Non-Current Liabilities

RCJ Chapter 11 (except 583-601)

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Key Issues

1. Effective interest method2. Types of non-current liabilities3. Understanding the financials4. Early retirement/swap5. Earnings management6. 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 =

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

beginning of period NBV

x the effective market rate

amount (par) principalliability

couponscash annualratecoupon

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Effective Interest Method (cont’d)

effective market rate (r%) can be > = < coupon rate (C%) 

cash payment can be > = < interest expense

 

par bond: effective rate

______ coupon rate

Discount bond:

effective rate

______ coupon rate

Premium bond:

effective rate

______ coupon rate

par bond: cash payment

______ interest expense

Discount bond:

cash payment

______ interest expense

Premium bond:

cash payment

______ interest expense

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Liability Spectrum

all cash as principal

Combination of periodic + principal

all cash as periodic

Zero Coupon Bond

Par Bond Lease(Mortgage)

Where on the spectrum do premium and discount bonds go?

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Liability Spectrum (cont’d)

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

all cash as principal

Combination of periodic + principal

all cash as periodic

Zero Coupon Bond

Par Bond Lease(Mortgage) Discount

BondPremium Bond

interestPrincipalCF Total

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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 Cash 1,000

CR Liability 1,000The periodic j.e.’s are:

Period Beg. Liab.

Interest Expense - DR

Liability - CR

Cash - CR

EndLiab

1 1,000 100 100 0 1,100

2 1,100 110 110 0 1,210

3 1,210 121 121 0 1,331

4 1,331 133 133 0 1,464

5 1,464 146 146 0 1,610

End 1,610 0 1610 DR 1610 0Total 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 Cash 1,000CR Liability 1,000

The periodic j.e.’s are:Period Beg.

Liab.Interest Expense -

DRLiability -

CRCash -

CREndLia

b

1 1,000 100 50 50 1,050

2 1,050 105 55 50 1,105

3 1,105 110 60 50 1,165

4 1,165 117 67 50 1,232

5 1,232 123 73 50 1,305

End 1,305 0 1305 1305 0Total cash outflows = (5 x 50) + 1305 = 1555PV of coupons = 50 x 3.791(5 yr,10% annuity factor)=190PV of principal = 810(810x1.105= 1305)

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3. Par Bond

The inception j.e. is:DR Cash 1,000

CR Liability 1,000The periodic j.e.’s are:

Period Beg. Liab.

Interest Expense - DR

Liability - CR

Cash - CR

EndLiab

1 1,000 100 0 100 1,000

2 1,000 100 0 100 1,000

3 1,000 100 0 100 1,000

4 1,000 100 0 100 1,000

5 1,000 100 0 100 1,000

End 1,000 100 1000 DR 1000 CR 0Total cash outflows = (5 x 100) + 1000 = 1500PV 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 Cash 1,000CR Liability 1,000

The periodic j.e.’s are:Period Beg.

Liab.Interest Expense -

DRLiability -

DRCash -

DREndLia

b

1 1,000 100 50 150 950

2 950 95 55 150 895

3 895 90 60 150 835

4 835 84 66 150 769

5 769 77 73 150 696

End 696 0 696 696 0Total cash outflows = (5 x 150) + 696 = 1446PV 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 Cash 1,000CR Liability 1,000

The periodic j.e.’s are:Period Beg.

Liab.Interest Expense -

DRLiability -

CRCash –

CREndLia

b

1 1,000 100 164 264 836

2 836 84 180 264 656

3 565 66 198 264 458

4 458 46 218 264 240

5 240 24 240 264 0

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

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Example (cont’d)

1. Zero Coupon = 16102. Discount Bond = 15553. Par Bond = 15004. Premium Bond = 14465. Lease(mortgage) = 1320

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.

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Implication of Effective Interest Method:Early Bond Retirement/ Debt-Equity Swap

DR Old B/P NBVDR Loss (plug)

CR New B/P or C/S or cash FMV CR Gain (plug)

gain/loss = NBV - FMV, due to change in interest rates

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

Increase in r%:

NBV ____ FMV

Decrease in r%:

NBV ____ FMV

or

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

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

2debt) B/S end.debt B/S beg.(

interestcash %interest effective

cash

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Bond Correction JE Put bonds on B/S at FMV (i.e., replace NBV with

FMV)DR B/P NBVDR R/E

CR B/P FMVDR 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/S2. 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 info2. AC causes non-comparability of instruments

issued at different times3. 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 DR CR if r% liability UHG (R/E) 2. recognize UHL DR CR if r% UHL (R/E) 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)