Companies incur expenses to run their daily operations and generate revenue. Such expenses are called operating expenses. But the company also incurs expenses that are outside its main line of operations. These expenses are incidental or peripheral to the company.
Borrowing money is the outside activity for a merchandising business, hence interest payment is the non-operating expense.
Non-operating expenses are the expenses incurred in the company that is not directly involved in the operational activities or main business activities of the company often reported on the income statement after the Income from Operations heading under Other expenses. Such expenses are usually non-recurring and don’t account for the daily expenses of the company.
Non-operating expenses include the financial obligations not related to core operations.
The examples of such expenses are:
Interest costs and other financing costs
Loss from sale of assets
Losses from exchange fluctuations
Loss from derivative instruments
Obsolete inventory costs
Lawsuit settlement expenses
Non-operating expenses are not considered while calculating the company’s profit. It is shown as a bottom-line item in the income statement.
Calculation of non-operating income:
Presentation of non-operating income in the income statement of the company:
For the year ended December 31,2020
In the income statement, interest expenses, legal fees, loss from the sale of assets fall under non-operating expenses. Non-operating expenses are usually deducted from EBITDA on an income statement.
It is depicted as a bottom-line item on the income statement and recorded just below the results from the continuous operations.
Non-recurring events give rise to non-operating losses hence, they are reported on a company’s income statement. They are shown separately from normal earnings so that analysts and investors can see how the business performed over a specific time period.
Assuming after subtracting the cost of goods sold and all of the operating expenses from the sales revenue, a company reported an operating income of $1,500,000 for one year. In addition to running its core business, the company also made some investments, which brought in $500,000 in dividends and $200,000 in interest income.
During the year, the company paid $ 600,000 interest for its previous financing year and sold a piece of land at a loss of $ 100,000 Also, it was sued and was charged for $ 150,000.
The company’s income from dividend, interest income and interest expenses are all non-operating gains or losses. Overall, the company incurred a net non-operating loss of $ 150,000 which is shown below.
Loss on sale of land
Costs of litigation
Non-operating income (loss)
In the technical sense in the above table, interest expenses, loss on the sale of land, and costs of litigation are non-operating expenses. The classification of items as non-operating expenses/income depends on the nature of the business being carried out.
For financial companies, interest income/expenses are treated as operating income/expenses while rest other companies treat it as operating income/expenses.
Non-recurring nature of non-operating expense and incomes provide scope for accounting manipulation. Non-operating income may be inflated to compensate for losses on operations. It can also account for incorrect operating income by including gains from unrelated activities.
A sudden increase in profit is more likely to be contributed by unrelated activities and can be non-operating in nature.
Non-operating incomes and expenses are excluded from the calculation of Earnings Per Share (EPS) as not being part of the company’s normal course of operations.
Non-recurring events can inflate/deflate the earnings of the company hence, depict the untrue financial position of the company. Write-offs or write-downs may be considered non-operating expenses if they occur due to one-time sudden events like a natural disaster, downturns of the economic conditions.
When it comes to the sources of financing, companies or businesses have two primary options. These are equity and debt. Both of these types of finance have their advantages or disadvantages. However, companies use a combination of both to reap the maximum possible benefits from them. That is why a company’s capital structure will include both of them.
However, to use both these sources of finance properly, companies need to understand the differences between equity and debt. While there are many differences between them, the top 6 differences are as below.
Equity is a type of finance that companies generate from their shareholders. In the case of different forms of businesses, equity comes from owners. However, apart from capital, equity also has other components, such as retained earnings, reserves, etc. Therefore, equity can come from external sources, primarily through shareholders and owners, or internal sources, such as profits.
On the other hand, debt represents liabilities taken from other parties, usually financial institutions. These include loans and debt instruments, such as bonds, that companies use to generate funds. Debts can either be short-term or long-term.
When it comes to equity, the primary return that companies provide to its shareholders comes through the profits it generates in its operations. Shareholders receive a percentage of the earnings of a company through dividends.
However, shareholders also get another type of return from investing in a company’s shares, which comes in the form of capital gains. If the company makes losses, however, it does not have to pay anything to its equity holders.
For debts, the primary source of returns provided by the company is interest payments. Every debt instrument carries terms that allow the debtholder to receive interest on their funds. Companies must pay interest on debts regardless of whether they make profits or losses.
