Ifsa Chapter12

CHAPTER 12
NONCURRENT (LONG-TERM) LIABILITIES

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BONDS: CONTENTS
1. Pricing of debt based on present value of future cash
payments.
2. How an issuer accounts for debt:
- Issued at par
- Issued at a price other than par
- Issuance, periodic interest payments, repayment
3. Role of debt covenants in protecting creditors.
Copyright 2013 CFA Institute
BONDS: BORROWERS CASH FLOWS
At issuance (Time 0),

borrower receives
cash in exchange for
0
bonds.
Issue price equals
present value of
future cash flows.
Pays periodic interest at the

coupon rate.
1
5
At maturity,
pays
principal
amount.
DETERMINING THE VALUE OF A BOND:

EXAMPLE
Assumptions about the debt instrument (the bond):
Principal = $1,000; Coupon interest rate = 10%; Maturity = 5 years
Future cash flows for a five-year, 10% bond, $1,000 principal.
Payments include periodic interest payments and principal payment.
The market value of a bond is equal to the present value of its future
cash flows.
nt
PV = ?
yme
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a
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t
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a
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Di
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at th unt rate
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ACCOUNTING FOR DEBT BY THE ISSUER:

EXAMPLE
Assumptions about the bond:
- Principal = $1,000.
- Coupon interest rate: Stated or contractual rate of interest to be
paid to the bondholders = 10%, annual.
- Maturity = 5 years.
Assumption about the debt market on the day of valuing:
- Market rate (yield or effective rate): Return the market demands on
that bond on day we are valuing it = 10%.
- For simplicity, assume a flat interest rate yield curve.
ACCOUNTING FOR DEBT:

EXAMPLE
Principal = $1,000; Coupon interest rate = 10%; Maturity = 5 years.
Market rate on the day we are valuing the bond = 10%.
Bond will be issued at par (i.e., 100% of face value).
Time
0
1
2
3
4
5
Total
PV = FV/[(1+i)n]
Interest
Paymen Principal
Total Present Value of
t
Payment Payment Total Payment
100
100
100
100
100
500
1,000
1,000
100
100
100
100
1,100
1,500
91
83
75
68
683
1,000
6
ISSUERS ACCOUNTING FOR DEBT AT

ISSUANCE: EXAMPLE
Principal = $1,000; Coupon interest rate = 10%, annual payments;
Maturity = 5 years.
Market rate on issuance date = 10%.
Issued at par.
Recorded in the long-term liability section of the balance sheet
because maturity date is > one year away
Issuers balance sheet: Increase cash for $1,000 and increase bond
payable for $1,000.
Issuers journal entry: Debit cash and credit bonds payable.
ASSETS =
+ $1000
Cash
LIABILITIES +
OWNERS EQUITY
+ $1000 Bond payable

7
ISSUERS ACCOUNTING FOR DEBT AT

INTEREST PAYMENT: EXAMPLE
Maturity = 5 years.
Issued at par.
For simplification, assume each interest payment occurs on the last
day of the fiscal year.
Issuers balance sheet when interest paid: Decrease cash and
increase interest expense (which reduces owners equity).
Issuers journal entry: Debit interest expense, credit cash.
ASSETS =
$100
Cash
LIABILITIES +
OWNERS EQUITY
$100 Interest expense
ISSUERS ACCOUNTING FOR DEBT

REPAYMENT
Maturity = 5 years.
Issued at par.
For simplification, assume principal repayment occurs on the last day
of the fiscal year.
Issuers balance sheet when principal repaid: Decrease cash and
decrease bonds payable.
Issuers journal entry: Debit bonds payable and credit cash.
ASSETS =
$1000
Cash
LIABILITIES +
OWNERS EQUITY
$1000 Bonds payable
ISSUERS ACCOUNTING FOR DEBT

OVER ITS LIFE: EXAMPLE
Principal = $1,000; Coupon = 10%; Maturity = 5 years; Issued at par.
Transaction
Year
Cash
Initial borrow Begin 1 $1,000
Bonds
Payable
$1,000
Premium or Common Retained

