AFL: Module 5

How are notes payable different from accounts payable?

Notes payable usually arise from actually borrowing cash (instead of from not paying for goods or services)

Notes payable are more formal (they are documented and charge interest)

Notes payable are usually borrowed from banks

What are credit facilites?

they give a company the right to borrow up to a specified limit without having to go through the loan approval process, but not the obligation to borrow

Do companies have to take the money from the credit facilities once they are approved to get it?

no

T/F Credit facilities are like credit cards, in that they provide companies with lines of credit

true

How do the credit facilities make money?

the company pays a fee for the arrangement, plus interest on the borrowing if it does borrow in the credit facility

Why is commercial paper unique?

because it is short term, usually 60-90 days

Where does commercial paper come from?

it is borrowed from banks and other institutions like money market funds

What represents the amounts borrowed via private placements which means borrowing from a specific lender?

commercial paper, credit facilities, and notes

Can you borrow money from the general public?

yes, in the form of bonds

What happens when a company issues a bond?

it arranges the terms of the bonds and sells the bonds through an underwriter (intermediary)

What is an example of an underwriter?

an investment bank

Bonds sell in increments of what?

1000 (par value)

What do bonds pay?

a stated interest rate (coupon rate)

What are the flavors of bonds?

Mortgage bonds, debentures, and subordinated debentures

What is a mortgage bond?

bonds that are secured by specific property

T/F in case of default on the bond, the bondholders of mortgage bonds have the first right to proceeds from the sale of that property

true

What is a debenture?

they are unsecured bonds

What kind of claim do debenture bondholders have against the debtor’s assets?

a general claim, so they are second in line basically

What are subordinated debentures?

debentures with only a general claim against the company’s total assets, but with a lower priority than other general creditors

Do subordinated debenture holders have a higher or lower risk/interest rate?

higher risk and higher interest rates

T/F most companies report a classified balance sheet

true

What is a classified balance sheet?

separating all of a company’s assets and liabilities into current vs noncurrent

What does current mean?

it generally implies cash within one year

What is a current asset?

one in which it is expected to be converted into cash within the next year

What is a current liability?

a liability that is expected to be paid off within the next year

What does breaking assets and liabilities between current and non current tell us?

a lot about a company’s solvency (liquidity)

What is solvency?

a measure of a company’s ability to pay debts as they come due

What is a company’s solvency tied to?

it is closely tied to its current assets vs its current liabilities

What is the formula for working capital?

current assets - current liabilities

What is the current ratio?

current assets/current liabilities

What is the quick ratio formula?

(current [cash market securities + receivables])/current liabilities

What do the debt to equity ratio and the debt to total assets ratio tell us about a company?

its level of risk

In computing the debt to equity ratios what are we only including?

interest paying debt

T/F Accounts payable is considered interest paying debt

false

T/F notes payable is considered interest paying debt

true

What is the interest coverage ratio?

deals with how easily a company can make the interest payments on its debt by comparing its net income to its interest expense

What is the interest coverage ratio formula?

(pretax NI + interest expense)/(interest expense)

How do bond rating agencies use ratios?

to assign bond ratings to bonds of various corporations

What are credit ratings?

assessments of the likelihood that a bond will be repaid

what is considered a junk bond?

anything BB+/Bal or below is considered a junk bond (speculative grade)

When are bonds rated?

when the bonds are first issued and after the bonds are first issued, the bonds continue to be rated

T/F as a company’s risk changes, the rating on its bonds changes

true

If a bonds risk changes what happens to the coupon rate, par value, and the bonds future cash flows?

none of them change

What happens to a bond when the discount rate changes?

the bond’s future cash flow changes, which means the present value of those future cash flows changes which means the market price of the bond changes

T/F the discount rate used to value a bond, and thus the value of a bond itself, is a function of risk

true

What is one way to reduce the risk of a bond?

impose debt covenants

What is a debt covenant?

they are restrictions a creditor puts on the borrower

What are examples of debt covenants?

maintenance of a specified level of retained earnings

prohibiting against paying dividends

maintaining certain working capital levels

maintaining certain current ratios

maintaining certain debt/equity ratios

What happens when you fail to comply with the provisions of a debt covenant?

it generally results in defaulting on the loan

What is defaulting?

a loan becomes due immediately

what are examples of contingent liabilities?

pending lawsuits

product warranty liabilities

tax disputes with the IRS

potential liabilities associated with restructuring

Why do contingent liabilities cause accounting challenges?

they require some tough judgment calls on whether they should in fact be recorded on the balance sheet as liabilities

what are the three flavors of contingent liabilities and what are they based on?

they are based on their likelihood of an unfavorable outcome

1) remote

2) reasonably possible

3) probable and estimable

What does a company do with a remote contingent liability?

the company ignores it

What does a company do with a reasonably possible contingent liability?