3) Dilution of control
When a company generates equity finance, its control gets diluted. What this means is that the more equity a company generates, the more shareholders it will have with associated voting rights.
However, in case the existing shareholders contribute more equity, a dilution of control may not occur. Nonetheless, a dilution of control is considered bad for companies.
On the other hand, debts don’t usually cause a dilution of interest. It is one of the reasons why companies prefer debt finance over equity finance. Similarly, debt doesn’t come with any voting rights, which allows the company to receive finance without any interference from the debtholders.
The cost of equity finance is generally higher compared to the cost of debt. It is because equity finance comes with a higher risk for shareholders and, therefore, they expect higher returns in exchange.
Similarly, equity finance is, theoretically, forever. Hence, in the long run, companies end up paying more to equity holders for their investments.
On the other hand, debt finance comes with lower costs. As mentioned, the only cost it usually comes with is the interest payments made on it. Similarly, debt finance has a finite life, depending on whether companies obtain short- or long-term loans. Therefore, debt finance is substantially inexpensive.
5) Payment timing
When it comes to the timing of their payments, equity holders usually get paid last. It is because equity holders receive a percentage of the profits of a company to calculate which, companies need to deduct all their expenses first, including any interest payments.
Once the company meets all its other obligations, it can pay the remaining amount to equity holders.
Debt holders, on the other hand, are priority payments for companies. Almost all types of debt require companies to pay them on time regardless of profits or other factors. That places debtholders first on the list of payments made by a company.
As mentioned, equity remains with a company for almost forever. That is why it is a long-term type of finance. Therefore, equity is best for when a company needs to finance long-term needs rather than short-term ones.
If a company uses equity for short-term needs, the costs will exceed the benefits and end up harming the company.
On the other hand, debt comes in short-term or long-term durations. The short-term debt usually lasts up to 1 or 2 years, while long-term debt is for five years or more. Based on the needs of a company, it can choose whether it wants short- or long-term finance. Usually, debt finance is best for short-term usage but can also help with long-term needs.
Equity is finance generated through shareholders.
Debt is finance that comes with liability, usually financial institutions.
Equity holders can get dividends or capital gains.
Debt holders usually gain through interest income.
Dilution of control
Equity causes a dilution of control and comes with voting rights.
Usually, debt doesn’t cause dilution of control or come with voting rights.
Equity is considered more costly.
Debt is relatively inexpensive.
Companies pay their equity holders last.
Debt holders get paid first.
Equity is best for long-term needs.
Usually, debt is great for short-term needs but also helps with long-term financing.
It is a written negotiable instrument in the form of unconditional order signed by the maker directing a certain person to pay a certain sum of money on a certain date payable on demand or expiry of the fixed period only to the certain person or order of the certain person or the bearer of the instrument.
Parties to Bills of Exchange
Drawer: The person who draws or makes the bills of exchange. He signs the bill.
Drawee: the person on whom the bills of exchange are drawn. He is known as the acceptor. He has to pay money to the drawer.
Payee: The person named in the bills of exchange and who is entitled to payment mentioned in the bill of exchange.
Such bills are generally drawn by the creditor (drawer) upon the debtor (drawee). It is similar to draft unless accepted by the debtor. Normally the drawer and the payee are the same person.
Types of Bills of Exchange:
Bills of exchange are categorized as follows:
Inland Bill: An inland bill is a bill that is made payable in the home country only.
Foreign Bill: The bill made payable in a foreign country is called Foreign Bill.
Usance Bill: This bill covers the period within which the payment is to be made.
Clean Bill: This bill doesn’t include any documents as opposed to the documentary bill. Hence, the interest is higher than the other bills.
Demand bill: This bill is payable on demand. It has no fixed period of payment.
Accommodation Bill: The bill which is sponsored to help another person in need, drawn and accepted without any condition is known as an accommodation bill.
Documentary bill: They are very popular in trade circles. These bills are accompanied by a bill of lading, air consignment note, truck/lorry receipts, railway receipts.
Features of Bills of Exchange:
It must be duly stamped.
It must be in writing.
It must be signed by the maker.
It must be an unconditional order.
The payment must be certain.
The payment must be made to a certain person.
The payment must be made on a certain date.
The amount mentioned in the bill must be paid on-demand or on the expiry of the fixed time.
