1. ACCOUNTING PRINCIPLES SIXTH CANADIAN EDITION Prepared by: Debbie Musil Kwantlen Polytechnic University Chapter 15 Non-current Liabilities

2. Bonds payable –Bond basics –Accounting for bond issues and retirements Notes payable –Fixed principal payments –Blended payments Lease liabilities –Finance and operating leases Statement presentation and analysis Copyright John Wiley & Sons Canada, Ltd. 2

3. STUDY OBJECTIVES: CHAPTER 15: Non-current Liabilities 1.Compare the impact of issuing debt instead of equity. 2.Account for bonds payable. 3.Account for instalment notes payable. 4.Account for leases. 5.Explain and illustrate the methods for the presentation and analysis of non-current liabilities. Copyright John Wiley & Sons Canada, Ltd. 3

4. Non-current Liabilities Debt that is not current is a non- current liability: –Current if settled within one year or normal operating cycle of company Common types: –Bonds payable –Notes payable –Finance leases Referred to as financial liabilities Copyright John Wiley & Sons Canada, Ltd. 4

5. Advantages of Debt over Equity Shareholder control is not affected –Debt holders have no voting rights Income tax savings –Interest expense deductible; dividends are not Earnings per share may be higher –No common shares are issued Return on equity may be higher –Lower profit and shareholders’ equity Copyright John Wiley & Sons Canada, Ltd. 5

6. STUDY OBJECTIVES: CHAPTER 15: Non-current Liabilities 1.Compare the impact of issuing debt instead of equity. 2.Account for bonds payable. 3.Account for instalment notes payable. 4.Account for leases. 5.Explain and illustrate the methods for the presentation and analysis of non-current liabilities. Copyright John Wiley & Sons Canada, Ltd. 6

7. Bond Basics Board of directors approve issuing bonds –Face value: amount due at maturity –Contractual interest rate (coupon rate): rate used to calculate amount of interest received Usually an annual rate but paid semi-annually –Maturity date: date when final payment is due Details are included in the bond certificate Once issued, bonds are traded on organized securities exchanges Usually issued in small denominations ($1,000) Copyright John Wiley & Sons Canada, Ltd. 7

8. Determining the Market Value of Bonds Market value (present value) depends on three factors: –Dollar amounts to be received –Length of time (n) until the amounts are received –Market (effective) rate of interest (i), which investors demand for loaning funds to the corporation Present value tables or formulas are used to determine present value Copyright John Wiley & Sons Canada, Ltd. 8

9. Market value of a bond = the present value of all future cash payments promised by the bond: –Periodic interest payments, plus –Repayment of principal (face value) when bond matures Market rates change daily and can therefore differ from contractual interest rate Determining the Market Value of Bonds 2 Copyright John Wiley & Sons Canada, Ltd. 9

10. Bonds may be issued at face value, a discount ( face value) –Due to contractual rate being higher or lower than market interest rate: Determining the Market Value of Bonds 3 Copyright John Wiley & Sons Canada, Ltd. 10

11. Issuing Bonds at Face Value If market interest rate = contractual rate, bonds are issued at face value (par) : Semi-annual interest payments and expense ($1,000,000 x 5% x 6/12 = $25,000) are recorded using the effective- interest method as follows Bonds payable are reported at amortized cost as a non- current liability if maturity date is more than one year away Copyright John Wiley & Sons Canada, Ltd. 11

12. If market interest rate > contractual rate, bonds are issued at a discount Selling price is determined as follows: Difference between selling price and face value of bonds is the amount of the discount = $1,000,000 face value - $957,345 selling price = $42,655 discount Issuing Bonds at a Discount Copyright John Wiley & Sons Canada, Ltd. 12

13. Issuing Bonds at a Discount 2 Entry to record bonds issued at a discount: Discount is an additional cost of borrowing –Deducted from face value of bonds payable on balance sheet –Allocated to interest expense (amortized) over the life of the bonds using the effective interest method Copyright John Wiley & Sons Canada, Ltd. 13

14. Three steps to calculate amortization: 1. Calculate bond interest paid 2. Calculate interest expense 3. Amortization amount is difference Effective-Interest Amortization Copyright John Wiley & Sons Canada, Ltd. 14

15. Amortizing Bond Discount For the first interest period: 1. Calculate bond interest paid = $1,000,000 x 5% x 6/12 = $25,000 2. Calculate interest expense = $957,345 x 6% x 6/12 = $28,720 3. Determine amortization amount = $25,000 - $28,720 = $3,720 Subsequent periods are calculated in a similar manner –Amortized cost of bond increases for each period based on amortization of discount Copyright John Wiley & Sons Canada, Ltd. 15

16. If market interest rate < contractual rate, bonds are issued at a premium Selling price is determined as follows: Difference between selling price and face value of bonds is the amount of the premium = $1,044,915 selling price - $1,000,000 face value = $44,915 premium Issuing Bonds at a Premium Copyright John Wiley & Sons Canada, Ltd. 16

17. Issuing Bonds at a Premium 2 Entry to record bonds issued at a premium: Premium reduces the cost of borrowing –Added to face value of bonds payable reported on balance sheet –Allocated to interest expense over the term of the bonds – called amortizing the premium Copyright John Wiley & Sons Canada, Ltd. 17

