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Financial Accounting (Fach) / Long Term Liabilities (Lektion)
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- Categorization of Long-Term Liabilities Secured Debt = Pledged specific assets as security for long-term liabilities. Loans from Single Sources (small debt needs filled by Banks, Insurance Companies & Pension Plans) Publicly Traded Bonds (Significant debt needs issued as bonds to the public)
- Foreign Currency Current Rate Method: Translate foreig debt into functional reporting currency by conversion rate as of the balance sheet date Temporal Method: May be used in certain other situations Borrowing in foreign markets has impact on exchange rate risk (1) Lessen risk: if profits earned in FC can be used to pay off debt using same currency. (2) Increase risk: if borrowing in FC for lower interest rate is not offset by matching FC income. IFRS & US GAAP are similar except for hyperinflation environment
- Translating Accounts of Foreign Currency Subsidiaries Current Rate Method Exchange Rate to Use For... Revenues & Expenses = Average rate for period Assets & Liabilities = Current exchange rate Shareholder equity – retained earnings = BB+ translated NI – translated dividends at historical rate Shareholder equity - other = Historical rates Translation adjustment (needed to make balance sheet balance) = Accumulated as separate component of equity.
- Lease Liabilities Definition: a lease is a contractual agreement between a lessor (party owning the asset) and a lessee, giving the lessee the right to use specific property, for a specific period of time in return for stipulated, and generally periodic, payments. Executory contract – a contract to pay defined amounts in the future in return for future benefits (1) Operating Lease = Off Balance Sheet Short-term lease Rental expense (2) Finance (Capital) Lease = On Balance Sheet Long-term lease non canceallable Record Lease asset & Lease liability (PV of minimum lease payments) Cash flow pattern for a capital lease is an annuity; each lease payment includes principal and interest component. Depreciation expense + Interest expense Record if: Must meet 1 of 4 LIFE Lease term is (>75% US GAAP; “major part” IFRS) of asset’s expected economic life. OWNERSHIP of asset is transferred to lessee at the end of the lease. BARGAIN PURCHASE Lease permits lessee to purchase asset at a price that is lower than fair market value. PV of the lease payments is (>90% US GAAP, “substantially all” – IFRS) of the fair market value of the asset when the lease is signed. (IFRS only) SPECIALIZED NATURE The leased assets are of such a specialised nature that only the lessee can use them without major modifications.
- Preferences to Fund Growth Companies usually prefer to fund growth in this order: 1. Internal capital (i.e. cash flow from operations)2. Issue debt (e.g. loans, bonds)3. Issue equity Reasons: Information assymetry Investors might suspect that managers looking to raise funds are holding back private information (Great expansion opportunities vs. Overvaluation? Companies often buy-back and reissue bonds if interest rates decline to reduce interest expense going forward. Issuance and repayment of bonds appears in the financing cash flow section. Interest payments are operating cash flows in US GAAP, operating or financing in IFRS.
- Pro & Cons of Bonds PRO Stockholders maintain control because bonds are debt, not equity. Interest expense is tax deductible. Return to shareholders can be positive if money is borrowed at a low interest rate and invested to earn a higher rate. CON Risk of bankruptcy exists because the interest and debt must be paid back as scheduled or else creditors will force legal action. Negative impact on CF exists because interest and principal must be repaid at a specified time in the future. Returns to shareholders could be lower if earnings do not cover interest expense
- Categorization of Bonds Identure: Legal document that describes all the details of a debt security to potential buyers. Unsecured (debenture) Bonds: No assets are pledged as a guarantee of repayment at maturity. Secured bonds: Specific assets are pledged as a guarantee of repayment at maturity. Callable bonds: Bond issuer is allowed to retire (“call”) bonds early at a stated price. Convertible bonds: Bondholder is allowed to convert bond into a stated number of common stock
- Early Redemption of Bonds Reasons: Restructuring; Declining interest rates & firm would like to refinance with a lower interest expense Gain on redemption Dr Bond payable (L) $1,000Cr Gain on bond redemption $50Cr Bond discount (XL) $100 Cr Cash (A) $850 Loss on redemption Dr Bond Payable Dr Loss on Bond Call Dr Bond Premium Cr Cash
- Accounting For Convertible Debt (Hybrid Security) Allows bondholder the option to convert into specified number of equity shares (usually at a specified date). Reduced interest rate, but in return bondholders received option to become “owners” by converting to equity. Accounting Treament: IFRS requires we split out the equity Option component (recognize as equity) Difference between PV of liability component and total proceeds we received from the issue. Debt component like Bonds (i.e. liability at PV) Discount Future CF of bonds (interest and principle) at rate of a similar debtinstrument without the conversion option (i.e. normal Bond) Dr Cash (A) £1,000 (proceeds received) Cr Bond Liability (L) £894 (PV of similar non-convertible bond) Cr Share Option (SE) £106 (difference)
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