Edited, memorised or added to reading list

on 14-Mar-2016 (Mon)

Do you want BuboFlash to help you learning these things? Click here to log in or create user.

lol
#lol
Empresas como Katcon, proveedora de sistemas de escape de gases de motor y vinculadas a dos secretarios de Jaime Rodríguez 'El Bronco', gobernador de Nuevo León, se beneficiaron de negocios derivados de la llegada de
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Fixed income Learning outcomes
#fixed #income

LEARNING OUTCOMES

The candidate should be able to:

  1. describe basic features of a fixed-income security;

  2. describe content of a bond indenture;

  3. compare affirmative and negative covenants and identify examples of each;

  4. describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities;

  5. describe how cash flows of fixed-income securities are structured;

  6. describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and identify whether such provisions benefit the borrower or the lender.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Basic features of a bond
#fixed #income

2.1. Basic Features of a Bond

All bonds, whether they are “traditional” bonds or asset-backed securities, are characterized by the same basic features. Asset-backed securities (ABS) are created from a process called securitization, which involves moving assets from the owner of the assets into a special legal entity. This special legal entity then uses the securitized assets as guarantees to back (secure) a bond issue, leading to the creation of ABS. Assets that are typically used to create ABS include residential and commercial mortgage loans (mortgages), automobile (auto) loans, student loans, bank loans, and credit card debt, among others. Many elements discussed in this reading apply to both traditional bonds and ABS. Considerations specific to ABS are discussed in the introduction to asset-backed securities reading

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Bond issuers
#fixed #income

Bond issuers are classified into categories based on the similarities of these issuers and their characteristics. Major types of issuers include the following:

  • Supranational organizations, such as the World Bank or the European Investment Bank;

  • Sovereign (national) governments, such as the United States or Japan;

  • Non-sovereign (local) governments, such as the state of Minnesota in the United States, the region of Catalonia in Spain, or the city of Edmonton in Canada;

  • Quasi-government entities (i.e., agencies that are owned or sponsored by governments), such as postal services in many countries—for example, Correios in Brazil, La Poste in France, or Pos in Indonesia;

  • Companies (i.e., corporate issuers). A distinction is often made between financial issuers (e.g., banks and insurance companies) and non-financial issuers; and

  • Special legal entities that securitize assets to create ABS that are then sold to investors.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Bond issuers classes
#fixed #income
Market participants often classify fixed-income markets by the type of issuer, which leads to the identification of three bond market sectors: the government and government-related sector (i.e., the first four types of issuers listed above), the corporate sector (the fifth type listed above), and the structured finance sector (the last type listed above).
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Bonds risk
#fixed #income
Bondholders are exposed to credit risk—that is, the risk of loss resulting from the issuer failing to make full and timely payments of interest and/or repayments of principal. Credit risk is inherent to all debt investments. Bond markets are sometimes classified into sectors based on the issuer’s creditworthiness as judged by credit rating agencies. One major distinction is between investment-grade and non-investment-grade bonds, also called high-yield or speculative bonds.2 Although a variety of considerations enter into distinguishing the two sectors, the promised payments of investment-grade bonds are perceived as less risky than those of non-investment-grade bonds because of profitability and liquidity considerations. Some regulated financial intermediaries, such as banks and life insurance companies, may face explicit or implicit limitations of holdings of non-investment-grade bonds. The investment policy statements of some investors may also include constraints or limits on such holdings. From the issuer’s perspective, an investment-grade credit rating generally allows easier access to bond markets and at lower interest rates than does a non-investment-grade credit rating.3
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Bonds Maturity
#fixed #income

2.1.2. Maturity

The maturity date of a bond refers to the date when the issuer is obligated to redeem the bond by paying the outstanding principal amount. The tenor is the time remaining until the bond’s maturity date. The tenor is an important consideration in the analysis of a bond. It indicates the period over which the bondholder can expect to receive the interest payments and the length of time until the principal is repaid in full.

Maturities typically range from overnight to 30 years or longer. Fixed-income securities with maturities at issuance (original maturity) of one year or less are known as money market securities. Issuers of money market securities include governments and companies. Commercial paper and certificates of deposit are examples of money market securities. Fixed-income securities with original maturities that are longer than one year are called capital market securities. Although very rare, perpetual bonds, such as the consols issued by the sovereign government in the United Kingdom, have no stated maturity date.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Par value
#fixed #income

2.1.3. Par Value

The principal amount, principal value, or simply principal of a bond is the amount that the issuer agrees to repay the bondholders on the maturity date. This amount is also referred to as the par value, or simply par, face value, nominal value, redemption value, or maturity value. Bonds can have any par value.

In practice, bond prices are quoted as a percentage of their par value. For example, assume that a bond’s par value is $1,000. A quote of 95 means that the bond price is $950 (95% × $1,000). When the bond is priced at 100% of par, the bond is said to be trading at par. If the bond’s price is below 100% of par, such as in the previous example, the bond is trading at a discount. Alternatively, if the bond’s price is above 100% of par, the bond is trading at a premium

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




2.1.4. Coupon Rate and Frequency
#fixed #income

The coupon rate or nominal rate of a bond is the interest rate that the issuer agrees to pay each year until the maturity date. The annual amount of interest payments made is called the coupon. A bond’s coupon is determined by multiplying its coupon rate by its par value. For example, a bond with a coupon rate of 6% and a par value of $1,000 will pay annual interest of $60 (6% × $1,000).

