Reading 28: Non-Current (Long-Term Liabilities)

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Reading 28: Non-Current (Long-Term Liabilities)

Learning Outcome Statements


• Covered
• 28a, 28b, 28c, 28d, 28e, 28f, 28g, 28h, 28i

• Not Covered
• 28j
Bond Terminology—I
• Par value: amount payable to the bondholders at maturity; also called face value, principal,
stated value, maturity value
• Coupon rate: interest rate used to calculate periodic interest payments; also called nominal
rate, stated rate
• Coupon payment: coupon rate times par value
• Market rate of interest: interest rate demanded by investors given the risks of an investment
• Effective interest rate: the market rate of interest when bonds are issued; used to compute
interest expense
• If the effective interest rate > coupon rate, bonds are issued at a discount (price < par)
• If the effective interest rate = coupon rate, bonds are issued at par (price = par)
• If the effective interest rate < coupon rate, bonds are issued at a premium (price > par)
• Interest expense: coupon payments plus amortization of any premium/discount; there are
two methods of amortization—effective interest method and straight-line
Bond Terminology—II
Example: Lynx Industries issues one thousand $1,000 par, 6% coupon, 5-year, annual-pay bonds for a
total of $958,998.

• The par value of a single bond is $1,000


• The coupon rate is 6%
• The (annual) coupon payment for a single bond is 6% × $1,000 = $60, for the entire issue is $60,000
• The maturity is 5 years
• The effective interest rate is 7% (covered in quant, fixed income)
• The initial (net) liability—book value—is $958,998
• The initial discount is $1,000,000 − $958,998 = $41,002
• First year’s interest expense
• Effective interest rate method: $958,998 × 7% = $67,130
 $60,000 is the coupon payment
 $7,130 is the amortization of the discount
• Straight-line amortization: $68,200
 $60,000 is the coupon payment
 $8,200 is the amortization of the discount
Effects on Financial Statements—I
• Issuance
• Balance sheet
 Liability equal to proceeds
1. IFRS subtracts issuance costs from liability
2. U.S. GAAP records issuance costs as an asset
 Cash increase equal to proceeds
• Income statement
 No effect
• Cash flow statement
 CFF inflow equal to proceeds
Effects on Financial Statements—II
• Life of the bonds
• Issued at a discount
 Balance sheet
1. Liability increases by amount of amortization
2. Cash decrease equal to coupon payments
 Income statement
1. Interest expense = coupon payment + amortization of discount
 Cash flow statement
1. CFF outflow equal to coupon payments
• Issued at par
 Balance sheet
1. Liability unchanged
2. Cash decrease equal to coupon payments
 Income statement
1. Interest expense = coupon payment
 Cash flow statement
1. CFF outflow equal to coupon payments
Effects on Financial Statements—III
• Life of the bonds (cont.)
• Issued at a premium
 Balance sheet
1. Liability decreases by amount of amortization
2. Cash decrease equal to coupon payments
 Income statement
1. Interest expense = coupon payment − amortization of premium
 Cash flow statement
1. CFO outflow equal to coupon payments
• Maturity
• Balance sheet
 Liability eliminated
 Cash decrease equal to par value
• Income statement
 No effect
• Cash flow statement
 CFF inflow equal to par value
Amortization of Premium/Discount—I
• Effective interest rate method
• Interest expense = beginning book value × effective interest rate
• Amortization of premium/discount = interest expense − coupon payment
• Required by IFRS, preferred by U.S. GAAP

• Straight-line method
• Amortization of premium/discount = initial premium/discount ÷ original
years to maturity
• Interest expense = coupon payment + amortization of premium/discount
• Allowed by U.S. GAAP
Amortization of Premium/Discount—II
Example (cont.): Lynx Industries issues one thousand $1,000 par, 6% coupon, 5-year, annual-pay
bonds for a total of $958,998. The effective rate is 7%.

The following amortization table illustrates the effective rate method.


Interest expense = Beginning book value × 7%, amortization = interest expense − coupon
payment, and ending book value = beginning book value + amortization.
Amortization of Premium/Discount—III
Example (cont.): Lynx Industries issues one thousand $1,000 par, 6% coupon, 5-year, annual-pay
bonds for a total of $958,998. The effective rate is 7%.

The following amortization table illustrates the straight-line method.


Amortization = $41,002 ÷ 5 = $8,200, interest expense = coupon payment + amortization, and
ending book value = beginning book value + amortization.
Amortization of Premium/Discount—IV
Example (cont.): Lynx Industries issues one thousand $1,000 par, 6% coupon, 5-year, annual-pay
bonds for a total of $1,043,295. The effective rate is 5%.

The following amortization table illustrates the effective rate method.


Interest expense = Beginning book value × 5%, amortization = interest expense − coupon
payment, and ending book value = beginning book value + amortization.
Amortization of Premium/Discount—V
Example (cont.): Lynx Industries issues one thousand $1,000 par, zero-coupon, 5-year, annual-pay
bonds for a total of $712,986. The effective rate is 7%.