Advantage of Bill of exchange:
It is a legal document. If the drawee fails to make payment in due time, the drawer can recover the amount legally.
Discounting facility: When the drawer requires immediate funds, the bill can be converted into cash by discounting it from a bank by paying some bank charges.
Endorsement of bills can be done from one person to another for adjustment and discharge of the debt.
The terms of bills of exchange are certain and can’t be altered.
Format of Bill of Exchange:
Importance of Bills of Exchange:
Adequate time for payment: Importer buying goods and services gets sufficient time limit to pay for the purchase by negotiating in bills of exchange.
Legal action: It serves as a basis for taking legal action in case the buyer fails to make the payment on the due date.
The government gets the benefit of flourishment of foreign trade through bills of exchange. This enhances the per capita income of the country.
Clear terms and conditions: The bills of exchange are signed by the acceptor only after accepting and reading the clear terms and conditions of the bills of exchange.
Easy transfer: The bills of exchange can be easily transferred to the third party. By endorsement of the bill, the liability to pay can be transferred to the third party.
Mutual accommodation: Such bills are drawn to meet the financial need of others. In this case, the bill is issued to mutually accommodate the other party.
Limitations of Bills of Exchange:
Bill of exchange poses an additional burden on the drawer if the bill is not accepted.
The discount allowed on the bill when encasing from the bank is an additional cost.
The drawee is liable to pay the bill in time as the period is fixed.
The bills have a physical form so they can’t facilitate electronic payment.
BOE has to exist in physical form so it may be stolen, lost, or torn.
It becomes difficult for the drawer to plan the cash flow as the credit date is not certain. The drawee might dishonor the payment.
Companies regularly borrow cash for assistance towards advancement and covering their bills. For sparing the interest cost, the issuer can facilitate the obligation through the provision of an alternative to buy common stock at an expected reduction. It encourages additional demand for the bonds, which would then be able to sell at a lower cost. It permits the holder to pick from accepting the ensured interest on bonds or convert to the organization’s offer to receive the dividend and exchange the shares in the capital market.
A convertible bond is a sort of bond that authorizes the holder to change over to share or common equity. As per the acknowledged bookkeeping guidelines given by the Financial Accounting Standards Board, convertible bonds are accounted as bonds in the U.S., disregarding the equity choice surrounding these tools. Conversion can be possible whenever prior to the maturity date, along with relying upon the bondholder’s tact.
What are convertible bonds?
A convertible bond is a conventional bond that comes with an additional conversion alternative, which permits a shareholder to trade the bond for an established number of common stock shares. Convertible bond comprises of both the components of value instrument and debt instrument. The holder possesses the choice either to convert it to the organization’s share or to acquire money at the time of maturity. Because of this choice, it permits the organization to issue bonds at a decreased interest rate with no concession.
It is essential in accounting to perceive the two components into the financial report. The financial liability will at first measure by utilizing limited income of interest installment and bonds supposed value. Accordingly, the additional balance needs to be recorded, which emerges from the distinction between interest paid and interest cost. The interest expense relies upon the successful interest rate while the interest paid to bondholders rely upon the coupon rate.
The conversion possibly bodes well when share costs rise sufficiently to make a profitable conversion. For instance, if a shareholder pays $1,000 for a bond, which converts to 10 shares of stock, the share cost must surpass $100 to create an appealing conversion. The conversion alternative permits the enterprise to issue the one with a lesser yield, as conversion is an important element that grows demand of a bond.
Types of Convertible Bonds
These convertible bonds need the holder to convert to a common share on its maturity date. The bondholders cannot get the money on its maturity date however should convert the bonds to share. The required bonds come under two rates; the first provides the shareholder with share value equivalent to its bonds. While the second one will restrict the worth that investors will get more than its par value. It is the strategy used by the organization to advance sell the share equity at a higher cost.
Vanilla Convertible bonds
This one is a well-known type, the organization awards right to the shareholder to convert the bonds over to common share base the conversion rate that is determined ahead of time. In addition, the bondholders will get revenue base on the coupon rate, which accompanies the fixed maturity date when bondholders may get the nominal rates.
Reverse convertible bonds permit the organization to reacquire the bonds or permit it to be converted over to share at the time of its maturity. The issuer may utilize the money to reacquire bonds otherwise; they will be transformed to equity share based on the conversion rate, which is fixed.