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




2.1.4. Coupon Rate and Frequency
#fixed #income
Coupon payments may be made annually, such as those for German government bonds or Bunds. Many bonds, such as government and corporate bonds issued in the United States or government gilts issued in the United Kingdom, pay interest semi-annually. Some bonds make quarterly or monthly interest payments. The acronyms QUIBS (quarterly interest bonds) and QUIDS (quarterly income debt securities) are used by Morgan Stanley and Goldman Sachs, respectively, for bonds that make quarterly interest payments. Many mortgage-backed securities (MBS), which are ABS backed by residential or commercial mortgages, pay interest monthly to match the cash flows of the mortgages backing these MBS.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




coupon rates
#fixed #income
A plain vanilla bond or conventional bond pays a fixed rate of interest. In this case, the coupon payment does not change during the bond’s life. However, there are bonds that pay a floating rate of interest; such bonds are called floating-rate notes (FRNs) or floaters. The coupon rate of a FRN includes two components: a reference rate plus a spread. The spread, also called margin, is typically constant and expressed in basis points (bps). The spread is set when the bond is issued based on the issuer’s creditworthiness at issuance: The higher the issuer’s credit quality, the lower the spread. The reference rate, however, resets periodically. Thus, as the reference rate changes, the coupon rate and coupon payment change accordingly
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




reference rates
#fixed #income
A widely used reference rate is the London interbank offered rate (Libor). Libor is a collective name for a set of rates covering different currencies for different maturities ranging from overnight to one year. Other reference rates include the Euro interbank offered rate (Euribor), the Hong Kong interbank offered rate (Hibor), or the Singapore interbank offered rate (Sibor) for issues denominated in euros, Hong Kong dollars, and Singapore dollars, respectively. Euribor, Hibor, and Sibor are, like Libor, sets of rates for different maturities up to one year.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Floating rate bonds
#fixed #income
assume that the coupon rate of a FRN that makes semi-annual interest payments in June and December is expressed as the six-month Libor + 150 bps. Suppose that in December 20X0, the six-month Libor is 3.25%. The interest rate that will apply to the payment due in June 20X1 will be 4.75% (3.25% + 1.50%). Now suppose that in June 20X1, the six-month Libor has decreased to 3.15%. The interest rate that will apply to the payment due in December 20X1 will decrease to 4.65% (3.15% + 1.50%)
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Flashcard 1328138816780

Tags
#fixed #income
Question
All bonds, whether they pay a fixed or floating rate of interest, make periodic coupon payments except for?

statusnot learnedmeasured difficulty37% [default]last interval [days]               
repetition number in this series0memorised on               scheduled repetition               
scheduled repetition interval               last repetition or drill






Currency Denomination bonds
#fixed #income

2.1.5. Currency Denomination

Bonds can be issued in any currency, although a large number of bond issues are made in either euros or US dollars. The currency of issue may affect a bond’s attractiveness. If the currency is not liquid or freely traded, or if the currency is very volatile relative to major currencies, investments in that currency will not appeal to many investors. For this reason, borrowers in developing countries often elect to issue bonds in a currency other than their local currency, such as in euros or US dollars, because doing so makes it easier to place the bond with international investors. Issuers may also choose to issue in a foreign currency if they are expecting cash flows in the foreign currency because the interest payments and principal repayments can act as a natural hedge, reducing currency risk. If a bond is aimed solely at a country’s domestic investors, it is more likely that the borrower will issue in the local currency.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Dual currency bonds
#fixed #income
Dual-currency bonds make coupon payments in one currency and pay the par value at maturity in another currency. For example, assume that a Japanese company needs to finance a long-term project in the United States that will take several years to become profitable. The Japanese company could issue a yen/US dollar dual-currency bond. The coupon payments in yens can be made from the cash flows generated in Japan, and the principal can be repaid in US dollars using the cash flows generated in the United States once the project becomes profitable.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




currency option bonds
#fixed #income
Currency option bonds can be viewed as a combination of a single-currency bond plus a foreign currency option. They give bondholders the right to choose the currency in which they want to receive interest payments and principal repayments. Bondholders can select one of two currencies for each payment.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Features of a bond
#fixed #income

Exhibit 1 brings all the basic features of a bond together and illustrates how these features determine the cash flow pattern for a plain vanilla bond. The bond is a five-year Japanese government bond (JGB) with a coupon rate of 0.4% and a par value of ¥10,000. Interest payments are made semi-annually. The bond is priced at par when it is issued and is redeemed at par.

Exhibit 1. Cash Flows for a Plain Vanilla Bond

The downward-pointing arrow in Exhibit 1 represents the cash flow paid by the bond investor (received by the issuer) on the day of the bond issue—that is, ¥10,000. The upward-pointing arrows are the cash flows received by the bondholder (paid by the issuer) during the bond’s life. As interest is paid semi-annually, the coupon payment is ¥20 [(0.004 × ¥10,000) ÷ 2] every six months for five years—that is, 10 coupon payments of ¥20. The last payment is equal to ¥10,020 because it includes both the last coupon payment and the payment of the par value.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Yield measure
#fixed #income

2.2. Yield Measures

There are several yield measures commonly used by market participants. The current yield or running yield is equal to the bond’s annual coupon divided by the bond’s price, expressed as a percentage. For example, if a bond has a coupon rate of 6%, a par value of $1,000, and a price of $1,010, the current yield is 5.94% ($60 ÷ $1,010). The current yield is a measure of income that is analogous to the dividend yield for a common share.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Yield measures
#fixed #income
The most commonly referenced yield measure is known as the yield to maturity, also called the yield to redemption or redemption yield. The yield to maturity is the internal rate of return on a bond’s expected cash flows—that is, the discount rate that equates the present value of the bond’s expected cash flows until maturity with the bond’s price. The yield to maturity can be considered an estimate of the bond’s expected return; it reflects the annual return that an investor will earn on a bond if this investor purchases the bond today and holds it until maturity. There is an inverse relationship between the bond’s price and its yield to maturity, all else being equal. That is, the higher the bond’s yield to maturity, the lower its price. Alternatively, the higher the bond’s price, the lower its yield to maturity. Thus, investors anticipating a lower interest rate environment (in which investors demand a lower yield-to-maturity on the bond) hope to earn a positive return from price appreciation. The reading on understanding risk and return of fixed-income securities covers these fundamentals and more.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




bond contractual agreement
#fixed #income
As a bond is a contractual agreement between the issuer and the bondholders, it is subject to legal considerations. Investors in fixed-income securities must also be aware of the regulatory and tax considerations associated with the bonds in which they invest or want to invest.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Bond indenture
#fixed #income

