Reading 25: Non-Current (Long-Term) Liabilities Flashcards
LOS 24.a
Determine the initial recognition, initial measurement and subsequent measurement of bonds.
When a bond is issued, assets and liabilities both initially increase by the bond proceeds. At any point in time, the book value of the bond liability is equal to the present value of the remaining future cash flows (coupon payments and 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.
A premium bond (coupon rate > market yield at issuance) is reported on the balance sheet at a value greater than its face value. As the premium is amortized (reduced), the book value of the bond liability will decrease until it reaches its face value at maturity.
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.
LOS 24.b
Describe the effective interest method and calculate interest expense, amortisation of bond discounts/premiums, and interest payments.
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.
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.
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.
LOS 24.c
Explain the derecognition of debt.
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.
LOS 24.d
Describe the role of debt covenants in protecting creditors.
Debt covenants are restrictions on the borrower that protect the bondholders’ interests, thereby reducing both default risk and borrowing costs. Covenants can include restrictions on dividend payments and share repurchases; mergers and acquisitions; sale, leaseback, 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 at specific levels.
LOS 24.e
Describe the financial statement presentation of and disclosures relating to debt.
The firm separately discloses details about its long-term debt in the footnotes. These disclosures are useful for determining the timing and amount of future cash outflows. 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 each of the next five years.
LOS 24.f
Explain motivations for leasing assets instead of purchasing them.
Advantages of leasing rather than purchasing an asset may include a smaller initial cash outflow, lower-cost financing, and less risk of obsolescence.
LOS 24.g
Explain the financial reporting of leases from a lessee’s perspective.
A finance lease is a lease that transfers the benefits and risks of ownership to the lessee. A lease that does not transfer these benefits and risks is an operating lease.
Under IFRS, for both finance and operating leases, except for short-term leases, a lessee reports a right-of-use asset and a lease liability on its balance sheet, both equal to the present value of the promised lease payments. The interest portion of each lease payment is reported as interest expense, while the principal-repayment portion of each payment reduces the lease liability. For short-term or low-value leases, rent expense is reported on the income statement and no balance sheet entries are required.
Under U.S. GAAP, reporting for a finance lease is the same as under IFRS. For an operating lease, the reporting is the same as under IFRS except that the entire lease payment is recorded as a lease expense. For short-term leases, rent expense is reported on the income statement and no balance sheet entries are required.
LOS 24.h
Explain the financial reporting of leases from a lessor’s perspective.
A lease that is classified as finance or operating by the lessee is classified the same way by the lessor.
Under both IFRS and U.S. GAAP, with a finance lease, the lessor removes the leased asset from its balance sheet and adds a lease receivable asset. The lessor reports the interest portion of the lease payments as income. For an operating lease, the lessor keeps the leased asset on its balance sheet, reports lease payments as income, and reports depreciation and other costs as expenses.
LOS 24.i
Compare the presentation and disclosure of defined contribution and defined benefit pension plans.
A firm reports a net pension liability on its balance sheet if the fair value of a 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.
Pension expense for a defined contribution pension plan is equal to the employer’s contributions.
LOS 24.j
Calculate and interpret leverage and coverage ratios.
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.
Leverage ratios, such as debt-to-assets, debt-to-capital, debt-to-equity, and the financial leverage ratio, focus on the balance sheet.
* Debt-to-assets ratio = total debt / total assets
* Debt-to-capital ratio = total debt / (total debt + total equity)
* Debt-to-equity ratio = total debt / total equity
* Financial leverage ratio = average total assets / average total equity
Coverage ratios, such as interest coverage and fixed charge coverage, focus on the income statement.
* Interest coverage = EBIT / interest payments
* Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments)
