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CHAPTER 12

NONCURRENT (LONG-TERM) LIABILITIES
Presenter’s name
Presenter’s title
dd Month yyyy

BONDS: CONTENTS
1. Pricing of debt based on present value of future cash
payments.
2. How an issuer accounts for debt:
- Issued at par
- Issued at a price other than par
- Issuance, periodic interest payments, repayment
3. Role of debt covenants in protecting creditors.

Copyright © 2013 CFA Institute

2

BONDS: BORROWERS’ CASH FLOWS

At issuance (Time 0),
borrower receives
cash in exchange for
0
bonds.
Issue price equals
present value of
future cash flows.

Copyright © 2013 CFA Institute

Pays periodic interest at the
coupon rate.
1

2

3

4

5
At maturity,
pays
principal
amount.

3

nt PV = ? Copyright © 2013 CFA Institute yme a p ch a e t te un a i o r c p s Di ppro a e at th unt rate o disc 4 . Maturity = 5 years • Future cash flows for a five-year.000 principal.DETERMINING THE VALUE OF A BOND: EXAMPLE • Assumptions about the debt instrument (the bond): Principal = $1.000. Coupon interest rate = 10%. • The market value of a bond is equal to the present value of its future cash flows. 10% bond. $1. • Payments include periodic interest payments and principal payment.

For simplicity. • Assumption about the debt market on the day of valuing: . . Copyright © 2013 CFA Institute 5 .Market rate (yield or effective rate): Return the market demands on that bond on day we are valuing it = 10%. assume a flat interest rate yield curve. .Principal = $1. . annual.Coupon interest rate: Stated or contractual rate of interest to be paid to the bondholders = 10%.ACCOUNTING FOR DEBT BY THE ISSUER: EXAMPLE • Assumptions about the bond: .Maturity = 5 years.000.

100% of face value).. Coupon interest rate = 10%. • Market rate on the day we are valuing the bond = 10%.000.000 1.000 6 .ACCOUNTING FOR DEBT: EXAMPLE • Principal = $1. Time 0 1 2 3 4 5 Total Copyright © 2013 CFA Institute PV = FV/[(1+i)n] Interest Paymen Principal Total Present Value of t Payment Payment Total Payment 100 100 100 100 100 500 1. • Bond will be issued at par (i.000 100 100 100 100 1.500 91 83 75 68 683 1.e.100 1. Maturity = 5 years.

000.ISSUER’S ACCOUNTING FOR DEBT AT ISSUANCE: EXAMPLE • Principal = $1. Coupon interest rate = 10%. • Recorded in the long-term liability section of the balance sheet because maturity date is > one year away • Issuer’s balance sheet: Increase cash for $1. Maturity = 5 years. • Issuer’s journal entry: Debit cash and credit bonds payable.000 and increase bond payable for $1. annual payments.000. • Market rate on issuance date = 10%. ASSETS = + $1000 Cash Copyright © 2013 CFA Institute LIABILITIES + OWNERS’ EQUITY + $1000 Bond payable 7 . • Issued at par.

Maturity = 5 years. • Issuer’s balance sheet when interest paid: Decrease cash and increase interest expense (which reduces owners’ equity). • Issuer’s journal entry: Debit interest expense.000. Coupon interest rate = 10%. annual payments. • For simplification.ISSUER’S ACCOUNTING FOR DEBT AT INTEREST PAYMENT: EXAMPLE • Principal = $1. credit cash. ASSETS = – $100 Cash Copyright © 2013 CFA Institute LIABILITIES + OWNERS’ EQUITY – $100 Interest expense 8 . • Issued at par. assume each interest payment occurs on the last day of the fiscal year.

000. assume principal repayment occurs on the last day of the fiscal year. • Issuer’s journal entry: Debit bonds payable and credit cash. • Issuer’s balance sheet when principal repaid: Decrease cash and decrease bonds payable.ISSUER’S ACCOUNTING FOR DEBT REPAYMENT • Principal = $1. annual payments. Coupon interest rate = 10%. ASSETS = – $1000 Cash Copyright © 2013 CFA Institute LIABILITIES + OWNERS’ EQUITY – $1000 Bonds payable 9 . • Issued at par. Maturity = 5 years. • For simplification.

ISSUER’S ACCOUNTING FOR DEBT OVER ITS LIFE: EXAMPLE Principal = $1.000 Copyright © 2013 CFA Institute –1. Transaction Year Cash Initial borrow Begin 1 $1.000.000 10 . Maturity = 5 years. Coupon = 10%.000 Premium or Common Retained (Discount) Stock Earnings 0 Pay interest 1 –100 0 –100 Pay interest 2 –100 0 –100 Pay interest 3 –100 0 –100 Pay interest 4 –100 0 –100 Pay interest 5 –100 0 –100 Pay principal 5 –1.000 Bonds Payable $1. Issued at par.