3.1. Bond Indenture

The trust deed is the legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders. Market participants frequently call this legal contract the bond indenture, particularly in the United States and Canada. The indenture is written in the name of the issuer and references the features of the bond issue, such as the principal value for each bond, the interest rate or coupon rate to be paid, the dates when the interest payments will be made, the maturity date when the bonds will be repaid, and whether the bond issue comes with any contingency provisions. The indenture also includes information regarding the funding sources for the interest payments and principal repayments, and it specifies any collaterals, credit enhancements, or covenants. Collaterals are assets or financial guarantees underlying the debt obligation above and beyond the issuer’s promise to pay.Credit enhancements are provisions that may be used to reduce the credit risk of the bond issue. Covenants are clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




bond indenture
#fixed #income
Because it would be impractical for the issuer to enter into a direct agreement with each of many bondholders, the indenture is usually held by a trustee. The trustee is typically a financial institution with trust powers, such as the trust department of a bank or a trust company. It is appointed by the issuer, but it acts in a fiduciary capacity with the bondholders. The trustee’s role is to monitor that the issuer complies with the obligations specified in the indenture and to take action on behalf of the bondholders when necessary. The trustee’s duties tend to be administrative and usually include maintaining required documentation and records; holding beneficial title to, safeguarding, and appraising collateral (if any); invoicing the issuer for interest payments and principal repayments; and holding funds until they are paid, although the actual mechanics of cash flow movements from the issuers to the trustee are typically handled by the principal paying agent. In the event of default, the discretionary powers of the trustee increase considerably. The trustee is responsible for calling meetings of bondholders to discuss the actions to take. The trustee can also bring legal action against the issuer on behalf of the bondholders
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Bond indenture
For a plain vanilla bond, the indenture is often a standard template that is updated for the specific terms and conditions of a particular bond issue. For exotic bonds, the document is tailored and can often be several hundred pages.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Bond indenture
#fixed #income

When assessing the risk–reward profile of a bond issue, investors should be informed by the content of the indenture. They should pay special attention to their rights in the event of default. In addition to identifying the basic bond features described earlier, investors should carefully review the following areas:

  • the legal identity of the bond issuer and its legal form;

  • the source of repayment proceeds;

  • the asset or collateral backing (if any);

  • the credit enhancements (if any); and

  • the covenants (if any).

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Legal Identity of the Bond Issuer and its Legal Form
#fixed #income

3.1.1. Legal Identity of the Bond Issuer and its Legal Form

The legal obligation to make the contractual payments is assigned to the bond issuer. The issuer is identified in the indenture by its legal name. For a sovereign bond, the legal issuer is usually the office responsible for managing the national budget, such as HM Treasury (Her Majesty’s Treasury) in the United Kingdom. The legal issuer may be different from the body that administers the bond issue process. Using the UK example, the legal obligation to repay gilts lies with HM Treasury, but the bonds are issued by the UK Debt Management Office, an executive agency of HM Treasury.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Legal Identity of the Bond Issuer and its Legal Form
#fixed #income
For corporate bonds, the issuer is usually the corporate legal entity—for example, Wal-Mart Stores Inc., Samsung Electronics Co. Ltd., or Volkswagen AG. However, bonds are sometimes issued by a subsidiary of a parent legal entity. In this case, investors should look at the credit quality of the subsidiary, unless the indenture specifies that the bond liabilities are guaranteed by the parent. When they are rated, subsidiaries often carry a credit rating that is lower than their parent, but this is not always the case. For example, in May 2012, Santander UK plc was rated higher by Moody’s than its Spanish parent, Banco Santander.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Legal Identity of the Bond Issuer and its Legal Form
#fixed #income
Bonds are sometimes issued by a holding company, which is the parent legal entity for a group of companies, rather than by one of the operating companies in the group. This issue is important for investors to consider because a holding company may be rated differently from its operating companies and investors may lack recourse to assets held by those companies. If the bonds are issued by a holding company that has fewer (or no) assets to call on should it default, investors face a higher level of credit risk than if the bonds were issued by one of the operating companies in the group.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Legal Identity of the Bond Issuer and its Legal Form
#fixed #income
For ABS, the legal obligation to repay the bondholders often lies with the special legal entity that was created by the financial institution in charge of the securitization process. The financial institution is known as the sponsor or originator. The special legal entity is most frequently referred to as a special purpose entity (SPE) in the United States and a special purpose vehicle (SPV) in Europe, and it is also sometimes called a special purpose company (SPC). The legal form for the special legal entity may be a limited partnership, a limited liability company, or a trust. Typically, special legal entities are thinly capitalized, have no independent management or employees, and have no purpose other than the transactions for which they were created.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Legal Identity of the Bond Issuer and its Legal Form
#fixed #income
Through the securitization process, the sponsor transfers the assets to the special legal entity to carry out some specific transaction or series of transactions. One of the key reasons for forming a special legal entity is bankruptcy remoteness. The transfer of assets by the sponsor is considered a legal sale; once the assets have been securitized, the sponsor no longer has ownership rights. Any party making claims following the bankruptcy of the sponsor would be unable to recover the assets or their proceeds. As a result, the special legal entity’s ability to pay interest and repay the principal should remain intact even if the sponsor were to fail—hence the reason why the special legal entity is also called a bankruptcy-remote vehicle.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Source of Repayment Proceeds
#fixed #income

