Nature of Fixed Liabilities
Fixed liabilities, called also capital, bonded, long-term, and funded liabilities or debts, comprise all debts of which the date of maturity is some distance ahead and considerably longer than that of current liabilities. Government regulating boards, for purposes of standardization, may set a minimum life-period for this group of liabilities and any kind of debt falling within the period is so classified. Thus, the Public Service Commission for the First District of the State of New York says: “Funded debt comprises all debt which by the terms of its creation does not mature until more than one year after date of creation.” Private undertakings do not need such exact uniformity. Any debt the maturity of which extends beyond the period adopted within that business for current liabilities will usually be grouped with the fixed liabilities, there seldom being an intermediate group.
Purpose of Fixed Liabilities
Fixed liabilities, as distinguished from current, are those issued distinctively for the purpose of raising capital. Due to insufficient original capitalization, funds may be needed for one or more of many purposes. Working capital may be required; extensions of plant and market may be desirable; additional equipment and improvement within the plant itself may be advisable; the control of the plant of a competitor may prove advantageous; it may be deemed wise to fund floating liabilities; the refunding of liabilities soon to mature may become necessary; the financial policy may dictate the unification of several diverse forms of debt—these and other purposes may be served by the assumption of long-term debts.
Corporation Bonds
The most common type of fixed liability is the bond. As an instrument of credit the bond is limited almost exclusively to corporations. The purchasing public, interested in securities of this kind, looks with suspicion on a long-term promise to pay issued by either a single proprietor or by a partnership. Such businesses are almost wholly dependent on the health and ability of individual owners. During a long period of years so many contingencies may arise and seriously cripple the business that the long-term debts of a partnership or sole ownership have no market, although isolated instances of such issues exist. The corporation, however, has continuity of life, is not so dependent on individuals, and therefore has avenues for the raising of funds open to it which are closed to other types of organization.
Nature of Bonds
A bond may be defined as an instrument under seal promising to pay a certain amount of money at a definite or determinable future time. From a legal standpoint, a bond is a contract setting forth the terms and conditions under which the obligation is assumed. Furthermore, it is a negotiable contract transferable from hand to hand, though in some cases registration is necessary to prove ownership in the eyes of the issuing corporation. From a financial standpoint, a bond is essentially a long-term promissory note. Bonds, as here used, are to be distinguished from the old real estate bond and mortgage. Bonds are usually secured by a lien on some definite property or prospect of property, just as the real estate bond and mortgage. The corporation bond, however, is a separate instrument, divisible into small parts, whereas the bond and mortgage is not usually an instrument of that type.
Corporation bonds are also to be distinguished from the surety bonds mentioned in the preceding chapter. These latter, as already noted, are instruments whereby individuals, firms, or corporations bind themselves as guarantors for the conduct of others or for the payment of sums of money for which the guarantor is not directly liable.
Difference between Bond and Real Estate Mortgages
With regard to the mortgage covering the bond issue, points of difference from the ordinary real estate mortgage are to be noted. To the ordinary mortgage there are two parties, viz., the party obligated and the party accommodated, the obligor and obligee. To the bond mortgage, the obligee is a trustee standing in the stead of the numerous bondholders who could not conveniently act individually. In this trustee the title to the property liened is vested for the benefit of the bondholders. The mortgage instrument itself is often a model of completeness and comprehensiveness, defining with minute care the relations, duties, rights, interests, and status of the issuing corporation, the bondholders, and the trustee under present circumstances and all possible future contingencies.
Kinds of Corporation Bonds
Since bonds were first issued, perhaps one hundred different kinds have been placed on the market. They all have the same fundamental characteristics but differ in minor particulars. No universally recognized basis exists for their classification, nor is such a basis possible, the use which they are to serve determining always the basis of analysis into classes. Thus, in the opinion of a leading authority[50] on the subject bonds may be classified under the following heads, according to:
The issuing corporation often distinguishes its bonds by means of some descriptive adjectives purporting to classify them or indicate their nature. Thus, consolidated first and improvement, general and refunding mortgage, first mortgage extension, general lien railway and land grant, are titles sometimes met, though a simpler title carrying also the interest rate is more common, as general mortgage 4’s of 1965, C. & A. 5’s, Toledo Light & Power 4’s, etc. As listed on the exchange the title usually gives the name of the issuing corporation (i.e., the obligor), the distinctive name of the bond, and its interest rate.