Accounting for Convertible Bonds
It qualifies the bondholders to change the bonds into a fixed number of shares of the responsible organization generally at the time of their maturity. These are a kind of compound monetary instrument with qualities of both equity and liability.
Convertible Bonds Example
Organization A issues 5% 2,000 convertible bonds with $ 1,000 par value. They are the convertible bonds that provide the privilege to the bondholders to change over to a common share at the time of the conversion rate of 20. The bonds are to be matured within 3 years with interest paid yearly. The interest rate is 8%.
It is referenced above as well that the convertible bond makes both equity and debt instruments. The debt will be estimated by utilizing limited income and the leftover equilibrium is recorded as equity.
Reasonable value of debt = $ 1,845,300
Other equity parts = $ 2,000,000 – $ 1,845,300 = $ 154,700
Convertible Bonds Advantages
Low-interest rate – The convertible bonds permits the organization to increase an asset with less interest rate as the shareholders consider the convertible alternative as an additional benefit. Therefore, the organization may save massive amount of money on interest payments.
Decrease the amount of share equity – For a temporary time, organization will have the option to increase assets without issuing share equity. The present bondholders will continue to be able to cast votes as before. Later on, the bonds are also converted, which will expand the stock value and increase the profit for the current investor also.
Interest rate – The organization needs to pay yearly interest to bondholders, which is the deductible cost and will save money on tax by the year’s end.
Convertible Bonds Disadvantages
Loss control – The organization may confront a deficiency of control when a major amount of share of bondholders choose to convert the bonds on some random date. It may occur when the share cost is greater than the bond’s nominal rate.
Decrease share cost – When big shareholders choose to convert during a comparable time, it will influence the market share, the share cost will diminish. This implies that the supply increment prompts a lower cost.
In short, convertible bonds are monetary instruments utilized by organizations to increase resources. Bondholders get them for their probable equity as well as return.
To create more appealing bonds for bondholders and to bring down the bond interest rate, the companies offer them the chance to get equity shares all at once based on their personal preference throughout the lifetime of the bonds.
Managing cash flow means managing working capital funds in and out of your business. This includes the aspects related to accounts receivable, accounts payable, office expenses, and so on. Tracking cash flow should be done periodically based on the size of the organization. It is advised that small businesses should track the cash flows on monthly basis due to the small number of ins and outs of funds.
Profit and cash flow are different things. Hence, businesses should prepare cash flows periodically to track the movement of cash. If you do not have positive cash flows or say cash in hand, it would become difficult to run the business on daily basis without any cash. Hence, invoicing lays a fundamental basis for smooth business functioning.
Effective cash management is necessary to attribute of a successful business but what if the majority of transactions of the business are done by the way of cash. There comes the problem in this digital world where almost all of the business transactions are either settled in real-time with the help of the internet. The nature of the business which basically deals in cash would certainly put the business at high risk for the following reasons:
Cash is the most liquid asset appearing in the balance sheet of the company. All the liquid assets are more susceptible to fraud and mismanagements as compared to other assets in the business. Management inexperience and incompetence play a big part in the inherently risky nature of cash.
2) Debt Covenant
The lenders place various debt covenants on cash to protect their money. This ensures that they have a higher chance of receiving cash from the business. The debt covenants may require that company maintain a certain level of cash compared to the total assets or to maintain minimum levels of working capital etc.
This may result in management to manipulate cash levels to maintain certain cash levels in order to meet debt covenants. This is difficult manipulation and requires the top-level management acceptance to do such manipulation in the cash.
3) Susceptibility to Theft
Cash is always considered to be inherently risky because it’s prone to theft and misappropriation. Cash can be manipulated if the employee sells the item and does not record the sale diverting the proceeds for personal use. Further, the non-employee may rob the business in case of high cash in the box which would be written as a business loss rather than misappropriation.
The high risk of cash here is that it may be manipulated and stolen by the staff with high authority. Hence, proper control shall be kept in place. Generally, the staff going through personal financial problems have a high temptation to steal the cash of the business. a dishonest employee records fraudulent sales returns or writes off the customer’s balance as uncollectible.
4) High Volume of activity
For some companies, the cash transactions during the accounting period are very high in comparison to other accounts in the books. When the business is set up in a way to deal with cash transactions, cash will be huge. The various cash transactions would include cash received from sales, cash received from receivables settlement, cash payment for expenses, cash payment for inventory, cash paid for debt settlement and interest, etc.
