Lecture 12 Debt

Question 1

What are liabilities?

Answer 1

Liabilities are present obligations of the entity that arise from past events and whose settlement is expected to result in an outflow of resources from the entity. The outflow must be probable and reasonably estimable.

On the balance sheet, liabilities are arranged in order of maturity and grouped into current liabilities, which mature within one year or one operating cycle, and non-current (long-term) liabilities.

Question 2

How to record a liability?

Answer 2

1) Determine whether events have occurred that require the recognition of a liability.

2) Estimate the expected future outflow required to settle the liability.

3)Record the journal entry to put the liability on the balance sheet:

DR (asset or expense account) xxx
CR liability xxx

4) When the liability is settled, record:
DR liability xxx
CR Cash xxx

Question 3

What do we do about highly uncertain liabilities?

Answer 3

Some potential liabilities, called (loss) contingencies, are highly uncertain and depend on yet unknown future events that are at least partly beyond the entity’s control.

Examples include losses from pending lawsuits and environmental cleanup obligations.

Contingent losses are only recognized as liabilities if they are reasonably estimable and their occurrence is probable (US GAAP) or ‘more likely than not’ (IFRS).

Otherwise, they are disclosed in a footnote (if the contingency is reasonably possible) or not at all (if the probability is remote).
If recognized, the liability is referred to as a contingency (US GAAP) or a provision (IFRS).

Contingent gains are never recognized or disclosed.

Question 5

What is the face value in long-term debt?

Answer 5

amount on which the interest payments are calculated; paid at maturity

Question 6

What is the maturity date in long-term debt?

Answer 6

Time of the last interest payment and the payment of the face value

Question 7

What is the coupon rate (nominal interest rate) in long-term debt?

Answer 7

Interest rate by which coupon (interest) payments are calculated

Question 8

What is the coupon payment in long-term debt?

Answer 8

face value × coupon rate

Question 9

What is the effective interest rate (market yield) in long-term debt?

Answer 9

discount rate that equates the present value of all future coupon and principal payments to the market value of the note

Question 10

How to Find the Present Value of long-term debt?

Answer 10

𝑃𝑉=𝐹∙𝑐∙(1−1/(1+𝑟)^𝑇 )/𝑟+𝐹/(1+𝑟)^𝑇

Question 11

How to record a note issuance?

Answer 11

When accounting for a note under the effective interest method, the note is initially (at the issuance date) recorded at its market value.

Face value and discount (or premium) are recorded in two separate accounts. In our example, the note issuance is thus recorded as:

DR cash xxx
DR note discount xxx
CR notes payable xxx

On the balance sheet, notes are shown net of any discount or premium. Notes maturing within the next year are shown as current liabilities.

Question 12

How to record an interest expense?

Answer 12

The interest expense for the period is computed as

interest expense = net book value (beginning of period) × effective interest rate

The effective interest rate used in this calculation is always the effective rate as of the issuance date.

Changes in the market yield subsequent to the issuance date are ignored.

The interest expense almost always differs from the coupon payment.

The difference is booked against the discount (or premium) account and is called the note discount (or premium) amortization.

Question 13

Why does book value equal present value under the effective interest method for long-term debt?

Answer 13

At the end of each subsequent year, the net amount of interest expense and coupon payment increases (or decreases) the carrying amount :

net carrying amount (ending) = net carrying amount (beginning) + discount (or premium) amortization
= net carrying amount (beginning) + interest expense – coupon payment

Question 14

What are debt issuance costs and how are they recorded?

Answer 14

The difference between the expected carrying amount (based on the stated ‘issued at’ percentage) and the actual carrying amount is likely due to debt issuance costs (transaction costs).

Debt issuance costs are subtracted from the proceeds (i.e., the carrying amount of the note) and thus increase the effective rate of interest.

Question 15

How is long-term debt treated in cash flow statements?

Answer 15

The discount or premium amortization is a non-cash component of interest expense.

If the cash flow statement is prepared under the indirect method, any discount or premium amortization becomes an adjusting item in the reconciliation between net income and net operating cash flow.

Question 17

How are repurchases of debt securities treated?

Answer 17

Recall that notes are carried on the balance sheet at the present value of the future payments to their holders, discounted by the market rate in effect at the issuance date.

The net book value of a note is therefore rarely the same as the market value of the note (except at the issuance date), so if the issuing company repurchases the note before maturity, it realizes a gain or loss.

Companies must provide disclosure of the fair market value of their notes in a footnote.

Question 18

What is the fair value option?

Answer 18

Novartis discloses the fair value of its debt, as required, but the fair value does not affect the company’s income statement and balance sheet.

Some companies, by contrast, have elected to recognize their debt at fair value on the balance sheet. This election is permitted by both IFRS and US GAAP and can be made for each debt instrument separately.

Under this ‘fair value option,’ the change in fair value from one period to the next is recognized as a gain or loss on the income statement.

(What impact would a deterioration in a company’s own credit risk have on net income if the company has chosen the fair value option?)

Question 19

How are post-retirement benefits treated?

Answer 19

Most companies provide part of their compensation to employees in the form of benefits to be received after the employees retire. Examples of these benefits include pensions, healthcare, and life insurance.

Like wages and salaries, these benefits are compensation for services the employees render today. Hence, by the matching principle, the employer also recognizes the expected cost of these benefits as an expense today.

The benefits are typically administered by entities separate from the employer itself (such as a trust). The employer is responsible for funding the entity.

Question 20

What are the types of post-retirement benefit plans?

Answer 20

Under a defined contribution plan, the company promises to make payments, specified by some formula, into the employee’s benefit account.
For example, a matching contribution to the employee’s retirement account of up to X% of the employee’s salary.

Under a defined benefit plan, the company promises to pay an amount of benefits, specified by some formula, after the employee retires.
For example, a pension equal to the average of the five highest annual salaries the employee earned during employment, multiplied by X% of the number of years the employee worked for the company.

Question 21

How do we account for defined contribution plans for post-retirement obligations?

Answer 21

Accounting for defined contribution plans is straightforward. The employer’s contribution is known today and typically paid along with the employee’s regular salary, and the employer has no obligation beyond making the specified contribution.

Hence, the employer recognizes an expense equal to the amount of its contribution every period, recorded by a journal entry of the form:

DR compensation expense xxx
CR cash (or accrued compensation) xxx

Question 22

How do we account for defined benefits?

Answer 22

In a defined benefit plan, by contrast, the amount of benefits to be paid after retirement is unknown today.

No cash payments are made to employees until after retirement, but the matching principle requires the employer to estimate these payments today and accrue a liability.