FRA Packet 4: Non-Current Liabilities

Non-Current Liabilities

Overview

  • Source: RCJ Chapter 12 (excluding 12-21/12-22), Chapter 16 (16-30/16-38), Chapter 9 (9-26/9-34).

Key Issues Discussed

  • Effective interest method.

  • Types of non-current liabilities.

  • Understanding financials related to these liabilities.

  • Early retirement/swapping of debt obligations.

  • Earnings management practices.

  • Importance of footnote disclosures in financial reports.

Effective Interest Method

Implications

  1. Calculation of Net Book Value (NBV):

    • NBV of the liability = Present Value (PV) of the future cash flows, discounted at the effective market-required interest rate present at the time of liability issuance.

    • Note: Changes in interest rates after the issuance are ignored.

  2. Interest Expense Calculation:

    • Interest Expense = Beginning of period NBV x effective market rate.

    • Example: Using exercise P12-9.

Parameters Influencing Cash Flows

  • Effective market rate (r%) can vary in relation to the coupon rate (C%):

    • For a par bond: effective rate = coupon rate.

    • For a discount bond: effective rate < coupon rate.

    • For a premium bond: effective rate > coupon rate.

Cash Payments vs. Interest Expense

  1. Par Bond:

    • Cash payment = interest expense.

  2. Discount Bond:

    • Cash payment < interest expense.

  3. Premium Bond:

    • Cash payment > interest expense.

Liability Spectrum

  • Types of Liabilities:

    • All cash as principal.

    • Combination of periodic and principal payments.

    • Zero Coupon Bonds.

    • Par Bonds.

    • Leases (mortgages).

Questions Addressed

  • Where do premium and discount bonds fit on this spectrum?

  • For a constant principal with borrowed cash, which liabilities incur the least versus the most total cash flows?

  • For a constant total cash flow, which liability requires the least versus the most cash at inception, aggravating the principal amount?

  • Are there scenarios where one liability is a better or worse deal than another?

Accounting Examples of Liabilities

Format of Presentation

  • All examples are labeled with their respective amortization schedules (also treated as journal entries).

  • Each example assumes a lifespan of 5 years, an effective market rate of 10%, and a present value of $1000 at inception, with variations in future cash outflows.

Example 1: Zero Coupon Bond

  • Entry at Inception:

    • Debit (DR) Cash 1,000

    • Credit (CR) Liability 1,000

  • Periodic Entries:

    • Period 1: 100 DR Liability, 100 CR Cash; End Liability = 1,100

    • Period 2: 110 DR Liability, 110 CR Cash; End Liability = 1,210

    • Period 3: 121 DR Liability, 121 CR Cash; End Liability = 1,331

    • Period 4: 133 DR Liability, 133 CR Cash; End Liability = 1,464

    • Period 5: 146 DR Liability, 146 CR Cash; End Liability = 1,610

  • Total Cash Outflow: 1,610

    • Calculation: 1610=1000imes1.1051610 = 1000 imes 1.10^5

Example 2: Discount Bond ($50 Coupon at 5%)

  • Entry at Inception:

    • Debit (DR) Cash 1,000

    • Credit (CR) Liability 1,000

  • Periodic Entries:

    • Calculation of interest expense and adjustments over periods.

    • Total Cash Outflows: 1555

    • Present Value (PV) of Coupons: 190 + PV of Principal: 810 = 1,305.

Example 3: Par Bond

  • Entry at Inception:

    • Debit (DR) Cash 1,000

    • Credit (CR) Liability 1,000

  • Periodic Entries:

    • Total Cash Outflows: 1500.

    • PV of Coupons: 379 + PV of Principal: 621 = 1,000.

Example 4: Premium Bond (15% Coupons = $150)

  • Entry at Inception:

    • Debit (DR) Cash 1,000

    • Credit (CR) Liability 1,000

  • Periodic Entries:

    • Total Cash Outflows: 1446.