DISCOUNT OR PREMIUM ON BONDS Often. Copyright © 2013 CFA Institute Coupon Rate 10% Market Rate (examples) Bonds Sell At a 8% Premium 10% Par 12% Discount 11 . Therefore. bonds sell above or below face value. the contractual interest rate and the market rate differ.

.000. What do we do with the difference? • We show it as a discount to bonds payable. 92. ASSETS = + $928 Cash Copyright © 2013 CFA Institute LIABILITIES + + $1.ISSUER’S ACCOUNTING FOR BONDS ISSUED AT A DISCOUNT • Principal = $1. Issued at 92.8% of face value).e. • Return the market demands on the bond on the day we are valuing it = 12%. • At issuance. Maturity = 5 years. cash increases by $928 and bonds payable increases by $1. Coupon interest rate = 10%. paid annually.000.000 Bond payable – $72 Bond discount OWNERS’ EQUITY 12 .8 (i.

BONDS ISSUED AT A DISCOUNT Issuer’s Balance Sheet Presentation Book value (also known as carrying value) Copyright © 2013 CFA Institute 13 .

000 Year 1 Copyright © 2013 CFA Institute –100 Discount –72 11 Commo Net Inc. Issue price 92.000 × 10% × 1 year = $100 • Interest expense = Carrying value × Effective rate × Time • Amortization of discount = Interest expense – Cash interest payment Transaction Initial borrowing Pay interest Cash   Bonds Payable Begin 1 $928   $1. Each year: • Cash interest payment = Principal x Coupon rate x Time = $1.ISSUER’S ACCOUNTING FOR BOND ISSUED AT A DISCOUNT Principal = $1.000. Coupon rate = 10%. Maturity = 5 years. Stock Earnings –111 $928 × 12% × 1   Interest expense 14 .8% of par to yield 12% (effective rate). n to Ret.

ISSUER’S ACCOUNTING FOR BOND ISSUED AT A DISCOUNT Principal = $1. Issue price = 92. Coupon rate = 10%.000. • Amortization of discount = Interest expense – Cash interest payment. Earnings –72 11 13 –111 Interest expense –113 Interest expense 15 . • Year 2.8% of par to yield 12% (effective rate). to Ret.000 Year 1 2 Copyright © 2013 CFA Institute –100 –100 Discount Common Stock Net Inc. ($928 + $11) × 12% × 1 • Interest expense = Carrying value × Effective rate × Time. Maturity = 5 years. Transaction Initial borrowing Pay interest Pay interest Cash Bonds Payable Begi n 1 928   1. Cash interest payment = $100.

Stock Earnings   –72 –100 11 –111 Interest exp.ISSUER’S ACCOUNTING FOR BOND ISSUED AT A DISCOUNT • Principal = $1.000 Discount Net Inc. • Issued at 92.8 to yield 12%.000 –1.000. –100 13 –113 Interest exp –100 14 –114 Interest exp –100 16 –116 Interest exp –100 18 –118 Interest exp –1. Common to Ret. Maturity = 5 years.000 16 . Coupon = 10%. Transactio n Year Initial Begin borrowing 1 Pay interest 1 Pay interest 2 Pay interest 3 Pay interest 4 Pay interest 5 Pay principal 5 Copyright © 2013 CFA Institute Cash Bonds   Payable 928   1.

Maturity = 5 years. • Return the market demands on the bond on the day we are valuing it = 8%. paid annually.We show it as a premium to bonds payable. 108% of face value). What do we do with the difference? . • At issuance.000.e.ISSUER’S ACCOUNTING FOR BOND ISSUED AT A PREMIUM • Principal = $1. cash increases by $1080 and bonds payable increases by $1..000. Coupon interest rate = 10%. Issued at 108 (i. ASSETS = + $1080 Cash Copyright © 2013 CFA Institute LIABILITIES + + $1000 Bond payable + $80 Bond premium OWNERS’ EQUITY 17 .

000 –1. Earnings   –86 Interest expense 80 –14 –100 –15 –85 Interest expense –100 –16 –84 Interest expense –100 –17 –83 Interest expense –100 –19 –81 Interest expense –1. Coupon interest rate = 10%. Maturity = 5 years.080   1.   Transactio n Year Initial Begin borrowing 1 Pay interest 1 Pay interest 2 Pay interest 3 Pay interest 4 Pay interest 5 Pay principal 5 Copyright © 2013 CFA Institute Assets = Liabilities + Cash Bonds   Payable 1. • Issue price = 108% of par to yield 8%.000 18 . to Ret.000.000 –100 Premium Owners’ Equity Commo n Stock   Net Inc.ACCOUNTING FOR BOND ISSUED AT A PREMIUM • Principal = $1.

