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CFA Level 1 LOS > (28) Non-Current (Long Term) Liabilities > Flashcards

(28) Non-Current (Long Term) Liabilities Flashcards

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1
Q

Bond

A

A bond is a contractual promise between a borrower (the bond issuer) and a lender (the bondholder) that obligates the bond issuer to make payments to the bondholder over the term of the bond. Typically, two types of payments are involved:

(1) periodic interest payments, and
(2) repayment of principal at maturity.

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2
Q

Bond terminology: Face Value

A

The face value, also known as the maturity value or par value, is the amount of the principal that will be paid to the bondholder at maturity. The face value is used to calculate the coupon payments.

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3
Q

Bond terminology: Coupon

A

The coupon rate is the interest rate stated in the bond that is used to calculate the coupon payments.

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4
Q

Bond terminology: Coupon payments

A

The coupon payments are the periodic interest payments to the bondholders and are calculated by multiplying the face value by the coupon rate.

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5
Q

Bond terminology: Effective rate of interest

A

The effective rate of interest is the interest rate that equates the present value of the future cash flows of the bond and the issue price. The effective rate is the market rate of interest required by bondholders and depends on the bond’s risks (e.g., default risk, liquidity risk), as well as the overall structure of interest rates and the timing of the bond’s cash flows. Do not confuse the market rate of interest with the coupon rate. The coupon rate is typically fixed for the term of the bond. The market rate of interest on the firm’s bonds, however, will likely change over the bond’s life, which changes the bond’s market value as well.

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6
Q

Bond terminology: Balance sheet liability

A

The balance sheet liability of a bond is equal to the present value of its remaining cash flows (coupon payments and face value), discounted at the market rate of interest at issuance. At maturity, the liability will equal the face value of the bond. The balance sheet liability is also known as the book value or carrying value of the bond.

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7
Q

Bond terminology: Interest expense

A

The interest expense reported in the income statement is calculated by multiplying the book value of the bond liability at the beginning of the period by the market rate of interest of the bond when it was issued.

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8
Q

Bond terminology: At the date of issuance, the market rate of interest may be equal to, less than, or greater than the coupon rate. How are these scenarios defined?

A

When the market rate is equal to the coupon rate, the bond is a par bond (priced at face value).

When the market rate is greater than the coupon rate, the bond is a discount bond (priced below par value)

When the market rate is less than the coupon rate, the bond is a premium bond (priced above par)

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9
Q

LOS 31. a: Determine the initial recognition, initial measurement and subsequent measurement of bonds.

A

When a bond is issued, assets and liabilities both initially increase be the bond proceeds. At any point in time, the book value of the bond liability is equal to the present value of the remining future cash flows (coupon payments at maturity value) discounted at the market rate of interest at issuance. The proceeds are reported in the cash flow statement as an inflow from financing activities.

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10
Q

LOS 31. a: Determine the initial recognition, initial measurement and subsequent measurement of bonds. What is a premium bond.

A

A premium bond (coupon > market yield at issuance) is reported on the balance sheet at a value greater than its face value. As a premium is amortized (reduced), the book value of the bond liability will decrease until it reaches its face value at maturity.

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11
Q

LOS 31. a: Determine the initial recognition, initial measurement and subsequent measurement of bonds. What is a discount bond?

A

A discount bond (market yield at issuance > coupon rate) is reported on the balance sheet at less than its face value. As the discount is amortized, the book value of the bond liability will increase until it reaches its face value at maturity.

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12
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.

A

Interest expense includes amortization of any discount or premium at issuance. Using the effective interest rate method, interest expense is equal to the book value of the bond liability at the beginning of the period multiplied by the bond’s yield at issuance.

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13
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. (Premium bond)

A

For a premium bond, interest expense is less than the coupon payment (yield < coupon rate). The difference between interest expense and the coupon payment is subtracted from the bond liability on the balance sheet.

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14
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. (Discount bond)

A

For a discount bond, interest expense is greater than the coupon payment (yield > coupon rate). The difference between interest expense and the coupon payment is added to the bond liability on the balance sheet.

