Part 10. Non-Current (Long-Term) Liabilities

Question 1

Bond

Answer 1

A contractual promise between a borrowers (the bond issuer) and a lender (the bondholder) that obligates the bond issuer to make payments to bondholder over the term of the bond.

2 types of payments:

• Periodic interest payments
• Repayment of principal at maturity

Question 2

Face value (maturity/ par value)

Answer 2

The amount of principal that will be paid to the bondholder at maturity, used to calculate the coupon payments.

Question 3

Coupon rate

Answer 3

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

Question 4

Coupon payments

Answer 4

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

Question 5

Effective rate of interest

Answer 5

The interest rate that equates the PV of future cash flows of the bond and the issue price.

This is required by bondholders and depends on the bonds risks (e.g. default risk, liquidity risk), as well as overall structure of IR and timing of bond cash flows.

Market rate of interest on firms bonds will likely change over bonds life, which changes the bonds market value as well.

Question 6

Balance sheet liability (of bond)

Answer 6

This is the PV of its remaining cash flows (coupon payments and face value), discounted at market rate of interest at issuance.

At maturity, the liability will equal the face value of bond, the balance sheet liability is known as book value or carrying value of bond.

Question 7

Interest expense

Answer 7

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

Question 8

At date of issuance, the market rate of interest may be equal to, less than or greater than coupon rate:

Answer 8

Par bond (priced at face value) = market rate equal to the coupon rate.

Discount bond (priced below par value) = market rate is greater than coupon rate

Premium bond (priced above par) = when market rate is less than coupon rate.

Question 9

Bonds issued par effects on FS:

Answer 9

• On BS, the assets and liabilities increase by bond proceeds (face value), and book value of bond liability does not change over the term of bond.
• On IS, interest expense for period is equal to coupon payment as yield at issuance and coupon rate are the same.
• Cash flow statement - issue proceeds reported as cash inflow from financing activities and coupon payments reported as cash outflows from operating activities (US GAAP as CFO, and IFRS as CCF outflows).
• At maturity repayment of face value reported as cash outflow from financing activities.

Question 10

Bonds issued at discount or premium:

Answer 10

• when the bonds yield at issuance is not equal to coupon rate, the proceeds received ( the PV of coupon payments + the PV of the face value) are not equal to par value.
• the bond is issued at a premium or discount, where issue date is usually relatively small for coupon bonds.
• if coupon rate < bonds yield, the proceeds received will be less than face value, this difference is known as discount.
• Bonds where the coupon rate is lower than the coupon rate that would make the market price of bond equal to its par value; investors will pay less than face value due to lower coupon rate.
• If coupon rate > bond yield, the bond price and proceeds received will be greater than face value, where investors pay more for above- market coupon payments, this is known as premium bonds.

Question 11

Balance sheet measurements

Answer 11

• when company issues bond, assets and liabilities both initially increase by bond proceeds, with book value of bond liability will equal the PV of remaining future cash flows (coupon payments and face value) discounted at bonds yield at issuance.
• premium bond is reported on BS at more than face value; as premium is amortized (reduced), the book value of bond liability will decrease until it reaches FV of bond at maturity.
• discount bond reported on BS at less than face value; as discount is amortized, the book value of bond liability will increase until it reaches FV at maturity.

Question 12

Calculating premium bond

Answer 12

• the yield < coupon rate, where the difference between interest expense and coupon payment is the amortization of the premium.
• the premium amortisation is subtracted each period from bond liability on BS, thus, interest expense will decrease overtime as bond liability decreases.

Question 13

Calculating discount bond

Answer 13

• the yield > coupon rate, so the difference between interest expense and coupon payment is the amortisation of the discount.
• the amortisation of discount each period is added to bond liability on BS, hence interest expense will increase over time as bond liability increases.

Question 14

Purpose of amortising the dscount rate:

Answer 14

1. To increase the book value of the bond liability over time.
2. To increase interest expense so coupon payment plus discount amortisation is approx. equal to interest expense that would have prevailed had bond been issued at par.
   so: amortising premium decreases book value of bond liability over time and decreases interest expense.

Question 15

IFRS vs US GAAP

Answer 15

IFRS:

• effective interest method of amortising a discount or premium is required.
• Reports cash interest paid as either an operating or financing cash flow.

