Many businesses buy merchandise or supplies on credit. Most also find it desirable to borrow cash from time to time to finance their activities. In this section we discuss the liabilities these borrowing activities create: namely, trade accounts and trade notes, bank loans, and commercial paper.
Current Liabilities—General Mills
Notes Payable The components of notes payable and their respective weighted average interest rates at the end of the period are as follows:
To ensure availability of funds, we maintain bank credit lines sufficient to cover our outstanding short-term borrowings. Commercial paper is a continuing source of short-term financing. We issue commercial paper in the United States, Canada, and Europe. Our commercial paper borrowings are supported by $2.9 billion of fee-paid committed credit lines, consisting of a $1.8 billion facility expiring in October 2012 and a $1.1 billion facility expiring in October 2010. We also have $401.9 million in uncommitted credit lines, which support our foreign operations. As of May 31, 2009, there were no amounts outstanding on the fee-paid committed credit lines and $134.7 million was drawn on the uncommitted lines.
In practice, there is little uniformity regarding precise captions used to describe current liabilities or in extent to which accounts are combined into summary captions. The presentation here is representative and fairly typical.
Real World Financials
Amounts reported the face of the sheet seldom are sufficient to adequately describe current liabilities. Additional descriptions are provided in disclosure notes.
Accounts Payable and Trade Notes Payable
Accounts payableobligations to suppliers of merchandise or of services purchased on open account. are obligations to suppliers of merchandise or of services purchased on open account. Most trade credit is offered on open account. This means that the only formal credit instrument is the invoice. Because the time until payment usually is short (often 30, 45, or 60 days), these liabilities typically are noninterest-bearing and are reported at their face amounts. As shown in Graphic 13-1, General Mills's accounts payable in 2009 was $803 million. The key accounting considerations relating to accounts payable are determining their existence and ensuring that they are recorded in the appropriate accounting period. You studied these issues and learned how cash discounts are handled during your study of inventories in Chapter 8.
Trade notes payable formally recognized by a written promissory note. differ from accounts payable in that they are formally recognized by a written promissory note. Often these are of a somewhat longer term than open accounts and bear interest.
Buying merchandise on account in the ordinary course of business creates accounts payable.
Short-Term Notes Payable
The most common way for a corporation to obtain temporary financing is to arrange a short-term bank loan. When a company borrows cash from a bank and signs a promissory note (essentially an IOU), the firm's liability is reported as notes payable (sometimes bank loans or short-term borrowings). About two-thirds of bank loans are short term, but because many are routinely renewed, some tend to resemble long-term debt. In fact, in some cases we report them as long-term financing (as you'll see later in the chapter).
Very often, smaller firms are unable to tap into the major sources of long-term financing to the extent necessary to provide for their capital needs. So they must rely heavily on short-term financing. Even large companies typically utilize short-term debt as a significant and indispensable component of their capital structure. One reason is that short-term funds usually offer lower interest rates than long-term debt. Perhaps most importantly, corporations desire flexibility. As a rule, managers want as many financing alternatives as possible.
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CREDIT LINES. Usually short-term bank loans are arranged under an existing line of credit allows a company to borrow cash without having to follow formal loan procedures and paperwork. with a bank or group of banks. These can be noncommitted or committed lines of credit. A noncommitted line of credit is an informal agreement that permits a company to borrow up to a prearranged limit without having to follow formal loan procedures and paperwork. Banks sometimes require the company to maintain a compensating balance on deposit with the bank, say, 5% of the line of credit.7 A committed line of credit is a more formal agreement that usually requires the firm to pay a commitment fee to the bank. A typical annual commitment fee is ¼% of the total committed funds, and may also require a compensating balance. A recent annual report of IBM Corporation illustrates a combination of committed and noncommitted lines of credit (Graphic 13-2).
A line of credit allows a company to borrow cash without having to follow formal loan procedures and paperwork.
Disclosure of Credit Lines—IBM Corporation
Real World Financials
K. Borrowings (in part)
LINES OF CREDIT: The company maintains a five-year, $10 billion Credit Agreement, which expires on June 28, 2012. The company’s other lines of credit, most of which are uncommitted, totaled approximately $11,031 million and $9,992 million at December 31, 2008, and 2007, respectively. Interest rates and other terms of borrowing under these lines of credit vary from country to country, depending on local market conditions.
General Mills' disclosure notes that we looked at in Graphic 13-1 indicate that the company has both noncommitted and committed lines of credit.
INTEREST. When a company borrows money, it pays the lender interest “rent” paid for the use of money for some period of time. in return for using the lender's money during the term of the loan. You might think of the interest as the “rent” paid for using money. Interest is stated in terms of a percentage rate to be applied to the face amount of the loan. Because the stated rate typically is an annual rate, when calculating interest for a short-term note we must adjust for the fraction of the annual period the loan spans. Interest on notes is calculated as:
This is demonstrated in Illustration 13-1.
