Reading 32: Non-Current

(Long-Term) Liabilities

Reading 32 - LOSs
LOSs Covered
32a, 32b, 32c, 32d, 32e, 32f, 32g, 32h,
32j
LOSs Not Covered
32i, 32k

Bond Terminology I
Par value: amount payable to the bondholders at maturity; also
called face value, principal, stated value, maturity value
Coupon rate: interest rate used to calculate periodic interest
payments; also called nominal rate, stated rate
Coupon payment: coupon rate times par value
Market rate of interest: interest rate demanded by investors given
the risks of an investment
Effective interest rate: the market rate of interest when bonds are
issued; used to compute interest expense

If the effective interest rate > coupon rate, bonds are issued at a discount
(price < par)
If the effective interest rate = coupon rate, bonds are issued at par (price =
par)
If the effective interest rate < coupon rate, bonds are issued at a premium
(price > par)

Interest expense: coupon payments plus amortization of any

premium/discount; there are two methods of amortization effective
interest method and straight-line

Bond Terminology II
Example: Lynx Industries issues one thousand $1,000 par, 6% coupon,
5-year, annual pay bonds for a total of $958,998.
The par value of a single bond is $1,000
The coupon rate is 6%
The (annual) coupon payment for a single bond is 6% $1,000 =
$60, for the entire issue is $60,000
The maturity is 5 years
The effective interest rate is 7% (covered in quant, fixed income)
The initial (net) liability book value is $958,998
The initial discount is $1,000,000 $958,998 = $41,002
First years interest expense
Effective interest rate method: $958,998 7% = $67,130

$60,000 is the coupon payment

$7,130 is the amortization of the discount

Straight-line amortization: $68,200

$60,000 is the coupon payment

$8,200 is the amortization of the discount

Effects on Financial Statements I

Issuance
Balance sheet

Liability equal to proceeds

IFRS subtracts issuance costs from liability
US GAAP records issuance costs as an asset
Cash increase equal to proceeds

Income statement
No effect
Cash flow statement
CFF inflow equal to proceeds

Effects on Financial Statements II

Life of the bonds
Issued at a discount

Balance sheet

Income statement

Liability increases by amount of amortization

Cash decrease equal to coupon payments
Interest expense = coupon payment + amortization of discount

Cash flow statement

CFF outflow equal to coupon payments

Issued at par
Balance sheet

Income statement

Liability unchanged
Cash decrease equal to coupon payments
Interest expense = coupon payment

Cash flow statement

CFF outflow equal to coupon payments

Effects on Financial Statements III

Life of the bonds (cont.)

Issued at a premium
Balance sheet

Income statement

Liability decreases by amount of amortization

Cash decrease equal to coupon payments
Interest expense = coupon payment amortization of premium

Cash flow statement

CFO outflow equal to coupon payments

Maturity

Balance sheet
Liability eliminated
Cash decrease equal to par value
Income statement
No effect
Cash flow statement
CFF inflow equal to par value

Amortization of Premium/Discount I
Effective interest rate method
Interest expense = beginning book value times
effective interest rate
Amortization of premium/discount = interest
expense coupon payment
Required by IFRS, preferred by US GAAP
Straight-line method
Amortization of premium/discount = initial
premium/discount original years to maturity
Interest expense = coupon payment + amortization
of premium/discount
Allowed by US GAAP

Amortization of Premium/Discount II
Example (cont.): Lynx Industries issues one thousand $1,000 par, 6%
coupon, 5-year, annual pay bonds for a total of $958,998. The
effective rate is 7%.

The following amortization table illustrates the effective rate method.

Interest expense = Beginning book value 7%, amortization =
interest expense coupon payment, and ending book value =
beginning book value + amortization.
Year

Beg. BV

Int. Exp. Coupon Amort.

End. BV

$958,998

$67,130

$60,000

$7,130

$966,128

966,128

67,629

60,000

7,629

973,757

973,757

68,163

60,000

8,163

981,920

981,920

68,734

60,000

8,734

990,654

990,654

69,346

60,000

9,346

1,000,000

Amortization of Premium/Discount III

Example (cont.): Lynx Industries issues one thousand $1,000 par, 6%
coupon, 5-year, annual pay bonds for a total of $958,998. The
effective rate is 7%.

The following amortization table illustrates the straight-line method.

Amortization = $41,002 5 = $8,200, interest expense = coupon
payment + amortization, and ending book value = beginning book
value + amortization.
Year

Beg. BV

Int. Exp. Coupon Amort.