At face value. at a discount.BOND PRICES SUBSEQUENT TO ISSUANCE • Bonds may be issued: . or at a premium depending on the market rates at that time. • Changes in value subsequent to issuance do not affect the value of the bond on the issuer’s statement unless the issuer has chosen the fair value option (much less common). Copyright © 2013 CFA Institute 19 . .Below face value: discount.Above face value: premium. . bonds may trade at face value. • Subsequent to issuance.

Amount of repurchase payment will depend on market rates at the time of repurchase Copyright © 2013 CFA Institute 20 .A firm may decide to retire bonds early .To reduce interest costs or to remove debt from balance sheet .But only if it has sufficient cash .Recognize gain or loss on redemption Gain or loss on bond repurchase = Net bonds payable − Repurchase payment .PAYMENT OF BONDS May be redeemed at maturity or before maturity .To account for retiring bonds early .Eliminate carrying value of bonds at redemption date .Record cash paid .

be entitled to a penalty payment or higher interest rate. .call for immediate repayment of the debt.Affirmative covenants . .DEBT COVENANTS • Covenants protect creditors by restricting activities of the borrower. .Negative covenants • If a borrower violates a debt covenant. or . lenders may . depending on the severity of the breach and the terms of the contract.choose to waive the covenant.renegotiate. Copyright © 2013 CFA Institute 21 .

ISSUER’S FINANCIAL STATEMENT PRESENTATION OF DEBT Excerpt from 2011 and 2010 balance sheets of Colgate-Palmolive Inc. Copyright © 2013 CFA Institute 22 .

ISSUER’S NOTE DISCLOSURES RELATING TO DEBT Brief excerpt from Note 5 of Colgate Palmolive’s 2011 financial statements. Copyright © 2013 CFA Institute 23 .

if any.LEASES • Leasing an asset is an alternative to purchasing. • Certain types of leases have perceived financial reporting advantages. • Leasing can reduce the risks of obsolescence. • Rather than borrowing and buying the asset. and disposition to the lessee. • Advantages to leasing an asset compared with purchasing it: • Leases can provide less costly financing. a company arranges to lease the asset. residual value. • The negotiated lease contract may contain less restrictive provisions than other forms of borrowing. Copyright © 2013 CFA Institute 24 . and are often at fixed interest rates. down payment. usually require little.

. and “capital lease” is U. .A lessee treats capital leases as on-balance-sheet obligations.“Finance lease” is IFRS terminology. . GAAP terminology.S.LEASES There are two main classifications of leases: finance (or capital) and operating leases.A lessee does not show operating leases on the balance sheet. Copyright © 2013 CFA Institute 25 .

GAAP) Copyright © 2013 CFA Institute Balance Sheet Income Statement Statement of Cash Flows No effect. Reduction of lease liability is a financing cash outflow. Reports interest expense on lease liability. Recognizes leased asset and lease liability.S. GAAP. 26 . Rent payment is an operating cash outflow. Interest portion of lease payment is either an operating or financing cash outflow under IFRS and an operating cash outflow under U. Reports depreciation expense on leased asset.S.LEASES FROM LESSEE’S PERSPECTIVE Lessee Operating Lease Finance Lease under IFRS (capital lease under U. Reports rent expense.

Statement of Cash Flows Rent payments received are an operating cash inflow.LEASES FROM LESSOR’S PERSPECTIVE Balance Sheet Operating Lease Copyright © 2013 CFA Institute Retains asset on balance sheet. 27 . Income Statement Reports rent income and depreciation expense on leased asset.

GAAP) Copyright © 2013 CFA Institute Removes asset from balance sheet.S. GAAP. Interest portion of lease payment received is either an operating or investing cash inflow under IFRS and an operating cash inflow under U.LEASES FROM LESSOR’S PERSPECTIVE Balance Sheet Finance Lease: When present value of lease payments equals the carrying amount of the leased asset (called a “direct financing lease” in U. Recognizes lease receivable. 28 . Receipt of lease principal is an investing cash inflow. Income Statement Statement of Cash Flows Reports interest revenue on lease receivable.S.

Recognizes lease receivable. 29 . Interest portion of lease payment received is either an operating or investing cash inflow under IFRS and an operating cash inflow under U.S. Reports profit on sale. Reports interest revenue on lease receivable.LEASES FROM LESSOR’S PERSPECTIVE Balance Sheet Finance Lease: When present value of lease payments exceeds the carrying amount of the leased asset (called a “sales-type lease” in U.S. Receipt of lease principal is an investing cash inflow. GAAP. GAAP) Copyright © 2013 CFA Institute Income Statement Statement of Cash Flows Removes asset.

