Chapter 10: Long-Term Liabilities Flashcards
Types of long-term liabilities (most common long-term (or non-current) liabilities)
Pension / post retirement plans Long-term loans Bonds payable Future income taxes lease liabilities
Why Are Long-Term Liabilities of Significance to Users?
It is equally important for users to have an awareness and understanding of potential liabilities such as contractual commitments or the possible outcomes of litigation against the company. These items may have significant impacts on the company’s operating results well into the future.
Transactions with Lenders
- company borrowing funds by taking out a loan or mortgage.
- Companies can also access debt funding through the issuance of notes or bonds
Companies are required to disclose the details of their long-term loans in the notes to their financial statements (such as term of loan, interest rate, and security and collateral)
long-term debt, long-term notes payable, loans payable, mortgages payable, notes payable, or bonds payable
Found on statement of financial position
mortgage loan
a long-term debt with land, a building, or a piece of equipment pledged as collateral or security for the loan.
-If failed to pay for, the lender has the right to seize the asset and sell it
Financing agreement
A lending agreement between a lender and a borrower that specifies the terms and conditions of the loan. These include loan term, interest rate, repayment provisions, and so on.
instalment loans
A type of loan in which payments (including both interest and a portion of the principal) are made periodically, rather than only at the end of the loan.
Blended payments
consisting of both interest and principal components
-The total amount of the payment is the same each period, but the portion of each payment that represents interest is reduced, as the outstanding loan principal is being repaid with each loan payment.
two basic transactions related to these debts
- Initial borrowing
2. Periodic loan payment
- Initial borrowing
At the time of borrowing, a company will simply record the receipt of the loan proceeds (the receipt of cash) and the corresponding loan liability
- NO INTEREST RECORDED AT TIME OF BORROWING
Initial borrowing accounts
Cash XXX
Long-Term Loan Payable/Mortgage Payable XXX
- Periodic loan payment
This loan payment, to be made monthly, quarterly, or in other periods, will normally include both an interest component and a principal component
Periodic loan payment accounts
Interest Expense XXX
Long-Term Loan Payable/Mortgage Payable XXX
Cash XXX
covenants
Conditions or restrictions placed on a company that borrows money. The covenants usually require the company to maintain certain minimum ratios and may restrict its ability to pay dividends.
Financial covenants
may require the company to:
- meet certain financial ratios
- may include limits on the company’s ability to borrow additional amounts
- to sell or acquire assets
- pay dividends
Non-financial covenants
may include:
- requirements to provide the lender with interim financial statements
- to have an annual audit conducted.
Bond
A corporation’s long‐term borrowing that is evidenced by a bond certificate. The borrowing is characterized by a face value, interest rate, and maturity date.
Bonds can be sold
through a public offering or through a private placement
Public offering
The offering of corporate bonds for sale to the public, both individuals and institutions
private placement
open only to specific institutional investors who have agreed to purchase the bonds in advance
institutional investors
Banks, insurance companies, pension funds, and other institutions that purchase corporate bonds or shares
indenture agreement
An agreement that accompanies the issuance of a bond and specifies all the borrowing terms and restrictions, or covenants
face value / principal amount for the bonds
A value in a bond contract that specifies the cash payment that will be made on the bond’s maturity date. The face value is also used to determine the periodic interest payments made on the bond
(usually $1,000 per bond.)
maturity date
The date in a bond contract that specifies when the principal amount borrowed must be repaid
Bond interest payments to the lenders (equation)
multiplying the bond interest rate (or contract rate or coupon rate ) by the face value and dividing by two (because the interest payments are semi-annual)
bond interest rate aka contract rate / coupon rate
An interest rate that is specified in a bond contract and used to determine the interest payments that are made on the bond
-Carefully considered, factors such as: bond term, credit rating of the issuer, special features, rates on alternative investments, and economic conditions
Effective rate (aka yield)
The interest rate that reflects the rate of return earned by investors when they purchase a bond, and the real interest cost to the issuer of the bond. It reflects the competitive market rate for similar bonds, and is used in determining the selling price of the bond.