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15
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. Describe that is happening here for a premium bond.

A
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16
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. Describe that is happening here for a discount bond.

A
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17
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. Cash flow impact of issuing a bond.

A
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18
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. (Fill in the blanks)

A
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19
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. (Fill in the blanks)

A
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20
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. (Fill in the blanks)

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21
Q

LOS 31. b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments. (Fill in the blanks)

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22
Q

LOS 31. c: Explain the derecognition of debt.

A

When bonds are redeemed before maturity, a gain or loss is recognized equal to the difference between the redemption price and the carrying (book) value of the bond liability at the reacquisition date. Under U.S. GAAP, any remaining unamortized bond issuance costs must also be written off and included in the gain or loss calculation. Writing off the unamortized issuance costs will reduce a gain or increase a loss. No write-off is necessary under IFRS because issuance costs are already included in book value of the bond liability.

23
Q

LOS 31. d: Describe the role of debt covenants in protecting creditors.

A

Debt covenants are restrictions on the borrower that protect the bondholders’ interests, thereby reducing both default risk and borrowing costs.

24
Q

LOS 31. d: Describe the role of debt covenants in protecting creditors. What are some examples of covenants?

A

Covenants can include:

  • restrictions on dividend payments and share repurchases;
  • mergers and acquisitions;
  • sale, leasebacks, and disposal of certain assets;
  • and issuance of new debt in the future

Other covenants require the firm to maintain ratios or financial statement items a specific levels.

25
Q

LOS 31. e: Describe the financial statement presentation of and disclosures relating to debt.

A

The firm separately discloses details about its long-term debt in the footnotes. These disclosers are useful for determining the timing and amount of future cash outflows.

26
Q

LOS 31. e: Describe the financial statement presentation of and disclosures relating to debt. What do the disclosures usually include?

A

The disclosures usually include:

  • a discussion of the nature of the liabilities
  • maturity dates
  • stated and effective interest rates
  • call provisions and conversion privileges
  • restrictions imposed by creditors
  • assets pledged as security
  • and the amount of debt maturing in the next five years.
27
Q

LOS 31. f: Explain motivations for leasing assets instead of purchasing them.

A

Compared to purchasing an asset, leasing may provide the lessee with less costly financing, reduce the risk of obsolescence, and include less restrictive provisions than a typical loan. Synthetic leases provide tax advantage and keep the lease liability off the balance sheet.

28
Q

LOS 31. g: Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee. Under IFRS, when is a lease considered a finance lease vs. operating lease?

A

Under IFRs, if substantially all the rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease by both the lessee and lessor. Otherwise, the lease is an operating lease.

29
Q

LOS 31. g: Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee. Under U.S. GAAP, when is a lease considered a finance lease vs. operating lease?

A

Under U.S. GAAP, the lessee must treat a lease as a capital (finance) lease if any one of the following criteria is met:

  • Title to the leased asset is transferred to the lessee at the end of the lease period.
  • A bargain purchase option exists.
  • The lease period is 75% or more of the asset’s economic life.
  • The present value of the lease payments is 90% or more of the fair value of the leased asset.

Under U.S. GAAP, the lessor capitalizes the lease if any one of the finance lease criteria for lessees is met, collectability of lease payments is reasonably certain, and the lessor has substantially completed performance.

30
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases. What is a finance lease?

A

A finance lease is, in substance, a purchase of an asset that is financed with debt. At any point in time, the lease liability is equal to the present value of the remaining lease payments.

31
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases. From the lessee’s perspective. (Operating lease as well)

A

From the lessee’s perspective, finance lease expense consists of depreciation of the asset and interest on the loan. The finance lease payment consists of an operating outflow of cash (interest expense) and a financing outflow of cash (principal reduction).

An operating lease is simply a rental arrangement; no asset or liability is reported by the lessee. The rental payment is reported as an expense and as an operating outflow of cash.

32
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases. From the lessor’s perspective.

