Shalin Bhansali

Liabilities
A] 3 essential conditions that a liability B] Classification of liabilities:
must meet: I. Based on credit period/maturity
Future transfer/sacrifice of economic benefits a) Current: due within 1 year (Accounts
is probable; AND payable
The obligation of future sacrifice of economic
benefits is known; AND b) Non-current: due beyond one year (term
The present obligation is based on loan)
transactions/events that have already
happened II. Based on requirement to pay interest
a) Interest bearing (bonds, leased, loans)
C] Bank Borrowings:
b) Non-interest bearing (expenses
a) Mortgage loans: loans secured by PP&E
outstanding)
b) Term loans: loan for fixed time period
c) Revolving credit lines: “credit card for
companies”; keep borrowing and paying – D] Features of Bank Borrowings:
continuous replenishment a) Covenants: provision stated in loan/bond
d) Line of credits: guarantees that funds will agreement to protect lender’s interest
be available when needed; draw funds till (restriction on sale of property, restriction
limit is reached on dividend payments, etc.) In case of
e) Letter of credits: for international violation, lender can demand principal
transactions’ buyer’s bank guarantees repayment.
payment to seller’s bank
b) Liquidation preference:
E] Accounting for bank borrowings: - Mortgage loans have the first right to sale
a) Loan is taken: Cash+ (Dr.), Borrowings+ proceeds of the concerned asset which
(Cr.) secures the mortgage loan
b) Interest is accrued: Interest expense+ - Senior loans can claim assets and satisfy
(Dr.), Interest payable+ (Cr.) their claims first; only then, subordinated
c) Interest is paid: Interest Payable- (Dr.), loans can claim
Cash- (Cr.)
d) Loan is repaid: Borrowings- (Dr.), Cash- c) Sinking Fund – company is required to
(Cr.) keep cash aside to repay LT borrowings

F] Bonds (borrowing money from public instead of bank); Why? Cheaper thank bank; but
heavily regulated
- Common forms of publicly traded debt: Commercial paper (short-term, for working
capital needs) and Bonds/Debentures (long-term, more regulated, traded on exchanges,
principal paid at maturity and interest paid annually/semi-annually)
- Important features: Security (mortgage bonds v/s debentures, senior v/s subordinated);
Callable bonds (company has the option to repay bond before its maturity); Convertible
bond (bondholder has the option to convert the bond to equity at a specified time)

Callable bonds are riskier than non-callable bonds, hence more company pays more interest
Convertible bonds are more valuable than non-convertible bonds, hence less interest
G] Some important terms:
Face value: The amount which the company will pay back to the lender (bondholder) on
maturity of the bond
Coupon rate: The rate of interest received by the lender (x% of face value)
Market rate: The rate of interest prevailing in the market when the bond is sold
 Shalin Bhansali
Liabilities
H] How to decide if a bond is issued at par, at premium, or at discount?
a) If coupon rate = market rate → issued at par (lender buys bond at the Face Value itself)
b) If coupon rate > market rate → issued at premium (investor buys bond at > Face Value)
c) If coupon rate < market rate → issued at discount (investor buys bond at < Face Value)

Intuitive thinking: If I am giving a higher coupon rate (interest) than the market rate to an
investor, he/she should give me more money than the face value of the bond (issued at
premium) and vice versa

I] How to determine how much the lender should pay at time = 0 to buy the bond?
Value at which bond is issued=
Present Value of interest payments throughout life of the bond
(+) Present Value of Face Value received at the end of the life of the bond (at maturity)

Question] Consider a 10%, 3-year bond with a face value of 1,000, issued 1/1/20X1.
Assume that the prevailing market rate is 9% the day the bond is issued.
How much should the lender pay at Time 0 to buy the bond? (Use the PVIF table here)

▪ Discount the coupon of Year 1 for 1 year: 100*0.9174 = 91.74

▪ Discount the coupon of Year 2 for 2 years: 100*0.8417 = 84.17
▪ Discount the coupon of Year 3 + Face Value for 3 years: (1000+100)*0.7722 = 849.42

