Module 7
Reporting and
Analyzing Nonowner
Financing Activities
Accounting Equation: Another Look
What is a Liability?
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“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
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Is debt bad?
Problems with having debt
Advantages of debt
Financial
 Control
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Business Financing
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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
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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
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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)
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Current non-operating liabilities
 Short-term interest-bearing loans: shortterm 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
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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
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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
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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
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Remember revenue recognition criteria
EARNED
 Realizable
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If not yet earned, but payment received, then it
is a liability.
Converted from a liability to revenue when
earned.
Uncertain Accruals
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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
Accrue Disclose
Treatment
Disclose
Ignore
Misreporting of Accruals
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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
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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
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Short-term bank loans (including the
accrual of interest)
Current maturities of long-term debt – longterm 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
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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
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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 longterm 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
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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
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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:
1. 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.
2. 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
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Bondholders normally expect to receive two
different cash flows:
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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?
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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.
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Cash Flows from Bonds
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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)
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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)
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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% semiannual yield).
Given this new discount rate, the bond will sell for
$8,640,999:
Bond Pricing:
Coupon Rate > Market Rate (Premium)
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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
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Net book value = principal plus unamortized
premium or less unamortized discount.
Coupon Rate vs. Market Rate
Bond Interest Expense
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2 components:
Cash interest payments (usually semi-annual).
 Amortization of bond premium or discount.
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GAAP requires the effective interest rate
method of amortization.
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SL method allowed only if it does not differ
materially from effective interest rate method.
Effective Interest Rate
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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
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Beginning book value.
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Interest expense.
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Face amount * stated interest rate.
Discount amortization.
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Beginning book value * effective interest rate.
Interest paid.
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Bonds payable – unamort. Disc. (or + Prem.).
Interest expense - interest paid.
Ending book value.
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B. payable - new unamort. Disc. (or + Prem.).
Accounting for
Long-Term Obligations
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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
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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:
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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
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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.