A

From the lessor’s perspective, a finance lease is either a sales-type lease or a direct financing lease. In either case, a lease receivable is created at the inception of the lease, equal to the present value of the lease payments. The lease payments are treated as part interest income (CFO) and part principal reduction (CFI).

With a sales-type lease, the lessor recognizes gross profit at the inception of the lease and interest income over the life of the lease. With a direct financing lease, the lessor recognizes interest income only.

33
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases.

A
34
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases.

A
35
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases. What are two things candidates typically find confusion with these ratio impacts?

A
36
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases. Describe the income differences of a direct financing lease and operating lease (table example other side).

A
37
Q

LOS 31. h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases. Describe the cash flow differences of a direct financing lease and operating lease (table example other side).

A
38
Q

LOS 31. i: Compare the disclosers relating to finance and operating leases.

A

Both lessees and lessors are required to disclose useful information about finance leases and operating leases in the financial statements or in the footnotes, including:

  • General description of the leasing arrangement
  • The nature, timing, and amount of payments to be paid or received in each of the next five years. Lease payments after five years can be aggregated.
  • Amount of lease revenue and expense reported in the income statement for each period presented.
  • Amounts receivable and unearned revenues form lease arrangements.
  • Restrictions imposed by lease agreements.
39
Q

LOS 31. j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans. When does a firm report a net pension liability and asset? How are changes reported?

A

A firm reports a net pension liability on its balance sheet if the fair value of the defined benefit plan’s assets is less than the estimated pension obligation, or a net pension asset if the fair value of the plan’s assets is greater than the estimated pension obligation. The change in the net pension asset or liability is reflected in a firm’s comprehensive income each year.

40
Q

LOS 31. j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans. Under IFRS, which costs are recorded on the Income Statement and which are recorded on the Other Comprehensive Income?

A

Under IFRS, service costs (including past service costs) and interest income or expense on the beginning plan balance are included in pension expense on the income statement. Remeasurements are recorded in other comprehensive income. These include actuarial gains or losses and the difference between the actual return and expected return on plan assets.

41
Q

LOS 31. j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans. Under US GAAP, which costs are recorded on the Income Statement and which are recorded on the Other Comprehensive Income?

A

Under U.S. GAAP, service costs, interest income or expense, and the expected return on plan assets are included in pension expense. Past service costs and actuarial gains or losses are recorded in other comprehensive income and amortized over time to the income statement.

42
Q

LOS 31. j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans. What is the pension expense for a defined contribution pension plan equal to?

A

Pension expense for a defined contribution pension plan is equal to the employer’s contributions.

43
Q

LOS 31. j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans. Under IFRS, which costs are recorded on the Income Statement and which are recorded on the Other Comprehensive Income? (chart)

A
44
Q

LOS 31. j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans. Under US GAAP, which costs are recorded on the Income Statement and which are recorded on the Other Comprehensive Income? (chart)

A
45
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. What do analysts use solvency ratios?

A

Analysts use solvency ratios to measure a firm’s ability to satisfy its long-term obligations. In evaluating solvency, analysts look at leverage ratios and coverage ratios.

46
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. What are four leverage ratios and what do they focus on?

A

Leverage ratios, such as debt-to-assets, debt-to-capital, debt-to-equity, and the financial leverage ratio, focus on the balance sheet.

47
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. Debt-to-assets ratio

A

Debt-to-assets ratio = total debt / total assets

48
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. Debt-to-capital ratio

A

Debt-to-capital ratio = total debt / (total debt + total equity)

49
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. Debt-to-equity ratio

A

Debt-to-equity ratio = total debt / total equity

50
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. Financial leverage ratio

A

Financial leverage ratio = average total assets / average total equity

51
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. What are two coverage ratios and what do they focus on?

A

Coverage ratios, such as interest coverage and fixed charge coverage, focus on the income statement.

52
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. Interest coverage ratio

A

Interest coverage = EBIT / interest payments

53
Q

LOS 31. k: Calculate and interpret leverage and coverage ratios. Fixed charge coverage ratio

A

Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments)

CFA Level 1 LOS (46 decks)

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