Bonds rank very much as mortgages do in the priority of their liens. A first mortgage bond has a first lien on the property securing it; a second mortgage bond has a second lien and its claim is said to be junior to that of the first. No attempt can here be made to explain the distinguishing features of the above-named issues. Attention is called to them only because the reader of a balance sheet—an investor or prospective creditor—often must have a knowledge of the various classes of bonds and a detailed knowledge of the conditions of particular issues. It is obvious that the accountant should have a knowledge of the particular issues of a business in order intelligently to draw up a balance sheet and make a report thereon.
Authority for the Issue of Bonds
A corporation has generally a charter right to issue bonds for the purpose of securing money, acquiring property, or in payment for labor or financial services rendered. The exercise of this right may be curtailed by, or be dependent upon, authority from a regulating body. Within the corporation itself, the right to issue vests in the stockholders. In some cases a majority vote suffices; in others as many as three-quarters of the votes may be required to authorize the issue. The directors themselves may, upon proper authorization from the stockholders, make the actual issue, and usually the initiative for a bond issue comes from them because they have intimate knowledge of the business and its needs.
Financial Considerations Involved in Issue
Financial considerations involved in the determination to issue bonds may be reviewed briefly. It is interesting to note that the bond has been used very extensively as a means of securing capital. There is, however, no necessary relationship between the amount of capital raised by stock issues and that raised by bond issues. The sale of additional stock or of bonds or other similar securities is the main source of corporation funds for capital purposes. Some concerns have obtained approximately one-half of their capital through the issue of bonds. Percentages of capital so raised ranging from 15% to 40% are not uncommon.
The manner of raising capital is largely a matter of credit, expediency, and the question of fixed operating expenses. It rarely happens that bonds carry with them the privilege of voice in the management of the corporation’s affairs; that is usually limited strictly to the shareholders. Accordingly, the issue of bonds instead of additional stock does not interfere with the management or control of the concern—so long as the contract requirements of the bond issue are adhered to.
Because of the definiteness of the income on bonds and usually the greater security of the principal, bonds may often find a market where stocks would not. On the other hand, if the stock can be marketed as advantageously as the bonds, no definite dividend rate is necessarily attached to them. The price at which stocks may be marketed, aside from the features of extra inducement which might influence the market, depends largely upon the prospective income rate judged mostly by what the company has been able to do in the past and any features of present condition or expected future condition which might influence the earning capacity of the corporation. Therefore, unless a dividend rate a little higher than the current interest rate is in prospect, the company usually finds it difficult to market its stock advantageously.
Bonds versus Stock Issues
The bond market furnishes opportunity for investment to quite a different class of people from those interested in stocks. Security, conservatism, and a definite income are the main elements desired. Thus conditions may oftentimes be such that one market or another may be more favorable for absorbing an issue of securities, dependent on conditions in that market as much as on the credit and standing of the issuing corporation.
Aside from these points which are usually given consideration, is the question of how heavy are the fixed charges the corporation can carry. While from the investor’s viewpoint an income at a fixed rate is highly desirable, from the corporation’s point of view it may impose so great a burden as to eat up all the profits. The bond interest constitutes a fixed charge deductible before the determination of profits. In case of failure to meet the bond interest, the mortgage covering the bonds is subject to foreclosure. Upon foreclosure at forced sale values always shrink greatly, oftentimes the shareholders lose their entire interest in the company, and all the net assets may be taken to satisfy the claims of the bondholders. As compared with an additional issue of stock—common or preference shares, as may best meet the situation—a bond issue may thus be of doubtful value. One of the knotty problems upon a reorganization following insolvency is that of lowering the fixed charges by converting some of the bond issues into preferred stocks in order to prevent the recurrence of operation at a loss and so of inability to meet bond interest.
Accounting for Bond Issue
Accounting for the bond issue presents much the same problems as those connected with an issue of stock. Inasmuch as most corporation issues are sold in block to a banker who in turn markets them to the investing public, often through a syndicate (or the process may be one of under-writing), there is usually no need for detailed subscription records and accounts. In the case of coupon bonds no record of individual ownership is required because the bonds pass by delivery, possession evidencing ownership and the interest coupon being payable to bearer. In the case of registered bonds, a record of individual holdings must be kept similar to the record of stockholders. The party in whose name the bond is registered on the company’s records is the prima facie owner to whom the periodic interest check is also sent. If the bond is registered as to principal but bears coupons for the interest, records of individual ownership are also required here.