LESSEE’S LEASE DISCLOSURES: EXAMPLE Copyright © 2013 CFA Institute 30 .

6 million as of October 2.” Copyright © 2013 CFA Institute 31 . respectively. The current portion of the total obligation is included in other accrued liabilities and the remaining long-term portion is included in other long-term liabilities on the consolidated balance sheets.” “We had capital lease obligations of $1. plant.LESSEE’S LEASE DISCLOSURES: EXAMPLE “We have subleases related to certain of our operating leases. with the latest maturity in 2014. $10. 2010. we recognized sublease income of $13. 2010. and October 3.1 million. Capital lease obligations expire at various dates. and equipment on the consolidated balance sheets.9 million. 2011. During fiscal 2011. and $7.7 million.4 million and $2. respectively. and 2009. Assets held under capital leases are included in net property.

TYPES OF POSTEMPLOYMENT BENEFITS: PENSION PLANS Amount of Future Benefit to Employee Contribution from Employer Defined contribution pension plan Depends on investment performance of plan assets Amount (if any) is defined in each period Defined benefit pension plan Defined based on plan’s formula Depends on current period estimate and investment performance of plan assets Copyright © 2013 CFA Institute 32 .

PRESENTATION AND DISCLOSURE FOR PENSION PLANS Type of Pension Plan Defined contribution Defined benefit Copyright © 2013 CFA Institute Balance Sheet Income Statement Footnote Disclosure None Company's contribution Minimal Net funded position Periodic expense Extensive 33 .

Coverage ratios .LEVERAGE AND COVERAGE RATIOS • Solvency: Company’s ability to meet its long-term debt obligations.Focus on the income statement and cash flows .Measure relative amount of debt in the company’s capital structure .Leverage ratios .Measure the ability of a company to cover its debtrelated payments Copyright © 2013 CFA Institute 34 . • Two types of commonly used solvency ratios: .Focus on the balance sheet .

LEVERAGE AND COVERAGE RATIOS Solvency Ratios Leverage ratios Debt-to-assets ratio Numerator Denominator Total debt Total assets Debt-to-capital ratio Total debt Total debt + Total shareholders’ equity Debt-to-equity ratio Total debt Total shareholders’ equity Financial leverage ratio Coverage ratios Interest coverage ratio Fixed charge coverage ratio Copyright © 2013 CFA Institute Average total assets Average shareholders’ equity EBIT Interest payments EBIT + Lease payments Interest payments + Lease payments 35 .

689 1.966 7.582 37.7%.985 155 59 3.252 30.903 3.112 285.646 1. Copyright © 2013 CFA Institute Debt to assets for 2008: 10.823 134.EVALUATING SOLVENCY RATIOS Short-term borrowings Current portion of long-term interest bearing debt Long-term interest bearing debt Total shareholders’ equity Total assets EBIT Interest payments Nokia (€ millions) 2008 2007 3.831 13 173 861 203 14. Debt to assets for 2007: 2.1%.2%.068 24.599 4.639 2.578 714 Ericsson (SEK millions) 2008 2007 1.117 16.9%.684 245. Debt to assets for 2007: 11.208 14.773 39.513 Debt to assets for 2008: 11.320 140.939 21. 36 .

112 285.831 13 173 861 203 14.823 134.3 37 .6 Interest coverage ratio for 2007: 20.684 245.582 37.578 714 Ericsson (SEK millions) 2008 2007 1.773 39.646 1.3 Copyright © 2013 CFA Institute Interest coverage ratio for 2008: 9.599 4.EVALUATING SOLVENCY RATIOS Short-term borrowings Current portion of long-term interest bearing debt Long-term interest bearing debt Total shareholders’ equity Total assets EBIT Interest payments Nokia (€ millions) 2008 2007 3.117 16.639 2.903 3.208 14.252 30.513 Interest coverage ratio for 2008: 32.985 155 59 3.320 140.939 21.068 24.966 7.689 1.0 Interest coverage ratio for 2007: 135.

• Analysts treat noncancellable operating leases as equivalent to on-balance-sheet debt. • A bond discount or premium is amortized by using the effective interest method. • Leverage and coverage ratios are used in assessing a company’s solvency.SUMMARY • Bonds are valued as the present value of future cash flows. Copyright © 2013 CFA Institute 38 . • Defined benefit pension plans with a net unfunded position give rise to liabilities. • Market interest rates reflect the risk of the issuer and the instrument.