3.1.2. Source of Repayment Proceeds

The indenture usually describes how the issuer intends to service the debt (make interest payments) and repay the principal. Generally, the source of repayment for bonds issued by supranational organizations is either the repayment of previous loans made by the organization or the paid-in capital from its members. National governments may also act as guarantors for certain bond issues. If additional sources of repayment are needed, the supranational organization can typically call on its members to provide funds.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Source of Repayment Proceeds
#fixed #income
Sovereign bonds are backed by the “full faith and credit” of the national government and thus by that government’s ability to raise tax revenues and print money. Sovereign bonds denominated in local currency are generally considered the safest of all investments because governments have the power to raise taxes to make interest payments and principal repayments. Thus, it is highly probable that interest and principal will be paid fully and on time. As a consequence, the yields on sovereign bonds are typically lower than those for otherwise similar bonds from other local issuers.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Source of Repayment Proceeds
#fixed #income
There are three major sources for repayment of non-sovereign government debt issues, and bonds are usually classified according to these sources. The first source is through the general taxing authority of the issuer. The second source is from the cash flows of the project the bond issue is financing. The third source is from special taxes or fees established specifically for the purpose of funding interest payments and principal repayments.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Source of Repayment Proceeds
#fixed #income
The source of payment for corporate bonds is the issuer’s ability to generate cash flows, primarily through its operations. These cash flows depend on the issuer’s financial strength and integrity. Because corporate bonds carry a higher level of credit risk than otherwise similar sovereign and non-sovereign government bonds, they typically offer a higher yield.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Source of Repayment Proceeds
#fixed #income

In contrast to corporate bonds, the source of payment for ABS does not depend on the claims-paying ability of an operating entity but on the cash flows generated by one or more underlying financial assets, such as mortgages or auto loans. Thus, investors in ABS must pay special attention to the quality of the assets backing the ABS.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Asset or Collateral Backing
#asset #backing #collateral #fixed #income #or

3.1.3. Asset or Collateral Backing

Collateral backing is a way to alleviate credit risk. Investors should review where they rank compared with other creditors in the event of default and analyze the quality of the collateral backing the bond issue.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




3.1.3.1. Seniority Ranking
#asset #backing #collateral #fixed #income #or #ranking #seniority
Secured bonds are backed by assets or financial guarantees pledged to ensure debt repayment in the case of default. In contrast, unsecured bonds have no collateral; bondholders have only a general claim on the issuer’s assets and cash flows. Thus, unsecured bonds are paid after secured bonds in the event of default. By lowering credit risk, collateral backing increases the bond issue’s credit quality and decreases its yield.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Asset or Collateral Backing
#fixed #income

3.1.3. Asset or Collateral Backing

Collateral backing is a way to alleviate credit risk. Investors should review where they rank compared with other creditors in the event of default and analyze the quality of the collateral backing the bond issue.

3.1.3.1. Seniority Ranking

Secured bonds are backed by assets or financial guarantees pledged to ensure debt repayment in the case of default. In contrast, unsecured bonds have no collateral; bondholders have only a general claim on the issuer’s assets and cash flows. Thus, unsecured bonds are paid after secured bonds in the event of default. By lowering credit risk, collateral backing increases the bond issue’s credit quality and decreases its yield.

A bond’s collateral backing might not specify an identifiable asset but instead may be described as the “general plant and infrastructure” of the issuer. In such cases, investors rely on seniority ranking—that is, the systematic way in which lenders are repaid in case of bankruptcy or liquidation. What matters to investors is where they rank compared with other creditors rather than whether there is an asset of sufficient quality and value in place to cover their claims. Senior debt is debt that has a priority claim over subordinated debt or junior debt. Financial institutions issue a large volume of both senior unsecured and subordinated bonds globally; it is not uncommon to see large as well as smaller banks issue such bonds. For example, in 2012, banks as diverse as Royal Bank of Scotland in the United Kingdom and Prime Bank in Bangladesh issued senior unsecured bonds to institutional investors.

Debentures are a type of bond that can be secured or unsecured. In many jurisdictions, debentures are unsecured bonds, with no collateral backing assigned to the bondholders. In contrast, bonds known as “debentures” in the United Kingdom and in other Commonwealth countries, such as India, are usually backed by an asset or pool of assets assigned as collateral support for the bond obligations and segregated from the claims of other creditors. Thus, it is important for investors to review the indenture to determine whether a debenture is secured or unsecured. If the debenture is secured, debenture holders rank above unsecured creditors of the company; they have a specific asset or pool of assets that the trustee can call on to realize the debt in the event of default.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Types of collateral backing
#fixed #income

3.1.3.2. Types of Collateral Backing

There is a wide range of bonds that are secured by some form of collateral. Some companies issue collateral trust bonds and equipment trust certificates. Collateral trust bonds are secured by securities such as common shares, other bonds, or other financial assets. These securities are pledged by the issuer and typically held by the trustee. Equipment trust certificates are bonds secured by specific types of equipment or physical assets, such as aircraft, railroad cars, shipping containers, or oil rigs. They are most commonly issued to take advantage of the tax benefits of leasing. For example, suppose an airline finances the purchase of new aircraft with equipment trust certificates. The legal title to the aircraft is held by the trustee, which issues equipment trust certificates to investors in the amount of the aircraft purchase price. The trustee leases the aircraft to the airline and collects lease payments from the airline to pay the interest on the certificates. When the certificates mature, the trustee sells the aircraft to the airline, uses the proceeds to retire the principal, and cancels the lease.

One of the most common forms of collateral for ABS is mortgaged property. MBS are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity.