(Discount)
Stock
Earnings
0
Pay interest
100
100
Pay interest
100
100
Pay interest
100
100
Pay interest
100
100
Pay interest
100
100
Pay principal
1,000
1,000
10
DISCOUNT OR PREMIUM ON BONDS

Often, the
contractual
interest rate
and the market
rate differ.
Therefore,
bonds sell
above or below
face value.
Coupon
Rate
10%
Market Rate
(examples)
Bonds Sell At a
8%
Premium
10%
Par
12%
Discount
11
ISSUERS ACCOUNTING FOR BONDS ISSUED

AT A DISCOUNT
Principal = $1,000; Coupon interest rate = 10%, paid
annually; Maturity = 5 years.
Return the market demands on the bond on the day we are
valuing it = 12%. Issued at 92.8 (i.e., 92.8% of face value).
At issuance, cash increases by $928 and bonds payable
increases by $1,000. What do we do with the difference?
We show it as a discount to bonds payable.
ASSETS =
+ $928
Cash
LIABILITIES +
+ $1,000 Bond payable
$72 Bond discount
OWNERS EQUITY
12
BONDS ISSUED AT A DISCOUNT

Issuers Balance Sheet Presentation
Book value (also known

as carrying value)
13
ISSUERS ACCOUNTING FOR BOND

ISSUED AT A DISCOUNT
Principal = $1,000; Coupon rate = 10%; Maturity = 5 years.
Issue price 92.8% of par to yield 12% (effective rate).
Each year:
Cash interest payment = Principal x Coupon rate x Time
= $1,000 10% 1 year = $100
Interest expense = Carrying value Effective rate Time
Amortization of discount = Interest expense Cash interest payment
Transaction
Initial
borrowing
Pay interest
Cash
Bonds
Payable
Begin
1
$928
$1,000
Year
100
Discount
72
11
Commo Net Inc.

n
to Ret.
Stock Earnings
111
$928
12% 1
Interest
expense
14
ISSUERS ACCOUNTING FOR

BOND ISSUED AT A DISCOUNT
Principal = $1,000; Coupon rate = 10%; Maturity = 5 years.
Issue price = 92.8% of par to yield 12% (effective rate).
Year 2, Cash interest payment = $100.
($928 + $11)
12% 1
Interest expense = Carrying value Effective rate Time.

Amortization of discount = Interest expense Cash interest payment.
Transaction
Initial
borrowing
Pay interest
Pay interest
Cash
Bonds
Payable
Begi
n 1 928
1,000
Year
1
2
100
100
Discount
Common
Stock
Net Inc.
to Ret.
Earnings
72
11
13
111
Interest
expense
113
Interest
expense
15

BOND ISSUED AT A DISCOUNT
Principal = $1,000; Coupon = 10%; Maturity = 5 years.
Issued at 92.8 to yield 12%.
Transactio
n
Year
Initial
Begin
borrowing
1
Pay
interest
1
Pay
interest
2
Pay
interest
3
Pay
interest
4
Pay
interest
5
Pay
principal
5
Cash
Bonds
Payable
928
1,000
Discount
Net Inc.
Common to Ret.
Stock Earnings
72
100
11
111
Interest exp.
100
13
113
Interest exp
100
14
114
Interest exp
100
16
116
Interest exp
100
18
118
Interest exp
1,000
1,000
16

BOND ISSUED AT A PREMIUM
Principal = $1,000; Coupon interest rate = 10%, paid
annually; Maturity = 5 years.
Return the market demands on the bond on the day we are
valuing it = 8%. Issued at 108 (i.e., 108% of face value).
At issuance, cash increases by $1080 and bonds payable
increases by $1,000. What do we do with the difference?
- We show it as a premium to bonds payable.
ASSETS =
+ $1080
Cash
LIABILITIES +
+ $1000 Bond payable
+ $80 Bond premium
OWNERS EQUITY
17
ACCOUNTING FOR BOND ISSUED

AT A PREMIUM
Principal = $1,000; Coupon interest rate = 10%; Maturity = 5 years.