End. BV

$958,998

$68,200

$60,000

$8,200

$967,198

967,198

$68,200

60,000

$8,200

975,399

975,399

$68,200

60,000

$8,200

983,599

983,599

$68,200

60,000

$8,200

991,800

991,800

$68,200

60,000

$8,200 1,000,000

Amortization of Premium/Discount IV
Example (cont.): Lynx Industries issues one thousand $1,000 par, 6%
coupon, 5-year, annual pay bonds for a total of $1,043,295. The
effective rate is 5%.

The following amortization table illustrates the effective rate method.

Interest expense = Beginning book value 5%, amortization =
interest expense coupon payment, and ending book value =
beginning book value + amortization.
Year

Beg. BV

Int. Exp. Coupon Amort.

End. BV

$1,043,295 $52,165

$60,000 ($7,835) $1,035,460

1,035,460

$51,773

60,000

(8,227) 1,027,233

1,027,233

$51,362

60,000

(8,638) 1,018,594

1,018,594

$50,930

60,000

(9,070) 1,009,524

1,009,524

$50,476

60,000

(9,524) 1,000,000

Amortization of Premium/Discount V
Example (cont.): Lynx Industries issues one thousand $1,000 par,
zero-coupon, 5-year, annual pay bonds for a total of $712,986. The
effective rate is 7%.

The following amortization table illustrates the effective rate method.

Interest expense = Beginning book value 7%, amortization =
interest expense, and ending book value = beginning book value +
amortization.
Year

Beg. BV

Int. Exp. Coupon Amort.

End. BV

$712,986

$49,909

$0

$49,909 $762,895

762,895

$53,403

53,403

816,298

816,298

$57,141

57,141

873,439

873,439

$61,141

61,141

934,579

934,579

$65,421

65,421 1,000,000

Practice Question 32-1

DeMarco-Robbins (DR) issues $5,000,000 of 5% coupon, 10-year
bonds at a time when market rates are at 4.8%. In year 2, DRs
interest expense using the effective rate method, compared to interest
expense using the straight-line method, should be:
A. Lower than it would be using straight-line
B. The same as it would be using straight-line
C. Higher than it would be using straight-line

Practice Question 32-1

DeMarco-Robbins (DR) issues $5,000,000 of 5% coupon, 10-year
bonds at a time when market rates are at 4.8%. In year 2, DRs
interest expense using the effective rate method, compared to interest
expense using the straight-line method, should be:
A. Lower than it would be using straight-line
B. The same as it would be using straight-line
C. Higher than it would be using straight-line

Correct answer: A. Lower that it would be using straight-line

For a premium, the amortization under the effective rate method is
higher in the early years and lower in the later years; in year 2 of 10,
the amortization would be higher than the straight-line amortization.
The amortization of a premium reduces interest expense, so reducing
it by a higher amount of amortization will result in a lower interest
expense.

Issuance Costs
Printing costs, legal fees, commissions, etc.
Reduces the net proceeds from the bond issuance
Reduces cash on balance sheet
Reduces CFF inflow
IFRS
Deducted from liability
Increases effective interest rate
US GAAP
Reported as an asset (deferred expense)
Amortized straight-line over the life of the bonds

Changing Market Rates I

As market rates change, fair market value of fixed-rate
bonds changes

Increase in interest rates, decrease in fair market value

Decrease in interest rates, increase in fair market value

Bonds are generally reported at amortized historical cost

Based on market rate at time of issuance

Overstates economic liability, leverage when interest rates rise
Understates economic liability, leverage when interest rates fall

Companies must disclose fair market value of financing

liabilities
Option to report financial liabilities at fair value

Gains/losses reported on income statement

Changing Market Rates II

Derecognition of Debt I
Retirement at maturity
No gain/loss to recognize
CFF outflow: par value
Retirement before maturity
Purchase on open market
Exercise call option
Early retirement (e.g., sinking fund) provision
Bondholder exercises a put option
Possible gain/loss

Gain if repurchase price < carrying value

Loss if repurchase price > carrying value
Carrying value includes unamortized issuance costs (US
GAAP)

Gain/loss is classified as unusual or infrequent

CFF outflow: repurchase price

Derecognition of Debt II
Example: Five years ago, Smokeys Restaurants issued $1,000,000
par of 6% coupon, semiannual pay, 10-year bonds for $950,000. The
issuance costs were $50,000, which Smokeys is amortizing over 10
years. The current carrying value of the bonds is $970,922.
Smokeys purchases half of the bonds on the open market at 98.25.
Compute the gain/loss (if any) that Smokeys will report on their
income statement.
Carrying value ($970,922 50%)
Unamortized issuance costs
($50,000 5/10 50%)
Purchase price ($1,000,000 50% 0.9825)
Loss on repurchase

