1 / 27

Non-Current Liabilities

This comprehensive overview addresses key issues related to non-current liabilities under Chapter 11, focusing on the effective interest method used for accounting. It explores various types of non-current liabilities, earnings management practices, and the implications of early retirement or debt swaps. The effective interest method's calculations and footnote disclosures are examined, including net book values, cash flows, premiums, and discounts associated with different bonds. This resource is essential for understanding financial statements and the management of long-term debt.

nicholas-carroll
Download Presentation

Non-Current Liabilities

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Non-Current Liabilities RCJ Chapter 11 (except 583-601)

  2. Key Issues • Effective interest method • Types of non-current liabilities • Understanding the financials • Early retirement/swap • Earnings management • Footnote disclosures Paul Zarowin

  3. Effective Interest Method 2 implications: • the net book value (NBV) of the liability = present value of the future cash flows • discounted at the effective (market required rate) rate in effect at the liability issuance [i.e., any subsequent changes in interest rates are ignored] • interest expense = Ex. P11-11, P11-12 except #3 Paul Zarowin

  4. Effective Interest Method (cont’d) effective market rate (r%) can be > = < coupon rate (C%) cash payment can be > = < interest expense Paul Zarowin

  5. Liability Spectrum all cash as principal Combination of periodic + principal all cash as periodic Lease (Mortgage) Zero Coupon Bond Par Bond Where on the spectrum do premium and discount bonds go? Paul Zarowin

  6. Liability Spectrum (cont’d) • For a constant principal (cash borrowed), which liability has least? most? total CF • For a constant Total CF, which liability yields least? most? cash at inception (higher principal) • Is any liability a better? worse? deal than any other all cash as principal Combination of periodic + principal all cash as periodic Lease (Mortgage) Zero Coupon Bond Par Bond Premium Bond Discount Bond Paul Zarowin

  7. Example We will show the accounting for each of the 5 examples, by using an amortization schedule (amortization table same as JE). In each case, the liability has a 5 year life, a 10% effective market rate, and a $1000 present value at inception. Only the pattern of (and total) future cash outflows differs. • Key: effective interest method Paul Zarowin

  8. 1. Zero Coupon Bond The inception j.e. is: DR Cash 1,000 CR Liability 1,000 The periodic j.e.’s are: Total cash outflows = 1610 (note: 1610 = 1000 x 1.105) Ex. E11-11 Paul Zarowin

  9. 2. Discount Bond (5% coupons=$50) The inception j.e. is: DR Cash 1,000 CR Liability 1,000 The periodic j.e.’s are: Total cash outflows = (5 x 50) + 1305 = 1555 PV of coupons = 50 x 3.791(5 yr,10% annuity factor)=190 PV of principal = 810(810x1.105= 1305)

  10. 3. Par Bond The inception j.e. is: DR Cash 1,000 CR Liability 1,000 The periodic j.e.’s are: Total cash outflows = (5 x 100) + 1000 = 1500 PV of coupons=100 x 3.791 = 379; PV of principal = 621 (621 x 1.105 = 1000) Paul Zarowin

  11. 4. Premium Bond (15% coupons = $150) The inception j.e. is: DR Cash 1,000 CR Liability 1,000 The periodic j.e.’s are: Total cash outflows = (5 x 150) + 696 = 1446 PV of coupons = 150 x 3.791 = 569; PV of principal = 431 (4311 x 1.105 = 696) Paul Zarowin

  12. 5. Lease (Mortgage) The inception j.e. is: DR Cash 1,000 CR Liability 1,000 The periodic j.e.’s are: Total cash outflows = 5 x 264 = 1320 PV of coupons = 264 x 3.791 = 1000 Paul Zarowin

  13. Example (cont’d) • Zero Coupon = 1610 • Discount Bond = 1555 • Par Bond = 1500 • Premium Bond = 1446 • Lease(mortgage) = 1320 Ranking of total cashflows: despite the fact that all PV=s are $1000, the later the liability is paid back (the longer the liability is outstanding), the greater the total cash outflows. Paul Zarowin

  14. Implication of Effective Interest Method:Early Bond Retirement/ Debt-Equity Swap DR Old B/P NBV DR Loss (plug) CR New B/P or C/S or cash FMV CR Gain (plug) gain/loss = NBV - FMV, due to change in interest rates Ex. E11-5, E11-9, P11-22 or Paul Zarowin

