Also known as a Senior Note, Senior Debt consists of a company’s outstanding loans collateralized by the business’ assets. As the name implies, Senior Debt holders are the first claimants of the business’ cash flows and/or liquidated assets if that business defaults on its debt and files for bankruptcy. Subordinated or junior debt in the form of Preferred and Common Equity shares has claims to any subsequent assets – but only after Senior Debt holders are made whole. 

Originating via financial institutions, revolving credit facilities, and Senior Term Debt are the primary ways companies obtain financing. Whether the debt is funded by another business, an individual backer, or a traditional bank lender, if the borrowing company files for bankruptcy and liquidates its assets, Senior Bondholders are first in line for available repayment.

Senior Debt Characteristics and Structure

Much like any type of borrowed money, each tier has different interest rates and amortization schedules, including Senior Debt. Senior Debt issuers put terms in the debenture restricting companies from issuing additional, lower-tier debt. Debt issuers often require borrowers to maintain specific credit profiles, which are determined by financing ratios such as interest service coverage and debt service coverage.

Other stipulations may include requiring the borrower to maintain or refrain from business activities beyond their essential commercial functions. If the stipulations are flouted, the lender may retract, modify the borrowing terms, or mandate immediate payment of accrued interest and principal. It’s important to note that since Senior Debt has more restrictive terms, interest rates are generally lower compared to unsecured/less senior debt.

When it comes to unsecured debt, primarily junior or subordinated debt, although it’s not collateralized, the terms stipulate that the lender(s) have a claim to the company’s assets in case of bankruptcy/liquidation and are next in line to get paid off from the assets of the company, minus any pledged assets for secured debt debtholders.

Accounting Considerations

The first step to account for Senior Debt is to break it up into short-term and long-term debt (within 12 months and longer than 12 months). For example, long-term debt, which turns into long-term liabilities from short-term obligations, like accounts payable, is recorded on the company’s balance sheet. This generally happens when the short-term obligations are re-classified into a lengthier note.

If a business obtains a $10 million bank loan, secured by their machinery and other assets, for a new product line, with a 7 percent interest rate for 15 years, along with the business assets, liabilities and shareholders’ equity, the long-term portion would be reported on the company’s balance sheet. It would be recorded as a liability on the balance sheet, where any other long-term debt and bonds issued or borrowed by the company.

The income statement would document its loan interest. It’s calculated by taking the principal multiplied by the interest rate.  Once the interest is determined, it’s classified as an expense on the income statement, lowering the company’s net income and profits. As the loan’s principal is paid over the 15-year loan life, a set amount of the loan principal is repaid each year.

Conclusion

Senior Debt can be an effective way to obtain funding, but businesses must understand how funding agreements work and how to properly account for them.

 

When it comes it understanding a net charge-off (NCO), it’s the difference between any recovery of delinquent debt and gross charge-offs a business sees in a defined accounting time frame. NCOs are debts a company projects with a low likelihood of being collected. It can happen when a customer stops paying outstanding invoices or sees a decline in their credit rating.  

The first step considers it as a gross charge-off; if any amount is recovered, it’s subtracted to arrive at net charge-offs. If businesses can recover a percentage of what’s been charged off, the recovered monies can be net against the gross charge-offs to realize net charge-offs. A business’ loan loss provision is lowered by the net charge-off amount at the end of the accounting time frame and then refilled for the next accounting time frame based on new estimates for loan losses. This is part of a business’ provision for credit losses (PCL) that projects a certain percentage of accounts unable to be collected.

Accounting in Detail

The following formula calculates net charge-offs (NCO). This assumes a gross charge-off booking of 6 percent of all outstanding loans, with 1 percent ultimately being recovered during a particular accounting time frame.

Net Charge-Offs = Gross Charge-Offs – Amount of Recovered Debt

= 6 percent – 1 percent = 5 percent

Once the figure is calculated, the 1 percent collected adjusts the loan loss provision in the accounting statements.