US GAAP:

• effective interest method of amortising a discount or premium is preferred, but SL method is allowed if results are not materially different.
• Must report cash interest paid in cash flow statement as an operating cash flow.

Question 16

zero-coupon bonds (pure discount bond)

Answer 16

• Makes no periodic interest payments.
• This is issued at a discount from its par value and annual interest expense implied, but not explicitly paid.
• The actual interest payment is included in the face value that is paid at maturity.
• The effects of zero-coupon bonds on FS are qualitatively the same as any discount bond, but impact is larger as discount is larger.

Question 16

zero-coupon bonds (pure discount bond)

Answer 16

• Makes no periodic interest payments.
• This is issued at a discount from its par value and annual interest expense implied, but not explicitly paid.
• The actual interest payment is included in the face value that is paid at maturity.
• The effects of zero-coupon bonds on FS are qualitatively the same as any discount bond, but impact is larger as discount is larger.

Question 17

Issuance costs

Answer 17

• issuing a bond involves legal and accounting fees, printing costs, sales commissions, and other fees.
• IFRS & US GAAP, means initial bond liability on BS (proceeds from issuing bond) is reduced by amount of issuance costs, increasing bonds effective IR, i.e. issuance costs is treated as unamortised discount.
• 2016 - US GAAP issuance costs capitalised as an asset, and allocated to IS over life of bond; this persists although the treatment of issuance costs have converged.
• Bond issuance costs (outflow) is usually netted against bond proceeds (inflow) and reported on cash flow statement as financing cash flow.

Question 18

FV reporting option

Answer 18

• An increase in bond yield will decrease in FV of bond liability, and vice versa. where divergence between BV of bond liability and FV of bond, being an economic liability at a point in time.
• There is an irrevocable option to report debt at FV, where gains (fall in bond liability) and losses (rise in bond liability) result from changes in bond market yields are reported in IS.
• In analysis, the market value of firms’ debt is more appropriate than BV, e.g. firm issued bond when IR is low is relatively better off when IR increase, as the firm could repurchase bond at now-lower market value.
• Decreasing bond liability on BS to market value increases equity and decreases debt-to-assets and debt-to-equity ratios; if IR decreased since issuance, adjusting debt to MV will have opposite effects.

Question 19

Derecognition of debt

Answer 19

• a firm may choose to redeem bonds before maturity as interest rates have fallen, as the firm has generated surplus cash through operations, or funds from the issuance of equity make it possible.
• A gain or loss is recognised by subtracting redemption price from BV of bond liability at reacquisition date.
  e. g. consider firm that reacquires $1m face amount of bonds at 102% of par when CV of bond liability is $995,000, with firm will recognise a loss of $25,000 ($995,000 CV - $1,020,000 redemption price).
• Had CV > redemption price the firm recognizes a gain.
• if capitalized then any remaining unamortized costs must be written off and included in gain or loss calculation, with no separate entry necessary if issuance cost were accounted for in initial bond liability as no separate asset representing unamortized issuance costs would be created.
• Gain or loss from redeeming debt reported in IS as part of continuing operations and add. info disclosed separately; but not part of firms day to day operations so change not included in IS for analysis or forecast.
• Presenting cash flow statement rising indirect method, any gain (loss) subtracted from (added to) net income in calculating cash flow from operations.
• The redemption price is reported as outflow from financing activities.

Question 20

Debt covenants

Answer 20

• The restrictions imposed by lender on borrower to protect lenders position.
• They can reduce default risk and thus borrowing costs.
• Restrictions are in form of affirmative or negative covenants.

Question 21

Affirmative covenants:

Answer 21

• When the borrower promises to do certain things.

such as:

• make timely payments of principal and interest.
• maintain certain ratios (such as current, debt-to-equity, and interest coverage ratios) in accordance with specified levels.
• maintain collateral if any in working order.

Question 22

Negative convenants:

Answer 22

• When the borrower promises to refrain from certain activities that might adversely affect its ability to repay outstanding debt.

such as:

• increasing dividends or repurchasing shares.
• issuing more debt.
• engaging in M&A

Question 23

Technical default

Answer 23

The bondholders can demand immediate repayment of principal if the firm violates a covenant.

