Chapter 7 - Liabilities

Current assets and long-term assests combined

Liabilities

Sources of funding

Assets

• Uses of funding

• Can be financed by:

  • Debt

  • Liabilites

  • Equity

  • Common shares

  • Retained Earnings

Capital structure

Mix of debt and equity

Which is risker: Debt financing or equity financing 

Debt financing is risker than equity financing 

Why is debt financing riskier? 

• Interest payments on debt are legal obligations

  • Creditors can force bankruptcy if a business fails to meet these obligations

Why use debt financing even if it is riskier? 

• Businesses that use debt financing are leveraged

Financial leverage

• Borrowing money (debt) to increase potential returns on equity (investment)

• Still is a financial risk as the company must pay back the debt + interest

How is financial leverage measured

Using financial ratios such as:

• Debt-to-equity

• Debt-to-total-assets

How does leverage affect Return on Equity (ROE)

It magnifies gains and losses.

Interest Rate includes:

• Contractual interest rate

• Market (effective) interest rate

Contractual interest rate

• Used to calculate interest payments

• Also called:

  • Coupon rate (≠ market rate)

  • Nominal rate

  • Face rate 

Market (effective) interest rate

• Demanded by investors

• Also called the yield

Value includes:

• Face value

• Makret value (or issues price)

Face value

Principal due at maturity

Market value (issues price)

• Price for a bond on the bond market

What is a bond?

Fixed income security that allows investors to receive interest payments for loaning their money to a government or corporation for a set period of time. 

Why do companies issue bonds?

To borrow large amounts of money from many lenders at once.

What is a bondholder?

An investor who lends money to the company by buying a bond.

How often is bond interest usually paid?

Twice a year

What are term bonds?

Bonds that all mature at the same time.

What are serial bonds?

Bonds that mature in installments.

What are secured bonds?

Bonds backed by specific assets.

What are unsecured bonds (debentures)?

Bonds backed only by the issuer’s reputation.

Bond price

• % of the face value (maturity) of the bond 

Bonds are taded at:

• Face value

• Discount 

• Premium

Bond pricing - Face value

• market value = face value 

  • Traded when the coupon rate = the market value 

Bond pricing - Discount

• Market value < face value 

• Traded when coupon rate < the market value

Bond pricing - Premium

• Market value > face value  

• Traded when the coupon rate > the market value 

Bonds Interest Payment

• Regardless of face, discount and premium value

  • Interest payment = face value x coupon rate 

Bonds Interest Expense

Interest expense is based on the market rate

Bonds Interest Expense - Face value

Interest expense = interest payment  

Bonds Interest Expense - Discount 

Interest expense > Interest payment 

Bonds Interest Expense - Premium

Interest expense < Interest payment  

Amortization

Gradually write down the cost of an intangible asset over its useful life 

Journal Entry for bonds issues at Discount

(DR) Interest Expense

(CR) Cash

(CR) Discount on bonds payable

Journal Entry for bonds issues at Premium

(DR) Interest Expense

(DR) Premium on bonds payable

(CR) Cash

Methods to Amortize Bonds Discount and bonds premium

• Effective Straight Line Method

• Straight line method

Why issue shares instead of debt?

No interest payments + no mandatory repayment.

Why issue debt instead of shares?

No dilution of ownership + potentially higher Earnings per share (EPS).

The payment of the face amount of a bond on its maturity date is regarded as what?

A financing activity 

Amortizing the discount on bonds payable does what?

Increases the recorded amount of interest expense 

Bond carrying value equals Bonds Payable 

Plus Premium on Bonds Payable. 

Minus Discount on Bonds Payable. 

Liabilities (according to IFRS)

Something your business already owes

Can be paid by:

• Cash

• Give another asset

• Deliver goods or services you own (i.e unearned revenue)

• Converted to shares (creditor accepts equity instead of cash)

Current liabilities

Obligation due within one year or within a company's operating cycle 

Operating cycle

• The time it takes for a company to convert its investments in inventory into cash flows from sales

• Typically is one year 

Types of current liabilities

• Known amounts

• Provisions (less certainty about timing or amount)

Types of known current liabilities

• Accounts Payable

• Accrued liabilities

• Income tax payable

• Unearned revenue

• Current portion of long-term debt

• Payroll liabilities

• Sales tax payable

• Short-term notes payable

• Dividend Payable 

Accounts Payable

Amounts owed to suppliers

Accrued liabilities

• Expenses incurred (used), but not paid

  • insurance payable

  • Rent

  • payable

  • Interest payable

Unearned revenue / Deferred revenue

• Cash advances from customers for services that have not been delivered yet

Current portion of long-term debt

• Business has a debt that is due after 1 year

• Long-term liability on the balance sheet

• As time passes, the business must reclassify the portion of debt into a current liability 

Payroll liabiliites includes;

• Payroll deductions

• Payroll expenses

Payroll deductions

• Paid by employers to the government on behalf of employees

• Income taxes 

• Canada Pension Plan (CPP)

  • Retirement fund

• Employment Insurance (EI)

  • Security in case they lose their job at some future date 

Payroll expenses

• Salary expenses

• Canada Pension Plan (CPP)

  • Employer's CPP contribution = Employee CPP contribution  

• Employment Insurance (EI)

  • Employee EI contribution x 1.4

Why are Income taxes, CPP and EI considered a liability?

• The liabilities will remain in the books until the company pays the money to the government

  • Hence why they owe this, making it a liability

Sales tax payable

The tax added to purchases when shopping 

3 Types of Sales Tax Payable 

• Goods and services tax (GST)

• Provincial/regional sales tax (PST)

• Harmonized sales tax (HST)

Harmoinized sales tax (HST)

• Ontario only has HST

  • HST combines GST and PST = 13% in Ontario

• Value-added sales tax

  • Businesses that buy a product and resell it for a profit will receive an input tax credit (ITC) for the HST they paid

Input tax (or Tax recoverable)

Tax paid when purchasing goods

Output Tax (or Tax payable)

Tax collected when selling goods or services 

Notes Payable and Notes Receivable (OR promissory notes)

• Written promise to pay a sum at the maturity date 

  • Plus interest

Why are notes payable and notes receivable issued?

• Gives the lender stronger legal protection

• The borrower signs it, the lender keeps it as proof

Example of issues N/R/NP

Dates in which journal entries should be made for notes payable/receivable

1. Initial transaction

2. End of accounting period

3. First interest payment date

4. Final payment

Interest 

• The cost of borrowing money

• Stated as an annual percentage date 

Maturity date

The date at which the debtor must pay the note

Principal

The amount of money borrowe dby the debtor

Term

The length of time the debtor must repay the note