Noncurrent Liabilities Chapter 9. Noncurrent Liabilities Noncurrent liabilities represent obligations of the firm that generally are due more than one.

Noncurrent LiabilitiesNoncurrent Liabilities

Chapter 9

Noncurrent Liabilities Noncurrent Liabilities

• Noncurrent liabilities represent obligations of the firm that generally are due more than one year after the balance sheet date.

Noncurrent Liabilities Noncurrent Liabilities

• The major portion of these liabilities consists of notes payable and bonds payable.

Long-Term Notes PayableLong-Term Notes Payable

• Long-term notes payable can be either interest-bearing or discounted.

Interest-Bearing NotesInterest-Bearing Notes

• With an interest-bearing note, the bank will loan the principal of the note for a specified period.


• The borrower will pay interest periodically and will repay the principal at the maturity date.


• Interest expense, of course, reduces Retained Earnings, as do all expenses.




Discounted NotesDiscounted Notes

• Discounted notes do not require periodic payments of interest.


• All long-term financing agreements involve interest, regardless of whether it is separately identified.


• If a company borrows $10 million for 2 years and, because of the terms of the note, will not make periodic interest payments, then the lender will be unwilling to provide the borrower the full $10 million face amount of the note.


• In this case, the note must be discounted, and the lender will lend the present value of the note, as computed by using the compound interest tables.


• Assuming an interest rate of 12%, a factor of 0.797 is pulled from the Present Value of $1 table.


• Multiplying $10 million by the factor, the present value (the amount which the borrower will receive in cash) is computed as $7,970,000.


• The difference, $2,030,000, is the discount, which represents the interest that is associated with the transaction.


• It will be recognized as Interest Expense by the borrower over the two-year period of the note.


• At the maturity date, the borrower will repay $10 million to the lender.



BondsBonds

• Bonds are individual notes, sold to individual investors as well as to financial institutions.

Bonds have several advantages:Bonds have several advantages:

• The sale of bonds provides access to a large pool of lenders.

• For some firms, selling bonds may be less expensive than other forms of borrowing.

• Bond financing may offer managers greater flexibility in the future.

Bonds Payable Bonds Payable

• Bonds payable represent a major source of borrowed capital for U.S. companies.


• Bonds involve the periodic payment of interest (usually every six months) and the repayment of the principal amount.


• The predicted interest rate usually becomes the coupon or face or nominal rate.


• It sets the cash interest payments the company will have to make.


• The market rate of interest will be known only when the bonds are sold.

Bonds PayableBonds Payable

• Because interest rates change constantly, it is rare that a bond coupon rate will equal the market rate when the bond is sold.


• If the principal of a bond is $500,000 and the coupon rate is 12%, then the company will pay $60,000 ($500,000 X 12%) cash interest each year, or $30,000 every six months.


• When interest is paid each six months, the interest rate is said to be compounded semiannually.


• Since the bonds pay interest twice a year, the interest rate must be halved (10% per year is 5% each six months) and the number of years must be doubled.


• A 6-year bond pays interest 12 times over the life of the bond.

Bonds Sold at ParBonds Sold at Par

• Bonds sell at par or face value when the coupon rate equals the market rate of interest on the date of sale.


• For a bond sold at par, on the date of sale, both Cash and Bonds Payable will increase by $100 million.


• On each of the two annual interest payment dates, Interest Expense will increase and Cash will decrease by $6 million.


• On the maturity date, both Cash and Bonds Payable will decrease by $100 million.




Bonds Sold at DiscountBonds Sold at Discount

• If, on the date of sale, the coupon rate does not equal the market rate, the bonds will sell at their present value.


• If the coupon rate is below the market rate of interest on the date of sale, then the bonds will sell at a discount.


• An investor will not pay face amount for a bond which has an interest rate lower than that which the investor could find elsewhere.

An example of a bond sold at a discount:An example of a bond sold at a discount:

• On January 3 a company sells $100,000,000 of bonds with a coupon rate of interest of 12% while the market rate of interest is 16%.

• The bonds are 10-year bonds and pay interest twice a year


• The present value of the bonds is calculated by adding the present value of the $10,000,000 to the present value of the annuity.



$100,000,000 x 0.215 = $ 21,500,000

$ 6,000,000 x 9.818 = 58,908,000

$ 80,408,000


• The coupon rate of interest is used to compute the cash interest payments ($10,000,000 X .12 X 6/12) and to compare against the market rate of interest (12% versus 16%) to let you know that the bonds are selling at a discount.


• After that, the present value computations and interest computations are driven by the market rate of interest.


• Because the bonds are 10-year bonds paying interest twice a year, there are 20 interest payment periods, and the market rate of interest will be halved, to 9%.


• Upon sale of the bonds, the company will increase Cash and net Bonds Payable by $80,408,000.


• The discount of $19,592,000 represents additional interest paid to bondholders.

Bonds Sold at Discount Bonds Sold at Discount

Amortization Amortization

• Periodic interest expense may differ from the periodic cash payments to the bondholders

• The reported value of the bonds will be adjusted for the difference through a process called amortization.


• For our bond, the first interest payment date will involve the following:


• For our bond, the first interest payment date will involve the following:– A decrease in Cash of $6,000,000 an

decrease in Interest Expense of $6,432,640 ($80,408,000 X 8%), and an increase in the reported value of Bonds Payable (because the discount is decreasing) of $432,640 ($6,432,640 - $6,000,000).

