NON-CURRENT (LONG-TERM) LIABILITIES

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Stanley McCoy
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1 NON-CURRENT (LONG-TERM) LIABILITIES 1 MRI = Market Rate of Interest CR = Coupon Rate IE = Interest Expense FV = Fair Value PV = Present Value A&L = Assets & Liabilities CV = Carrying Value BS = Balance Sheet CFS = Cash Flow Statement O.L = Operating Lease F.L = Finance Lease GP = Gross Profit BV = Book Value IS = Income Statement CFO = Cash Flow From Operation CFF = Cash Flow from Financing 32. a Debt Issuance Bond Issued at Par Bond Issued at Discount Bond Issued at Premium MRI (return required by bondholders) = CR. PV of coupon + PV of face amount = par value. A&L by face value on B.S. Interest expense = coupon paid (I.S). Issuance proceeds as CFF inflow, coupon payment in CFO & repayment of face value, outflow from CFF. Under U.S. GAAP or as CFO or CFF under. CR < MRI = discount. Investors pay less than face value because of low coupon. B/S Impact CR > MRI= Premium. Investor will pay more for attractive coupon rate. A & L by bond sale proceeds. Price of the bond at issuance = PV of future cash payments. Interest exp & Value of bond at issuance is calculated using market rate of interest at issuance. 31. b I.E includes amortization of discount or premium at issuance if not issued at par. I.E (effective I.R method) = BV of bond liability t 1 MRI at issuance. Premium bonds I.E < coupon payment, difference is amortization of premium. I.E as bond liability & reduces periodic premium amortization & vice versa in case of a discount bond. Zero Coupon Bonds No periodic payments of interest & interest expense is implied. Actual interest payments are included in face value. F.S impact is qualitatively same as any other discount debt. Issuance Cost Bond issuance costs usually netted against bond proceeds & reported as CFF. Initial bond liability on B/S is reduced by amount of issuance cost, effective I.R. Capitalize as an asset & allocate over term of bond.

2 2 32. c Extinguishing Debt At maturity BV & face value of liability is same so no G/L. Firm may choose to redeem bonds before maturity due to various reasons. When redeemed before maturity G/L is calculated by subtracting redemption price from BV of liability. Unamortized issuance cost must be written off & included in G/L calculation (). No write-off is necessary under (already included in BV of liability). In CFS, G/L is eliminated from N.I in arriving at CFO & cash paid to redeem bonds is shown as an outflow from financing activities. FV Reporting Option If yield, bond s carrying amount no longer equal to its market value. Yield, FV of liability & vice versa. Option to report debt at FV ( & ) & G/L in I.S. MV of debt is more appropriate then B.V. When I.R were low at issuance, firm is better off when I.R rise (low MV of debt, debt, equity, debt to assets & debt to equity) & vice versa. 32. d Debt Covenants Restriction imposed by lender on borrower to protect lender s position & to reduce default risk. Affirmative Covenants Borrower promises to do certain things e.g. timely interest & principal payment, maintain ratios etc. Negative Covenants Refrain certain activities that adversely affect ability to repay e.g. Limit paying dividends & issuing more debt etc. If technical default (covenant violated), bondholder can demand immediate repayment of principal. 32. e Firms provide disclosure about long term debt in footnotes & MD&A. Disclosure usually includes maturity dates, stated & effective I.R, restrictions by creditors & the amount of scheduled debt repayments for the next five years. Discussion in MD&A can be both quantitative & qualitative.

3 3 32. f Lease contractual arrangement whereby the owner (lessor) grants lessee the right to use the asset for a particular period & payment. Leasing can have less costly financing, reduce obsolescence risk, less restrictive provisions, off B.S financing & tax reporting advantages. Lease Classification Finance lease Operating lease In substance, purchase of asset with debt. Equal amounts to both A&L. Dep. expense on assets & interest exp. to liab. Rental arrangement. No A or L. Periodic payments as rental expense. 32. g Lessee s Perspective If all rights & risks of ownership are transferred to lessee, finance lease. Circumstances for a finance lease include: Title transferred at end of lease. Lessee can purchase assets at significant lower price in future. Lease term covers major portion of asset s economic life. The PV of lease payments is substantially equal to FV of leased asset. Specialized asset, that only lessee can use without modifications. Capital lease if any of following occur: Title transferred at lease end. Bargain purchase option. Lease period is 75% or more of asset s life. PV of lease payment is 90% or more of FV leased asset Lease not meeting any of above criteria is operating lease & preferred by lessee (no Liability). Lessor s perspective U.S. GAAP If all rights & risks of ownership are transferred, finance lease, otherwise operating. If any one of lease criteria is met, & reasonably assured cash collectability, & lesser has substantially performed under the lease, capital lease, otherwise operating. Operating lease rental income & depreciation on asset. Capital lease replace asset with lease investment account.