$485,461
(12,500)
(491,250)
($18,289)

Practice Question 32-2

Canfield & Miller has a $10 million bond issue maturing this year.
Theyve been sufficiently profitable that they can pay off the issue with
cash on hand. When they do, their debt-to-asset ratio will most likely:

A. Decrease
B. Remain unchanged
C. Increase

Practice Question 32-2

Canfield & Miller has a $10 million bond issue maturing this year.
Theyve been sufficiently profitable that they can pay off the issue with
cash on hand. When they do, their debt-to-asset ratio will most likely:

A. Decrease
B. Remain unchanged
C. Increase
Correct answer: A. Decrease
Canfield & Millers profitability suggests positive equity, so their
liabilities are less than their assets; furthermore, their debt is likely less
than their liabilities, so their debt is less than their assets, and their
existing debt-to-asset ratio is less than one. When the same amount is
subtracted from the numerator and the denominator, the ratio will
decrease.

Presentation / Disclosures
Long-term liabilities are aggregated as a single amount
Liabilities due within one year: current liabilities
Footnotes
Stated and effective interest rates
Maturity dates
Pledged collateral
Scheduled repayments over the next 5 years
Covenants

Timely principal and interest payments

Maintenance of pledged collateral
Dividend restrictions
Minimum working capital levels
Maximum leverage levels
Minimum liquidity ratios

Motivations for Leasing

Fixed interest rates
No down payment
Less risk of obsolescence
No concern about disposal
Fewer restrictions (covenants)
Tax benefits of ownership (e.g., depreciation, interest)
Synthetic leases: benefits of ownership without balance
sheet disclosure

Finance vs. Operating Leases, US GAAP

Lessee must treat a lease as a finance (capital) lease if
any of these conditions apply:
Lease term is 75% of the assets economic life
Present value of minimum lease payments 90% of
the fair value of the asset

Discount rate is lower of:

Rate inherent in lease
Lessees incremental borrowing rate

Ownership transfers at the end of the lease term

Bargain purchase option exists

Lessor must treat a lease as a finance lease if lessee

must, and
Collectability of lease payments is reasonably
assured
Lessor has performed substantially under the lease

Finance vs. Operating Leases, IFRS

IFRS requires lessee and lessor to treat a lease as a
finance lease if substantially all risks, rewards of
ownership are transferred to lessee
Situations that normally result in a finance lease
Lease term is majority of assets economic life
Present value of minimum lease payments is
substantially all of the fair value of the asset
Ownership transfers at the end of the lease term
Lessee has the option to purchase the asset at
sufficiently below fair market value when the option
is exercisable that it is likely to exercise the option
Leased asset is sufficiently specialized that only the
lessee can use it without modification

Lessee Finance Lease Accounting I

Example: Castle Enterprises leases equipment for five annual
payments of $80,000, payable in advance. The equipment has a
salvage value of $50,000, and the present value of the lease payments
(at the 9% rate implicit in the lease) is 95% of the fair market value of
the equipment, so Castle treats it as a finance lease. Castle uses
straight-line depreciation over the life of the lease.
The present value of the lease payments is $371,674. Castle records
an asset (Investment in Equipment) for $371,674, and a liability
(Leases Payable) for $371,674.
The annual depreciation expense is ($371,674 $50,000) / 5 =
$64,335

Lessee Finance Lease Accounting II

Example (cont.):
The
amortization
table for the
lease liability
is:

Year
1
2
3
4
5

The depreciation
schedule for the
lease asset is:

Beg. BV Payment Interest Principal End. BV

$371,674 $80,000 $26,251 $53,749 $317,925
317,925 80,000 21,413 58,587 259,338
259,338 80,000 16,140 63,860 195,478
195,478 80,000 10,393 69,607 125,872
125,872 80,000
4,128
75,872
50,000
Year
1
2
3
4
5

Beg. BV
$371,674
307,339
243,004
178,670
114,335

Dep'n Accum. Dep'n

$64,335
$64,335
64,335
128,670
64,335
193,004
64,335
257,339
64,335
321,674

End. BV
$307,339
243,004
178,670
114,335
50,000

Lessee Finance Lease Accounting III

Example (cont.):
Operating expenses (depreciation), non-operating expenses (interest),
CFO (interest) and CFF (principal):
Year Op. Exp. Non-Op. Exp.
1
$64,335
$26,251
2
64,335
21,413
3
64,335
16,140
4
64,335
10,393
5
64,335
4,128
Total $321,674
$78,326