18. Amortizing Bond Premium For the first interest period: 1. Calculate bond interest paid = $1,000,000 x 5% x 6/12 = $25,000 2. Calculate interest expense = $1,044,915 x 4% x 6/12 = $20,898 3. Determine amortization amount = $25,000 - $20,898 = $4,102 Subsequent periods are calculated in a similar manner –Carrying value of bond decreases for each period based on amortization of premium Copyright John Wiley & Sons Canada, Ltd. 18

19. Summary of Differences Interest payment is the same as it is based on face value of bond Interest expense changes as amortized cost of bond changes –Discount: interest expense increases as amortized cost increases towards face value of bond –Premium: interest expense decreases as amortized cost declines towards face value of bond Copyright John Wiley & Sons Canada, Ltd. 19

20. Amortized cost of bonds at maturity will equal their face value –Regardless of the issue price of bonds Entry to record redemption of bonds at maturity: –After last interest payment has been recorded Copyright John Wiley & Sons Canada, Ltd. 20 Bond Retirements: Redeeming Bonds at Maturity

21. To record redemption of bonds: –Update any unrecorded interest If redeemed between semi-annual interest payment dates –Eliminate amortized cost of bonds at redemption date = face value of bonds - (+) unamortized discount (premium) –Record cash paid –Recognize gain or loss on redemption Gain (loss) if cash paid ) amortized cost of bonds Copyright John Wiley & Sons Canada, Ltd. 21 Bond Retirements: Redeeming Bonds before Maturity

22. STUDY OBJECTIVES: CHAPTER 15: Non-current Liabilities 1.Compare the impact of issuing debt instead of equity. 2.Account for bonds payable. 3.Account for instalment notes payable. 4.Account for leases. 5.Explain and illustrate the methods for the presentation and analysis of non-current liabilities. Copyright John Wiley & Sons Canada, Ltd. 22

23. Instalment Notes Payable Similar to short-term notes payable except term exceeds one year Interest rate can be fixed or variable (floating) over the term of the note May be unsecured or secured by specific assets (collateral) –Secured notes are commonly known as mortgages Repayable in a series of periodic payments (instalments), which consist of interest and principal, either: –Fixed principal payments plus interest, or –Blended principal and interest payments Copyright John Wiley & Sons Canada, Ltd. 23

24. Notes Payable: Fixed Principal Payments Periodic payments vary due to change in interest owed: –Principal is repaid in equal periodic amounts –Interest is calculated on the outstanding principal balance Copyright John Wiley & Sons Canada, Ltd. 24

25. Notes Payable: Blended Payments Equal periodic payments that include principal and interest: –Amount of interest and principal changes with each payment –Interest decreases and principal increases each period Copyright John Wiley & Sons Canada, Ltd. 25

26. STUDY OBJECTIVES: CHAPTER 15: Non-current Liabilities 1.Compare the impact of issuing debt instead of equity. 2.Account for bonds payable. 3.Account for instalment notes payable. 4.Account for leases. 5.Explain and illustrate the methods for the presentation and analysis of non-current liabilities. Copyright John Wiley & Sons Canada, Ltd. 26

27. Lease: contractual arrangement between two parties: –Lessor: owner of the asset –Lessee: allowed to use the asset in return for a series of periodic payments Advantages of leasing: –Reduced risk of obsolescence –100-percent financing –Income tax advantages Two types of leases: finance and operating Copyright John Wiley & Sons Canada, Ltd. 27 Lease Liabilities

28. Lease Liabilities: Finance Leases Substantially all benefits and risks of ownership are transferred from lessor to lessee Leased asset is recorded as an asset; lease obligation is recorded as a liability Copyright John Wiley & Sons Canada, Ltd. 28

29. Lease Liabilities: Finance Leases 2 Under IFRS, any one of the following conditions must be met: 1.Ownership of property is transferred to lessee 2.Lease contains a bargain purchase option 3.Lease term covers major part of life of property 4.Present value of lease payments amount to substantially all of fair value of property 5.Specialized for use only by lessee Under ASPE, must meet any one of first four conditions, and third and fourth are as follows: 3.Lease term ≥ 75% of economic life of asset 4.PV of lease payments ≥ 90% of FV of asset Copyright John Wiley & Sons Canada, Ltd. 29

30. Lease Liabilities: Operating Leases Benefits and risks of ownership are not transferred to lessee Leases can be structured to avoid meeting criteria for a finance lease –Known as off-balance sheet financing –Detailed disclosure in notes to financial statements is required Copyright John Wiley & Sons Canada, Ltd. 30

31. STUDY OBJECTIVES: CHAPTER 15: Non-current Liabilities 1.Compare the impact of issuing debt insterad of equity. 2.Account for bonds payable. 3.Account for instalment notes payable. 4.Account for leases. 5.Explain and illustrate the methods for the presentation and analysis of non-current liabilities. Copyright John Wiley & Sons Canada, Ltd. 31

32. Statement Presentation Non-current liabilities are reported in a separate section of the balance sheet, immediately after current liabilities Copyright John Wiley & Sons Canada, Ltd. 32

33. Measures the percentage of total assets financed by creditors (not shareholders) Higher the percentage, greater the risk of company defaulting on its obligations Analysis: Debt to Total Assets Copyright John Wiley & Sons Canada, Ltd. 33

34. Interest coverage ratio indicates company’s ability to meet interest payments as they come due Uses EBIT: Earnings before interest and tax = Net income + interest expense + income tax expense Analysis: Interest Coverage Copyright John Wiley & Sons Canada, Ltd. 34

35. Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein. Prepared by: A. Davis, MSc, BComm, CA, CFE Copyright Copyright John Wiley & Sons Canada, Ltd.