▪ Add all the above 3 values → that gives you the worth of the bond today, which is the
amount a lender will pay to buy the bond today: 91.74 + 84.17 + 849.42 = 1025.33

Pay-offs ? 100 100 100 + 1000

Time periods 0 1 2 3
0.9174
0.8417

0.7722

Here, since coupon rate (10%) > market rate (9%), the present value of the bond at time 0 is more
than 1000 (Face Value), which is why it was issued at a premium of 25.33 (1025.33 – 1000)
How is this transaction recorded in the Financial Statements?
Cash increases by 1025.33
Net Bonds Payables increases by 1025.33. But, on the balance sheet (under liab.), this is shown as:
Bonds Payable (Face Value) 1000
Add: Premium on issue 25.33
Net Bonds Payable (Net Liability) 1025.33

Now, we have 2 objectives:

1) Pay interest at the end of every year (equal to coupon rate x Face Value)
2) Bring the net value of the bond on the balance sheet to the Face Value by the time it
matures (at the end of 3 years in the above example, the Net Bonds Payable should by 1000)
 Shalin Bhansali
Liabilities
J] Some more important terms:
Interest Payment for a year: The coupon (interest) payments made to the lenders (coupon rate
x face value)
Interest Expense for a year : Net liability at the start of the year x Market rate when bond was
issued
Discount amortized in a year: Interest Expense – Interest Payment
Premium amortized in a year: Interest Payment – Interest Expense
Net Liability: How much is our bond-related liability? [Face Value + unamortized discount –
unamortized premium]

Continuing the same example, let’s see how the bond is reflected on the FS every year

Year Beg. Net Coupon Payment Interest Expense Amortization Ending net
Liability (coupon % x FV) of Discount liability
(1) (2) (3) = market rate % x (1) (5) = (2) – (3) (1) – (5)

1 1025.33 100 92.28 7.72 1017.61

(1025.33*9%) (100 – 92.28) (1025.33 – 7.72)
2 1017.61 100 91.59 8.41 1009.20
(1017.61*9%) (100 – 91.59) (1017.61 – 8.41)
3 1009.20 100 90.83 9.17 1000.03
(1009.20*9%) (100 – 90.82) (1009.20 – 9.17)

Now, solve the same question again, but now assume the market rate to be 11%

How much should the lender pay at Time 0 to buy the bond? (Use the PVIF table here)

▪ Discount the coupon of Year 1 for 1 year: 100*0.9009 = 90.09

▪ Discount the coupon of Year 2 for 2 years: 100*0.8116 = 81.16
▪ Discount the coupon of Year 3 + Face Value for 3 years: (1000+100)*0.7312 = 804.32

▪ Add all the above 3 values → that gives you the worth of the bond today, which is the
amount a lender will pay to buy the bond today: 90.09 + 81.16 + 804.32 = 975.57
Here, since coupon rate (9%) < market rate (11%), the present value of the bond at time 0 is less
than 1000 (Face Value), which is why it was issued at a discount of 25.43 (1000 – 975.57)

How is this transaction recorded in the Financial Statements?

Cash decreases by 975.57
Net Bonds Payables increase by 975.57. But, on the balance sheet, this is shown as:

Bonds Payable (Face Value) 1000

Less: Discount on issue (25.43)
Net Bonds Payable (Net Liability) 975.57
 Shalin Bhansali
Liabilities
Let’s see how this bond is reflected on the financial statements every year

Year Beg. Net Coupon Payment Interest Expense Amortization Ending net
Liability (coupon % x FV) of Premium liability
(1) (2) (3) = market rate % x (1) (5) = (2) – (3) (1) + (5)

1 975.57 100 107.31 7.31 982.88

(975.57*11%) (107.31 - 100) (975.57 + 7.31)
2 982.88 100 108.12 8.12 991.00
(982.88*11%) (108.12 – 100) (982.88 + 8.12)
3 991.00 100 109.01 9.01 1000.01
(991*11%) (109.01 – 100) (991 + 9.01)

Journal Entries:

1. At the time of selling the bond and borrowing money:

Cash Dr.
Discount on issue Dr. Either discount or premium will come
Bonds Payable Cr. in this entry, depending on the question
Premium on issue Cr.

