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Noncurrent Liabilities Chapter 9

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

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

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

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

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

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

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Interest-Bearing Notes

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

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

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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.

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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.

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Discounted Notes Assuming an interest rate of 12%, a factor of 0.797 is pulled from the Present Value of $1 table.

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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.

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

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

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

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Discounted Notes

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

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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.

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

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

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

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

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

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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.

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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.

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

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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.

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

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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.

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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.

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

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

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Bonds Sold at Par

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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.

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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.

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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.

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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

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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.

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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

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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.

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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.

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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%.

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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.

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

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Bonds Sold at Discount

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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.

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

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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).

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Amortization

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

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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.

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

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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%.

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

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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.

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

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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

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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.

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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.

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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.

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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.

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

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

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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.

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

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

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

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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.

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

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

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Convertibility Investors usually view convertibility as a very attractive feature.

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

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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.

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

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

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

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

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Book and Tax Differences All events that affect the tax impact of temporary differences should be recognized currently in the financial statements.

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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.

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

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

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

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

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Depreciation The tax eventually must be paid.

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

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

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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.

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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%.

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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

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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.

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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.

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

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

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

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

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

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

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

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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.

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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

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