4 4 32. h Reporting by the lessee Operating lease Finance Lease B.S is unaffected. Rent expense (lease payment) in I.S. CFS, lease payment as CFO outflow. A&L (lower of PV of future minimum lease payment & FV of leased asset). Asset is dep. in I.S & interest expense (lease liability t 1 lease rate) is recognized. CFS, principal (outflow from financing), interest: outflow from CFO (), CFO or CFF (). Ratios & F.S effects of leases B.S I.S CFS Turnover ratios will be lower under finance lease. ROA, leverage ratios, current ratio & working capital under capital lease. EBIT for capital lease. Total expense over life of lease is same. N.I in early years will be lower under finance lease (sum of dep. & interest is > lease payment) & higher in later years. CFO & CFF under finance lease & vice versa in case of O.L. Total CFs are unaffected. Reporting by the lessor Sale-Type Lease PV of lease payment > CV of asset Direct Financing Lease PV of lease payment = CV of asset No distinguish b/w sales-type & direct financing. Similar treatments for sales-type leases originated by dealers or manufacturers. Sales-type lease Lessor (normally manufacturer or dealer) sells asset for PV of lease payment & provides loan of same amount to buyer. Sale = PV of lease payment, cost = CV of asset & difference is GP. Principal portion reduces lease receivable & interest portion is recognized as interest income. In CFS, interest is inflow from CFO & Principal as inflow from CFI. Direct Financing Lease No GP is recognized, simply providing a financing function. Remove asset from B.S & create lease receivable by same amount. CFS treatment is similar as under sales-type. Operating Lease Rental income by lessor. Keep asset on B.S & depreciate it.

5 5 32. i Both lessee & lessor are required to disclose useful information about leases, including ; General description of leasing arrangement. Timing, nature & amount to be paid or received in each of next five years & payments after 5 years are aggregated. Lease revenue & expense in I.S & amount receivable & unearned revenues. Restrictions imposed by lease agreements. I.R used in lease calculations is not always disclosed. 32. j, k Types of Pension Plans Defined Contribution Plans (DCP) Defined-Benefit Plans (DBP) Company contributes a defined amount into the plan (treated as pension expense). Cash flows contributed to the plan are treated as an operating cash outflows. Impact on assets & liabilities in cash & a liability is recognized if some portion of agreed upon amount has not yet been paid. More complicated than DCP. Company promises future benefits to be paid to employees during retirement. Assumptions are made to determine future obligation. The pension obligation is allocated over the employee s employment as part of pension expense. Recognition of DBP Most DBPs are funded through pension trust fund. If the fair value of plan assets > (<) the PV of pension obligation, the plan has a surplus (deficit) & the company s balance sheet will reflect a net pension asset (liability). Defined Benefit Plan in net pension asset or liability have three components. / & & Employees service costs PV of in the pension benefit earned by the employee by providing one more year of service. Net interest expense or income net pension asset or liability discount rate (reflective of high quality corporate bond yield). Remeasurements: Actuarial G/L resulting from made to assumptions. Actual return on plan asset any return included in net interest exp or income in net pension asset or liability each period is viewed as having five components. Three components are recognized in P&L in the period incurred. Service costs. Interest exp. Expected return on assets ( amount of expense recognized). Past service costs & actuarial G/L are recognized in OCI & subsequently amortized over time (smooth pension expenses).

6 6 32. l In evaluating solvency (ability to satisfy long-term obligations), analysts look at leverage & coverage ratios Ratios Leverage ratios Coverage ratios Measure amount of debt (interest bearing obligation) in capital structure. Debt-to-assets ratio = total debt / total assets (% of total assets financed with debt). Debt-to-capital ratio = total debt / (total debt + total equity) (total capital excludes non-interest bearing liabilities). Debt-to-equity ratio = total debt / total equity (amount of debt financing relative to equity base). Financial leverage ratio = Avg. total assets / Avg total equity (leverage used in DuPont) Higher these ratios, higher the leverage. Sufficiency of earnings to repay interest & other fixed charges. Interest coverage = EBIT / interest payment. Fixed charges coverage = EBIT + lease payment / interest + lease payments. Lower the ratios, the greater difficulty to make payments.

Chapter 11. Notes, Bonds, and Leases

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