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
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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
x
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: effective rate ______ coupon rate
Discount bond:
effective 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 ______
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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?
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Liability Spectrum (cont’d)
all cash as principal Zero Coupon Bond Combination of periodic + principal Par Bond Discount Bond all cash as periodic Lease (Mortgage)
Premium Bond
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
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1. Zero Coupon Bond
The inception j.e. is:
DR
The periodic j.e.’s are:
Period 1 2 3 4 5 End 1,000 1,100 1,210 1,331 1,464 1,610
CR
Cash
Liability
1,000
1,000
Beg. Liab. Interest Expense - DR Liability - CR Cash - CR EndLiab 100 110 121 133 146 0 100 110 121 133 146 1610 DR 0 0 0 0 0 1610 1,100 1,210 1,331 1,464 1,610 0
Total cash outflows = 1610 (note: 1610 = 1000 x 1.105)
Ex. E11-11
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2. Discount Bond (5% coupons=$50)
The inception j.e. is:
DR CR Cash Liability 1,000 1,000
The periodic j.e.’s are:
Period 1 2 3 4 5 1,000 1,050 1,105 1,165 1,232
Beg. Liab. Interest Expense - DR Liability - CR Cash - CR EndLiab 100 105 110 117 123 50 55 60 67 73 50 50 50 50 50 1,050 1,105 1,165 1,232 1,305 0
End 1,305 0 1305 1305 Total cash outflows = (5 x 50) + 1305 = 1555 PV of coupons = 50 x 3.791(5 yr,10% annuity factor)=190 PV of principal = 810(810x1.105= 1305)
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3. Par Bond
The inception j.e. is:
DR CR Cash Liability 1,000 1,000
The periodic j.e.’s are:
Period 1 2 3 4 5 End 1,000 1,000 1,000 1,000 1,000 1,000
Beg. Liab. Interest Expense - DR Liability - CR Cash - CR EndLiab 100 100 100 100 100 100 0 0 0 0 0 1000 DR 100 100 100 100 100 1000 CR 1,000 1,000 1,000 1,000 1,000 0
Total cash 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 Cash Liability 1,000 1,000
The periodic j.e.’s are:
Period 1 2 3 4 5 End 1,000 950 895 835 769 696
Beg. Liab. Interest Expense - DR Liability - DR Cash - DR EndLiab 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)
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5. Lease (Mortgage)
The inception j.e. is:
DR CR Cash Liability 1,000 1,000
Cash – CR 264 264 264 EndLiab 836 656 458
The periodic j.e.’s are:
Period 1 2 3 1,000 836 565
Beg. Liab. Interest Expense - DR Liability - CR 100 84 66 164 180 198
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5
458
240
46
24
218
240
264
264
240
0
Total cash outflows = 5 x 264 = 1320 PV of coupons = 264 x 3.791 = 1000
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Example (cont’d)
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
NBV
New B/P or C/S or cash
DR Loss (plug)
or
CR
FMV
CR
Gain (plug)
gain/loss = NBV - FMV, due to change in interest rates
Increase in r%: NBV ____ FMV
Decrease in r%:
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)
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Bond Footnote Disclosures
FMV of outstanding B/P’s annual (cash) principal repayments for next 5 years cash interest paid for the year (not necessarily = interest expense)
C11-3, except #6, C11-4
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Analyzing Long-Term Debt
Will projected cash flows be adequate to service debt? 1. Principal payments 2. effective cash interest %
cash interest (beg. B/S debt end. B/S debt) 2
3. Future cash interest payments over the next 5 years=
(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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effective cash interest % * debt outstanding each year
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
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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 entity’s debt.
The way loss contingencies are disclosed depends on:
how high the probability of their occurrence; and whether of not they are measurable.
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Loss Contingencies (cont’d)
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?
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Adelphia case (cont’d)
In case the Rigases won’t 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 Adelphia’s share price?
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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
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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/L’s (gains trading) 4. AC recognizes G/L’s gradually over instrument’s 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 FV’s, 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%
2. recognize UHL if r%
DR liability
DR UHL (R/E)
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CR UHG (R/E)
CR liability
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Adjusting for FV (cont’d)
Adjustment to I/S: recognize change (from BOY to
EOY) in UHG/UHL on I/S
change in UHG/UHL is current year’s UHG/UHL
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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 FV’s 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)
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