Financial institutions, particularly in Europe, issue covered bonds. A covered bond is a debt obligation backed by a segregated pool of assets called a “cover pool”. Covered bonds are similar to ABS but offer bondholders additional protection if the financial institution defaults. A financial institution that sponsors ABS transfers the assets backing the bonds to a special legal entity. If the financial institution defaults, investors who hold bonds in the financial institution have no recourse against the special legal entity and its pool of assets because the special legal entity is a bankruptcy-remote vehicle; the only recourse they have is against the financial institution itself. In contrast, in the case of covered bonds, the pool of assets remains on the financial institution’s balance sheet. In the event of default, bondholders have recourse against both the financial institution and the cover pool. Thus, the cover pool serves as collateral. If the assets that are included in the cover pool become non-performing (i.e., the assets are not generating the promised cash flows), the issuer must replace them with performing assets. Therefore, covered bonds usually carry lower credit risks and offer lower yields than otherwise similar ABS.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Credit enhancements
#credit-enhancement #fixed-income

3.1.4. Credit Enhancements

Credit enhancements refer to a variety of provisions that can be used to reduce the credit risk of a bond issue. Thus, they increase the issue’s credit quality and decrease the bond’s yield. Credit enhancements are very often used when creating ABS.

There are two primary types of credit enhancements: internal and external. Internal credit enhancement relies on structural features regarding the bond issue. External credit enhancement refers to financial guarantees received from a third party, often called a financial guarantor. We describe each type in the following sections.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




3.1.4.1. Internal Credit Enhancement
#fixed #income

The most common forms of internal credit enhancement are subordination, overcollateralization, and reserve accounts.

Subordination, also known as credit tranching, is the most popular internal credit enhancement technique. It relies on creating more than one bond class or tranche and ordering the claim priorities for ownership or interest in an asset between the tranches. The cash flows generated by the assets are allocated with different priority to tranches of different seniority. The ordering of the claim priorities is called a senior/subordinated structure, where the tranches of highest seniority are called senior followed by subordinated or junior tranches. The subordinated tranches function as credit protection for the more senior tranches, in the sense that the most senior tranche has the first claim on available cash flows. This type of protection is also commonly referred to as a waterfall structure because in the event of default, the proceeds from liquidating assets will first be used to repay the most senior creditors. Thus, if the issuer defaults, losses are allocated from the bottom up—that is, from the most juniorto the most senior tranche. The most senior tranche is typically unaffected unless losses exceed the amount of the subordinated tranches, which is why the most senior tranche is usually rated Aaa/AAA.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




3.1.4.1. Internal Credit Enhancement
#fixed #income
Overcollateralization refers to the process of posting more collateral than is needed to obtain or secure financing. It represents a form of internal credit enhancement because the additional collateral can be used to absorb losses. For example, if at issuance the principal amount of a bond issue is $100 million and the value of the collateral is $110 million, the amount of overcollateralization is $10 million. Over time, the amount of overcollateralization changes, for instance as a result of amortization, prepayments or defaults in the case of MBS. A major problem associated with overcollateralization is the valuation of the collateral. For example, one of the most significant contributors to the 2007–2009 credit crisis was a valuation problem with the residential housing assets backing MBS. Many properties were originally valued in excess of the worth of the issued securities. But as property prices fell and homeowners started to default on their mortgages, the credit quality of many MBS declined sharply. The result was a rapid rise in yields and panic among investors in these securities.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




3.1.4.1. Internal Credit Enhancement
#fixed #income
Reserve accounts or reserve funds are another form of internal credit enhancement, and come in two forms: a cash reserve fund and an excess spread account. A cash reserve fund is a deposit of cash that can be used to absorb losses. An excess spread account involves the allocation into an account of any amounts left over after paying out the interest to bondholders. The excess spread, sometimes called excess interest cash flow, is the difference between the cash flow received from the assets used to secure the bond issue and the interest paid to bondholders. The excess spread can be retained and deposited into a reserve account that serves as a first line of protection against losses. In a process called turboing, the excess spread can be used to retire the principal, with the most senior tranche having the first claim on these funds.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




3.1.4.2. External Credit Enhancement
#fixed #income

3.1.4.2. External Credit Enhancement

The most common forms of external credit enhancement are bank guarantees and surety bonds, letters of credit, and cash collateral accounts.

Bank guarantees and surety bonds are very similar in nature because they both reimburse bondholders for any losses incurred if the issuer defaults. However, there is usually a maximum amount that is guaranteed, called the penal sum. The major difference between a bank guarantee and a surety bond is that the former is issued by a bank, whereas the latter is issued by a rated and regulated insurance company. Insurance companies that specialize in providing financial guarantees are typically called monoline insurance companies or monoline insurers. Monoline insurers played an important role in securitization until the 2007–2009 credit crisis. But financial guarantees from monoline insurers have become a less common form of credit enhancement since the credit crisis as a consequence of the financial difficulties and credit rating downgrades that most monoline insurers experienced

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




3.1.4.2. External Credit Enhancement
#fixed #income
A letter of credit from a financial institution is another form of external credit enhancement for a bond issue. The financial institution provides the issuer with a credit line to reimburse any cash flow shortfalls from the assets backing the issue. Letters of credit have also become a less common form of credit enhancement since the credit crisis as a result of the credit rating downgrades of several financial institutions that were providers of letters of credit.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




3.1.4.2. External Credit Enhancement
#fixed #income
Bank guarantees, surety bonds, and letters of credit expose the investor to third-party (or counterparty) risk—that is, the possibility that a guarantor cannot meet its obligations. A cash collateral account mitigates this concern because the issuer immediately borrows the credit-enhancement amount and then invests that amount, usually in highly rated short-term commercial paper. Because a cash collateral account is an actual deposit of cash rather than a pledge of cash, a downgrade of the cash collateral account provider will not necessarily result in a downgrade of the bond issue backed by that provider.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Covenants
#fixed #income

3.1.5. Covenants

Bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. An indenture will frequently include affirmative (or positive) and negative covenants. Affirmative covenants enumerate what issuers are required to do, whereas negative covenants specify what issuers are prohibited from doing.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Covenants
#fixed #income
Affirmative covenants are typically administrative in nature. For example, frequently used affirmative covenants include what the issuer will do with the proceeds from the bond issue and the promise of making the contractual payments. The issuer may also promise to comply with all laws and regulations, maintain its current lines of business, insure and maintain its assets, and pay taxes as they come due. These types of covenants typically do not impose additional costs to the issuer and do not materially constrain the issuer’s discretion regarding how to operate its business.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Negative covenants
#fixed #income
negative covenants are frequently costly and do materially constrain the issuer’s potential business decisions. The purpose of negative covenants is to protect bondholders from such problems as the dilution of their claims, asset withdrawals or substitutions, and suboptimal investments by the issuer.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Negative covenants
#fixed #income
  • Restrictions on debt regulate the issue of additional debt. Maximum acceptable debt usage ratios (sometimes called leverage ratios or gearing ratios) and minimum acceptable interest coverage ratios are frequently specified, permitting new debt to be issued only when justified by the issuer’s financial condition.