Financial Institutions Illustrate Accounting Considerations

Banks’ business models and financials demonstrate their ability to pay their depositors competitive interest rates while also being able to make loans. Since banks earn profits via net interest margin, earning a spread between what banks pay depositors on interest rates and what borrowers are charged on loans, the spread is integral to measuring profitability. To generate the total value of a bank’s balance sheet, it’s imperative for banks to estimate and project their charge-offs as accurately as possible.

Financial institutions determine credit loss provisions by analyzing their balance sheets and the level of risk represented by outstanding loans. They look at the ratio of loan losses to overall losses, which is their net charge-off rate. The net charge-off rate is used to evaluate a loan’s book quality against other banks.

How Different Risks Impact Net Charge-Off Levels

Banks that have different loan mixes will see different risk and reward payoffs. If one bank offers primarily secured loans, while it may have lower net interest margins, it will also have lower charge-offs because the collateral backing them is less risky overall. This is compared to other lenders that have a higher level of unsecured loans, such as credit cards and commercial loans. This scenario, in the case of riskier loans, may result in higher net interest margins, but also greater potential for higher losses.

Journal Entry Examples

The following journal entries illustrate how to account for bad debts. Using the direct write-off method, when debt collection efforts have been exhausted, bad debts are recorded as follows:

Expenses for bad debt: Debit $750

Accounts Receivable: Credit $750

If, however, the business recovers anything from the customer’s outstanding invoices, the following journal entries would be added if $200 were received:

Cash: Debit $200

Accounts Receivable: Credit $200

Conclusion

While this is primarily for early-stage companies with a low percentage of credit sales, it illustrates how businesses can update their books when projecting their numbers to account for net charge-offs.

According to the May 2019 Financial Stability Report from the Board of Governors of the Federal Reserve System, there was more than $15 billion in outstanding commercial credit. While there are many ways companies can obtain funding, additional paid-in-capital (APIC) is one way to accomplish this goal.

Defining APIC

This term refers to the gap between a share’s par value and the distribution price. If an investor pays more than what the company sets for its IPO price offer, that is what determines APIC.

Defining Par Value

Par value is the initial offer price a publicly traded company decides to offer shares to investors during its initial public offering (IPO) on exchanges. Depending on the actual initial price for an IPO, it can be done for publicity reasons, to reduce litigation risks and to aid in improving shareholder return on investment.

Market Value

Based on how well a publicly traded company performs, this is the prevailing price that investors assign to the share price, which varies dynamically.

Determining APIC

Calculating APIC is done as follows:

APIC = (Issue Price – Par Value) x Number of Shares Acquired by Investors

If a company establishes a stock price of $2 per share, investors can decide to bid up each share price to $3 or $7 or $20 via their purchases. If there are 2 million shares outstanding selling for a total of $44 million, the excess of $40 million (beyond the $4 million in par value) is the APIC.

Based on these circumstances, a company’s balance sheet should have the following entries:

– $4 million (paid-in-capital)

– $40 million (additional paid-in-capital)

When accounting for these stock purchases in this scenario, APIC is recorded on the balance sheet under the shareholder equity (SE) section. This can be seen as increasing a company’s bottom line because it results in them receiving additional cash from stockholders.

When it comes to recording the journal entry, the total cash generated by the IPO is recorded as an asset (debit) on the balance sheet, while the common stock and APIC are recorded as equity (credits).

Utility

The utility metric can yield a considerable amount of a business’ share capital, prior to retained earnings starting to accumulate. It helps provide a financial cushion for the company if retained earnings demonstrate a shortfall.

Companies that issue shares permit the business to not increase its fixed costs. Since this method is chosen instead of issuing bonds, there are no interest payments due to buyers of the bonds. Investors are not due any payments, including no dividend obligations. Business assets are also not subject to investor claims. Once shares are issued to investors, the generated funds are non-restricted, so the company can direct the funds as necessary.

APIC lets businesses produce money without any required assets backing the transaction. Depending on the company’s future performance, buying stock at the IPO can generate massive returns.

Further considerations

When there are additional share offerings post IPO, either common or preferred shares, the APIC levels may grow, necessitating them to be documented on the business’s financial statements. If share repurchases are made, levels can be decreased.

While each business has many options to raise money, if a company uses this method, it’s important to ensure that they are accounted for properly. As always, contact a professional to ensure the best personalized advice.