Chapter 7: Liabilities & Financing Leverage

Session 11: Chapter 7

• Assets represent investment management
• Liabilities and equity shows how those assets were financed

Current and Long-term Liabilities

• Current liabilities require payment within a year
• Companies maximize non-interest-bearing liabilities as a financing source
• Long-term liabilities need payments over several years
• Companies match interest-bearing liabilities repayment with relevant asset cash inflows
• Financing leverage increases when a company uses liabilities to acquire assets and finances them

Discounts

• Cash discounts encourage buyers to pay within a specified time
• Cash discounts are part of credit terms
• They are stated as a percentage of the purchase price
• Net-of-discount method is used

Rates

• Coupon rate is stated in the bond contract
• It computes interest paid to bondholders
• It is also known as the contract or stated rate
• Market rate is the rate investors expect to earn on a debt security investment
• It Determines price

Par Discount and Premium Values

• Market rate = coupon rate when issues at par (face) value
• Market rate > coupon rate when issued at a discount
• Market rate < coupon rate when issued at a premium

Times interest earned (TIE)

• TIE measures how many times interest expense is covered by a company's earnings
• TIE = earnings before interest and taxes / interest expense

Liabilities

• Accrued liabilities are expenses incurred during the period but not yet paid
• Debit side of accrual is reflected as an expense in income statement
• Accrued expenses become a liability on the balance sheet
• They also become an expense on the income statement
• Provisions are liabilities that are not always certain
• Provisions have a potential obligation
• Probable outflow of economic benefit will occur
• The amount is reasonably estimable
• Recognition creates an accrual
• It recognizes the most likely amount
• This increases liability and an expense
• Examples may include lawsuits and warranty

Warranties

• Warranties are manufacturer commitments to repair or replace defective products within a specified time

Contingent Liability

• A potential obligation arises from an uncertain event, regardless of the company's ability to determine the amount
• Present obligation exists, but payment is not probable, or the payment amount cannot be reliably estimated

Account Payable Turnover and DPO

• Account Payable Turnover gauges how quickly management pays its suppliers, calculated as COGS / Average accounts payable
• DPO calculates the average number of days payable outstanding: 365 / Accounts payable turnover

Interest Rates

• Coupon rate is stated in a bond contract and is used to compute interest paid to bondholders
• Coupon rate also known as the contract or stated rate
• Market rate is what an investor expects to earn on a debt security investment and is used to price a bond issue
• Market rate is also known as the yield rate

Bond Issues

• Bonds have periodic interest payments during the bond's life, usually semiannual, referred to as an interest annuity, and the rate printed on the certificate
• Bonds have a single payment of principal amount at maturity, often called face value, is printed on the bond certificate, and needs to be paid by borrower
• Gain/loss on bond repurchase is Bonds payable net of repurchase payment

Session 12: Chapter 8

• Leases are contracts between an asset owner and a party that wants to use the asset
• Lessor is the owner of the asset
• Lessee gains use of an asset, often at less equity than purchasing

Leasing Vs Financing

• Leasing requires less equity investment
• Assets can be used for a limited part of their useful life
• Payments can be structured to meet lessee's needs
• Lessor retains tax benefits of depreciation

Lessee Reporting of Leases

• Right-of-use leases report the leased asset and lease liability on the balance sheet
• The asset is then depreciated and liability amortized like debt
• Payments are divided between interest and principal
• Short-term/low-value leases have no balance sheet reporting of leased asset nor the lease liability
• Lease payments are recorded as rent expense when paid

Lease Agreements

• Short-term and low-value leases require no accounting entry when the lease agreement is signed
• Neither lease assets nor liabilities are recorded on the balance sheet
• Lease payment is reported as rent expenses in income statement
• Benefits of short term or low value for lessee has no asset reported
• Asset turnover ratios are higher
• No lease liability is reported on the balance sheet, therefore, improving financial leverage ratios
• Expenses are less than reported under capital lease in early years of lease term resulting in a higher net income reported

Chapter 9: Equity

• Financing sources can come from creditors borrowing funds from debtholders or through equity investors which involves obtaining funds from shareholders via reinvested retained earnings

Capital

• Contributed capital is cumulative cash inflows from stock sales minus net cash paid to repurchase company's own stock
• Two classes of stock exist of either common or preferred stock
• Additional paid in capital and Treasury stock exist as deductions
• Contributed capital = # of shares * Price per share, representing common or additional paid in capital
• Retained earnings are cumulative profits minus losses less any dividends to shareholders: REe = REb + Ni - Div
• Accumulated other that comprehensive income are changes to equity not part of income
• Common stock is the primary ownership unit in a company
• Common shareholders have voting rights
• Par value is an arbitrary value assigned to each share of stock
• It is specified in the corporate charter
• Specifies the allocation of proceeds from stock issuances between common stock and additional paid-in capital on the balance sheet
• Number of shares of stock