    • PV of Coupons = 569 + PV of Principal = 431 = 696.

Example 5: Lease (Mortgage)

  • Entry at Inception:

    • Debit (DR) Cash 1,000

    • Credit (CR) Liability 1,000

  • Periodic Entries:

    • Total Cash Outflows: 1320.

    • Calculation of periodic interest and principal repayment.

Summary of Cashflows from Examples

  • Zero Coupon: 1610

  • Discount Bond: 1555

  • Par Bond: 1500

  • Premium Bond: 1446

  • Lease (mortgage): 1320

  • Ranked Total Cashflows: Despite equal present values at inception, total cash outflows increase with the duration of liability.

Implications of Effective Interest Method

Early Bond Retirement/Debt-Equity Swap

  • Journal Entries:

    • DR Old B/P NBV

    • CR New B/P, C/S or Cash at FMV

    • Gain or loss = NBV - FMV, influenced by changes in interest rates.

Earnings Management

Considerations

  • Continuous issuance of bonds leads to various vintage bond payables (B/P).

  • Companies selectively manage income through bond retirements to recognize gains or losses.

  • Early debt redemption gains/losses historically categorized as extraordinary items before 2002.

Footnote Disclosures Required for Bonds

  • Fair Market Value (FMV) of outstanding long-term bonds payable.

  • Projected cash principal repayments for the next 5 years.

  • Total cash interest paid for the year.

  • Ample information on the firm’s ability to manage debt through projected cash flows.

Convertible Debt

Definition

  • Bonds with an attached option to convert into common stock at a predetermined conversion price.

  • Convertible bonds typically yield lower than straight bonds due to the embedded conversion option.

Accounting Entries for Convertible Debt

  1. Issuance of Convertible Debt:

    • Same treatment as straight bonds, ignoring the conversion feature.

    • Journal Entry: DR Cash, CR Bonds Payable.

  2. Interest Payments:

    • Journal Entry: DR Interest Expense, CR Cash.

  3. Conversion of Bonds:

Methods for Accounting

  • Market Value Method:

    • Record at market value at the time of conversion.

  • Book Value Method:

    • Use book value to calculate accounting entries upon conversion:

      • DR Bonds Payable, CR Common Stock (at market value), and record any loss if applicable.

Financial Statement Analysis Implications

  1. Difficulty in estimating future cash outflows due to conversion probabilities.

  2. Recorded interest expenses may understate the true cost of debt.

Cash Settled Convertible Debt

Distinctions

  • Split into debt and equity components when settled in cash.

  • Accounting requires consideration of relevant effective interest rates and cash received compared to debt.

  • Effective interest method applies, with disclosure of values during conversions.

Hybrid Securities

Overview

  • Securities possessing both debt and equity characteristics, such as mandatory redeemable preferred stock.

  • Historically treated as debt, but categorized in a 'mezzanine' space between debt and equity on balance sheets.

Fair Value (FV) Accounting Principles

Features of FV Accounting

  • FV presented on balance sheets.

  • Recognized in income statements under Unrealized Holding Gains (UHG) and Unrealized Holding Losses (UHL).

SFAS No. 159 Considerations

  • Allows firms to reassess their debts at fair value during specific triggers.

  • Potential impacts on long-term I/S through recognition of gains and losses.

Pros and Cons of SFAS No. 159

Advantages

  • Reduces opportunities for 'gains trading' and mitigates income statement volatility.

  • Provides timely insights using current market prices and rates in decision-making.

Disadvantages

  • Potential to overstate balance sheets and income statements during financial distress conditions.

  • Can lead to inaccurate interpretations of a firm’s financial health based on debt values.

Adjusting for Fair Value

Adjustment Process

  • Balance Sheets should reflect true liabilities through upward or downward adjustments to FV.

  • Recognition of Unrealized Holding Gains or Losses (UHG/UHL) in financial statements based on interest rate changes relevant to the firm’s liabilities.