  • Negative pledges prevent the issuance of debt that would be senior to or rank in priority ahead of the existing bondholders’ debt.

  • Restrictions on prior claims protect unsecured bondholders by preventing the issuer from using assets that are not collateralized (called unencumbered assets) to become collateralized.

  • Restrictions on distributions to shareholders restrict dividends and other payments to shareholders such as share buy-backs (repurchases). The restriction typically operates by reference to the borrower’s profitability; that is, the covenant sets a base date, usually at or near the time of the issue, and permits dividends and share buy-backs only to the extent of a set percentage of earnings or cumulative earnings after that date.

  • Restrictions on asset disposals set a limit on the amount of assets that can be disposed by the issuer during the bond’s life. The limit on cumulative disposals is typically set as a percentage of a company’s gross assets. The usual intent is to protect bondholder claims by preventing a break-up of the company.

  • Restrictions on investments constrain risky investments by blocking speculative investments. The issuer is essentially forced to devote its capital to its going-concern business. A companion covenant may require the issuer to stay in its present line of business.

  • Restrictions on mergers and acquisitions prevent these actions unless the company is the surviving company or unless the acquirer delivers a supplemental indenture to the trustee expressly assuming the old bonds and terms of the old indenture. These requirements effectively prevent a company from avoiding its obligations to bondholders by selling out to another company.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Negative covenants
#fixed #income
The common characteristic of all negative covenants is ensuring that the issuer will not take any actions that would significantly reduce its ability to make interest payments and repay the principal. Bondholders, however, rarely wish to be too specific about how an issuer should run its business because doing so would imply a degree of control that bondholders legally want to avoid. In addition, very restrictive covenants may not be in the bondholders’ best interest if they force the issuer to default when default is avoidable. For example, strict restrictions on debt may prevent the issuer from raising new funds that are necessary to meet its contractual obligations; strict restrictions on asset disposals may prohibit the issuer from selling assets or business units and obtaining the necessary liquidity to make interest payments or principal repayments; and strict restrictions on mergers and acquisitions may prevent the issuer from being taken over by a stronger company that would be able to honor the issuer’s contractual obligations.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




role of financial reporting
#fra-introduction

The role of financial reporting is to provide information about a company's financial position and performance for use by parties both internal and external to the company. Financial statements are issued by management, who is responsible for their form and content.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Role of Financial statement analysis
#fra-introduction
The role of financial statement analysis, on the other hand, is to take these financial statements and other information to evaluate the company's past, current, and prospective financial position and performance for the purpose of making rational investment, credit, and similar decisions.

The primary users of financial statements are equity investors and creditors.

  • Equity investors are primarily interested in the company's long-term earning power, growth, and ability to pay dividends.
  • Short-term creditors (e.g., banks and trade creditors) are more interested in the company's immediate liquidity, because they seek an early payback of their investment.
  • Long-term creditors (e.g., corporate bond owners such as insurance companies and pension funds) are primarily concerned with the company's long-term asset position and earning power.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Major financial statements
#fra-introduction
Financial statements are the most important outcome of the accounting system. They communicate financial information gathered and processed in the company's accounting system to parties outside the business.

The four principal financial statements are:

  • Income statement (statement of earnings)
  • Balance sheet (statement of financial position)
  • Cash flow statement
  • Statement of changes in owners' or stockholders' equity

These four financial statements, augmented by footnotes and supplementary data, are interrelated. In addition, there are other sources of financial information, such as management discussion and analysis, auditor's reports, etc.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Income statement
#fra-introduction #has-images
Income Statement

The income statement summarizes revenues earned and expenses incurred, and thus measures the success of business operations for a given period of time. It explains some but not all of the changes in the assets, liabilities, and equity of the company between two consecutive balance sheet dates.

The income statement lists income and expenses as they are directly related to the company's recurring income. The format of the income statement is not specified by U.S. GAAP and actual format varies across companies. The following is a generic sample:

The goal of income statement analysis is to derive an effective measure of future earnings and cash flows. Analysts need data with predictive ability, hence income from continuing (recurring) operations is considered to be the best indicator of future earnings. As operating expenses do not include financing costs such as interest expenses, income from continuing operations is independent of the company's capital structure.

In the typical income statement this means segregating the results of normal, recurring operations from the effects of nonrecurring or extraordinary items to improve the forecasting of future earnings and cash flows. The idea here is that recurring income is persistent. If an item in the unusual or infrequent component of income from continuing operations is deemed not to be persistent, then recurring (pre-tax) income from continuing operations should be adjusted.

The net income figure is used to prepare the statement of retained earnings.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Balance Sheet
#fra-introduction
Balance Sheet

A balance sheet provides a "snapshot" of a company's financial condition. Think of the balance sheet as a photo of the business at a specific point in time. It reports major classes and amounts of assets, liabilities, stockholders' equity, and their interrelationships as of a specific date.

Assets = Liabilities + Stockholders' Equity

  • Assets are the economic resources controlled by the company.
  • Liabilities are the financial obligations that the company must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the company by the creditors.
  • Equity ownership is the owner's investments and the total earnings retained from the commencement of the company. Equity represents the source of financing provided to the company by the owners.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Cash Flow statement
#fra-introduction

Cash Flow Statement

The primary purpose of the cash flow statement is to provide information about a company's cash receipts and cash payments during a period. It reports the cash receipts and cash outflows classified according to operating, investment, and financing activities.