Entry of Issue on Books
Placing the bond issue on the books is accomplished by either of two methods. Assuming an issue of $500,000 of first mortgage 5% bonds of which $350,000 are sold at par for cash, the balance remaining unissued for the present, the entries would be:
First Method
| (1) Unissued First Mortgage Bonds | $500,000.00 | |
| First Mortgage Bonds Payable | $500,000.00 | |
| (2) Cash | 350,000.00 | |
| Unissued First Mortgage Bonds | 350,000.00 | |
Entry (1) is used to make a memorandum entry of the authorized issue. Entry (2) shows the amount sold for cash. The balance in the Unissued Bond account is treated as an offset to the Bonds Payable account. Sometimes the title “Treasury Bonds” is used instead of “Unissued,” but the term is apt to be misleading because of the restricted meaning given the word in connection with treasury stock.
Second Method
| (3) Cash | $350,000.00 | |
| First Mortgage Bonds Payable | $350,000.00 |
Under the second method, the desired information as to authorized issue would be carried parenthetically in the account title. At the present time the tendency is to deprecate an unnecessary multiplication of accounts as is brought about through the use of memorandum accounts. The second method is therefore the preferred method and in its operation brings onto the books the same information as the first method.
Entry of Premium or Discount on Books
Bringing the bond premium or discount onto the books is accomplished in the same manner as for stock. Thus, using the above data and assuming $100,000 of the bonds sold at 101 and the remaining $50,000 at 99¾, the entries would be, illustrating only the second method:
| (4) Cash | $101,000.00 | |
| First Mortgage Bonds Payable | $100,000.00 | |
| (5) Cash | 99,750.00 | |
| Discount on First Mortgage Bonds Payable | 250.00 | |
| First Mortgage Bonds Payable | 100,000.00 | |
Subsequent handling of the premium and discount accounts will be shown on page 368.
Bonds may be issued for cash or property, as in the case of stock. Unless there is evidence to the contrary, when bonds are issued for property they are brought onto the books at par value, the courts holding here as with stock that the parties to the transaction (usually the corporation’s directors) are in a better position to judge the value of the property taken over than anyone else. This oftentimes results in an inflation of property values—an injection of water—and should not be countenanced where a true basis for determining the value of the bond is offered. Thus, if almost simultaneously with the issue of the bonds for property, some are sold for cash, the cash price received would usually be a fair basis for booking the premium or discount on those issued for property. The sale for cash must be a bona fide sale in the open market if it is to represent the market’s judgment of the offering. Sometimes an objection is raised to a Bond Discount account appearing on the books; hence the practice, wherever possible, of charging the discount against some asset account as a part of the cost of that asset. When the true nature of bond discount or premium in its relation to the periodic interest charge is appreciated, the objection has no weight.
Entry of Interest Payments on Books
Booking the payment of the periodic interest is accomplished by a charge to Bond Interest and a credit to Cash. This interest should never be entered in the regular Interest and Discount account. If the bonds are coupon bonds with the coupons redeemable through a designated trust company, a check for the full amount of the interest on the outstanding bonds should be issued and booked as above. If the coupons are redeemable at the company’s office, an entry debiting Bond Interest and crediting Coupons Payable should be made, to record the interest charge and the liability therefor. As the coupons are redeemed, Coupons Payable is charged and Cash credited, any balance remaining in Coupons Payable account representing the liability existing because of coupons not yet presented for redemption. In the case of bonds registered both as to principal and interest, the interest checks made payable to the registered parties constitute a charge to Bond Interest and a credit to Cash. It is sometimes advisable to transfer by one check the total bond interest payable to a special bank account and issue the individual interest checks against this fund. Whenever the books are closed it is always necessary, unless the end of the fiscal period coincides with the bond interest date, to take account of the accrued bond interest as on that date. The adjusting entry here is similar to that for any accrued expense.
Relation of Bond Interest to Premium or Discount
The main problem in connection with accounting for bond interest is that of the relation between bond premium or discount and the periodic bond interest. At practically any time in the market there is a rate at which the bonds could be sold at par. This rate is known as the effective rate. If a company puts an issue of bonds on the market at a higher rate than this, the market will offer a premium for them. The amount of the premium will be, theoretically, the present value of the periodic sum represented by the difference between the stated bond interest and the effective interest, these periodic payments extending over the life of the bond. In other words, the premium represents the price paid to buy the additional interest, dollar for dollar, on a compound interest basis. The premium is therefore not an earning, an item of income, but is an offset to the excess bond interest. The portion of it applicable to each period represents the excess interest which deducted from the bond interest shows the real or effective cost of the money borrowed and to be paid back. Thus, the bond interest rate based on the money actually received, i.e., par plus premium, is exactly the same as the market or effective rate on par. In other words, the corporation is paying for its actual borrowings simply the current market rate of interest.