Issue price = 108% of par to yield 8%.
Transactio
n
Year
Initial
Begin
borrowing
1
Pay
interest
1
Pay
interest
2
Pay
interest
3
Pay
interest
4
Pay
interest
5
Pay
principal
5
Assets =
Liabilities +
Cash
Bonds
Payable
1,080
1,000
100
Premium
Owners Equity
Commo
n
Stock
Net Inc.
to Ret.
Earnings
86
Interest
expense
80
14
100
15
85
Interest
expense
100
16
84
Interest
expense
100
17
83
Interest
expense
100
19
81
Interest
expense
1,000 1,000
18
BOND PRICES SUBSEQUENT TO ISSUANCE

Bonds may be issued:
- At face value.
- Below face value: discount.
- Above face value: premium.
Subsequent to issuance, bonds may trade at face value, at
a discount, or at a premium depending on the market rates
at that time.
Changes in value subsequent to issuance do not affect
the value of the bond on the issuers statement unless
the issuer has chosen the fair value option (much less
common).
19
PAYMENT OF BONDS
May be redeemed at maturity or before maturity
- A firm may decide to retire bonds early
- To reduce interest costs or to remove debt from balance sheet
- But only if it has sufficient cash
- To account for retiring bonds early
- Eliminate carrying value of bonds at redemption date
- Record cash paid
- Recognize gain or loss on redemption
Gain or loss on bond repurchase = Net bonds payable
Repurchase payment
- Amount of repurchase payment will depend on market rates at the
time of repurchase
20
DEBT COVENANTS
Covenants protect creditors by restricting activities of the
borrower.
- Affirmative covenants
- Negative covenants
If a borrower violates a debt covenant, depending on the
severity of the breach and the terms of the contract, lenders
may
- choose to waive the covenant,
- be entitled to a penalty payment or higher interest rate,
- renegotiate, or
- call for immediate repayment of the debt.
21
ISSUERS FINANCIAL STATEMENT

PRESENTATION OF DEBT
Excerpt from 2011 and 2010 balance sheets of Colgate-Palmolive Inc.
22
ISSUERS NOTE DISCLOSURES

RELATING TO DEBT
Brief excerpt from Note 5 of Colgate Palmolives 2011 financial
statements.
23
LEASES
Leasing an asset is an alternative to purchasing.
Rather than borrowing and buying the asset, a company arranges to
lease the asset.
Advantages to leasing an asset compared with purchasing it:
Leases can provide less costly financing; usually require little, if
any, down payment; and are often at fixed interest rates.
The negotiated lease contract may contain less restrictive
provisions than other forms of borrowing.
Leasing can reduce the risks of obsolescence, residual value, and
disposition to the lessee.
Certain types of leases have perceived financial reporting advantages.
24
LEASES
There are two main classifications of leases: finance (or
capital) and operating leases.
- Finance lease is IFRS terminology, and capital lease is
U.S. GAAP terminology.
- A lessee treats capital leases as on-balance-sheet
obligations.
- A lessee does not show operating leases on the balance
sheet.
25
LEASES FROM LESSEES PERSPECTIVE
Lessee
Operating Lease
Finance Lease
under IFRS
(capital lease
under U.S. GAAP)
Balance
Sheet
Income
Statement
Statement of Cash Flows
No effect.
Reports rent
expense.
Rent payment is an operating

cash outflow.
Recognizes
leased
asset and
lease
liability.
Reports
depreciation
expense on
leased
asset.
Reduction of lease liability is a

financing cash outflow.
Reports
interest
expense on
lease
liability.
Interest portion of lease payment

is either an operating or financing
cash outflow under IFRS and an
operating cash outflow under
U.S. GAAP.
26
LEASES FROM LESSORS PERSPECTIVE