AmortizationAmortization


• For our bond, the first interest payment date will involve the following:


• For our bond, the first interest payment date will involve the following:– The value of the bonds will continue

to rise toward $100,000,000 over the life of the bond, and the discount will be completely amortized by the maturity date.


• A bond is sold at a premium when the coupon rate of interest is higher than the market rate.

An example of a bond sold at a premium: An example of a bond sold at a premium:

• On January 3 a company sells $100,000,000 of bonds with a coupon rate of interest of 12%, but now the market rate of interest is 8%.


• The bonds are 10-year bonds and pay interest twice a year.




• Using the same bond as above, an example of a bond sold at a premium:


• Using the same bond as above, an example of a bond sold at a premium:

$100,000,000 x 0.456 = $ 45,600,000

$ 6,000,000 x 13.590 = 81,540,000

$127,140,000


• The premium of $27,140,000 represents a reduction in interest paid to bondholders to compensate for the fact that the coupon rate is too high.

Bonds Sold at PremiumBonds Sold at Premium

• The reported value of the bonds will be adjusted for the difference between interest expense and cash interest payments through a process called amortization.

Early Retirement of BondsEarly Retirement of Bonds

• Changes in market rates of interest may motivate firms to buy back their outstanding bonds prior to their scheduled maturity dates.


• Any difference between the reported value of the bonds and the repurchase price must be accounted for as either an extraordinary gain or loss.


• Extraordinary gains or losses are reported separately, net of tax, at the bottom of the income statement.

Other Aspects of Borrowing AgreementsOther Aspects of Borrowing Agreements

• Borrowing agreements – indentures – can include other important provisions.

Restrictive CovenantsRestrictive Covenants

• A lender may insist that a borrower agree to various restrictions in order that the lender be protected from possible default by the borrower.


• Violations of these restrictive covenants constitute technical default on the debt and usually come with penalties for the borrower.


• Analysts are always concerned with the existence of such covenants.

CollateralCollateral

• Debt agreements sometimes require that specific assets of the borrower be pledged as security in the event of default by the borrower.


• If a lender is not happy with the assets to be pledged as collateral, then he may require that a sinking fund be established to secure the debt.


• Such a fund is segregated cash and/or investments, administered by a third party, dedicated to repayment of the debt.

ConvertibilityConvertibility

• Sometimes bonds are convertible, meaning that the bondholder has the option to exchange the debt for a predetermined number of shares of stock.

ConvertibilityConvertibility

• Investors usually view convertibility as a very attractive feature.

Financial Reporting of Income TaxFinancial Reporting of Income Tax

• The objectives of income measures for financial reporting may differ from measures for income tax purposes.


• Income measures for financial reporting purposes should help financial analysts to assess the firm's future ability to generate cash.


• Income measures for income tax purposes must comply with the relevant provisions of the IRS tax code.

Book and Tax DifferencesBook and Tax Differences

• Book measurements are used for financial reporting purposes, while tax measurements must comply with income tax laws.


• In most cases, differences between book and tax measurements are temporary in nature.


• Accounting standards for reporting income tax expenses and liabilities reflect a basic premise.


• All events that affect the tax impact of temporary differences should be recognized currently in the financial statements.

Two types of events can affect expected tax impacts:Two types of events can affect expected tax impacts:

• A change in the amount of temporary differences between the book and the tax bases of a firm's assets (or liabilities).

• A change in tax rates that will apply to those temporary differences.

DepreciationDepreciation

• A frequently occurring temporary difference appears in the area of depreciation.


• A company may use straight-line depreciation for the books but an accelerated method for tax depreciation.


• Use of the accelerated method will lower current net, and therefore taxable, income.


• The temporary difference simply allows a firm to postpone its tax payments to later years.


• The tax eventually must be paid.


• Accounting standards require that firms recognize a liability for such future income taxes.

Deferred Income Tax LiabilityDeferred Income Tax Liability

• The liability for future income taxes is referred to as a deferred income tax liability.


• It is computed by multiplying the difference between the asset's book and tax bases by the appropriate income tax rate.


• An assets with a book basis of $7,000,000 and a tax basis of $5,000,000, gives a deferred income tax liability of $800,000 if the income tax rate is 40%.


• An assets with a book basis of $7,000,000 and a tax basis of $5,000,000, gives a deferred income tax liability of $800,000 if the income tax rate is 40%.

$7,000,000 – $5,000,000 = $2,000,000

$2,000,000 x 40% = $800,000


• Deferred tax accounting appears to provide a better matching of expenses on the income statement, at least when tax rates are expected to be stable over time.

Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting

• Others items causing temporary differences include revenue and expense measurements in areas such as leasing, warranties, debt refinancing, and exchanges of assets.


• Just as there are deferred tax liabilities, there are also deferred tax assets.


• These occur when the difference between book and tax measurements results in earlier recognition of taxable income.


• The reduction in income tax will occur in future years.


• To sum up, a deferred tax liability causes current taxable income to be lower than book income.


• The increase in income tax occurs in future years.


• A deferred tax asset causes current taxable income to be higher than book income.


• The benefit, the decrease in income tax, will occur in future years.


• Deferred tax obligations are classified as current or noncurrent based upon the current or noncurrent classification of the related asset.


• While long-term obligations are reported at their present values, deferred tax obligations are not discounted to their present values.

Noncurrent LiabilitiesNoncurrent Liabilities

End of Chapter 9

Noncurrent Liabilities Chapter 9. Noncurrent Liabilities Noncurrent liabilities represent obligations of the firm that generally are due more than one.

Documents