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Analyzing Debt Financing Activities

 DEBT FINANCING
Financial liabilities
- Interest-bearing
- Private: loans (e.g. from banks)
- Public: securities (e.g. bonds)
Operating Liabilities: arise in the normal course of business
- Non-interest bearing  e.g. Accounts payable

 Distinguishing Feature of Debt (compared to equity): IT MATURES

 Non-current / Long-term (LT): > 1 year
 Current / Short-term (ST): < = 1 year  includes:
 current portion of the LT debt
 Revolving lines of credit (or revolvers

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 Accounting for LT-Debt - Illustration
Bond Issue
Face Value 100,000

Coupon rate 6% payable annually

Maturity 3 years

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 Accounting for LT-Debt - Illustration
interest expense = Effective interest rate X Present Value at the Beginning of the Period)

Effective (market) interest rate = 6%  issued at par

year Coupon PV Premium Interest Premium (Discount) Total Interest
payment (Discount) expense Amortization Expense +
Amortization
0 100,000 -0-

1 6,000 100,000 -0- 6,000 -0- 6,000

2 6,000 100,000 -0- 6,000 -0- 6,000

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 Accounting for LT-Debt - Illustration
Effective (market) interest rate = 3%  issued at premium

year Coupon PV Premium Interest Premium (Discount) Total Interest

payment (Discount) expense Amortization Expense +
Amortization

0 108,486 8,486

1 6,000 105,740 5,740 3,255 2,745 6,000

2 6,000 102,913 2,913 3,172 2,828 6,000

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 Accounting for LT-Debt - Illustration

Effective (market) interest rate = 10%  issued at discount

year Coupon PV Premium Interest Premium Total Interest

payment (Discount) expense (Discount) Expense +
Amortization Amortization
0 90,053 (9,947)
1 6,000 93,058 (6,942) 9,005 (3,005) 6,000
2 6,000 93,364 (3,636) 9,306 (3,306) 6,000
3

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 Test Your Knowledge
Complete the table for year 3

Effective (market) interest rate = 6%  issued at par

year Coupon PV Premium Interest Premium (Discount) Total Interest
payment (Discount) expense Amortization Expense +
Amortization
0 100,000 -0-

1 6,000 100,000 -0- 6,000 -0- 6,000

2 6,000 100,000 -0- 6,000 -0- 6,000

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 Test Your Knowledge
ANSWER

Effective (market) interest rate = 6%  issued at par

year Coupon PV Premium Interest Premium (Discount) Total Interest
payment (Discount) expense Amortization Expense +
Amortization
0 100,000 -0-

1 6,000 100,000 -0- 6,000 -0- 6,000

2 6,000 100,000 -0- 6,000 -0- 6,000

3 6,000 100,000 -0- 6,000 -0- 6,000

©2020 All rights reserved. American University of Beirut, Suliman S. Olayan School of Business. 8
 Test Your Knowledge
Complete the table for year 3
Effective (market) interest rate = 3%  issued at premium

year Coupon PV Premium Interest Premium (Discount) Total Interest

payment (Discount) expense Amortization Expense +
Amortization

0 108,486 8,486

1 6,000 105,740 5,740 3,255 2,745 6,000

2 6,000 102,913 2,913 3,172 2,828 6,000

©2020 All rights reserved. American University of Beirut, Suliman S. Olayan School of Business. 9
 Test Your Knowledge
ANSWER
Effective (market) interest rate = 3%  issued at premium

year Coupon PV Premium Interest Premium (Discount) Total Interest

payment (Discount) expense Amortization Expense +
Amortization

0 108,486 8,486

1 6,000 105,740 5,740 3,255 2,745 6,000

2 6,000 102,913 2,913 3,172 2,828 6,000

3 6,000 100,000 -0- 3,087 2,913 6,000

©2020 All rights reserved. American University of Beirut, Suliman S. Olayan School of Business. 10
 Test Your Knowledge
Complete the table for year 3

Effective (market) interest rate = 10%  issued at discount

year Coupon PV Premium Interest Premium Total Interest

payment (Discount) expense (Discount) Expense +
Amortization Amortization
0 90,053 (9,947)
1 6,000 93,058 (6,942) 9,005 (3,005) 6,000
2 6,000 93,364 (3,636) 9,306 (3,306) 6,000
3