When the volume of cash transactions is high, it becomes more susceptible to error than other accounts in financial statements. Hence, this is the reason why cash is considered high risk as compared to other accounts.
Cash can be easily transferred between branches or countries. Such ease and convenience put cash more prone to fraud or illegal activity such as money laundering. Hence, the business places various authorization checks at the gate for cash transactions. Improper authorization can lead to misstatement in cash, imbalances, or any other form of error in balances or procedures related to cash transactions.
Money laundering is easily done through transferring cash from one bank to another in front and creating a separate backdrop transaction in behind. Auditors would find it very difficult to deal in such kind of transactions where layering has been done meticulously to evade the system.
In the modern-day and age, it can be seen that the importance of financial institutions can be gauged by the fact that consumer lending and borrowing is highest than it ever has been.
This is predominantly because of the high degree of emphasis that is placed on financial transactions to ensure that circular flow of resources within the economy continues at an accelerating pace.
Given the fact that numerous financial institutions, yet it can be seen that different financial institutions are specialized in different domains, and cater to different needs of the customers.
Types of Financial Institutions
As a matter of fact, it can be seen that there are 9 types of major financial institutions that predominantly provide a variety of services from mortgage loans to investment vehicles.
Therefore, some of these financial institutions have specialized offerings, and cater to a specific purpose, whilst others are more general and are directed towards the general public. The description of the different types of financial institutions is given below:
Central Bank: Central Banks are referred to as the main financial institutions in an economy. This is because of the reason that the Central Bank is primarily responsible for overseeing the operations and managing all other banks within the company. In most cases, the Central Bank is also responsible for drafting the monetary policy and supervising the regulation of existing financial institutions.
Retail and Commercial Banks: Retail banks offer products to retail customers, whereas commercial banks work directly with businesses. In this regard, this particular financial institution is seen to serve both commercials, and individual account holders, so that they are able to offer financial services in accordance with the policies that are set forth by the Central Bank.
Internet Banks: Internet Banks are a fairly new addition to the financial institution market. They work on a similar domain as retail and conventional banks. However, the underlying difference between internet banks, and typical banks, is the fact that internet banks rely on the virtual presence and virtual functioning, as opposed to typical brick and mortar structures.
Credit Unions: Credit Unions are mainly established to extend financial services to a particular demographic. They operate like retail banks but offer lesser services in comparison. Additionally, it can also be seen that credit unions are mainly owned by the members of the respective demographic, and therefore, they work for the benefit of the members only.
Savings and Loan Associations: Savings and Loan Associations are held mutually, and they mainly rely on collaborative efforts to reach respective financial goals. Furthermore, individual consumers also make use of savings and loan associations for deposit accounts, personal loans, as well as mortgage lending.
Investment Banks and Companies: Investment Banks do not accept deposits. They are mainly formed with the objective of helping businesses, individuals as well as governments to raise capital, with the help of securities. They are also referred to as mutual fund companies. They pool funds from individual and institutional investors in order to provide them access to considerably larger avenues in the securities market.
Brokerage Firms: Brokerage firms mainly help individuals to buy and sell securities from the existing available investors. In this regard, users of brokerage firms have exposure to different types of stocks, securities as well as mutual funds.
Insurance Companies: Insurance Companies are mainly Financial Institutions that are formed with the objective to mitigate the inherent risk involved. Therefore, individuals and companies mainly use it to protect against the financial loss because of health, or any other unprecedented action.
Mortgage Companies: Mortgage Companies are financial institutions that are formed with the basis to originate or subsequently fund mortgage loans. Some of these mortgage companies are established with the basis to serve clients who are in between real estate transactions only.
Therefore, it can be seen that there are numerous types of financial institutions that are established to cater to different clients based on their requirements.
In this regard, it is also rudimentary to highlight the fact that all of the financial institutions are mostly formed, and subsequently looked after by the governments. Hence, all financial institutions are supposed to comply with the government to ensure that they work and operate under the law.
The importance of financial institutions can not be denied because of the important role they play in a given economic scenario. This is essentially because of the fact that they contribute immensely in building investor trust, as a result of which people do not hesitate to invest their savings into the options that suit them best.