Noncurrent Liabilities

1
Noncurrent Liabilities

• Chapter 9

2
Noncurrent Liabilities

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

3
Noncurrent Liabilities

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

4
Long-Term Notes Payable

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

5
Interest-Bearing Notes

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

6
Interest-Bearing Notes

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

7
Interest-Bearing Notes

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

8
Interest-Bearing Notes
9
Interest-Bearing Notes
10
Interest-Bearing Notes
11
Discounted Notes

• Discounted notes do not require periodic payments
  of interest.

12
Discounted Notes

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

13
Discounted Notes

• 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.

14
Discounted Notes

• 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.

15
Discounted Notes

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

16
Discounted Notes

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

17
Discounted Notes

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

18
Discounted Notes

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

19
Discounted Notes

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

20
Discounted Notes
21
Discounted Notes
22
Bonds

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

23
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.

24
Bonds Payable

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

25
Bonds Payable

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

26
Bonds Payable

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

27
Bonds Payable

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

28
Bonds Payable

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

29
Bonds Payable

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

30
Bonds Payable

• 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.

31
Bonds Payable

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

32
Bonds Payable

• 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.

33
Bonds Payable

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

34
Bonds 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.

35
Bonds Sold at Par

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

36
Bonds Sold at Par

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

37
Bonds Sold at Par

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

38
Bonds Sold at Par
39
Bonds Sold at Par
40
Bonds Sold at Par
41
Bonds 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.

42
Bonds Sold at Discount

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

43
Bonds Sold at 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.

44
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

45
An example of a bond sold at a discount

• 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.

46
An example of a bond sold at a discount

• 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

47
An example of a bond sold at a discount

• 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.

48
An example of a bond sold at a discount

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

49
An example of a bond sold at a discount

• 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.

50
An example of a bond sold at a discount

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

51
An example of a bond sold at a discount

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

52
Bonds Sold at Discount
53
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.

54
Amortization

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

55
Amortization

• 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).

56
Amortization
57
Amortization

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

58
Amortization

• 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.

59
Bonds Sold at Discount

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

60
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.

61
An example of a bond sold at a premium

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

62
An example of a bond sold at a premium

• The present value of the bonds is calculated by
  adding the present value of the 100,000,000 to
  the present value of the annuity.

63
An example of a bond sold at a premium

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

64
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

65
An example of a bond sold at a premium

• 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.

66
Bonds 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.

67
Early Retirement of Bonds

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

68
Early Retirement of Bonds

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

69
Early Retirement of Bonds

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

70
Other Aspects of Borrowing Agreements

• Borrowing agreements indentures can include
  other important provisions.

71
Restrictive 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.

72
Restrictive Covenants

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

73
Restrictive Covenants

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

74
Collateral

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

75
Collateral

• 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.

76
Collateral

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

77
Convertibility

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

78
Convertibility

• Investors usually view convertibility as a very
  attractive feature.

79
Financial Reporting of Income Tax

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

80
Financial Reporting of Income Tax

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

81
Financial Reporting of Income Tax

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

82
Book and Tax Differences

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

83
Book and Tax Differences

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

84
Book and Tax Differences

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

85
Book and Tax Differences

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

86
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.

87
Depreciation

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

88
Depreciation

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

89
Depreciation

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

90
Depreciation

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

91
Depreciation

• The tax eventually must be paid.

92
Depreciation

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

93
Deferred Income Tax Liability

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

94
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.

95
Deferred Income Tax Liability

• 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.

96
Deferred Income Tax Liability

• 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

97
Deferred Income Tax Liability

• 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.

98
Other 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.

99
Other Aspects of Income Tax Reporting

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

100
Other Aspects of Income Tax Reporting

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

101
Other Aspects of Income Tax Reporting

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

102
Other Aspects of Income Tax Reporting

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

103
Other Aspects of Income Tax Reporting

• The increase in income tax occurs in future years.

104
Other Aspects of Income Tax Reporting

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

105
Other Aspects of Income Tax Reporting

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

106
Other Aspects of Income Tax Reporting

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

107
Other Aspects of Income Tax Reporting

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

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Noncurrent Liabilities

• End of Chapter 9