Chapter 12 - Long-Term Financial Liabilities

Business Debt

• Businesses incur this to finance operations, expansion, or large capital projects

• Can be necessary for new businesses lacking cash reserves, or for established companies needing to finance growth or replenish cash after downturns

Sources of Financing

1. Internally Generated Free Cash Flow

2. Borrowing from Creditors

3. Issuing Capital Shares

Internally Generated Free Cash Flow

• Cash from operations used to purchase assets

• Advantages: easy access, no obligation to repay

• Disadvantages: misses leveraging opportunities

Borrowing from Creditors

• Cash obtained through debt (short-term or long-term)

• Advantages: can leverage borrowed funds to generate higher returns than the cost of interest

• Disadvantages: increases liquidity and solvency risk due to repayment obligations

Issuing Capital Shares

• Cash raised by issuing equity (shares)

• Advantages: No repayment obligations; does not affect liquidity or solvency

• Disadvantages: Dilutes ownership; potential reduction in dividends or share value

Leveraging

• Using borrowed funds to increase profit margins, where the cost of debt (interest) is less than the ROI

Risk Consideration

• While leveraging can increase profits, it also increases financial risks, including liquidity and solvency risks

Debt Financing

• Tax-deductible interest expenses

• Creates financial obligations and increased risk

Equity Financing

• No repayment obligations, but dilutes shareholder ownership

• Dividends are not tax-deductible

Long-Term Debt

Mirror Image Concept:

• A financial liability for the borrower is a financial asset for the creditor

Characteristics:

• Financial liabilities representing a fixed obligation to deliver cash or other assets to repay debt

Examples:

• Bonds, long-term notes, and mortgages payable

Notes Payable

• A formal, unconditional written promise to pay a specified sum to a creditor either on demand or at a defined future date

• Negotiable instruments like cheques or bank drafts and are supported by a written promissory note

Recognition and Initial Measurement

• Notes payable are initially recognized at their FV upon execution, typically at the signing of the note

• Subsequent measurement is done at amortized cost using the effective interest rate method

Characteristics of Notes Payable

• Generally require repayment of a principal amount and interest

• Can be structured as a lump sum a series of payments, or a mix of both

• May be secured (with collateral) or unsecured

• Interest-bearing notes have a stated interest rate

• Non-interest-bearing notes have an embedded interest component

Classification

• Short-term if due within 12 months and long-term if due after this period

• Long-term involve more formal procedures, including board approval and legal documentation, and may include restrictive covenants

Long-Term Notes Payable

• Initially measured at PV which reflects the discounted value of all future cash flows (principal and interest)

• PV calculation factors in the interest component, which becomes more significant with longer maturities

PV Calculations and Interest Rates

• Relationship between stated interest rate and market rate determines whether a note trades at face value, discount, or premium

• Premiums or discounts are amortized over the life of the note using the effective interest method under IFRS or optionally under ASPE

Subsequent Measurement and Derecognition

• Notes payable are subsequently measured at amortized cost, adjusted for any amortization of premiums or discounts

• Upon derecognition (settlement or retirement), carrying amount is adjusted to the face value

• Any gain or loss is recognized only if settled early

Impairment

• If this happens due to the debtor’s financial difficulties, it’s recorded as the difference between carrying value and the PV of expected cash flows

Trouble Debt Restructuring

• Can involve either a settlement of debt or modification of terms

• Impact depends on whether the modification is substantial (greater than 10% difference in PV)

Bonds Payable

• A method for businesses to raise significant amounts of capital by borrowing from multiple investors

• Bonds are a formal debt instruments issued with specific details, including face value, interest rates, payment schedules, and maturity dates, outlined in a bond indenture

Bond Issuance Process

• Sold to investors through underwriters or brokers

• May purchase the entire issue and resell it or sell the bonds on behalf of the issuer for a commission

• Assigned credit ratings by agencies to reflect the riskiness of the bond issue

• Higher ratings (e.g., AAA) allow companies to borrow at lower interest rates

• Lower ratings (e.g., junk bonds) necessitate higher interest rates due to increased risk

Types of Bond

• Registered

• Coupon/Bearer

• Term/Serial

• Secured/Unsecured

• Callable/Convertible

Registered Bonds

• Registered in the investor’s name, requiring re-registration if sold

Coupon/Bearer Bonds

• Not registered to an individual, allowing the holder to receive interest and face value at maturity

Term Bonds

• Mature on a single date

Serial Bonds

• Mature in installments

Secured/Unsecured Bonds

• Former are backed by collateral, latter (debentures) are not

Callable Bonds

• Can be repaid before maturity by the issuer

Convertible Bonds

• Can be converted into company equity

Initial and Subsequent Measurement

• Bonds are initially recognized at fair value (PV of future cash flows)

