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“Any debt the maturity of which extends beyond the period adopted within that business for current liabilities will usually be grouped with the fixed liabilities, there seldom being an intermediate group.”—Kester. In Chapter Two, page 27, we quoted from the Public Service Commission of New York on what comprised “Funded Debt.” Long-term obligations, usually in the form of mortgaged or bonded indebtedness, are called fixed liabilities—sometimes known as LOAN CAPITAL as distinguished from SHARE CAPITAL. Loan capital usually has as security some specific form of property, such as land, buildings, equipment, etc., which have been classified and included among the fixed assets of the concern. Under these circumstances the general creditors can only claim the equity or difference between the realizable value of the specific portion of the assets, and the amount of the loan which has been secured by it. When it becomes necessary or advisable to raise additional capital and it is not desired to increase the share capital, long time notes or bonds, usually secured by mortgages, are issued. In the case of an individual or a partnership, it is quite customary to issue notes secured by first or second mortgages on the fixed assets or real property owned, but in the case of a corporation it is more common to issue bonds.
Definition. A mortgage is a conditional title to property given by the owner to another to secure the payment of a debt or the discharge of some obligation. It is similar to a deed and conveys title to the property on which the mortgage is placed, but upon some condition. That condition is the failure to make prompt payment of an obligation or debt at maturity. The tendency is to regard a mortgage as a lien on the property and not as an actual conveyance. The mortgagor retains physical possession of the property and is entitled to the income therefrom and may use the property just as though it were his own. Of course, he must not impair its value and he must comply with all the conditions in the mortgage contract. The holder of a mortgage (the mortgagee) has practically no control over the property or over the operation of the concern involved.
Real or Personal Property May Be Mortgaged. “In equity, whatever property, real or personal, is capable of an absolute sale, may be the subject of a mortgage.”
Mortgages on chattel property are usually for a short period of time and are classed as current liabilities, but mortgages on real property as security for notes or bonds, due at some time in the future beyond that for which liabilities are classed as current, would be considered fixed liabilities.
Kinds of Mortgages. Mortgages are known as either chattel or real estate mortgages, depending on the property which is the basis of the security. They are sometimes known as purchase money or building and loan mortgages, depending on the purpose of the mortgage. They may also be classified as to precedence as first mortgages, second mortgages, etc. A first mortgage takes precedence over a second mortgage and so on. In case of liquidation of capital assets, holders of mortgages stand in order according to the class of mortgage held.
Chattel Mortgages. The only difference between a chattel mortgage and a real estate mortgage is in the kind of property conveyed as security. Chattel mortgages are placed on chattel or personal property. Real estate mortgages are placed on real property. Purchase Money Mortgages. These are mortgages given for part or the whole of the purchase price of land. They take precedence over all claims of the general creditors. The mortgage may be given either to the person from whom the land is purchased or to a third person. Building and Loan Mortgages. These are frequently given to secure funds for erecting a building. The money is paid over as the building is constructed and reaches certain stages mentioned in the mortgage contract, or the entire amount may be delivered to a trust company to be held in trust and paid over as the installments fall due. If the money is held by the mortgagee and paid in installments, interest can only be charged from the date of the actual payment of the installments, but if placed in the hands of a trust company to be paid in installments, interest may be charged on the full amount. Of course, the trust company will also pay a low rate of interest on the amount deposited. Accounting Procedure. Mortgages used as security for notes are usually classed as mortgages payable on the books of account, while those used as security for bonds are classed as bonds payable. The usual procedure with mortgages payable is the same as with notes payable. The Mortgages Payable account is credited with each mortgage issued and debited when the mortgage has been paid. These transactions will usually be found recorded in the general journal and cash book. They are not sufficiently numerous to require special columns and, therefore, all items are posted individually.
Unlike bonds, mortgages are seldom sold at either a discount or a premium. The amount received is usually equal to the face of the mortgage, hence mortgages should be recorded, like notes, at their face or par value. In other words, the interest rate on mortgages is nearly always equal to the effective market rate for the particular type of equity involved.
Definition. A bond is simply a long-term note—an interest bearing, negotiable instrument, under seal, promising to pay a certain sum of money at a definite or determinable future date. It is usually secured by a pledge of certain properties, real or personal, as to either or both principal and interest.
Bonds vs. Notes. A corporation may borrow money the same as an individual. If only a small amount is desired or it is wanted for a short time only, notes are usually given. These notes may be secured or unsecured. If unsecured, they are classed as current liabilities and are called notes payable on the books of account. If secured by a mortgage, they are usually called mortgages payable on the books of account and may be classed as either current or fixed liabilities, depending on the length of time to maturity.
When the amount to be borrowed is large and is wanted for a long period of time, say from five to fifty years, then bonds instead of notes are given. There is said to be a bond issue. This consists of a number of bonds, which may vary in denomination, but which are all of like general tenor, and if secured are all secured alike under one “deed of trust”.