Balance
Sheet
Operating Lease
Retains
asset on
balance
sheet.
Income
Statement
Reports rent
income
and depreciation
expense on
leased asset.
Statement of Cash
Flows
Rent payments received
are an operating cash
inflow.
27
Balance Sheet
Finance Lease:
When present
value of lease
payments equals
the carrying
amount of the
leased asset
(called a direct
financing lease
in U.S. GAAP)
Removes
asset from
balance sheet.
Recognizes
lease
receivable.
Income
Statement
Statement of Cash
Flows
Reports
interest
revenue on
lease
receivable.
Interest portion of lease

payment received is
either an operating or
investing cash inflow
under IFRS and an
operating cash inflow
under U.S. GAAP.
Receipt of lease
principal is an investing
cash inflow.
28

Balance
Sheet
Finance Lease:
When present
value of lease
payments
exceeds the
carrying amount
of the leased
asset (called a
sales-type
lease in U.S.
GAAP)
Income
Statement
Statement of Cash
Flows
Removes
asset.
Reports profit
on sale.
Recognizes
lease
receivable.
Reports interest
revenue on
lease
receivable.
Interest portion of
lease payment
received is either an
operating or investing
cash inflow under
IFRS and an
operating cash inflow
under U.S. GAAP.
Receipt of lease
principal is an
investing cash inflow.
29
LESSEES LEASE DISCLOSURES: EXAMPLE
30
LESSEES LEASE DISCLOSURES: EXAMPLE

We have subleases related to certain of our operating leases.
During fiscal 2011, 2010, and 2009, we recognized sublease income
of $13.7 million, $10.9 million, and $7.1 million, respectively.
We had capital lease obligations of $1.4 million and $2.6 million as
of October 2, 2011, and October 3, 2010, respectively. Capital lease
obligations expire at various dates, with the latest maturity in 2014.
The current portion of the total obligation is included in other
accrued liabilities and the remaining long-term portion is included
in other long-term liabilities on the consolidated balance sheets.
Assets held under capital leases are included in net property, plant,
and equipment on the consolidated balance sheets.
31
TYPES OF POSTEMPLOYMENT BENEFITS:

PENSION PLANS
Amount of
Future Benefit to
Employee
Contribution
from Employer
Defined
contribution
pension plan
Depends on
investment
performance of
plan assets
Amount (if any)

is defined in
each period
Defined
benefit
pension plan
Defined based
on plans
formula
Depends on
current period
estimate and
investment
performance of
plan assets
32
PRESENTATION AND DISCLOSURE

FOR PENSION PLANS
Type of Pension Plan
Defined contribution
Defined benefit
Balance
Sheet
Income
Statement
Footnote
Disclosure
None
Company's
contribution
Minimal
Net funded
position
Periodic
expense
Extensive
33
LEVERAGE AND COVERAGE RATIOS

Solvency: Companys ability to meet its long-term debt
obligations.
Two types of commonly used solvency ratios:
- Leverage ratios
- Focus on the balance sheet
- Measure relative amount of debt in the companys
capital structure
- Coverage ratios
- Focus on the income statement and cash flows
- Measure the ability of a company to cover its debtrelated payments
34
LEVERAGE AND COVERAGE RATIOS

Solvency Ratios
Leverage ratios
Debt-to-assets ratio
Numerator
Denominator
Total debt
Total assets
Debt-to-capital ratio
Total debt
Total debt + Total

shareholders equity
Debt-to-equity ratio
Total debt
Total shareholders equity
Financial leverage ratio

Coverage ratios
Interest coverage ratio
Fixed charge coverage ratio
Average total assets Average shareholders equity

EBIT
Interest payments
EBIT + Lease
payments
Interest payments + Lease

payments
35
EVALUATING SOLVENCY RATIOS
Short-term borrowings
Current portion of long-term
interest bearing debt
Long-term interest bearing debt
Total assets
EBIT
Interest payments
Nokia
( millions)
2008
2007
3,578
714
Ericsson
(SEK millions)
2008
2007
1,639
2,831
13
173
861
203
14,208 14,773
39,582 37,599
4,966 7,985
155
59
3,903
3,068
24,939 21,320
140,823 134,112
285,684 245,117
16,252 30,646
1,689
1,513
Debt to assets for