The following amortization table illustrates the effective rate method.


Interest expense = Beginning book value × 7%, amortization = interest expense, and ending book
value = beginning book value + amortization.
Practice Question
DeMarco-Robbins (DR) issues $5,000,000 of 5% coupon, 10-year bonds at a time when market rates are at
4.8%. In year 2, DR’s interest expense using the effective rate method, compared to interest expense
using the straight-line method, should be:

A. Lower than it would be using straight line.


B. The same as it would be using straight line.
C. Higher than it would be using straight line.
Issuance Costs
• Printing costs, legal fees, commissions, etc.
• Reduces the net proceeds from the bond issuance
• Increases effective interest rate
• Reduces cash on balance sheet
• Reduces CFF inflow
• U.S. GAAP (Prior to 15 December 2015)
• Reported as an asset (deferred expense) and amortized straight-line over the
life of the bonds
• IFRS and U.S. GAAP (Now)
• Initial balance sheet liability for bonds is the sales proceeds net of issuance
costs
• U.S. GAAP (Now) – Option to record asset for issuance costs on lines of credit
Changing Market Rates—I
• As market rates change, fair market value of fixed-rate bonds changes
• Increase in interest rates, decrease in fair market value
• Decrease in interest rates, increase in fair market value

• Bonds are generally reported at amortized historical cost


• Based on market rate at time of issuance
• Overstates economic liability, leverage when interest rates rise
• Understates economic liability, leverage when interest rates fall

• Companies must disclose fair market value of financing liabilities

• Option to report financial liabilities at fair value


• Gains/losses reported on income statement
Fair Value Reporting Option
Financial liabilities reported at fair value are designated as financial liabilities at fair value
through profit or loss under IFRS or as liabilities under the fair value option under U.S. GAAP.
• A company electing to measure a liability at fair value will report decreases in the liability’s fair
value as income and increases in the liability’s fair value as losses.
Changes in a liability’s fair value can result from changes in market rates and/or changes in the
credit quality of the issuing company.
• Companies must report the portion of the change in value attributable to changes in their
credit risk in other comprehensive income.
• Only the portion of the change in value not attributable to changes in their credit risk will be
recognised in profit or loss.
Derecognition of Debt—I
• Retirement at maturity
• No gain/loss to recognize
• CFF outflow: par value
• Retirement before maturity
• Purchase on open market
• Exercise call option
• Early retirement (e.g., sinking fund) provision
• Bondholder exercises a put option
• Possible gain/loss
 Gain if repurchase price < carrying value
 Loss if repurchase price > carrying value
 Carrying value includes unamortized issuance costs (U.S. GAAP)
• Gain/loss is classified as unusual or infrequent
• CFF outflow: repurchase price
Derecognition of Debt—II
Example: Five years ago, Smokey’s Restaurants issued $1,000,000 par of 6% coupon, semiannual-
pay, 10-year bonds for $950,000. The issuance costs were $50,000, which Smokey’s is amortizing
over 10 years. The current carrying value of the bonds is $970,922.

Smokey’s purchases half of the bonds on the open market at 98.25. Compute the gain/loss (if any)
that Smokey’s will report on their income statement.

Carrying value ($970,922 × 50%) $485,461


Unamortized issuance costs
($50,000 × 5/10 × 50%) (12,500)
Purchase price ($1,000,000 × 50% × 0.9825) (491,250)
Loss on repurchase ($18,289)
Practice Question
Canfield & Miller has a $10 million bond issue maturing this year. They’ve been sufficiently
profitable that they can pay off the issue with cash on hand. When they do, their debt-to-asset ratio
will most likely:

A. Decrease.
B. Remain unchanged.
C. Increase.
Presentation/Disclosures
• Long-term liabilities are aggregated as a single amount
• Liabilities due within one year: current liabilities
• Footnotes
• Stated and effective interest rates
• Maturity dates
• Pledged collateral
• Scheduled repayments over the next 5 years
• Covenants
 Timely principal and interest payments
 Maintenance of pledged collateral
 Dividend restrictions
 Maximum leverage levels
 Minimum liquidity ratios
Motivations for Leasing
• Fixed interest rates

• No down payment

• Less risk of obsolescence

• No concern about disposal

• Fewer restrictions (covenants)


Lessee Accounting—IFRS
• Under IFRS, after inception, the lessee records:
• Depreciation expense on the right-of-use asset.
• Interest expense on the lease liability.
• Reduces the balance of the lease liability for the portion of the lease payment that
represents repayment of the lease liability.
Lessee Accounting—U.S. GAAP
Lessee accounting after inception depends whether the lessee categorizes a
lease as a finance lease or an operating lease.
• A finance lease is similar to purchasing an asset while an operating lease is similar to
renting an asset.
• Criteria for categorizing a lease as a finance lease include indicators that the benefits
and risks of owning the leased asset have been transferred to the lessee.
• A lessee’s accounting for a finance lease under U.S. GAAP is the same for leases under IFRS.
• For an operating lease after inception, under U.S. GAAP, the lessee recognizes a single
lease expense, which is a straight-line allocation of the cost of the lease over its term.
Effects on Financial Statements
IFRS:
• Each and every lease will require recognition of (1) a right-to-use asset and (2) a lease liability,
resulting in a subsequent allocation of lease payments between (1) depreciation and (2) interest
expense.