Deed of Trust. This is a mortgage on certain specified property placed in the hands of a trustee who represents the bondholders. The deed of trust states at length the terms and conditions under which the bonds are issued and under which the property for their security is held. In the bonds, reference is made to the deed of trust by which they are secured. It will be seen, therefore, that both the deed of trust and the bonds issued refer to each other in such a manner that all terms and conditions are clearly stated in both instruments. The trustee has the right to act in behalf of the bondholders and may bring foreclosure proceedings if it becomes necessary to do so. If the trustee fails to do so, any bondholder may bring foreclosure proceedings for the benefit of all the bondholders. Of course, he must show the court that this action is necessary to safeguard the interest of the bondholders and that the trustee refuses to act.
Security. Formerly bonds were commonly supposed to be secured by real estate mortgages, except when otherwise specifically designated. In these times, bonds may or may not be secured at all. Often they are nothing more than promissory notes; in fact, are not so valuable because they do not mature for a longer time. It will be readily seen, therefore, that an auditor must be able to determine the value of the security in order to place a valuation on the bonds.
There are so many different kinds of bonds that we can only describe a few of each kind here. They may be subdivided as to security, as to purpose, as to payment of interest, and as to payment of principal.
AS TO SECURITY
Debenture Bonds. We have already stated that bonds may be secured or unsecured. Unsecured bonds are usually termed “Debentures” or “Debenture Bonds.” This term is also often used to describe bonds partially secured, those secured by collateral and those on which the payment of the interest is contingent upon the earnings of the company. This interest may be cumulative or non-cumulative. An unsecured debenture bond is a mere promise to pay and is inferior to any secured liabilities of the company. It is, however, superior to preferred stock in that the liability on account of interest payable ranks ahead of the dividends on the preferred stock. The value of unsecured bonds depends entirely on the financial strength of the issuing company. No foreclosure proceedings can be instituted because no mortgage has been given. Bonds secured by depositing stocks and bonds of another company (owned by the issuing company) in the hands of a trustee, are frequently known as “collateral trust bonds" and may be classed as debentures as stated above. Example: Lake Shore & Michigan Southern 25-year debenture 4s, due
September 1, 1928, were originally debentures, but are now secured by direct second lien on the Lake Shore property of New York Central System.
Mortgage Bonds. Mortgage bonds, as the name implies, are those secured by a mortgage, or deed of trust on part or all of the property of the issuing company. These bonds may be known as first, second, third, etc. mortgage bonds according to the rank of the mortgage or deed of trust by which they are secured. A first mortgage bond is a first lien on the property mortgaged except in cases where a builder's lien, receiver's certificate or some similar obligation takes precedence. A second mortgage bond is one in which the security is a second mortgage on the same property. Example: American Smelting & Refining First Mortgage 5s, due
April 1, 1947, secured by first mortgage on entire property of company and by pledge of capital stock of five subsidiaries.
Income Bonds. These have already been defined as bonds on which the payment of interest is contingent upon the earnings of the issuing company. Such bonds are a lien on the net income of the company. If there are no net profits, the interest is not a liability unless it is cumulative. The principal of such bonds may be secured or unsecured. If unsecured they are frequently called debenture bonds.
Guaranteed Bonds. These are bonds the payment of which, either as to principal or interest, or both, is guaranteed by another company. This guarantee to be binding must be in writing and must be written on the bond itself, or be attached to it. Such bonds are frequently issued. For instance, a subsidiary company may issue bonds guaranteed by the parent or holding company of which it forms a part.
AS TO PURPOSE
Improvement Bonds are bonds issued for the purpose of property improvements. They may be either debenture or mortgage bonds and may be secured or unsecured as to principal or interest, or both. Example: Miami Conservancy District, Ohio, 5%% bonds, issued December 1, 1917, “for the prevention of floods and protection of certain cities, including Dayton, Hamilton, Middletown, Piqua, Troy and other smaller municipalities.” Refunding Bonds are bonds issued to raise funds to replace or redeem other bonds which are maturing. In some instances they are exchanged directly for the old bonds, but more often sold and the money used to retire the maturing bonds. The interest rate on these bonds may be higher or lower than on those bonds being retired, depending on money conditions at the time of issue.
Example: Illinois Central Refunding Mortgage 4s, due November 1, 1955. Secured by a direct mortgage on 21, 172 miles of road, etc.
Adjustment Bonds are bonds issued for the purpose of readjusting or consolidating existing indebtedness. They are very similar to refunding bonds.
Purchase Money Bonds are bonds given to secure funds with which to purchase the property by which they are secured. (See Purchase Money Mortgages, Page 178.)
AS TO PAYMENT OF INTEREST
Registered Bonds are registered on the books of the issuing company in the name of some particular individual or company in much the same manner as capital stock. The interest and principal are then payable only to the registered holder of the bonds. Such bonds may be transferred by assignment. When assignment is made the assignee surrenders the old bond and is given in exchange a bond issued in his own name. The transfer is made on the books of the issuing company.
Coupon Bonds are bonds usually made payable to bearer and to which are attached interest coupons. These interest coupons are always made payable to bearer. They are clipped off at maturity and presented for payment. There will be as many coupons attached as there are interest due dates. United States Government Liberty and Victory Bonds are issued in