Chapter 8

Chapter 8: Reporting and Analyzing Liabilities Asset disclosures tell us where a company invests its funds Liability disclosures tell us how those assets are financed Financial leverage: increases when it finances assets with liabilities Liability payments increases proportionally with level of liability financing Current operating liabilities Accounts payable: obligations to others 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. Journalized by a debit to expense account and credit to related liability Current nonoperating liabilities Short-term interest-bearing debt: short-term bank borrowings and notes expected to mature in whole or in part during the upcoming year; including any accrued interest payable on these obligations Current maturities of long-term debt: long-term borrowings that are scheduled to mature in whole or in part during the upcoming year including any accrued interest for the period on these obligations Purchase of inventory: increase in inventory and increase in accounts payableSale of inventory: increase in sales revenue and increase in accounts receivableCost part of sales transaction: decrease in inventory and increase in COGSCollection of receivable: decreases accounts receivable, increases cashCash payment of accounts payable: B|S transaction Accounts payable reflect a source of interest-free financing; also increases profitability b/c it causes a reduction in level of interest-bearing debt required to finance operating assets Contingent liability: if obligation is probable and the amount estimable; not reported if obligation is only reasonably possible, regardless of company?s estimate disclosed in footnotes All accrued liabilities result in a liability on the B|S and an expense on the I|S Accrued liabilities are linked with restructuring programs; often represent early recognition of expenses leading to an understatement of income, in a desire to relieve future periods of these expenses. Like big bath Cookie Jar Reserves: accrued liabilities set up to smooth income over future periods GAAP requires that the warranty liability reflect the estimated amount of cost that the company expects to incur as a result of warranty claims Companies try to structure financing so that debt service requirements (payments) of financing obligations coincide with cash inflows from assets financed Current assets financed with current liabilities, long-term assets are financed with long-term liability Seasonal swings in working capital are often financed with a bank line of credit (short-term debt) Short-term funds: Cash received is reported on B|S with increase in liabilities (notes payable) Borrowing has no effect on income or equity GAAP requires the borrower to accrue the interest liability and the related interest expense each time financial statements are issued Interest Expense = Principal x Annual Rate x Portion of Year Outstanding Long-term Liabilities: Face amount (principal): of bond or note is repaid at maturity and interest payments are made in interim Pricing of Debt Coupon (contract or stated) rate: coupon rate of interest is stated in the bond contract. Used to compute dollar amount of interest payments Market (yield) rate: interest rate that investors expect to earn on the investment for this debt security. Rate is used to price the bond issue. Bondholders expect to receive two different cash flows Periodic interest payments (usually semiannual) during the bond?s life. Often in the form of equal cash flows at periodic intervals, called an annuity Single payment of face (principal) amount of bond at maturity When pricing bonds, identify the number of interest payments and use that number when computing the present value of both the interest payments and the principal (face) payment at maturity Par (face) value: coupon rate = market rate; effective cost include: Cost to issuing company is cash interest paid Discount: if bond carries a coupon rate lower than market rate, bond is less desirable; effective cost include: Cash interest paid Discount incurred Difference between par and lower issue price, must be reflected in I|S as expense Premium: if bond carries a coupon rate higher than market rate, bond is more desirable; effective cost include Cash interest paid Cost reduction due to premium received Premium is benefit that must go from B|S I|S as reduction of interest expense When bond sells at par, issuing company receives cash proceeds and accepts obligation to make payments When a bond is sold at a discount, cash proceeds and net bond liability are recorded at the amount of proceeds received (not the face value) When a bond is sold at a premium, cash proceeds and net bond liability are recorded at the amount of the proceeds received (not the face value) Companies report bonds payable at historical (adjusted) cost Call provision: included in a bond indenture, gives company right to repurchase the bond Gain or Loss on Bond Repurchase = Bonds Payable, Net ? Repurchase Payment Net bonds payable is net amount reported on B|SIf loss is reported in I|S loss on bond retirementIf gain is reported in I|S gain on bond retirement Debt-to-equity ratio = Total liabilities / Total stockholder?s equitymeasures company?s financial leverage Times Interest Earned (TIE) = EBIT / Interest expensemeasures how many times interest expense is covered by earnings in the firm Operating cash flows to liabilities (OCFL) = Net cash flow from operations / Total liabilitieslinks operating cash flows with the firm?s debt level; reflect a company?s credit risk exposure Rate of interest that a company must pay on its debt is a function of the maturity of debt and the creditworthiness of the issuing company Default: nonpayment of interest and principal or failure to adhere to various conditions Collateral: companies can provide security for debt in the form of mortgages on assets Covenants: debt agreements can contain restrictions on issuing company to protect debt holders Options: debt obligations involve contracts between the borrowing company and debt holders