U.S. GAAP
• Lessee will report depreciation expense and interest expense only in for finance leases.
• For operating leases, lessee reports a single lease expense.

Further, on the statement of cash flows, IFRS allows companies to classify interest paid under
operating, investing, or financing activities. U.S. GAAP requires companies to classify interest paid
under operating activities.
Lessor Accounting—IFRS
A lessor may classify a lease as (1) a finance lease or (2) an operating lease.
For a finance lease:
• At inception, lessor removes underlying leased asset from balance sheet.
• Instead, recognizes a lease asset composed of lease receivables and the asset’s expected
salvage value.
• If lessor is a manufacturer or dealer, selling profit may arise. Over the lease term, lessor
recognizes finance income.
For an operating lease:
• Lessor recognizes lease receipts as income and related costs (e.g., deprecation of the
leased asset) as expenses.
Lessor Accounting—U.S. GAAP
Under U.S. GAAP, a lessor may classify a lease as a (1) sales-type, (2) operating,
or (3) direct financing lease.
• If benefits and risks of ownership have been transferred to lessee, lessor will classify
the lease as a sales-type lease.
• If above conditions not met, the lease will be classified as an operating lease or
direct financing lease.
• For an operating lease, lessor accounting under U.S. GAAP is similar to the IFRS treatment.
• A lease is considered a direct financing lease under U.S. GAAP if the lease contract provides
for a third-party guaranteed residual value, which, combined with the future lease
payments by lessee, will equal or exceed the fair value of the leased asset.
Defined Contribution Plans
• Company contributes money to the plan, has no further obligation
• Accounting
• Income statement
 Pension expense equals required contribution

• Balance sheet
 Decrease in cash equal to actual contribution
 Liability if actual contribution < required contribution
 Asset if actual contribution > required contribution

• Cash flow statement


 CFO outflow equal to actual contribution
Defined Benefit Plans—I
• Company contributes money to the plan, promises to pay future pension benefits
• Company must estimate future obligation
• Wage/salary growth rate
• Average retirement age
• Average longevity after retirement
• Discount rate
• Accounting
• Balance sheet
 Net pension asset if plan assets > PV of benefit obligation
 Net pension liability if plan assets < PV of benefit obligation
Defined Benefit Plans—II
• Accounting (cont.)
• Change in net pension asset/liability during period
 IFRS
1. Employee service cost
2. Net interest expense or income
3. Actuarial gains/losses
4. Actual return − Expected return
 U.S. GAAP
1. Employee service cost
2. Interest expense
3. Expected return on plan assets
4. Past service costs
5. Actuarial gains/losses
Defined Benefit Plans—III
• Accounting (cont.)
• Balance sheet
 IFRS—not amortized
1. Actuarial gains/losses
2. Actual return − expected return
 U.S. GAAP—amortized
1. Past service costs
2. Actuarial gains/losses
• Income statement
 IFRS
1. Employee service cost
2. Net interest expense or income
 U.S. GAAP
1. Employee service cost
2. Interest expense
3. Expected return on plan assets
Practice Questions with Solutions
Practice Question
DeMarco-Robbins (DR) issues $5,000,000 of 5% coupon, 10-year bonds at a time when market rates are at
4.8%. In year 2, DR’s interest expense using the effective rate method, compared to interest expense
using the straight-line method, should be:

A. Lower than it would be using straight line.


B. The same as it would be using straight line.
C. Higher than it would be using straight line.

Answer: A

For a premium, the amortization under the effective rate method is higher in the early years and lower in
the later years; in year 2 of 10, the amortization would be higher than the straight-line amortization.

The amortization of a premium reduces interest expense, so reducing it by a higher amount of


amortization will result in a lower interest expense.
Practice Question
Canfield & Miller has a $10 million bond issue maturing this year. It has been sufficiently profitable
that it can pay off the issue with cash on hand. When it does, its debt-to-asset ratio will most likely:

A. Decrease
B. Remain unchanged
C. Increase

Answer: A

Canfield & Miller’s profitability suggests positive equity, so its liabilities are less than its assets;
furthermore, its debt is likely less than its liabilities, so its debt is less than its assets, and its
existing debt-to-asset ratio is less than 1. When the same amount is subtracted from the numerator
and the denominator, the ratio will decrease.

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