It is therefore incorrect to show on the books the cost of the loan at any other figure than the effective interest. The actual periodic payment of interest is, however, at the bond interest rate. This must be brought down to the effective rate by application to it of a portion of the premium which represents the sum paid for the privilege of receiving the higher rate of interest. Similarly, bonds are marketed at a discount when the bond interest rate is lower than the market rate prevailing on similar security at the time the bonds are floated. This may be looked upon as a payment by the company in lump sum to compensate a purchaser for the difference in the income on the bond and what he might obtain on the open market. The discount should be applied, therefore, periodically to bring the cost of the loan up to its true figure, viz., the market or effective rate. An illustration will clarify the points of the above discussion.
Example of True Interest Cost
Assume a 7% bond, interest every six months, payable in 25 years (50 periods), par $1,000, sold in a market whose prevailing interest rate is 6%. By the method developed on page 273, the value of such a bond is found to be $1,128.6488, the premium being $128.6488. At the effective rate the real cost to the issuing company is 3% on $1,128.6488, or $33.8595. The actual sum paid as interest is $35, i.e., 3½% on $1,000. The difference between the effective and actual bond interest, or $1.1405, is the portion of the premium to be used that period in order to reduce the amount of actual interest paid to the real or effective cost of the loan. The bookkeeping entries are:
| (6) Bond Interest | $35.00 | |
| Cash | $35.00 | |
| (7) Premium on Bonds | 1.14 | |
| Bond Interest | 1.14 | |
Similar calculations and entries for each of the succeeding 49 periods would be made, the application of the effective rate always being, of course, to the amortized value of the bond as on that date. This process is called scientific amortization of the premium (or discount) of the bond. Its effect is readily seen to be to spread over the life of the bond the premium (or discount) and so not to take credit for it in a lump sum during the period in which the bond is matured. There are four cases to which this principle of showing the true interest cost is applicable, as follows:
At the close of a fiscal period which does not coincide with the bond interest period, not only must the bond interest accrued to date be shown as an accrued expense, but also there must be so shown the portion of the premium (or discount) accrued to that date required to bring the bond interest cost down to the effective basis.
Presentation on Balance Sheet
The final problem in connection with bonds concerns the manner of their showing on the balance sheet. That has perhaps been sufficiently indicated. The amount of the authorized issue should be short-extended, and the amount unissued subtracted therefrom with the net amount outstanding full-extended as the significant figure in the balance sheet.
Other Fixed Liabilities
Real Estate Mortgages. Another item among the fixed liabilities is the simple real estate mortgage. This is usually called a bond and mortgage, the bond being simply the promise to pay and the mortgage being the security for the amount of money borrowed. In some states the more formal document called the bond is used as a contract according to which a named sum is to be paid in case the amount borrowed on the mortgage is not paid. This named sum is usually the amount borrowed, although in some states it is twice this amount. In booking a note or bond supported by a mortgage, the customary title is “Mortgage Payable” rather than “Notes Payable” which is generally understood to be applicable in the main to current liabilities. In case the double amount is named in the bond, it is not customary to take cognizance of the contingent liability thereunder.
Loans on Collateral. Short-time loans are frequently made on collateral security. Stocks and bonds, particularly of the borrowing company or its subsidiaries, may also be made the basis of a long-time loan. This may take the form of a bond issue, promissory notes, or other similar obligations. Accounting for the loan and its showing on the balance sheet follow the principles already laid down. The title of the loan account should carry the word “Collateral” or other similar term to show its nature. Accounting for the collateral is usually accomplished by a memorandum in the stocks, bonds, or investments account to show exactly what securities have been withdrawn for deposit as collateral. No further record is needed other than a complete list of such securities; the securities are still owned by the company, though deposited under a conditional contract with someone else. If the loan is dishonored at maturity and the securities are sold in satisfaction thereof, the necessary entries must be made to show the sale of the securities, the profit or loss attendant thereupon, and the repayment of the loan. In showing the pledged securities on the balance sheet, it is well to present the securities in two groups or classes, viz., those pledged as collateral for the loan shown contra and those not so pledged.
Short-Term Securities. When the market is not favorable to the issue of long-term securities, because of the high rate of return demanded by investors, corporations often have recourse in their borrowings to short-term securities—usually note issues with maturities ranging from one to five years, two- and three-year terms being the commonest. The financial consideration in their issue is merely a speculation that by the time of their maturity the market will be more favorable for the flotation of long-term securities. Thus the company hopes at the maturity of the notes to free itself from the need of paying so high an interest rate as it is required to pay now for the short-term securities. These notes may be in different denominations and are accounted for just as other notes. On the balance sheet they are grouped with the fixed liabilities until within a short time of maturity, when they must be shown with the other current items.