Sources of Capital

Liabilities

Types of liabilities

Contingent, Executory and Contractual

A contingent liability is a possible commitment. The amount to be paid in a contingent liability is dependent upon a future event occurring. A common example is a lawsuit. A company can be relatively sure that it will have to pay, however, measurement of the amount will not become clear until the jury has entered its verdict or a judge has issued an opinion. The accountant’s problem is not whether to disclose the lawsuit, rather, what amount (liability) should be assigned to the balance sheet if any. If the financial statements prematurely report an amount, that figure could be used against the company in the legal process used to resolve the suit.

Statement of Financial Accounting Standards #5 provides guidance as to what if any amount is to be recorded as a liability. Two conditions are necessary. The amount must be reasonably estimated and the probability of payment deemed likely. These are difficult guidelines to follow; however, the profession is attempting to set some level of responsibility for the adequate measure and disclosure to these potential commitments.

Some of the most valued and closely tracked "non transactions" are executory contracts. Boeing receives an order from United Airlines to deliver 38 Boeing 777 airliners at a total value of 2 billion dollars. Boeing stock rises 4 points, every employee at the plant rejoices and the accountant basically does nothing, maybe sharpens a pencil or two. Reciprocal promises are not accounting transactions. Either payment must be made or construction of the jets must begin before any accounting event is recognized.

This is highly relevant to the financial analyst. Part of the art of valuing a company is the measurement of events that are not obviously present in the financial statements but are important in determining the value of a company. Back orders are considered an important indicator of future growth in the semi-conductor industry.

Bonds

Bonds are contracts between companies and investors. Simply put, an investor agrees to supply a company with money (capital) today for the promise to receive in return their initial investment and an agreed upon interest payments in the future. Bonds represent a huge source of capital for corporations. The Bond financing industry has grown to the trillion-dollar level over the past decades. Since bonds are issued by Governments, non-for profits and corporations, the bond market is extremely competitive.

Terminology: Bonds are contractual promises to pay the holder both interest and principle over a specific schedule. The contract may be fixed or variable with maturity dates, interest rate (either, explicit or implicit) and may contain convenants, or require collateral. Let us start understanding bonds by looking at some simple transactions.

1/1/01                Cash                            100,000
                                        Bonds Payable                    100,000

To record the issue of 100/$1000 bonds at 8% for 10 years at par.

Recording of Interest Payment

6/30/01                Interest Expense          4,000
                                        Cash                                          4,000

To record first interest payment due in 6 months.

If the market rate of interest for this bond is greater than 8% at the time of issue the Bond will not sell for par. Will the market pay more or less than face value for the bond?

The market pays less than par or face value effectively increasing the yield on the bond to a rate greater than 8%. This is called issue bonds at a discount.

Example if the market paid only $980 for the $1000 bond then the entry would look like:

1/1/01                Cash                                $98,000
                           Bond Discount                                         2,000
                                        Bonds Payable                    $100,000

After six months would interest expense be greater or less than $4,000

If the true interest rate on the bond was 8.37%,

then

6/30/01                Interest Expense            $4,100
                                        Bond Discount                        100
                                        Cash                                     4,000

*This example uses straight-line amortization of Bond discount. The true interest rate is actually not 8.37% although it is close.

This process continues every six months until maturity at that time the bond discount account will be fully amortized and the net carrying value of the bonds will be $100,000.

Leases

Leases are rights to use assets. When we lease a car, we do not take title rather a financial institution holds the title. I argue that leases are essentially financing arrangements although the follow four reasons are cited for reasons to lease.

Leases are either Capital or Operating.

Capital lease means we have essentially bought the asset and should account for it as such. An Operating lease should be simply an expense like going to Jack’s Tool Rental and renting a lawn mower.

If we rent a car month by month we would account for the transaction as follows:

3/01/01            Rent Expense (auto)                $500
                                        Cash or Payable                    $500

the next month would look the same.

What if we used a lease contract to essentially buy the car then we would set-up an asset and a liability to account for the installment purchase.

3/01/01            Auto lease                    $25,000
                                    Obligation under lease
                                    contract                                        $25,000

to record a five year lease at $500 per month for 60 months.

Every year we would amortize (depreciate) the Auto lease and each month we would record the payments:

4/01/01            Obligation under lease contract       $350
                                            Interest expense              $150*
                                            Cash                                                   $500

to record one month lease payment.

*Interest expense amount is approximated for illustration purposes. Actual interest expense is $25,000 * 7.42% * 1/12 = $154.58