CFO
($26,251)
(21,413)
(16,140)
(10,393)
(4,128)
($78,326)

CFF
($53,749)
(58,587)
(63,860)
(69,607)
(75,872)
($321,674)

Lessee Operating Lease Accounting

Example: Moat Industries leases equipment for five annual payments
of $80,000, payable in advance. The equipment has a salvage value
of $50,000, and the present value of the lease payments (at the 9%
rate implicit in the lease) is 85% of the fair market value of the
equipment, so Moat treats it as an operating lease.
Moat doesnt record an asset and doesnt record a liability. Moat will
have no depreciation expense. Their only expense each year will be
$80,000 in rental expense, an operating expense. The cash outflows
will all be CFO.

Practice Question 32-3

Operating expenses and total expenses under a finance lease,
compared to those under an operating lease, are most likely:

A.
B.
C.

Operating
Expenses
Lower
Lower
Higher

Total
Expenses
Lower
The same
Higher

Practice Question 32-3

Operating expenses and total expenses under a finance lease,
compared to those under an operating lease, are most likely:

A.
B.
C.

Operating
Expenses
Lower
Lower
Higher

Total
Expenses
Lower
The same
Higher

Correct answer: B. Lower The same

Expenses under a finance lease are split between operating expenses
(depreciation) and interest (non-operating); expenses under an
operating lease are all operating expenses (rent). Total expenses are
the same and equal to the total lease payments so operating
expenses under a finance lease must be lower than those under an
operating lease.

Lessor Lease Accounting I

Operating lease

Lessor retains asset on balance sheet

Lessor records rental income

Finance lease

Lessor removes asset from balance sheet

Lessor records lease receivable
Sales-type lease
Dealer, manufacturer leasing their own products
Profit recorded on sale
Revenue is lower of fair value of asset or PV of minimum
lease payments
Cost is carrying value less PV of residual
Interest income recognized during lease period
Direct financing lease
Finance company
No profit recorded on sale
Interest income recognized during lease period

Lessor Lease Accounting II

Example: Gauntlet Products leases to equipment to Castle Enterprises
for five annual payments of $80,000, payable in advance. The
equipment has a salvage value of $50,000, and the present value of
the lease payments (at the 9% rate implicit in the lease) is 95% of the
fair market value of the equipment, so Castle treats it as a finance
lease. The carrying value of the equipment on Gauntlets balance
sheet is $260,000. Gauntlet treats the lease as a sales-type lease.

The present value of the lease payments is $371,674, and the present
value of the residual is $32,496. Gauntlet records revenue of
$339,178 (= $371,674 $32,496) and expenses of $260,000, for a
gross profit of $79,178. Gauntlet also records a lease receivable of
$339,178.

Lessor Lease Accounting II

Example (cont.):
The amortization table for the lease receivable is:

Year
1
2
3
4
5

Beg. BV Payment Interest Principal End. BV

$339,178 $80,000 23,326 $56,674 282,504
282,504 80,000 18,225 61,775 220,729
220,729 80,000 12,666 67,334 153,394
153,394 80,000
6,606
73,394
80,000
80,000
80,000
0
80,000
0

Defined Contribution Plans

Company contributes money to the plan, has no further
obligation
Accounting
Income statement

Pension expense equals required contribution

Balance sheet
Decrease in cash equal to actual contribution
Liability if actual contribution < required contribution
Asset if actual contribution > required contribution

Cash flow statement

CFO outflow equal to actual contribution

Defined Benefit Plans I

Company contributes money to the plan, promises to
pay future pension benefits
Company must estimate future obligation
Wage/salary growth rate
Average retirement age
Average longevity after retirement
Discount rate
Accounting
Balance sheet

Net pension asset if plan assets > PV of benefit obligation

Net pension liability if plan assets < PV of benefit obligation

Defined Benefit Plans II

Accounting (cont.)
Change in net pension asset/liability during period

IFRS
Employee service cost
Net interest expense or income
Actuarial gains/losses
Actual return expected return
US GAAP
Employee service cost
Interest expense
Expected return on plan assets
Past service costs
Actuarial gains/losses

Defined Benefit Plans III

Accounting (cont.)
Balance sheet

IFRS not amortized

Actuarial gains/losses
Actual return expected return
US GAAP amortized
Past service costs
Actuarial gains/losses

Income statement
IFRS
Employee service cost
Net interest expense or income
US GAAP
Employee service cost
Interest expense
Expected return on plan assets