• Subsequently measured at amortized cost

• Transaction fees are capitalized and amortized over the bond’s life

Bond Classification

• Bonds are typically classified as long-term liabilities

• If mature within the next 12 months, classified as short-term liabilities

Bonds Issued at Par

• Bonds issued at face value are simple to account for

• Interest expense matches cash interest payments

• Bond is recorded at face value both at issuance and maturity

Bonds Issued at a Discount

• Market rate is higher than bond stated rate

• Effective interest rate method ensures consistent interest expense recognition over the bond’s life, with discounts being amortized

Bonds Issued at a Premium

• Stated interest rate exceeds market rate

• Investors pay more for these bonds, and the premium is amortized over the bond’s life using similar methods to discount bonds

Bonds Issued Between Interest Payment Dates

• Investors purchasing bonds between interest payment dates must pay accrued interest since the last payment date

• The issuer pays the full interest for the period, adjusting for the exact time the bond was held by the investor

Repayment Before Maturity

• Companies may repay bonds before maturity, particularly callable bonds, to take advantage of lower interest rates

• Re-acquisition price may be higher than the carrying value, resulting in a loss on redemption for the issuing company

The Fair Value Option

• Debt instruments are continually remeasured to their fair value

• Can be used under IFRS if it provides more relevant information

Credit Risk and Fair Value:

• Affects the grade assigned by rating agencies

• A deteriorating grade due to increased risk leads to a higher effective interest rate, causing a decrease in the bond’s fair value, which is recorded as a gain

Defeasance

• A method to manage early debt repayment penalties by setting up a trust to cover payments

Legal Defeasance

• Creditor agrees to transfer the debt obligation to the trust

In-Substance Defeasance

• The debt is not derecognized as the company remains legally responsible

Off-Balance Sheet Financing

Operating Leases:

• Structured to avoid meeting lease capitalization criteria, allowing companies to report lease payments as rental expenses without recording a debt obligation

Securitization:

• Companies sell receivables and investments to special purpose entities (SPEs) in exchange for cash, avoiding debt recording

Parental Control of Another Company:

• Through mergers and acquisitions, companies can access another company’s funds

• ASPE allows investee companies to report their investments under equity or cost method

Classification of Long-Term Debt

Current Liability

• Long-term debt maturing and any portion of principal due within one year is classified as a current liability

Refinancing:

• If long-term debt is refinanced, it is reported as a current liability unless a refinancing agreement is in place

  • ASPE: The refinancing agreement must be secured before financial statements are released

  • IFRS: The refinancing agreement must be in place before financial statement reporting date

Basic Debt Disclosures

• Maturity Date

• Interest Rate

• Breakdown of amounts due in the next five years

• Assets pledged as security

• Restrictions by creditors

• Call provisions

• Conversion details such as options to convert the debt into equity

• Liquidity and solvency risks related to company’s ability to meet short-term and long-term obligations

Reporting Requirements

• IFRS demands more extensive details

• ASPE disclosures are slightly less detailed but still robust

Importance of Cash Flow and Debt Management

Cash Flow Awareness

• Companies must carefully manage cash flow to ensure that debt, including interest, can be repaid without straining resources

Liquidity and Solvency Ratios

• Management and investors monitor these ratios to ensure optimal company performance and maintain access to debt financing at reasonable interest rates

Debt Management and Leverage

Leverage

• Companies must strike a balance between too little and too much debt

  • Too little may mean missed opportunities for leveraging

  • Too much can strain cash flows and increase borrowing costs

Consequences of High Debt

• Companies with excessive debt may face higher interest rates and stricter debt covenants, which are monitored by creditors

Debt to Equity Ratio

• Measures the proportion of debt relative to equity

Debt to Total Assets Ratio

• Indicates the percentage of assets financed by debt

Times Interest Earned

• Assesses the company’s ability to cover its interest payments

Benchmarking Ratios

• Ratios are meaningful when compared to historical trends or industry standards

• For example, a debt to total assets ratio below 50% suggests a reasonable financial structure

Aggressive Accounting Practices

• Companies under pressure to meet restrictive covenants may resort to aggressive accounting, leading to potential reporting bias

Consequences of Bias

• If creditors discover biased reporting, may call for immediate repayment, worsening the company’s financial ratios and potentially leading to further financial difficulties

Trend Analysis

• Analyzing historical data can reveal trends in debt management, helping to identify potential issues

Debt Composition Analysis

• Visual tools like donut charts can illustrate the composition of a company’s debt, such as the proportion of secured vs. unsecured debt, providing insights into the company’s financial strategy and risks