  15. Earnings Management and Bond Retirement/Swap • firms continually issue bonds • they have many vintages of B/P outstanding • some have risen in value • some have fallen in value • firms pick which bonds to retire • manage income by choosing to recognize gains or losses • gains or losses on early debt redemption were extraordinary items (pre 2002) Paul Zarowin

  16. Bond Footnote Disclosures • FMV of outstanding B/P’s • annual (cash) principal repayments for next 5 years • cash interest paid for the year (not necessarily = interest expense) C11-3, except #6, C11-4 Paul Zarowin

  17. Analyzing Long-Term Debt Will projected cash flows be adequate to service debt? • Principal payments • Future cash interest payments over the next 5 years= effective cash interest % * debt outstanding each year (remember to subtract the debt that will be redeemed) • compare to cash flow forecasts for the firm: will projected cash flows be adequate to service interest and principle payments? C11-5, except #7 Paul Zarowin

  18. Bond Correction JE Put bonds on B/S at FMV (i.e., replace NBV with FMV) DR B/P NBV DR R/E CR B/P FMV DR R/E DR or CR to R/E is a plug for cumulative unrecognized gain or loss, from not marking to mkt Paul Zarowin

  19. Loss Contingencies • An event which raises the possibility of future loss is a loss contingency (the actual loss is yet to occur). • Examples: • Legal suit against the company. • Company is the guarantor for another entity’s debt. • The way loss contingencies are disclosed depends on: • how high the probability of their occurrence; and • whether of not they are measurable. Paul Zarowin

  20. Loss Contingencies (cont’d) • 3 probability degrees of future loss: probable, reasonably possible and remote. • A loss should only be recorded if: (1) the liability is probable; and (2) the amount of the loss can be reasonably estimated. DR loss(I/S) CR loss contingency(B/S) • If either (or both) condition is not met the liability should be disclosed only in a footnote. • When the probability of a future loss is remote, it will be disclosed in a footnote only under certain circumstances. Paul Zarowin

  21. Example of Loss Contingency: Adelphia Case • Adelphia is one of the biggest cable companies in the US, and is controlled by the Rigas Family. • The Rigas Family took a private loan of 3.1 billion dollars private loan, and Adelphia provided the collateral for this loan. • How should have Adelphia reported this collateral in its financial reports? Paul Zarowin

  22. Adelphia case (cont’d) • In case the Rigases won’t pay the loan, Adelphia as the grantor will have to step in and pay back the loan. • The fact that the company guarantied $3.1 billion loans of the Rigas family, was not disclosed under "contingent liabilities" in the company's 2000 financial statements. • In case this contingent liability would have been disclosed, what could have been the impact on Adelphia’s share price? Paul Zarowin

  23. Fair Value (FV) Accounting 3 features of FV accounting: • FV on B/S • recognize on I/S UHG and UHL (should be separate line from interest) • FV Interest expense = wt. Avg. current period FV x wt. Avg. current period r% UHG/UHL = FV – NBV Note: 2 and 3 may be difficult to separate, so aggregate Paul Zarowin

  24. FV is better than amortized cost (AC) Because: • AC uses old info • AC causes non-comparability of instruments issued at different times • AC allows income manipulation via realized G/L’s (gains trading) • AC recognizes G/L’s gradually over instrument’s remaining life, via misstated interest (interest is not same as G/L) • Current prices and rates based on new info are better predictors of future prices/rates than old prices and rates based on old info Paul Zarowin

  25. Adjusting for FV Solution: adjust financial statements for FV’s, to create a more accurate picture of profitability, solvency,etc. Adjustment to B/S: write liabilities up or down to FV 1. recognize UHG DRCR if r%  liability UHG (R/E) 2. recognize UHL DRCR if r%  UHL (R/E) liability Paul Zarowin

  26. Adjusting for FV (cont’d) Adjustment to I/S: recognize change (from BOY to EOY) in UHG/UHL on I/S • change in UHG/UHL is current year’s UHG/UHL Paul Zarowin

  27. Problems/Limitations of FV • measurement error if market is not liquid – key is disclosure of estimation assumptions and sensitivity of FV’s to these assumptions • mismatching of assets (not FV) vs liabilities (FV) • problem if r% is due to firm specific risk; • ex. r% rises due to financial difficulty – write-down of bonds (gain) implies success (eg, D/E falls) • ex. r% falls due to financial success – write-up of bonds (loss) implies problem (eg, D/E rises) Paul Zarowin

More Related