disclose it in the footnotes

What does a company do with a probable and estimable contingent liability?

a company records a liability and will probably disclose the relevant info in the footnotes

DR: expense XX
CR: liability (or reserve) XX

What happens when a contingent liability is probable but not estimable?

the company just discloses it in the footnotes

T/F as part of accountants’ audit procedures they get help from legal counsel

true, they need information about the likelihood of losing asserted claims, amount of loss on the asserted claims, and the existence of unasserted claims

T/F Accountants and auditors have issued because attorneys want max disclosure and auditors want min disclosure

false, attorneys want min disclosure and auditors want max disclosure

who is the middle man between attorneys and auditors?

management

What is the most common form of earnings management?

restructuring liabilities

Before a company can record a restructuring reserve it must do what?

have a formal restructuring plan that is approved by the Board of Directors

identify and notify the affected employees

In years after the restructuring reserve is recorded, the company must do what?

disclose the following in its footnotes:

the original liability

how much of the liability was paid off in the current period

how much of the liability was reversed because of overestimations

new accruals for unanticipated costs

ending balance of the liability

What is book NI?

a company’s GAAP NI

T/F a company’s book NI probably equals its tax NI

true

What is a municipal bond?

a bond is issued by a state or local gov

What is the matching principle?

you have to match expenses in the same period as the associated income

What does the matching principle tell us?

since a company reported a look of income to its shareholders on its GAAP income statement in year X, it must also report the associated tax expense on the GAAP income statement in year X even though it didn’t actually pay the tax until year X + 1

Under the matching principle, what does the company record in year X?

DR: tax expense X

CR: deferred tax liability (DTL) X

What is the journal entry for when the deferred tax liability becomes current?

DR: DTL X

CR: CTL X

What do like-kind exchanges give rise to?

deferred tax liabilities

What happens when a property is sold at a gain for cash?

the gain is reported for GAAP and taxed

What happens when a property is sold at a gain for a like kind property?

the gain is usually still reported far GAAP but not taxed until the new property is sold for case —> we have a gain being recorded for GAAP purposes now but not actually taxed until later

What is the regular and tax journal entry for when a company buys land for 200 and then the land appreciates to 300 and the company sells it for 300?

regular journal entry:

DR: cash 300

CR: land 200

CR: gain 100

tax journal entry:

DR: tax expense X

CR: CTL X

What is the regular and tax journal entry for when a company buys land (YMCA) for 200 and then the land appreciates to 300 and the company sells it for 300?

regular journal entry:

DR: YMCA 300

CR: land 200

CR: gain 100

tax journal entry:

DR: tax expense X

CR: DTL X

If because of temporary differences current GAAP NI > current tax income we record what?

DR: tax expense X

CR: DTL X

When future GAAP NI < future tax income the DTL reverses and we record?

DR: DTL X

CR: CTL X

T/F When in early years GAAP NI > tax income we record at DTL that eventually turns into a CTL

true

T/F when in early years GAAP net income < tax income we record at DTA (deferred tax asset) that eventually reduces to CTL

true

What do deferred tax liabilities mean?

we pay more tax later because of NOL

What are NOLs?

they are used as tax deductions against taxable income earned in future years

T/F NOLs result in less tax in the future

true

T/F it is possible that a deferred tax asset might never actually be realized

true

T/F While for federal tax purposes incurred after 2017 do not expire, for state tax purposes NOLs still do often have time limits

true

What are other similar rules that affect other DTAs?

carry forward limitations on tax credits

We sometimes end up with the need to record a what against the deferred tax asset account?

a valuation allowance to reflect the fact that we might no tbe able to ever enjoy that asset

T/F Valuation allowance is a contra asset which is netted against deferred tax liabilities

false, deferred tax assets

When is the valuation allowance required?

if it is more likely than not that the deferred tax asset will not be realized AND if it is later determined that it is more likely than not that the deferred tax asset will be realized, we just reverse the journal entry that established the allowance in the first place

What is off balance sheet financing?

the games people play to keep debt off the balance sheet

Why is off balance sheet financing done?

to make the company look safer and this subject to lower interest rates

How is off balance sheet financing done?

by keeping ownership of highly leveraged subsidiaries just under 50% by obtaining use of assets by leasing instead of purchasing

When you lease something, what kind of payments do you make?

periodic payments

When you borrow to buy something, what kind of payments do you make?

periodic payments

If you borrow to buy, what do you end up with?

you end up owning an asset

When you lease what do you end up with?

nothing

Are the periodic payments higher with leasing or borrowing to buy?

borrowing to buy

T/F with lending and borrowing, the economics are similar but the accounting is very different

true

If you buy something on credit, what do you record?

an asset and a debt

What is a lease?

an executory contract under which neither party has done anything other than make a promise

What do the new rules say about a lease with a term over 12 months?

it must be treated as if the company borrowed to buy