2. (in case of bond issued at discount) At the end of the year while recording interest
expense and interest payment:

Interest expense Dr. → Net Liability at end of last year/beginning of this year x market rate %
Discount amortization Cr. → Balancing figure → (Interest Expense – Interest Payment)
Cash Cr. → Interest Payment (coupon payment)

OR

2. (in case of bond issued at premium) At the end of the year while recording interest
expense and interest payment:

Interest expense Dr. → Net Liability at end of last year/beginning of this year x market rate %
Premium amortization Dr. → Balancing figure → (Interest Payment – Interest Expense)
Cash Cr. → Interest Payment (coupon payment)

3. Repayment of the bond at the end of its life (at maturity)

Bonds Payable Dr. → Face Value
Cash Cr. → Face Value
J] Leases:
Lease is a contract that conveys the right of one party (lessee) to control the use of an asset
owned by another (lessor), for a specified period of time in exchange for consideration
(periodic rental payments called Minimum Lease Payments).
Why do companies lease assets instead of purchasing them? for easier access to assets,
to finance assets (avoid upfront payment), and/or to limit risk (such as obsolescence)
associated with the outright purchase of assets.
 Shalin Bhansali
Liabilities
J] Types of Leases:

a) Financing Lease: Leases that transfer substantially all benefits and risks of ownership
b) Operating Lease: All leases other than Financing Lease; do not transfer substantially all
benefits and risks of ownership

Key language to identify a lease as a financing lease:

▪ transfers ownership to lessee at end of the term
▪ option to purchase asset at a bargain price
▪ lease term is >=75% of useful life of asset
▪ PV of rentals and MLPs at start of lease term is >=90% of fair value of asset less investment
tax credit
▪ gain or loss from fluctuation of fair value of asset accrue to the lessee
▪ lessee can cancel the lease and losses of the lessor if any are borne by lessee
▪ asset is of a specialized nature and is of no use to lessor at the end of its life

Whether a lease is a financing lease or an operating lease depends on the substance of the
transaction and not just the form of the contract.

Accounting of Lease

Lease period <1 Lease period >1

year year

Recognize the lease payments as Recognize the property

an expense in P&L (just like acquired through lease in the
payment of rent) Balance sheet as a ‘Right of
Use Asset’ at PV of MLPs
Recognize the asset on the BS, but
since life is 1 year, it will be fully Recognize the lease
depreciated by the end of the year contract as a liability in the
Balance Sheet (same
amount as asset)

Pay-offs ? MLP 1 MLP 2 MLP 3

Every year, depreciate the asset
Time 0 1 2 3 (SLM) on the Balance Sheet and
Dis Rate1 recognize the expense in P&L
periods
Dis Rate2 (just like any other PP&E)

Dis Rate3 Every year, you pay MLP to the

lessor. This is allocated to
interest payment (P&L) and
PV of MLPs → this is the value at which towards reduction of lease
asset is recognized on the Balance Sheet (reduction of liability)
when it is taken on lease
 Shalin Bhansali
Liabilities
Question: HM Co leases an asset on January 1, 20X1
Lease has a 3 years duration with annual MLPs of $10,000, $15,000 and $20,000 to be paid
at the end of year 1, 2, and 3 , respectively. Assume an interest rate of 8% p.a. for the lease.
Calculation of Present Values of MLPs (Use the PVIF table here):
▪ Discount the MLP of Year 1 for 1 year: 10000*0.9259 = 9259
▪ Discount the MLP of Year 2 for 2 years: 15000*0.8573 = 12860
▪ Discount the MLP of Year 3 for 3 years: 20000*0.7938 = 15876
Add all the above 3 values → that gives you the present value of the MLPs:
9259 + 12860 + 15876 = 37995 (~38000)