The cash flow statement is useful because it provides answers to the following simple yet important questions:

  • Where did the cash come from during the period?
  • What was the cash used for during the period?
  • What was the change in the cash balance during the period?

The statement's value is that it helps users evaluate liquidity, solvency, and financial flexibility.

  • Liquidity refers to the "nearness to cash" of assets and liabilities, or having enough cash available to pay debts when they are due.
  • Solvency refers to the company's ability to pay its debts as they mature. Cash flows reflect the company's liquidity and long-term solvency.
  • Financial flexibility refers to a company's ability to respond and adapt to financial adversity and unexpected needs and opportunities. For example, cash flow information can be used to evaluate the effects of major investment and financing decisions.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Statement of Changes in Owners' Equity
Statement of Changes in Owners' Equity

This statement reports the amounts and sources of changes in equity from capital transactions with owners. It reports ownership interests in order of preference upon liquidation and dividends. For example, the first item listed gets paid off first after creditors in the event of liquidation.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Financial footnotes
#fra-introduction
Financial footnotes are an integral part of financial statements. They provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc. They are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Supplementary Schedules
#fra-introduction
Supplementary Schedules: In some cases additional information about the assets and liabilities of a company is provided as supplementary data outside the financial statements. Examples include oil and gas reserves reported by oil and gas companies, the impact of changing prices, sales revenue, operating income, and other information for major business segments. Some of the supplementary data is unaudited.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Management Discussion and Analysis (MD&A)
#fra-introduction

Management Discussion and Analysis (MD&A)

This requires management to discuss specific issues on the financial statements, and to assess the company's current financial condition, liquidity, and its planned capital expenditure for the next year. An analyst should look for specific concise disclosure as well as consistency with footnote disclosure.

Note that the MD&A section is not audited and is for public companies only.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Financial statements Other Sources of Information
#fra-introduction
Other Sources of Information

  • Interim reports. Publicly held companies must file form 10-Q (interim report) on a quarterly basis. It is far less detailed than annual financial statements, as it contains unaudited basic financial statements, unaudited footnotes to financial statements, and management discussion and analysis.

  • Proxy statements. An analyst should look for litigation, executive compensation, and related-party transactions, known as proxy statements. Proxy statements should be considered an integral part of the financial report, and they may contain special compensation "perks" for officers and directors, as well as lawsuits and other contingent obligations facing the company.

  • Companies' websites, press releases, and conference calls.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Auditors
#fra-introduction
The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles. In contrast, the company's management is responsible for the preparation of the financial statements. The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable. The auditor also examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




auditors report
#fra-introduction
An auditor's report (also called the auditor's opinion) is issued as part of a company's audited financial report. It tells the end-user the following:

  • Whether the financial statements are presented in accordance with generally accepted accounting principles.
  • It identifies those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
  • Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




auditors report
#fra-introduction
An auditor's report is considered an essential tool when reporting financial information to end-users, particularly in business. Since many third-party users prefer or even require financial information to be certified by an independent external auditor, many auditees rely on auditor reports to certify their information in order to attract investors, obtain loans, and improve public appearance. Some have even stated that financial information without an auditor's report is "essentially worthless" for investing purposes.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




The Types of Audit Reports
#fra-introduction

The Types of Audit Reports

There are four common types of auditor's reports, each one representing a different situation encountered during the auditor's work. The four reports are as follows:

  • An unqualified opinion report is issued by an auditor when the financial statements presented are free of material misstatements and are in accordance with GAAP, which, in other words, means that the company's financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. It is regarded by many as the equivalent of a "clean bill of health" to a patient, which has led many to call it the "clean opinion."
  • A qualified opinion report is issued when the auditor encountered one or two situations that did not comply with generally accepted accounting principles; however, the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or "clean opinion," but the report states that the financial statements are fairly presented with a certain exception which is otherwise misstated.
  • An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and generally do not comply with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained to assess the auditee's financial position and results of operations is materially incorrect, unreliable, and inaccurate.

  • A disclaimer of opinion, commonly referred to simply as a disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit a company but could not complete the work due to various reasons and does not issue an opinion.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




#fra-introduction
Auditor's Report on Internal Controls

Following the enactment of the Sarbanes-Oxley Act of 2002, the Public Company Accounting Oversight Board (PCAOB) was established in order to monitor, regulate, inspect, and discipline audit and public accounting firms of public companies. The PCAOB Auditing Standards No. 2 now requires auditors of public companies to include an additional disclosure in the opinion report regarding the auditee's internal controls, and to opine about the company's and auditor's assessment of the company's internal controls over financial reporting. These new requirements are commonly referred to as the COSO Opinion.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




financial statement analysis Framework
#fra-introduction

he financial statement analysis framework provides steps that can be followed in any financial statement analysis project, including the following:

  • Articulate the purpose and context of the analysis.

    What is the purpose of the analysis? Evaluating an equity or debt investment? Or issuing a credit rating?

    The context needs to be defined clearly too: Who is the intended audience? What is the nature and content of the final report? What is the time frame? What is the budget?

  • Collect input data.

    Gather a company's financial data from financial statements and other sources described in Subject c (other financial information sources). Also gather information on the economy and industry to understand the environment in which the company operates.

  • Process data.

    Compute ratios or growth rates, prepare common-size financial statements, create charts, perform statistical analyses, make adjustments to financial statements, etc.

  • Analyze / interpret the processed data.

    Interpret the output to support a conclusion (e.g., a buy decision).

  • Develop and communicate conclusions and recommendations.

    Communicate the conclusion or recommendation in an appropriate format.

  • Follow up.

    Periodic review is required to determine if the original conclusions and recommendations are still valid.

