Accounting Principles – Capital Liabilities

This term is used to denote that class of liabilities incurred in connection with the acquisition of funds for capital purposes. Emphasis is to be placed upon the word liabilities. Capital invested by the proprietor as represented by the proprietor’s capital account or by capital stock is not included in this class.

Capital invested is to be considered as an accountability rather than a liability. Capital liabilities usually take the form of bonds, debentures, long-term notes or the so-called bonds and mortgages.

It is a difficult matter to define a bond in such manner that it will be distinctive. There are, however, some common grounds on which all can agree as to the definition of a bond. It is an instrument containing a promise to pay a definite sum of money at a time which is fixed or determinable, with interest at a given rate. When this has been said a bond has been defined. The definition does not differentiate it, however, from every other class of instruments. An attempt to differentiate it results in an academic discussion.
For practical purposes a bond seems to have been sufficiently described. A discussion, however, of the theoretical phase of the subject brings out some very interesting facts in connection with bonds. There appears offhand to be some distinguishing features to bonds. One of these is that a bond is secured by a mortgage on certain property. If we accept this -as conclusive someone raises the question as to whether or not collateral notes are secured by a mortgage on certain property. If we attempt to say that the interest on bonds is payable at a fixed rate per annum we are confronted with the fact that in the case of income bonds the interest is only paid when earned. Some authors give as the distinguishing feature of a bond the fact that it is issued as a part of a series of like tenor and amount and in most cases under a common security. The flaw which can be picked in this distinction is that collateral notes meet this requirement. The point of formality is sometimes introduced to distinguish a bond from a note. It is said, for example, that a bond is more formai than a note and in its common law form resemble* a deed through seal and witnesses. These facts are all true of collateral notes.

From the above the difficulties which surround the task of defining a bond will be apparent and no impregnable definition seems possible. A happy solution of the academic question may possibly exist in saying of a bond that it is an instrument containing a promise to pay a definite sum of money at a future time which is fixed or determinable with interest and when so referred to within, or upon the face of, the instrument. From a practical standpoint it is really of more importance to be familiar with the effect of the bond upon the financial condition of a concern and the treatment of the ramification of bonds in the form of interest, than with determining just what it is.

In considering the relation of the capital liabilities to the financial condition the principal point of interest is whether such liabilities are, or are not, secured. It matters little whether the obligation is called a bond, a collateral note or a collateral trust certificate if the obligation is secured by a mortgage upon certain assets of the organization. It is important to distinguish between liabilities which are secured and those which are unsecured, the latter being represented by such instruments as debentures and income bonds.

A debenture is a long-term note. It is similar to a bond in every respect, except as to the matter of security. A debenture is unsecured. It would seem incongruous to use the term debenture bond. Doubtless no one will dispute that a bond is secured and while the definition of a bond was controverted because of the fact that other instruments were secured it does not seem proper to include under bonds an instrument which is unsecured. A debenture may be defined as an unsecured instrument which contains a promise to pay a definite sum of money at a time which is fixed or determinable with interest and when so referred to within, or upon the face of, the instrument.

Concerning income bonds it may be said that they are usually unsecured. They sometimes acquire mortgage rights if the interest is unpaid and are sometimes secured in a way by the pledging of net earnings after interest on prior claims has been met. The vital point regarding income bonds is that the interest is not paid unless earned. The determination of this earning is largely in the hands of the directors and on account of the contingency connected with the payment of interest they are not a very desirable class of instrument to offer to the public for the purpose of obtaining funds.

Bonds, long-term notes, debentures, income bonds, etc., have to be considered with regard to the order in which they rank. Bonds and secured notes will at all times take preference over debentures and income bonds. Bonds considered separately will rank in accordance with the priority of the mortgage which accompanies them.

One thing is true of all instruments, regardless of whether they are secured or unsecured. It is possible for all, although not probable in some cases, for them to be sold or disposed of either at a premium or at a discount. The accountant is concerned with the disposition of such premium or discount and as usual two methods of handling such items are available.

