# Noncurrent Liabilities Chapter 9. Noncurrent Liabilities Noncurrent liabilities represent obligations of the firm that generally are due more than one.

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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 two-year 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 \$100,000,000 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 \$10,000,000 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 \$10,000,000 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

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.

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 \$6,000,000 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).

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 \$100,000,000 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 \$100,000,000 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 \$100,000,000 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: \$100,000,000 x 0.456 = \$ 45,600,000 \$ 6,000,000 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 \$7,000,000 and a tax basis of \$5,000,000, gives a deferred income tax liability of \$800,000 if the income tax rate is 40%.

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

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 are 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.

Noncurrent Liabilities End of Chapter 9

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