PREVIOUS LOS
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Business activities
#fra-introduction
Business activities can be classified into three groups:

  • Operating activities involve those activities conducted in the course of running a business. These activities determine net income and changes in the working capital account (accounts receivable, inventory, and accounts payable). Examples:

    • Selling goods and services
    • Employing managers and workers
    • Buying goods and services
    • Paying taxes

  • Investing activities are those associated with spending funds to begin and continue operations. In general, these activities affect the long-term asset items on the balance sheet. Examples:

    • Buying resources such as land, buildings, and equipment needed in the operation of the business.
    • Selling these resources when no longer needed.

    Selling land, buildings, and equipment is associated with investing activities, even though it results in a cash inflow, because it involves resources used to begin and continue operations.

  • Financing activities are related to obtaining or repaying capital. In general, these activities affect the debt and the equity items on the balance sheet. Examples:

    • Issuing stock
    • Paying dividends to stockholders
    • Obtaining loans from creditors
    • Repaying amounts plus interest to creditors

    Payments of dividends and interest are associated with financing activities, even though they involve cash outflows, because they are necessary to obtain funding.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Accounts
#fra-introduction
An account is a label used for recording and reporting a quantity of almost anything. It is the:

  • Means by which management keeps track of the effects of transactions.
  • Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Assets
#fra-introduction
Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

  • An asset is usually listed on the balance sheet.
  • It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




#fra-introduction
Types of Assets

  • Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
  • Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
  • Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
  • Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




#fra-introduction
Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

  • Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
  • Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Owners equity
#fra-introduction
Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

  • Contributed capital is the amount invested in the business by the owners.
  • Retained earnings are the company's undistributed earnings: accumulated earnings since inception less any losses, dividends, or transfers to contributed capital.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




#fra-introduction

Revenue

Income (often referred to as "revenue") for a company is generated by delivering or producing goods, rendering services, or other activities that constitute the company's ongoing major or central operations. Not all cash receipts are revenues; for example, cash received through a loan is not revenue.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




#fra-introduction
Expenses

Expenses are outflows from delivering or producing goods, rendering services, or carrying out other activities that constitute an entity's ongoing major or central operations. An expense represents an event in which an asset is used up or a liability is incurred. Not all cash payments are expenses; for example, cash dividends paid to stockholders are not expenses.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Accounting equations
#fra-introduction
Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:

Assets (A) = Liabilities (L) + Owners' equity (E)

This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.

If the equation is rearranged:

Assets - Liabilities = Owners' equity

The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.

Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.

Owners' equity = Contributed capital + Retained earnings
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Accounting equations
#has-images
Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.

Revenue - Expenses = Net income (loss)

Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.

Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.

Ending retained earnings = Beginning retained earnings + Net income - Dividends

The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends

  • Dividends and expenses decrease owners' equity.
  • Revenues increase owners' equity.

Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation:

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Accounting equations
#fra-introduction

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of $10 par value stock.

Assets=Liab.Owners' Equity
CashA/RSuppliesLandBuilding A/PCommon StockRetained Earnings
1$50,000 $50,000
A = $50,000 L + OE = $50,000
Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.

Assets=Liab.Owners' Equity
CashA/RSuppliesLandBuilding A/PCommon StockRetained Earnings
1$50,000 $50,000
2-35,000 $10,000$25,000 $50,000
bal$15,000 $10,000$25,000 $50,000
A = $50,000 L + OE = $50,000
This transaction only affects one side of the accounting equation: assets.
Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged.

3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.

Assets=Liab.Owners' Equity
CashA/RSuppliesLand
...
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Accrual and valuation adjustments
Under strict cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.

  • A balance sheet must list all assets and liabilities at the end of the accounting period.
  • An income statement must list all revenues and expenses applicable to the accounting period.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Accruals and valuation adjustments
#fra-introduction
Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.

The four basic types of adjusting entries are:

  • Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.

  • Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.

  • Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).

  • Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Accruals and valuation adjustments
#fra-introduction
In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.

  • If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
  • If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other comprehensive income.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




financial statements relation
#fra-introduction #has-images
Here are financial statements based on previous transactions for ABC Realty.

statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Flow of Information in an Accounting System
#fra-introduction #has-images
It is important for an analyst to understand the flow of information through a financial reporting system.

1. Journal entries and adjusting entries

Journalizing is the process of chronologically recording transactions.

  • General journal is the simplest and most flexible.
  • A separate journal entry records each transaction.
  • Useful for obtaining detailed information regarding a particular transaction.

2. General ledger and T-accounts

The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarizing and classifying process. The general ledger contains all the same entries as those posted to the general journal; the only difference is that the data are sorted by date in the journal and by account in the ledger.

There is a separate T-account for each item in the ledger. A T-account appears as follows:

3. Trial balance and adjusted trial balance

A trial balance is a list of all open accounts in the general ledger and their balances.

  • For every amount debited, an equal amount must be credited.
  • The total of debits and credits for all the T-accounts must be equal.
  • A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
  • It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

4. Finance statements

The financial statements can be prepared from the adjusted trial balance.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on




Using Financial Statements in Security Analysis
#fra-introduction

Financial statements are the primary information that firms publish about themselves, and investors and creditors are the primary users of financial statements. Analysts, who work for investors and creditors, may need to make adjustments to reflect items not reported in the statements or assess the reasonableness of managements' judgments. For example, an important first step in analyzing financial statements is identifying the types of accruals and valuation entries in a company's financial statements.

Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.

For example, companies may improperly record costs as assets rather than as expenses and amortize the assets over future periods. The goal is to impress shareholders and bankers with higher profits. Consider advertising expenses, which should be charged against income immediately. Certain companies, particularly those selling memberships to customers (e.g., health clubs and Internet access providers), aggressively capitalize these costs and spread them over several periods.

Companies may amortize long-term assets too slowly. Slow depreciation or amortization keeps assets on the balance sheet longer, resulting in a higher net worth. With slow amortization, expenses are lower and profits are higher.
statusnot read reprioritisations
last reprioritisation on reading queue position [%]
started reading on finished reading on