KEY POINTS for bonds
The contract rate is used to calculate the semi-annual interest payment.
The yield is used to calculate the semi-annual interest expense.
collateral
the company pledges as security to the lenders
If collateral is pledged:
it means that if the company defaults on either the interest payments or the maturity payment, the bondholders can force the pledged assets to be sold in order to settle the debt.
debenture
A bond that is issued with no specific collateral
Debentures can be either
senior or subordinated
The distinction between senior and subordinated is
the order in which the bondholders (creditors) are paid in the event of bankruptcy: senior creditors are paid before subordinate claims
Convertible bonds
A bond that is convertible into common shares under certain conditions
investment banker
The intermediary who arranges the issuance of bonds in the public debt market on behalf of others. The investment banker sells the bonds to its clients before the bonds are traded in the open market
Underwriters
An investment bank that arranges and agrees to sell the initial issuance of bonds or other securities
Issuing bonds can be expensive:
companies generally issue bonds only when their borrowing requirements are significant, usually $100 million or more (100,000,000)
Bonds differ from loans and mortgages in a number of ways, including the following:
- Bonds are generally sold to a pool of investors (acting as lenders), whereas loans and mortgages are generally made by a single lender.
- Issuing bonds can enable a company to tap into a much larger pool of lenders than it could when entering into loans or mortgages.
- Bonds normally have much longer terms than are available with loans and mortgages. It is not unusual for bonds to have a 40-year term, which is much longer than the usual terms of loans and mortgages.
- Bonds generally require semi-annual, interest-only payments, with the principal repaid only at the end of term. Loans often require blended repayments of principal and interest, with a monthly payment frequency.
- There is a secondary market for many corporate bonds, meaning they can be purchased through investment dealers or on major exchanges. This enables lenders to sell the debt to others rather than having to wait to collect it at maturity.
- Some corporate bonds are convertible into common shares at the option of the bondholder. The conversion price is specified in the indenture agreement.
(see Exhibit 10.2)
How Are Bonds Priced in the Marketplace?
Bond prices are established in the marketplace by the economic forces of supply (from companies wanting to issue bonds) and demand (from investors wanting to buy them)
The _____ the level of risk, the _____ the yield rate has to be
higher
higher
(for buyers to accept a higher risk of default, they have to be compensated for that risk with a higher rate of return)
par
In the context of bond prices, a term used to indicate that a bond is sold or issued at its face value
(For example, if a company issued bonds with a face value of $100 million at par, then investors would have paid $100 million for them.)
The only way that an investor can increase the return (or yield) they will receive on the bond would be to
pay less than the face value of the bond
regardless of whether the investors pay less or more than the bond’s face value on issuance:
they will receive the full amount of the bond’s face value on maturity
discount
In the context of bond prices, a term used to indicate that a bond is sold or issued at an amount below its face value. (base index less than 100)
Example of discount:
For example, if the company issuing $100 million in bonds issued them at 98.4, investors would have paid $98.4 million ($100,000,000 × [98.4/100]) for them
These investors would still receive $100 million on maturity, with the $1.6-million difference being additional interest income to the investors and additional interest expense to the issuing company.
premium
In the context of bond prices, a term used to indicate that a bond is sold or issued at an amount above its face value (that is, more than 100)
Example of premium:
For example, if the company issuing $100 million in bonds issued them at 101.5, investors would have paid $101.5 million ($100,000,000 × [101.5/100]) for them.
These investors would receive only $100 million on maturity, with the $1.5-million difference reducing the interest income of the investors and the interest expense of the issuing company
(see exhibit 10.3)
notes payable refers to
both notes payable and bonds payable
Issuing bonds accounts
Cash 98,400,000
Notes Payable 98,400,000