©2020 All rights reserved. American University of Beirut, Suliman S. Olayan School of Business. 11
 Test Your Knowledge
ANSWER

Effective (market) interest rate = 10%  issued at discount

year Coupon PV Premium Interest Premium Total Interest

payment (Discount) expense (Discount) Expense +
Amortization Amortization
0 90,053 (9,947)
1 6,000 93,058 (6,942) 9,005 (3,005) 6,000
2 6,000 93,364 (3,636) 9,306 (3,306) 6,000
3 6,000 100,000 -0- 9,636 (3,636) 6,000

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 Accounting Treatment
Balance sheet:
- LT debt is always reported on the at present value, also known as amortized cost,
- LT debt is not reported at the face value.
- Each year, the amortization of bond discount gets added to the carrying value of the bond so that the
carrying value of the bond now reflects the updated present value.
- In case of premium, the amortization of the premium is subtracted from the bond's present value so that the
carrying value of the bond now reflects the updated present value.

Income statement:
- Reflects the interest expense and not the coupon payment.

Cash flow statement:

- The coupon payment reduces cash flow from operating activities. Fourth, the

Debt-Related Disclosures

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Analyzing Debt Financing

1. Amortized Cost versus Face Value

2. Fair value accounting
3. Future Debt retirement
4. Unutilized Credit Lines
5. Protections
6. Seniority
7. Security
8. Covenants

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LEASE FINANCING

A lease that transfers substantially all the benefits and risks of ownership is
Capital lease accounted for as an asset acquisition and a liability incurrence by the lessee.
Similarly, the lessor treats such a lease as a sale and financing transaction.

the lessee (lessor) accounts for the minimum lease payment as a rental
Operating lease expense (revenue), and no asset or liability is recognized on the balance
sheet.

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 WARNING: OFF BALANCE SHEET FINANCING!

Structuring a lease as an operating lease when, in substance, it is a capital lease  neither the leased asset nor its
corresponding liability are recorded on the balance sheet even though many of the benefits and risks of
ownership are transferred
Capital lease to the lessee. As such operating leases:

• understate liabilities by keeping lease financing of the balance sheet. Not only does this conceal liabilities
from the balance sheet, it also positively impacts solvency ratios (such as debt to equity) that are often used
Operating
in credit analysis.lease
• understate assets. This can inflate both return on investment and asset turnover ratios.
• delay recognition of expenses in comparison to capital leases. This means operating leases overstate income
in the early term of the lease but understate income late in the lease term.
• understate current liabilities by keeping the current portion of the principal payment of the balance sheet.
This inflates the current ratio and other liquidity measures.
• include interest with the lease rental (an operating expense). Consequently, operating leases understate both
operating income and interest expense. This inflates interest coverage ratios such as times interest earned.
• helps meet debt covenants and improves prospects for additional financing.

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CONTINGENCIES
Potential gains and losses whose resolution depends on one or more future events

Loss contingencies:
• potential claims on a company's resources and are known as contingent liabilities.
• arise from litigation, threat of expropriation, collectability of receivables, claims arising from product warranties or
defects, guarantees of performance, tax assessments, self-insured risks, and catastrophic losses of property.
• 2 conditions before a company records it as a loss.
• it must be probable that an asset will be impaired or a liability incurred.
• the amount of loss must be reasonably estimable.

Gain Contingencies: Consistent with conservatism in financial reporting, companies do not recognize gain contingencies in
financial statements. They can, however, disclose gain contingencies in a note if the probability of realization is high.

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TEST YOUR KNOWLEDGE

1. What are the three ways in which lenders protect themselves?

2. Answer by True or False:

All operating leases are a form of off-balance sheet financing.

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TEST YOUR KNOWLEDGE

1. What are the three ways in which lenders protect themselves?

ANSWER: Seniority, collateral, and covenants. Information in the notes to
the annual report provides details about these protections.
2. Answer by True or False:
All operating leases are a form of off-balance sheet financing.
ANSWER: FALSE

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