Let’s see how this lease is reflected on the financial statements every year
Year Beg. Lease MLP for the year Interest Expense Reduction in Ending Lease
Liability Lease Liability
(1) (2) (3) = Interest Rate % x (1) (4) = (2) – (3) (1) - (4)

1 38000 10000 3040 6960 31040

(38000*8%) (10000 - 3040) (38000 - 6960)
2 31040 15000 2483 12517 18523
(31040*8%) (15000 - 2483) (31040 - 12517)
3 18523 20000 1482 18518 5 (~0)
(18523*8%) (20000 - 1482) (18523 - 18518)

Journal Entries (2,3, and 4 happen every year; 1 happens only at inception of the lease):
1. At the time of taking the asset on lease:

Right of Use Asset Dr. 38000 → PV of MLPs

Lease Liability Cr. 38000

2. At the end of every year while recording payment of MLP:

Lease Liability Dr. → Column (4) → 6960 for Year 1

Interest expense Dr. → Column (3) →3040 for Year 1
Cash Cr. → MLP → 10000 for Year 1

3. At the end of every year, while depreciating the Right of Use Asset (Use SLM; useful
life = term of the lease)

Depreciation Dr. → 38000/3 = 12667

To Accumulated Depreciation (of Right of Use Assets)→ 12667
Some other concepts:-
Operating Liabilities: non-interest bearing obligations arising out of normal course of
operations. They can be Current: accounts payable, outstanding expenses; or Non-Current:-

a. Deferred Revenue – Revenue received in advance (you haven’t fulfilled your part of the deal
yet (customer deposits); also called unearned revenue; liability+ on BS, cash+ on BS
b. Warranty Reserves – Recognize expense on P&L and create a reserve on BS (Liability);
similar to Allowance for Bad Debts, except that ABD is a contra asset and WR is a reserve)
c. Restructuring Reserves – same concept as b. above, but purpose is to provide for
restructuring expenses
 Shalin Bhansali
Shareholder’s Equity
Major components of Shareholder’s Equity:-
Component Meaning
Common Stock Equity shareholders, can get dividend but not compulsory
(dividend amount can vary)
Preferred Stock Preference shareholders, entitled to a fixed rate of dividend
Treasury Stock Company’s own shares which have been bought back from
shareholders (represented as a negative value)
Retained Earnings Op. Balance + NI for the year – Dividends declared
Non-controlling Interest Value of its >50% subsidiaries not held by the parent company

How can shareholder’s equity change?

Reason for Meaning
change
Issue of stock ▪ Authorized: How much capital am I authorized to raise?
▪ Issued: How many shares have I issued to shareholders?
▪ Outstanding: How many shares are still held by shareholders? = Issued
shares – Treasury Stock
▪ Par Value: ***irrelevant in real life***
▪ Market Value: Value at which stock is traded in the market
▪ Additional Paid-in Capital (or Securities Premium): Price at which
stock is sold (Issue Price) – Par Value

If 100 shares with par value of 10 is sold for 100, 10 goes to Common
stock, and 90 goes to Additional PIC (or Securities Premium).

If then we buy back 50 shares at 120, 120x50 = 6000 is treasury stock

(negative figure)

Then if you again re-issue 30 of those shares for 130, 120*30 = 3600 will
get reduced from initial treasury stock of 6000, and 10*30 = 300 will get
added to additional PIC (or Securities Premium).
Buyback When a company buys its own shares from its shareholders
(Repurchase) Reasons? – to increase EPS, to eliminate hostile takeovers, to reissue
of stock shares to officers of company under ESOPs, to increase trading of
company’s shares, to increase trading of its shares

Once shares are bought, either retire them (deduct from authorized
capital) or keep as treasury stock (negative amount)
Dividends ▪ Distribution to shareholders (cash, shares, property, liquidating)
(they must be ▪ Not necessary for company to make profits to declare dividends; can
declared by the even declare if they’ve made a loss (except if covenants)
Board of ▪ Date of declaration (when declared), date of record (shareholders as
Directors) on this date will get dividend), date of payment (when paid)
Market Capitalization = MV of share x no. of outstanding shares; Market to Book ratio = Market Cap ÷ SE