2008: 11.2%.
Debt to assets for
2007: 2.9%.
Debt to assets for

2008: 10.7%.
Debt to assets for
2007: 11.1%.
36
EVALUATING SOLVENCY RATIOS
Short-term borrowings
Current portion of long-term
interest bearing debt
Long-term interest bearing debt
Total assets
EBIT
Interest payments
Nokia
( millions)
2008
2007
3,578
714
Ericsson
(SEK millions)
2008
2007
1,639
2,831
13
173
861
203
14,208 14,773
39,582 37,599
4,966 7,985
155
59
3,903
3,068
24,939 21,320
140,823 134,112
285,684 245,117
16,252 30,646
1,689
1,513
Interest coverage
ratio for 2008: 32.0
Interest coverage
ratio for 2007: 135.3
Interest coverage
ratio for 2008: 9.6
Interest coverage
ratio for 2007: 20.3
37
SUMMARY
Bonds are valued as the present value of future cash flows.
Market interest rates reflect the risk of the issuer and the
instrument.
A bond discount or premium is amortized by using the
effective interest method.
Analysts treat noncancellable operating leases as
equivalent to on-balance-sheet debt.
Defined benefit pension plans with a net unfunded position
give rise to liabilities.
Leverage and coverage ratios are used in assessing a
companys solvency.
38

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CHAPTER 12

NONCURRENT (LONG-TERM) LIABILITIES

Copyright 2013 CFA Institute

BONDS: BORROWERS CASH FLOWS

At issuance (Time 0),

Copyright 2013 CFA Institute

Pays periodic interest at the

DETERMINING THE VALUE OF A BOND:

Copyright 2013 CFA Institute

ACCOUNTING FOR DEBT BY THE ISSUER:

Copyright 2013 CFA Institute

ACCOUNTING FOR DEBT:

ISSUERS ACCOUNTING FOR DEBT AT

Copyright 2013 CFA Institute

+ $1000 Bond payable

ISSUERS ACCOUNTING FOR DEBT AT

Copyright 2013 CFA Institute

ISSUERS ACCOUNTING FOR DEBT

Copyright 2013 CFA Institute

$1000 Bonds payable

ISSUERS ACCOUNTING FOR DEBT

Initial borrow Begin 1 $1,000

Premium or Common Retained

Copyright 2013 CFA Institute

DISCOUNT OR PREMIUM ON BONDS

Copyright 2013 CFA Institute

ISSUERS ACCOUNTING FOR BONDS ISSUED

Copyright 2013 CFA Institute

BONDS ISSUED AT A DISCOUNT

Book value (also known

Copyright 2013 CFA Institute

ISSUERS ACCOUNTING FOR BOND

Copyright 2013 CFA Institute

Commo Net Inc.

ISSUERS ACCOUNTING FOR

Interest expense = Carrying value Effective rate Time.

Copyright 2013 CFA Institute

ISSUERS ACCOUNTING FOR

ISSUERS ACCOUNTING FOR

Copyright 2013 CFA Institute

ACCOUNTING FOR BOND ISSUED

Principal = $1,000; Coupon interest rate = 10%; Maturity = 5 years.

BOND PRICES SUBSEQUENT TO ISSUANCE

Copyright 2013 CFA Institute

ISSUERS FINANCIAL STATEMENT

Copyright 2013 CFA Institute

ISSUERS NOTE DISCLOSURES

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

LEASES FROM LESSEES PERSPECTIVE

Copyright 2013 CFA Institute

Statement of Cash Flows

Rent payment is an operating

Reduction of lease liability is a

Interest portion of lease payment

LEASES FROM LESSORS PERSPECTIVE

Copyright 2013 CFA Institute

LEASES FROM LESSORS PERSPECTIVE

Copyright 2013 CFA Institute

Interest portion of lease

LEASES FROM LESSORS PERSPECTIVE

Copyright 2013 CFA Institute