Noncurrent Liabilities Chapter 9 Noncurrent Liabilities Noncurrent liabilities

Noncurrent Liabilities Chapter 9

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

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

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

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

Interest-Bearing Notes • The borrower will pay interest periodically and will repay the principal at the maturity date.

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

Interest-Bearing Notes

Discounted Notes • Discounted notes do not require periodic payments of interest.

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

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.

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.

Discounted Notes • Assuming an interest rate of 12%, a factor of 0. 797 is pulled from the Present Value of $1 table.

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.

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

Discounted Notes • It will be recognized as Interest Expense by the borrower over the twoyear period of the note.

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

Discounted Notes

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

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

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

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

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

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

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.

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.

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

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.

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

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.

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.

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

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

Bonds Sold at Par

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.

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.

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.

An example of a bond sold at a discount: • On January 3 a company sells $100, 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

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 to the present value of the annuity.

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 to the present value of the annuity. $100, 000 x 0. 215 = $ 21, 500, 000 $ 6, 000 x 9. 818 = 58, 908, 000 $ 80, 408, 000

An example of a bond sold at a discount: • The coupon rate of interest is used to compute the cash interest payments ($10, 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.

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.

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%.

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.

An example of a bond sold at a discount: • The discount of $19, 592, 000 represents additional interest paid to bondholders.

Bonds Sold at Discount

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.

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

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

Amortization

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

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 over the life of the bond, and the discount will be completely amortized by the maturity date.

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

An example of a bond sold at a premium: • The bonds are 10 -year bonds and pay interest twice a year.

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 to the present value of the annuity.

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

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 x 0. 456 = $ 45, 600, 000 $ 6, 000 x 13. 590 = 81, 540, 000 $127, 140, 000

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.

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.

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.

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.

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

Other Aspects of Borrowing Agreements • Borrowing agreements – indentures – can include other important provisions.

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.

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

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

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

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.

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

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

Convertibility • Investors usually view convertibility as a very attractive feature.

Financial Reporting of Income Tax • The objectives of income measures for financial reporting may differ from measures for income tax purposes.

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.

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

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

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

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

Book and Tax Differences • 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: • 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.

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

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

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

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

Depreciation • The tax eventually must be paid.

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

Deferred Income Tax Liability • The liability for future income taxes is referred to as a deferred income tax liability.

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.

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

Deferred Income Tax Liability • An assets with a book basis of $7, 000 and a tax basis of $5, 000, gives a deferred income tax liability of $800, 000 if the income tax rate is 40%. $7, 000 – $5, 000 = $2, 000, 000 x 40% = $800, 000

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.

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.

Other Aspects of Income Tax Reporting • Just as there are deferred tax liabilities, there also deferred tax assets.

Other Aspects of Income Tax Reporting • These occur when the difference between book and tax measurements results in earlier recognition of taxable income.

Other Aspects of Income Tax Reporting • The reduction in income tax will occur in future years.

Other Aspects of Income Tax Reporting • To sum up, a deferred tax liability causes current taxable income to be lower than book income.

Other Aspects of Income Tax Reporting • The increase in income tax occurs in future years.

Other Aspects of Income Tax Reporting • A deferred tax asset causes current taxable income to be higher than book income.

Other Aspects of Income Tax Reporting • The benefit, the decrease in income tax, will occur in future years.

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.

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.