Non-Current Liabilities

RCJ Chapter 11 (except 583-601)

Key Issues
1. 2. 3. 4. 5. 6. Effective interest method Types of non-current liabilities Understanding the financials Early retirement/swap Earnings management Footnote disclosures

Paul Zarowin

Effective Interest Method

2 implications: 1) the net book value (NBV) of the liability = present value of the future cash flows


discounted at the effective (market required rate) rate in effect at the liability issuance [i.e., any subsequent changes in interest rates are ignored]

2) interest expense = beginning of period NBV

the effective market rate

annual cash coupons coupon rate ! liability principal (par) amount

Ex. P11-11, P11-12 except #3

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Effective Interest Method (cont d)

effective market rate (r%) can be > = < coupon rate (C%) par bond: Discount bond: effective rate effective rate ______ coupon rate ______ coupon rate ______ coupon rate

Premium bond: effective rate

cash payment can be > = < interest expense par bond: Discount bond: cash payment ______ cash payment ______ interest expense interest expense interest expense
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Premium bond: cash payment ______

Paul Zarowin

Liability Spectrum
all cash as principal Zero Coupon Bond Combination of periodic + principal Par Bond all cash as periodic Lease (Mortgage)

Where on the spectrum do premium and discount bonds go?

Paul Zarowin

Liability Spectrum (cont d)

all cash as principal Zero Coupon Bond Combination of periodic + principal Par Bond Discount Bond Premium Bond all cash as periodic Lease (Mortgage)

Total CF ! Principal  interest

# For a constant principal (cash borrowed), which liability has least? most? total CF # For a constant Total CF, which liability yields least? most? cash at inception (higher principal) # Is any liability a better? worse? deal than any other
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Example
We will show the accounting for each of the 5 examples, by using an amortization schedule (amortization table same as JE). In each case, the liability has a 5 year life, a 10% effective market rate, and a $1000 present value at inception. Only the pattern of (and total) future cash outflows differs.
 Key: effective interest method

Paul Zarowin

1. Zero Coupon Bond

The inception j.e. is:
DR CR
Period 1 2 3 4 5

Cash Liability

1,000 1,000
Liability CR 100 110 121 133 146 Cash CR 0 0 0 0 0 1610 EndLiab 1,100 1,210 1,331 1,464 1,610 0
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The periodic j.e. s are:

Beg. Liab. Interest Expense - DR 1,000 1,100 1,210 1,331 1,464 100 110 121 133 146

End 1,610 0 1610 DR Total cash outflows = 1610 (note: 1610 = 1000 x 1.105)

Ex. E11-11

Paul Zarowin

2. Discount Bond (5% coupons=$50)

The inception j.e. is:
DR CR
Period 1 2 3 4 5

Cash Liability

1,000 1,000
Liability CR 50 55 60 67 73 Cash CR 50 50 50 50 50 EndLiab 1,050 1,105 1,165 1,232 1,305 0

The periodic j.e. s are:

Beg. Liab. Interest Expense - DR 1,000 1,050 1,105 1,165 1,232 100 105 110 117 123

End 1305 Total cash1,305 outflows = (5 x 50)0+ 1305 = 1555 1305 PV of coupons = 50 x 3.791(5 yr,10% annuity factor)=190 PV of principal = 810(810x1.105= 1305)

3. Par Bond
The inception j.e. is:
DR CR
Period 1 2 3 4 5

Cash Liability

1,000 1,000
Liability CR 0 0 0 0 0 Cash CR 100 100 100 100 100 EndLiab 1,000 1,000 1,000 1,000 1,000

The periodic j.e. s are:

Beg. Liab. Interest Expense - DR 1,000 1,000 1,000 1,000 1,000 100 100 100 100 100

End 100 1000 DR 1000 CR 0 Total cash1,000 outflows = (5 x 100) + 1000 = 1500 PV of coupons=100 x 3.791 = 379; PV of principal = 621 (621 x 1.105 = 1000)
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4. Premium Bond (15% coupons = $150)

The inception j.e. is:
DR CR
Period 1 2 3 4 5 End

Cash Liability

1,000 1,000

The periodic j.e. s are:

Beg. Liab. Interest Expense - DR Liability - DR Cash - DR EndLiab 1,000 950 895 835 769 696 100 95 90 84 77 0 50 55 60 66 73 696 150 150 150 150 150 696 950 895 835 769 696 0

Total cash outflows = (5 x 150) + 696 = 1446 PV of coupons = 150 x 3.791 = 569; PV of principal = 431 (4311 x 1.105 = 696)
Paul Zarowin 11

5. Lease (Mortgage)
The inception j.e. is:
DR CR
Period 1 2 3 4 5

Cash Liability

1,000 1,000
Liability CR 164 180 198 218 240 Cash CR 264 264 264 264 264 EndLiab 836 656 458 240 0

The periodic j.e. s are:

Beg. Liab. Interest Expense - DR 1,000 836 565 458 240 100 84 66 46 24

Total cash outflows = 5 x 264 = 1320 PV of coupons = 264 x 3.791 = 1000

Paul Zarowin 12

Example (contd)
Ranking of total cashflows: despite the fact that all PV=s are $1000, the later the liability is paid back (the longer the liability is outstanding), the greater the total cash outflows. 1. 2. 3. 4. 5. Zero Coupon = 1610 Discount Bond = 1555 Par Bond = 1500 Premium Bond = 1446 Lease(mortgage) = 1320
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Implication of Effective Interest Method: Early Bond Retirement/ Debt-Equity Swap

DR Old B/P DR Loss (plug) CR CR NBV New B/P or C/S or cash Gain (plug) FMV

or

gain/loss = NBV - FMV, due to change in interest rates Increase in r%: Decrease in r%: NBV ____ FMV NBV ____ FMV

Ex. E11-5, E11-9, P11-22

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Earnings Management and Bond Retirement/Swap

 firms continually issue bonds  they have many vintages of B/P outstanding  some have risen in value  some have fallen in value  firms pick which bonds to retire  manage income by choosing to recognize gains or losses  gains or losses on early debt redemption were extraordinary items (pre 2002)

Paul Zarowin

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Bond Footnote Disclosures

 FMV of outstanding B/Ps  annual (cash) principal repayments for next 5 years  cash interest paid for the year (not necessarily = interest expense)

C11-3, except #6, C11-4

Paul Zarowin

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Analyzing Long-Term Debt

Will projected cash flows be adequate to service debt? 1. Principal payments

cash interest 2. effective cash interest % ! (beg. B/S debt  end. B/S debt) 2
3. Future cash interest payments over the next 5 years= effective cash interest % * debt outstanding each year (remember to subtract the debt that will be redeemed) 4. compare to cash flow forecasts for the firm: will projected cash flows be adequate to service interest and principle payments? C11-5, except #7
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Bond Correction JE
Put bonds on B/S at FMV (i.e., replace NBV with FMV) DR B/P NBV DR R/E CR B/P FMV DR R/E DR or CR to R/E is a plug for cumulative unrecognized gain or loss, from not marking to mkt

Paul Zarowin

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Loss Contingencies


An event which raises the possibility of future loss is a loss contingency (the actual loss is yet to occur).


Examples:
 

Legal suit against the company. Company is the guarantor for another entitys debt.

The way loss contingencies are disclosed depends on:

 

how high the probability of their occurrence; and whether of not they are measurable.

Paul Zarowin

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Loss Contingencies (contd)



3 probability degrees of future loss: probable, reasonably possible and remote. A loss should only be recorded if:

(1) the liability is probable; and (2) the amount of the loss can be reasonably estimated.
DR loss(I/S) CR


loss contingency(B/S)

If either (or both) condition is not met the liability should be disclosed only in a footnote. When the probability of a future loss is remote, it will be disclosed in a footnote only under certain circumstances.
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Example of Loss Contingency: Adelphia Case



Adelphia is one of the biggest cable companies in the US, and is controlled by the Rigas Family. The Rigas Family took a private loan of 3.1 billion dollars private loan, and Adelphia provided the collateral for this loan. How should have Adelphia reported this collateral in its financial reports?

Paul Zarowin

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Adelphia case (contd)



In case the Rigases wont pay the loan, Adelphia as the grantor will have to step in and pay back the loan. The fact that the company guarantied $3.1 billion loans of the Rigas family, was not disclosed under "contingent liabilities" in the company's 2000 financial statements. In case this contingent liability would have been disclosed, what could have been the impact on Adelphias share price?

Paul Zarowin

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Fair Value (FV) Accounting

3 features of FV accounting: 1. FV on B/S 2. recognize on I/S UHG and UHL (should be separate line from interest) 3. FV Interest expense = wt. Avg. current period FV x wt. Avg. current period r% UHG/UHL = FV NBV Note: 2 and 3 may be difficult to separate, so aggregate

Paul Zarowin

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FV is better than amortized cost (AC)

Because: 1. AC uses old info 2. AC causes non-comparability of instruments issued at different times 3. AC allows income manipulation via realized G/Ls (gains trading) 4. AC recognizes G/Ls gradually over instruments remaining life, via misstated interest (interest is not same as G/L) 5. Current prices and rates based on new info are better predictors of future prices/rates than old prices and rates based on old info
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Adjusting for FV
Solution: adjust financial statements for FVs, to create a more accurate picture of profitability, solvency,etc. Adjustment to B/S: write liabilities up or down to FV 1. recognize UHG if r% o 2. recognize UHL if r% q DR liability DR UHL (R/E)
Paul Zarowin

CR UHG (R/E) CR liability

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Adjusting for FV (contd)

Adjustment to I/S: recognize change (from BOY to EOY) in UHG/UHL on I/S


change in UHG/UHL is current years UHG/UHL

Paul Zarowin

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Problems/Limitations of FV
1. measurement error if market is not liquid key is disclosure of estimation assumptions and sensitivity of FVs to these assumptions 2. mismatching of assets (not FV) vs liabilities (FV) 3. problem if (r% is due to firm specific (risk;
a. ex. r% rises due to financial difficulty write-down of bonds (gain) implies success (eg, D/E falls) b. ex. r% falls due to financial success write-up of bonds (loss) implies problem (eg, D/E rises)

Paul Zarowin

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