio (or quick ratio) tells us whether the
entity could pay all its current liabilities if they came due
immediately
Acid-test ratio = (Cash + Short-term investments + Net current receivables )
Current liabilities
The norm for the acid-test ratio ranges from industry to
industry
EVALUATING THE ABILITY TO SELL INVENTORY
AND COLLECT RECEIVABLES

The inventory turnover ratio measures the number of times a
company sells its average level of inventory during a year
Inventory turnover = Cost of sales / Average inventory



A high rate of turnover indicates ease in selling inventory
Inventory turnover varies widely with the nature of the business
Days in inventory ratio measures the average number of days
inventory is held by the company
Days in inventory = 365 days / Inventory turnover ratio
EVALUATING THE ABILITY TO SELL INVENTORY AND
COLLECT RECEIVABLES

The accounts receivable turnover ratio measures the ability to collect
cash from credit customers
Accounts receivable turnover =

Net credit sales
Average net accounts receivable
The higher the ratio, the faster the cash collections
The days’ sales in receivables ratio also measures the ability to
collect receivables
Days’ sales in average accounts receivable
= 365 days / Accounts receivable turnover ratio
Days’ sales in receivables tell us how many days’ sales remain in
Accounts receivable
EVALUATING THE ABILITY TO PAY LONG-TERM
DEBT


Three key indicators of a business’s ability to pay non-current liabilities
are the debt ratio, the debt to equity ratio, and the times-interest-earned
ratio
The debt ratio shows the proportion of assets financed with debt
Debt ratio = Total liabilities / Total assets

If the debt ratio is 1, then all the assets are financed with debt

The debt to equity ratio shows the proportion of total liabilities relative
to the proportion of total equity that is financing the company’s assets
Debt to equity ratio = Total liabilities / Total equity
EVALUATING THE ABILITY TO PAY LONG-TERM
DEBT

The times-interest-earned ratio relates profit before interest and taxes
to interest expense
Times-interest-earned ratio = (Profit before tax + Interest expense)
Interest expense

It measures the number of times profit before interest and taxes can
cover (pay) interest expense

A high interest-coverage ratio indicates ease in paying interest
expense
EVALUATING PROFITABILITY

Gross profit percentage measures the percentage of each dollar of
sales that results in gross profit
Gross profit percentage = Gross profit / Net sales

The rate of return on net sales ratio shows the percentage of each net
sales dollar earned as profit
Rate of return on net sales = Profit / Net sales
EVALUATING PROFITABILITY

The rate of return on total assets measures a company’s success in
using assets to earn a profit
Rate of return on total assets = (Profit before tax+ Interest expense)
Average total assets
EVALUATING PROFITABILITY

The asset turnover ratio measures the amount of net sales generated for
each average dollar of total assets invested
Asset turnover ratio = Net sales / Average total assets

This ratio measures how well a company is using its assets to generate
sales revenues
EVALUATING PROFITABILITY

Earnings per share (EPS) is the amount of profit earned for each of the
company’s outstanding ordinary shares
Earnings per share =

(Profit – Preference dividends)
Number of ordinary shares outstanding
Most companies strive to increase their EPS each year
EVALUATING PROFITABILITY
EVALUATING SHARE INVESTMENTS
The price/earnings ratio (P/E) is the ratio of the market price of an
ordinary share to the company’s earnings per share
P/E ratio = Market price per ordinary share / Earnings per share
It shows the market price of $1 of earnings
FINANCIAL STATEMENT ANALYSIS – LIMITATIONS AND RED
FLAGS

Limitations:
– Business decisions are made in a world of uncertainty
– Short-term results may not be representative of the company’s
performance over the long term
– Analysis signals that something is wrong, but it doesn’t identify the
problem or show how to correct it.

Red flags in financial statement analysis:
– Movement of sales, inventory and receivables
– Earnings problems
– Decreased cash flow
– Too much debt
– Inability to collect receivables
– Build-up of inventories
ANALYSIS OF NON-FINANCIAL DATA
• The non-quantitative parts of the annual report may hold more
important information than the financial statements
– The chairman’s report may describe a turnover of top managers
– The managing director’s report will reveal management’s opinion
of the year’s results
– Both the chairman’s report and the managing director’s report express
the views of corporate insiders
ANALYSIS OF NON-FINANCIAL DATA
• The Corporations Act 2001 requires that all financial statements of public
companies be audited by independent accountants
– The auditor’s report may indicate a major problem with the company
– The auditor’s opinion states whether the company’s statements give a
true and fair view of the company’s financial position and
performance, and comply with accounting standards
– This is how investors gain assurance that they can rely on a
company’s financial statements
(P153 Independent auditor’s report, WOW 2021)
SUMMARY





Horizontal analysis allows a company to see the percentage
change from one year to the next
Vertical analysis shows the relationship of each item on the
statement to a base amount
Vertical analysis can be used to prepare common-size
statements to compare companies with each other
Ratio analysis is used to analyse financial statement data in
various areas
Annual reports also include non-financial information that
provides an insight into a company