IFA 2 - Chapter 12 - Non Current Liabilities

financial leverage

quantifies the relationship between the relative level of a firm’s debt and its equity base - it is a measure of solvency

increase financial leverage…

• can increase ROE

• increases exposure to risk and amplifies risk of bankruptcy

debt rating agencies

independent agencies that evaluate the strength of governments and companies that issue PUBLICLY traded debt and preferred shares

the higher the rating (AAA = prime), the lower the risk of default.

bonds

a contract between the company/government that issued it and the entity that purchases it - it is a common form of long term debt

covenants

restrictions on borrower’s activities while the bond is outstanding

• positive covenant - requires individual to do something

• negative covenant - requires individual not to do something

bond’s indenture

fancy term for the bonds contract. It specifies the bond’s terms such as maturity date, interest/payment dates, securities that are pledged, covenants, etc.

secured bond

bond backed by specific collateral

debentures

unsecured bonds

stripped bonds

zero coupon bonds, meaning they pay no interest

serial bonds

mature in blocks at a time meaning that payments of face value are made in chunks as it matures until the bond is paid off at the end

callable bonds

permits early issuer redemption (i.e. they can pay you back early and save on interest)

convertible bonds

can be converted by holder to another security (complex financial instrument)

inflation-linked/real-return bonds

bonds where the rate adjusts for inflation in different periods

perpetual bonds

bonds that never mature and you receive interest payments into perpetuity

maturity/face value

principal amount of the bond to be paid by the issuer to the owner on the date of maturity

FV button in calculator

coupon/stated rate

interest rate specified in the bond indenture and used to calculate the cash outflow that is the interest payment

used to calculate PMT in calculator

yield or market rate

rate of return on the bond that is actually earned by the invesTOR. Used to calculate interest expense

effective interest rate

yield on the date of issuance of the debt and interest expense for the COMPANY aka the issuer.

This is usually higher than the yield/market rate (which the purchaser receives) because the issuer must take into account and pay issuance costs

will be equal to yield/market rate if the bond is sold at par with no issuance costs

bonds - initial measurement

bonds will be recorder at fair value minus debt issuance costs

the net amount is recorded so that we can recognize issuance costs throughout the bond’s life (as opposed to all at once at the beginning)

FVPL bonds are recorded at their gross amount with fees and the issue cost will be expensed to P&L (i.e. the income statement

fair value of bonds differs from face value when

• note is non-interest bearing

• coupon rate differs from market rate

• note is used for non-cash (where we must use the fair value of the consideration received)

market rate = coupon rate

bond sells at par/face value

market rate > coupon rate

bond sells at a discount

market rate < coupon rate

bond sells at a prenium

all financial liabilities except for those at FVPL are measured and reported at…

amortized cost

2 methods of amortized cost for non FVPL bonds

straight line method (only allowed under ASPE): allocates the same amount of discount/prenium to each interest period

effective interest method (required under IFRS): allocates the same percentage (aka the effective rate) of discount/prenium over the bonds term

eventually, both will be equal/immaterial difference it is just a timing issue

accounting for bonds - EIR method (inc. JEs)

step one: establish the EIR

step two: amortize the premium or discount

If discount:

• Dr. Bond interest expense

  • Cr. Bonds payable (the discount amortized)

  • Cr. Cash

If premium

• Dr. Bond Interest expense

• Dr. Bonds payable (premium amortized)

  • Cr. Cash

if interest payments do not correspond with year end (and thus payment) replace cash with interest payable and calculate amounts taking into account the fraction of time that has passed

derecognition

to remove a liability from the balance sheet

derecognition - debt

debt is removed when extinguished meaning:

• it has been paid off by cash or providing goods/services

• the company no longer has the legal obligation for the liability

• the debt has been discharged, cancelled, or expired

at maturity, amortized cost of a loan equals the principal amount due. There is no gain or loss on the extinguishment

derecognition - debt JEs

• Dr. Bonds payable

• Dr. Interest payable (if any interest payments remain)

  • Cr. Cash

paying off debt before maturity - required steps

step one: update records to account for interest expense and amortization of discounts and premiums that have yet to be recorded as of the derecognition date

step two: record the outflow of assets expended to extinguish the obligation

step three: record gain or loss on debt retirement which is equal to the amount paid MINUS the book value of the liability being derecognized

Companies may retire full amount of debt or a portion of it (if only a portion, derecognition happens on a prorata basis)

early retirement of bond - JES

if gain on redemption:

• Dr. Bonds payable

  • Cr. Gain on redemption

  • Cr. Cash

if loss on redemption:

• Dr. Bonds payable

• Dr. Loss on redemption

  • Cr. Cash

why may a firm retire debt early?

this typically happens when interest rates have gone down from when the debt was originally issued and so the firm wants to borrow at a lower rate and pay back the loan at a higher rate

• however, companies don’t do this often due to having to pay issuance costs when the refinance.

Bonds vs. notes payable (upfront, at every period, and at the end)

Upfront:

• Bonds: cash is received

• Note payable: asset is received (no cash is paid) - to figure out the value of the asset, we find the PV (using market interest rate) of the blended payments calculated with the note’s rate

Every period:

• Bonds: interest/coupon payments

• Note payable: Blended payments (both interest and principal) or no payments

End:

• Bonds: face value left to pay

• Note payable: nothing of loan amount left to pay (FV = 0)

accounting for a legal obligation associated with the retirement of a tangible long-lived asset that results from its acquisition, construction, or normal operations

referred to as AROs (asset retirement obligations)

this is not a financial liability because no one has an asset in response to it.

But we must still recognize it in the period it is incurred provided that a fair estimate can be made for its fair value

since there is often a long time interval between the obligation being created and the asset’s retirement, there is a need to discount these future costs.

• thus we establish a provision for estimated future liability and discount it with an appropriate interest rate and recognize this as an interest expense

AROs - allocation and recognition

capitalized ARO costs are not recorded in a separate account but instead capitalized into the carrying amount of the underlying asset

• this allows these costs to be amortized over the underlying asset’s useful life

AROs - JEs

at inception:

• Dr. Asset

  • Cr. Site restoration obligation

if need to record decrease in liability:

• Dr. Site restoration obligation

  • Cr. Asset

If need to record increase in liability

• Dr. Asset

  • Cr. Site restoration obligation

Note that since the site restoration obligation is capitalized into the cost of the asset, depreciation will be calculated included that amount in the net book value so be careful if need to recalculate depreciation expense that is is included in the revision

interest expense - ARO - IFRS

interest expense recognized as ARO is amortized to maturity using the effective interest method, with depreciation allowed to follow a straight line (IFRS)

interest expense AROs - ASPE

ASPE does not require a legally binding constructive obligation like IFRS but needs a reasonable expectation to exist

ASPE uses accretion, which is an operating expense for interest, instead of interest expense

at inception, IFRS recorded a site restoration obligation and ASPE recognizes ARO

Why do users care about a company’s debt level

• the higher the debt, the higher the risk that a company cannot repay it

• Capital markets increase borrowing rates for companies with higher loads, making it more difficult to access funds

debt to total assets

total debt / total assets

times interest earned

(income tax + interest expense ) / interest expense