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November 12 Class Notes - WEEK 9 Chapter 10 - COMM 2AA3

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McMaster University
Aadil Merali Juma

Week COMM 2AA3 Chapter 10: Reporting and Interpreting Current Liabilities November 11, 12, 2013  Financing the Business o Businesses finance the acquisition of assets by:  Debt  Equity (financing by owners) o Capital Structure – the mix of debt and equity (that is used to finance business) o A = L + SE  Assets financed by liabilities (debt) and shareholders equity (equity; share capital (private), common shares (public)) o Covenants – lender giving loan will take covenants; cannot fall below or rise about a certain ratio  Bank pulls back loan if covenant not met  Companies are biased toward reporting ST and LT debt; high current ratio by classifying LT debt as ST o Debt financing is cheaper but riskier than equity because interest payments are legal obligations and creditors can force bankruptcy  Debt financing has the advantage of financial leverage – owners can potentially increase the return on their investments when they finance new projects with debt  Wealth transfer – transactions that create value to shareholders at the expense of creditors (eg/ leveraged buyouts, or LBO)  Equity  Return on Investment = NI / amount of equity owners put in  amount of income that investment generated  Shares – get dividends; shares gain value; capital gain = amount share appreciated by  No covenants to pay dividends  Shareholders do not charge interest  No legal obligations  Companies would still rather borrow money  Eg/ Financial Leverage – As of 1/1/2008, ABC Inc. had total assets of $1 million, and total SE of $1 million. As of that day, ABC has an investment opportunity that costs $100,000 and will generate annual return of 15%. ABC does not have enough cash to make the investment, they have to either a) raise capital or b) borrow at 12% interest rate. Assume that ABC can secure the financing and start the investment on 1/1/2008. Net income for 2008 without the project is $300,000  Return from the new project = 100,000 x 14% = $15,000  Profit after the new project = 300,000 + 15,000 – Interest = 303,000 (Interest = 12,000)  Return on Equity = New Profit / SE  As long as the return that the project gives is greater than the interest rate (finance rate, cost of borrowing money)  better to borrow than issue shares  Three essential characteristics of a liability o A present obligation that entails settlement by probably future transfer or use of cash, goods or services o There is little or no discretion to avoid the obligation o Obligation arises from a transaction or event which has already occurred (i.e. past transactions)  Current Liabilities o Expected to be paid  From existing current assets or through the creation of other current liabilities  Within one year or operating cycle, whichever is longer o Debts that do not meet both criteria are classified as long-term liabilities o Short term debt expected to be refinanced might not be classified as a current liabilities 1 Week COMM 2AA3  Bank lending money for LT – want to see LT debt-equity ratio (how much LT debt business has), interest accumulates, can business pay it off with its current income trends?  Company bias to classify as much debt as possible as ST debt  Refinancing – pay off one debt with another debt (one bank loan by a different bank loan) – still LT debt, just changing financer; appears to be ST debt  Types of Current Liabilities include: 1. Accounts Payable – Trade A/P – amounts owed for goods, supplies or services purchased on open account; recorded when title has passed; recorded at amount payable 2. Notes Payable – written promises to pay a sum of money on a specified future date; arises from purchases, financing or other transactions  May be classified as either short term (due within one year) or long term  May be interest bearing or zero-interest bearing (non-interest bearing) – interest expense is determined wherever financial statements are prepared  Interest Bearing Notes – interest rate is stated explicitly on note o Interest is always annual o Recording is required when  Note is issues  Interest is paid  End of year (adjusting entry) o For Long Term notes, payments can be for  Interest Only (principal later)  Fixed Principles + Interest on the remaining balance (eg/ mortgage)  Equal payments consisting of interest and principal  (Last two types are likely LT N/P) o Eg/ Short Term Notes – Interest Bearing; on Oct 1, 2006, Borrower Inc. borrows $10,000 from Lender Inc. and signs a 12%, 6-month note in exchange for the money. Interest is payable bi-monthly. Prepare the journal entries for both companies for the duration of the note  EXAMPLE ON AVENUE – refer to ppt  Non-Interest Bearing Notes – although interest rate is not states explicitly on note, the note still earns interest o Eg/ Short Term Notes – Non-Interest Bearing; Borrower Inc. signs to Lender Inc. a 6-month note for $10,000 and in exchange receives $9,400. There are no periodic interested payments for non interest bearing notes  EXAMPLE ON AVENUE – refer to ppt 3. Current Portion/Maturities of Long Term Debt  The portion of long-term debt maturing within 12 months from balance sheet date is reported as a current liability  Long term debts should not be reported as current liabilities if
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