Actg Chap 9: Long-Term Liabilities

Front 1

debt financing

Back 1

borrowing money (liabilities)

Front 2

equity financing

Back 2

obtaining additional investment from stockholders (stockholders' equity)

Front 3

Why choose debt financing over equity financing?

Back 3

Debt financing = interest expense incurred is tax deductible

Dividends paid to shareholders is NOT tax deductible (dividends aren't an expense)

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capital structure

Back 4

mixture of liabilities and stockholders' equity that a business uses

Front 5

3 primary sources of long-term debt financing:

Back 5

bonds, notes, and leases

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bond

Back 6

- most common form of corporate debt
- a formal debt instrument that obligates the borrower to repay a stated amount (aka principal or face amount), at a specified maturity date
- interest is paid back to borrower
- easy to distribute -> provide most access to cash
- intangible asset

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Security

Back 7

negotiable instrument representing financial value
- 2 types: debt and equity
- i.e. stocks, bonds, notes

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How are bonds distributed?

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Bonds are underwritten (aka sold) by investment houses to an issuing company (the borrower)
- i.e. Citigroup, JPMorgan Chase, Merrill Lynch

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Private placement

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Issuing company chooses to sell the debt securities directly to a single investor (i.e. individual like me, large investment fund or insurance company)
- keeps costs (actg, registration, printing, legal, etc) down

Front 10

Why are issue costs lower with private placement?

Back 10

Privately placed securities aren't subject to the costly and lengthy process of registering with the SEC that is required of all public offerings

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bond indenture

Back 11

contract between a firm issuing bonds to borrow money (the issuer) and the investors (people who purchase bonds as investments)
- specify: interest rate, maturity date, convertability

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Secured vs. unsecured bond

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- secured bonds = supported by specific assets the issuer has pledged as collateral (borrower's pledge to lender to secure
repayment of a loan)

VS.

- unsecured bonds = aka debentures; aren't backed by a specific asset (collateral); secured by "faith"; more common

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sinking fund

Back 13

designated fund to which an organization makes payments each year over the life of its outstanding debt
- way to ensure that sufficient funds are available to pay a large sum over an extended period of time
- an investment used to set aside money to pay the outstanding debt as it becomes due

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term bonds

Back 14

require payment of the full principal amount of the bond at a single maturity date; more common

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serial bond

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requires payments in installments over a series of years

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borrower (issuer)

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issuing company (i.e. JP Morgan)
- eventually a corporation, insurance company, or individual might be issued a bond by the issuing company
-owes the holders a debt - pays them interest

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callable bonds

Back 17

aka redeemable; allows the borrower to repay the bonds early before their scheduled maturity date at price (stated in the bond contract; exceeds the bond's face amount)
- occurs when interest rates go down - protects the borrower from decreasing interest rates
- more common
- implies company has capital to pay it off

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convertible bonds

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allow the lender (or investor) to convert each bond into a specified number of shares of common stock
- sell at a higher price, lower interest rates

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How to price a bond (3 ways):

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present value of the face value + present value of periodic interest

- can be issued at:
1) face value (aka principle, par, stated value): market interest % = corporate bond %; combo of pricing lump sum and annuity
2) discount = corporation receives less cash than face value of bond; occurs when market interest % > corporate interest %
3) premium = corp receives more cash than face of bond; market int % < corp int %

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market interest rate

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true interest rate used by investors to value a company's bond issue
- higher the market interest rate = lower bond issue price
- will be higher for high risk companies

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stated interest rate

Back 21

rate quoted in the bond contract used to calculate the cash payments for interest
- never changes (stated in bond indenture)

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periods to maturity

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number of years to maturity X # of interest payments per year

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carrying value

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= book value; the value of the asset recorded on the balance sheet
- amount owed during a certain period

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Journal entry for issuance of bonds

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- debit cash
- credit bonds payable

at first semi-annual interest payment:
- debit interest expense
- credit cash

- the carrying value will increase from the amount original borrowed to the amount at maturity (i.e. market interest rate causes bond to be less than issue price)

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calculation for interest expense:

Back 25

carrying value (amount owed during that period) X market rate (semi-annual or annual)

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calculation for cash paid for interest:

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face amount X stated rate (semi-annual or annual) X time

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What does an amortization schedule for bonds show?
- at premium
- at discount

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- at premium = shows decreases in carrying value from higher carrying value down to original face value

- at discount = shows increase in carrying value from lower carrying value up to original face value

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retirement of bonds

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When the issuing corporation buys back its bonds from the investors
- can occur at maturity of bond or prior (prior occurs more often; feature of callable bond)

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long-term notes payable

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each installment payment includes: amount that represents interest, amount that represents reduction of outstanding loan balance

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lease

Back 30

contractual agreement by which the lessor (owner) provides the lessee (user) the right to use an asset for a specific period of time

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operating leases vs. capital leases

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- operating = like a rental
- capital = occurs when a lessee buys an asset and borrows the money through a lease to pay for the asset (4 year lease for a car - ownership is transferred at the end of the lease term)

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When you're recognized as high risk...

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Market will call for a higher rate (stated or not)