Share Limits and Types

• Authorized shares are the upper limit on the N* of shares a corporation can issue
• They are established in articles of incorporation
• Can be increased by affirmative shareholder vote
• Issued shares are the actual number of shares that have been sold to shareholders
• Outstanding shares = Number of issued shares - number of shares repurchased as treasury stock

Preferred Stock

• Preferred stock possesses preference or priority with respect to common stock
• Typical preferences are dividend or liquidation
• Preferred shareholders receive dividends on their shares before common shareholders in dividend preference
• If the company fails, assets sold in liquidation go first to pay debtors, next to preferred shareholders and finally to common shareholders in liquidation preference
• Call feature allows issuer the right but no obligation to repurchase the preferred shares at a specified price
• Conversion feature enables preferred shareholders to convert their shares at option at a predetermined conversion ratio

Stock Issuances

• Stock issuances are used to obtain cash and other assets for use in the business
• Creates an increase in assets and stockholder's equity
• Common or preferred stock account increases by par value * No. of shares sold
• Additional paid in capital account increases by the remainder of the issue price

Types of Stock

• Stock repurchase is when a company buys its own stock from investors at market price
• It reduces the number of shares outstanding in order to increase the value of possible undervalued stock
• Sends positive market signals which affects share price favorably
• To offset the dilutive effects of an employee stock option program
• Repurchased stock is called treasury stock
• Treasury stock never results in gain or loss on income statement
• Difference between cost of stock and relate price in adjustment to additional paid-in capital
• Treasury stock account is a contra-stockholders' equity account and is deducted from total stockholders equity on balance sheet

Earned Capital

• Earned Capital represents the cumulative profit that has been retained by the company
• Can be an accumulated deficit if the company runs on net losses
• Increased by net income, Decreased by net losses and decreased by dividends to shareholders
• Cash, Property and Stock dividends
• Cash Dividends are most are paid in cash and quarterly or annually, yet all companies pay them
• Cumulative Preferred Stock has dividend priority over that of common stock
• Cumulative or non cumulative features exist
• Unpaid prior years' dividends are paid to preferred shareholders before any payment for current year during a cumlative feature
• Dividend rate is stated on stock certificates as either a percentage or dollar amount
• Unpaid prior year's dividends are called Dividends in Arrears (dividends owed).

Dividends and Splits

• Stock dividends and splits have additional shares of stock distributed to shareholders
• Retained earnings is reduced and contributed capital is increased in stock dividends
• These are not monetary transactions or affect final statement in any way
• Stocks splits are a proportionate distribution of shares to existing shareholders
• They are similar in substance to a stock dividend
• A typical stock split is 2-for-1, meaning the company distributes one additional share for each share owned by the stockholders
• Stock splits must reduce par value proportionately
• Some states prohibit reducing par value
• A stock split may be effected in the form of a dividend

Earnings

• Basic EPS is calculated as Earnings available for common shareholders / Weighted average number of common shares outstanding
• Value of EPS is influenced by a number of factors
• EPS is of limited use in evaluating operating performance

Session 13: Chapter 10: Financial Investment

• Financial investment is dependent on both the type and the amount of securities purchased
• Accounting for investments depends on the exertable degree investor company exert over the investee company
• Debt and share investments exist

Debt Investment

• Debt investment is investment in government and company bonds
• Entries record acquisition
• Investments are recorded at cost, including all expenditures, necessary to acquire these investments, such as the price paid plus brokerage fees
• Interest Revenue needs to be recorded on the Income Statement
• Sale occurs when calculating gain or loss as the difference between the net proceeds from the sale (price- brokerage fees) and the cost

Levels of Influence

• Passive investors cannot exert influence over the investee company
• Generally less than 20% of the outstanding voting shares of the investee is owned by investor
• Can be investments in shares, bonds or notes of other companies
• Significant influence investors can exert influence over, but not control, the investee company. It is called an "associate”
• Level of influence can result from percentage of voting shares owned
• Percentage of voting shares owned, legal agreements or the result of being a sole supplier or customer
• Influence generally assumed if ownership is between 20% to 50% of the outstanding voting shares
• Investor has control over investee that Is called a “subsidiary"
• Ability to elect a majority of the board of directors
• Ability to affect the strategic corporate direction
• Can affect hiring of executive management
• Control is presumed when ownership is 50% or more of the outstanding voting shares
• Control can occur at less than 50% through things like legal agreements or technology licensing

Explores investment management through assets, liabilities, and equity. Covers current and long-term liabilities, highlighting strategies for maximizing non-interest-bearing liabilities and matching repayments with asset cash inflows. Also discusses cash discounts and coupon & market rates.