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Non-Current Liabilities

Non-Current Liabilities. RCJ Chapter 11 (except 583-601). Key Issues. Effective interest method Types of non-current liabilities Understanding the financials Early retirement/swap Earnings management Footnote disclosures. Effective Interest Method. 2 implications:

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Non-Current Liabilities

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  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

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