Taking up first the case of a bond or other instrument sold at a discount, three questions may be asked: first, “Shall the discount be charged immediately to profit and loss?”; second, “Shall the discount be charged annually direct to profit and loss ?”; and third, “Shall it be treated as addition to interest paid annually on bonds and charged to such interest account?” Very few concerns probably would charge such an item immediately to profit and loss. It is thought that most accountants would favor spreading the discount over the life of the bond. If this point may be considered as having been settled, then the question remains, “Shall the discount when it is written off annually be charged to the interest account which will subsequently be closed out to profit and loss, or charged direct to profit and loss?” It is quite true that the ultimate result would be the same in both cases. There is then a further question, “What is to be accomplished by first charging the amount written off each year to the interest account?” It can be answered by saying that in so doing you show the actual expenses in one place of using the money acquired through the bonds.

A $1,000 bond payable 20 years hence bearing interest at 6% and sold at 98 would necessitate the setting up of a discount account with a debit of $20. When the bond was sold the entry covering the transaction would show two charges, one of $980 to cash and one of $20 to discount. These entries would be offset by a credit to bonds payable. The interest on this bond for one year would be $60. Among the nominal accounts there would appear one for interest on bonds payable. This account prior to closing would show a debit balance of $60. The accounts would ultimately be closed out to profit and loss. In closing the accounts for the year some cognizance must be taken of the account for discount, showing a debit balance of $20. If this account is written off direct to profit and loss annually, it will practically ignore the fact that the maker of the bond has paid $61 for the use of the money rather than $60. Discounting the bond is not at all different from discounting any note, except that by the terms of most bonds the interest runs with the bond. Discount has the effect of increasing the interest paid. It is in connection with instances of this kind that we hear of bonds being bought at 98 to yield 6.1%. The man who buys a bond at 98 receives not only 6% computed on the face of the bond, but in addition $20 which will be paid to him at maturity.

After the foregoing discussion it would seem best in charging off discount to charge it to the interest account and thus make such account show the true expenses of the borrowed capital. The accounting procedure would be somewhat similar except reversed as to actual operations where bonds are sold above par or at a premium. In this case the bonds might be sold at 102, meaning that in each instance the maker of the bond would receive $20 more than he would have to pay at maturity. The premium has the effect of decreasing the yield on a bond and therefore a corresponding effect upon the expenses of securing funds. For this reason it would seem desirable to follow the same practice indicated in the case of discount, namely, to credit the premium on bonds sold to an account so designated and amortize the premium by entries, annually or oftener, extending over the life of the bond. Thus the amount, whatever it may be, will be charged to the premium account and credited to the account called interest on bonds payable.

There is still to be considered in connection with bonds the manner of treating the interest. If the books were run on a cash basis we should expect to find the interest on bonds and similar instruments charged to the interest account for such instruments at the time it was paid and credited to cash. It is not probable that a concern sufficiently large to have outstanding bonds would make use of the cash basis. In fact it is perhaps this very matter oftener than any other which makes a concern realize the importance and necessity of running their books on the accrual basis. When in connection with a bond we see the expression January 1st and July 1st, it means that such dates are the dates on which the interest is due and payable. The use of such expression should never convey the idea that the interest is not to be booked until paid. Regardless of the date of payment the interest continues to accrue and even though not payable until January 1st there would be in the case of interest payable January 1st and July 1st, six months’ interest accrued at the close of the business on December 31st. The correct way of treating interest is to accrue it in accordance with the time elapsed, thereby charging the expense account for interest and crediting the liability for the interest accrued. A distinction is sometimes made in the balance sheet as between interest accrued and due and interest accrued not due, for the reason that such a distinction renders a balance sheet more comprehensive and useful in attempting to base administrative judgment thereon. It seems scarcely necessary to say in discussing the question of accruals that having charged interest and credited interest accrued, when the interest is paid, charge is made against the interest accrued account.

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