Note Issued for Cash
Interest on notes is calculated as:
On May 1, Affiliated Technologies, Inc., a consumer electronics firm borrowed $700,000 cash from First BancCorp under a noncommitted short-term line of credit arrangement and issued a six-month, 12% promissory note. Interest was payable at maturity.
Sometimes a bank loan assumes the form of a so-called noninterest-bearing note notes that bear interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset.. Obviously, though, no bank will lend money without interest. Noninterest-bearing loans actually do bear interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset. For example, the preceding note could be packaged as a $700,000 noninterest-bearing note, with a 12% discount rate. In that case, the $42,000 interest would be discounted at the outset, rather than explicitly stated:8
The proceeds of the note are reduced by the interest in a noninterest-bearing note.
Notice that the amount borrowed under this arrangement is only $658,000, but the interest is calculated as the discount rate times the $700,000 face amount. This causes the effective interest rate to be higher than the 12% stated rate:
When interest is discounted from the face amount of a note, the effective interest rate is higher than the stated discount rate.
We studied short-term notes from the perspective of the lender (note receivable) in Chapter 7.
SECURED LOANS. Sometimes short-term loans are secured, meaning a specified asset of the borrower is pledged as collateral or security for the loan. Although many kinds of assets can be pledged, the secured loans most frequently encountered in practice are secured by inventory or accounts receivable. For example, Collins Industries, Inc., which sells vehicle chassis to major vehicle manufacturers, disclosed the secured notes described Graphic 13-3.
Disclosure of Notes Secured by Inventory—Collins Industries, Inc.
Real World Financials
Note 4: Chassis Floorplan Notes Payable (in part)
Chassis floorplan notes are payable to a financing subsidiary of a chassis manufacturer. These notes are secured by the related chassis and are payable upon the earlier of the date the Company sells the chassis or 180 days from the date of the note.
When accounts receivable serve as collateral, we refer to the arrangement as pledging accounts receivable. Sometimes, the receivables actually are sold outright to a finance company as a means of short-term financing. This is called factoring receivables.9
Some large corporations obtain temporary financing by issuing commercial paper unsecured notes sold in minimum denominations of $25,000 with maturities ranging from 30 to 270 days., often purchased by other companies as a short-term investment. Commercial paper refers to unsecured notes sold in minimum denominations of $25,000 with maturities ranging from 30 to 270 days (beyond 270 days the firm would be required to file a registration statement with the SEC). Interest often is discounted at the issuance of the note. Usually commercial paper is issued directly to the buyer (lender) and is backed by a line of credit with a bank. This allows the interest rate to be lower than in a bank loan. Commercial paper has become an increasingly popular way for large companies to raise funds, the total amount having expanded over fivefold in the last decade. In fact, large companies have become so dependent on obtaining financing through the commercial paper market that a freeze-up of that market contributed to a global economic crisis in 2008.10
Large, highly rated firms sometimes sell commercial paper to borrow funds at a lower rate than through a bank loan.
A disclosure note in the March 31, 2009, 10Q of GMAC Financial Services describes the challenges it was facing from a combination of a tight commercial paper market and a poor credit rating, as shown in Graphic 13-4.
Disclosure of Commercial Paper Backed by a Line of Credit—GMAC Financial Services.
Real World Financials
12. Short-Term Debt (in part)
We obtain short-term funding from the sale of floating-rate demand notes under our Demand Notes program. These notes can be redeemed at any time at the option of the holder without restriction. Our domestic and international unsecured and secured commercial paper programs also provide short-term funding, as do short-term bank loans. Renewing our short-term debt maturities, particularly unsecured debt, including Demand Notes, continues to be challenging due to the heightened credit market turmoil and our credit-rating profile.
The name commercial paper refers to the fact that a paper certificate traditionally is issued to the lender to signify the obligation, although there is a trend toward total computerization of paper sold directly to the lender so that no paper is created. Since commercial paper is a form of notes payable, recording its issuance and payment is exactly the same as our earlier illustration.
In a statement of cash flows, the cash a company receives from using short-term notes to borrow funds as well as the cash it uses to repay the notes are reported among cash flows from financing activities. Most of the other liabilities we study in this chapter, such as accounts payable, interest payable, and bonuses payable, are integrally related to a company's primary operations and thus are part of operating activities. We discuss long-term notes in the next chapter.
7A compensating balance is a deposit kept by a company in a low-interest or noninterest-bearing account at the bank. The required deposit usually is some percentage of the committed amount or the amount used (say, 2% to 5%). The effect of the compensating balance is to increase the borrower's effective interest rate and the bank's effective rate of return.
8Be sure to understand that we are actually recording the note at 658,000, not $700,000, but are recording the interest portion separately in a contra-liability account, discount on notes payable. The entries shown reflect the gross method. By the net method, the interest component is netted against the face amount of the note as follows:
9Both methods of accounts receivable financing are discussed in , “Cash and Receivables.”
10Alan Greenspan, “Finance and Economics: Banks Need More Capital,” The Economist, December 20, 2008, p. 122.