Question 24

Use of convenants:

Answer 24

• A necessary component of credit analysis of a bond.
• These protect bondholders from actions the firm may take that would harm the value of bondholders’ claims to firms’ assets and earnings (i.e. decrease credit quality).
• the extent that covenants restrict e.g. firm’s ability to invest, take on add. debt or pay dividends is important when valuing a firm’s equity, and valuation and analysing its debt securities.

Question 25

Footnote disclosure ususally includes:

Answer 25

• the nature of liabilities
• maturity dates
• stated and effective interest rates
• call provisions and conversion privileges
• restrictions imposed by creditors
• assets pledged as security
• amount of debt maturing in each of next 5 years.

Question 26

Leasing assets

Answer 26

• When a firm (lessee) purchases the right to use an asset from another firm (lessor) for a specified period, which can range from month to many years.
• The lessee makes periodic payments to lessor for use of asset, where a lease can be considered as an alternative to financing purchase of an asset.

Question 27

Advantage of leasing:

Answer 27

• Less costly financing
• Less restrictive provisions; not include all covenants
• Less risk of obsolescence; lessee often returns leased asset to lessor, and does not bear risk of unexpected decline in assets end of lease value.

Question 28

Financial reporting of lease in perspective of lessee:

Answer 28

IFRS:

• A&L both equal PV of promised lease payments are reported on BS.
• Asset record on BS is not leased asset itself, but right to use leased asset for specified period.
• Periodic lease payments reported like payments on amortising loan.
• Interest portion of each lease payment reported as interest expense, but principal repayment portion of each payment reduced outstanding lease liability.
• ST leases and leases of low value assets, no BS entries are required.
• Rent expense reported in IS as operating cash flow.

US GAAP:

• The benefits and risks of owning assets are not substantially transferred to the lessee, the lease is classified as an operating lease.
• Financial reporting of operating lease same for financial lease with one exception, where principle lease payment used to reduce BS lease liability.
• The interest expense is always operating cash flow.

Question 29

Financial reporting of lease in perspective of lessor:

Answer 29

IFRS:

• 2 identifications: financial leases and operating leases
• financial lease = the lessor removes leased asset from BS, and adds lease receivable asset = value of expected lease payments and any est. residual value.
• if lessor is manufacturer or dealer, it will also report revenue (= lease asset amount) and cost of goods sold (= net BV of asset).
• Lessor reports interest portion of lease payments as income.
• Operating lease, lessor reports lease payments income and depreciation and other costs associated with leasing assets as expenses.

US GAAP:

• Lessor classifies a lease as a sales-type lease if it meets transfer of ownership criteria (same as for lessees) and collection of lease payments judged to be probable.
• Lease is a direct financing lease if it meets all the conditions:
• the transfer of ownership criteria are not met.
• 3rd party guarantees the residual value of the asset at end of the lease.
• the sum of promised lease payments and assets residual value is greater than or equal FV of the asset.
• Other leases classified as operating leases.

Question 30

Pension

Answer 30

A form of deferred compensation earned overtime through employee service; the most common being defined contribution plans and defined benefit plans.

Question 31

Defined contribution plan

Answer 31

A retirement plan in which firm contributes a sum each period to employees retirement account, based on a number of factors including yrs of service, the employees age, compensation, profitability and % of employees contribution,

Pension expense = employers contribution, with no future obligation to report on BS as a liability.

Question 32

Defined benefit plan

Answer 32

The firm promises to make periodic payments to employees after retirement, with benefits usually based on employees’ years of service, and compensation at or near retirement.

e.g. retirement benefit of 2% on final salary for each year of service, so 20yrs of service and a final salary of $100,000, means receiving $40,000 ($100,000 final salary x 2% x 20 years of service) each year upon retirement until death.

Estimating future obligations to employees involves forecasting variables such as future compensation levels, employee turnover, average retirement age, mortality rates, and appropriate discount rates.

Question 33

Net pension asset/liability

Answer 33

Key element of analysis for defined benefit plan.

• if FV of plans assets > est. pension obligation, the plan is said to be overfunded and sponsoring firm records a net pension asset on BS.
• if FV of plans assets < est. pension obligation, the plan is underfunded and firm records net pension liability.