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Reading 28: Non-current Liabilities (Bond recognition and measurement.…
Reading 28: Non-current Liabilities
Bond recognition and measurement.
Bond issued at a premium
Market yield at issuance < Coupon rate
Face value < Price
Balance sheet
Initial liability = issue price > face value
Liability decreases overtime as premium is amortized (until book value = face value at maturity)
Book value is equal to PV of remaining cash flows discounted at the market rate at issuance
Face amount is repaid at maturity (borrower keeps premium)
Income statement
Interest expense: Book value \( \times \) market rate at issuance
Expense decreases over time as BV declines to face value
Bond issued at discount
Market yield at issuance > coupon rate
Face Value > Price
Balance sheet
Initial liability = issue price < face amount
Liability increases over time as the discount is amortized (until it = par value @ maturity date)
Book value is equal to PV of remaining cash flows discounted at the market rate at issuance
Face amount (including discount) is repaid at maturity
Income statement
Interest expense: Book value \( \times \) market rate at issuance
Interest expense increases over time as book value increases to face amount
the same for zero-coupon bond
Only affect Income statement, not CFO (since coupon = 0)
Terminology
Par value: the face value to be paid at maturity
Coupon rate: rate used to calculate the coupon payment
Initial liability: Issue price (PV of future cash flows discounted at the market rate of interest at issuance)
Effective interest rate: The discount rate (IRR) that equates PV of future cash flows (coupon payments and par value) with the issue price.
Interest expense: Book value \( \times \) effective interest rate
Effects on financial statement when issuing debt
Balance sheet: create a liability equal to proceeds received
Income statement: Interest expense = beginning-of-period book value \( \times \) market rate at the time of issuance
Cash-flow statement:
CFO is reduced by cash (coupon) interest
CFF is increased by proceeds at issuance
CFF is decreased by principal paid at maturity
Bond issued at face value
Market rate = Coupon rate
Balance sheet
Initial liability = issue price = face value
Liability remains at face value over bond term (no amortization required)
Face amount is repaid at maturity
Income statement
Interest expense = book value \( \times \) market rate at issuance
Since market rate and coupon rate are the same, expense is equal to the coupon payment
Methods to amortize bond premium/discount
Effective interest rate method
(IFRS requires / GAAP recommends)
Interest expense =Market yield at issuance \( \times \) beginning balance sheet liability
Difference between coupon interest and interest expense is amortization
Straight-line amortization method
(GAAP permits)
Annual amortization = \( \frac{discount}{years} \) or \( \frac{premium}{years} \)
Interest expense
= coupon - amortizations (if premium bond)
= coupon + amortizations (if discount bond)
Issuance Cost
Cost incurred at time of issuance for legal fees, underwriting fees, printing, etc.
IFRS & GAAP requires
Deducted from initial bond liability
Result is higher effective interest rate (YTM)
Permitted under GAAP
Included as an asset (prepaid expense)
Amortized over bond's life
Controversial: Not really and asset - no future economic benefit
When Interest Rates Changes
Balance sheet (book or carrying) value of debt liability is typically amortized value, not market (fair) value
Changes in market interest rates DO NOT affect amortized value (carrying value) of firm debt.
IFRS & GAAP give firms IRREVOCABLE option to report debt at fair value
For fixed coupon debt: market rates up / fair value down
For analysis, market value is more relevant than book value
Market value reflects the cost to buy back the debt and cancel the liability
Lower market values reflect stronger solvency positions
De-recognition of debt
When bonds are redeemed (bought back) before maturity.
In Income Statement, a gain (or loss) = redemption price - carrying value
If price > carrying value, loss in income statement
if price < carrying value, gain in income statement
this is included in income from continuing operations
Under GAAP, any remained unamortized bond issuance cost is written off, decreasing the gain (or increasing the loss) calculation.
Under IFRS, since issuance cost is already included in book value of bond liability, no write-off is necessary
Debt covenant
Debt covenant are restriction on borrowers that protect bond holder's interest.
violation = technical default (lender can demand payment)
Types
Affirmative covenants: borrower (the bond issuer) agrees to make timely payments, maintain certain ratios, maintain collateral, pay taxes
Negative covenant: Borrower will refrain from paying dividends and repurchasing shares, engaging in M&A, or issuing more debt, etc,
Financial presentation & disclosure
Disclose about long-term debt in foot note.
Useful for determining the timing and amount of future cash outflows.
usually include:
discussion on liability nature
maturity dates
stated rate and effective interest rate
call provision
conversion privileges
restriction imposed by creditors
assets pledged
amount of debt maturing in the next 5 years.
current market value
balance sheet
Split between current and long-term liabilities
Leasing assets
Motivations
Potentially cheaper financing
No down payment
Fixed rates
May have fewer covenants (than borrow to buy)
Short period of use
Less obsolescence risk
Lessee Reporting
IFRS
Add PV of lease payment as lease asset (intangible right-to-use) and lease liability on BS
Asset amortization is expensed on income statement
Lease payments treated like amortizing debt
Interest portion expense on income statement
Principal portion reduces lease liability on balance sheet
GAAP
Finance lease
If benefits and risks of ownership have been substantially transferred to the lessee
same treatment as IFRS
Asset amortization and interest expense are shown separately on income statement
principal portion of payment reduces liability in balance sheet
lease payment = principal portion + interest portion
Annual lease expense starts big, then reduces during the lease term
Operating lease
All other long-term leases
On balance sheet, recorded as PV of future payment
Amortization and interest expense are combined as Full lease payment on income statement, CFO
Annual lease expense =\(\frac{\sum Lease.Payment}{Lease.Term} \)
Annual lease expense is constant during the lease term
if Interest rate decreases during lease term, interest portion will decrease, and amortization portion will increase to balance the constant total lease expense
Lessor Reporting
IFRS
Finance (capital) lease
balance sheet
Remove leased asset
Add lease receivable
Income statement
add interest income
If manufaturer or dealer
report PV of lease (including lease payment and residual value) as revenue
report carrying value of assets as CoGS
report difference as profit at lease inception
Operating lease
Lease asset remain on BS
Depreciation and other lease costs are expense
Lease payments are revenue
GAAP
Sales-type lease
conditions
collection of lease payments is probable
ownership risk transferred to lessee
lease term is > 75% of asset useful life
Treatment
same as IFRS
direct financing lease
Conditions
third party guarantees asset's residual value
lease payments + residual \( \geq \) fair value of asset
ownership risk is not transferred to lessee
treatment
remove asset from balance sheet
add lease receivables (= PV of lease payment + profit from sale + residual value) to balance sheet
interest on lease receivable (= opening lease receivable x discount rate) is recorded on income statement
no profit on sale
operating lease
lease that does not meet the conditions for sales-type or direct financing
same treatment as IFRS
Contribution and pension plan
service costs, interest income (expense)
IFRS
are included in pension expense on the income statement.
Re-measurements (actuarial gains/ losses) are recorded in other comprehensive income.
GAAP
are also included in pension expense on the income statement, together with expected return on plan assets
past service costs, actuarial gains (loss) are recorded in other comprehensive income and are amortized overtime to income statement.
Defined contribution Plan Reporting
Income statement
Pension expense = employer's contribution
Balance sheet
No future obligation to report as a liability
Decrease in cash or current liability if not paid by fiscal year-end
Enployer pays fixed % of salary into pension each year, not responsible to the pension result when employee retires
Defined benefit plan reporting
employer pays fixed payment after retirement until dead, bears all risks
balance sheet
If plan assets < Estimate obligation
Net pension liability
if plan assets > Estimated obligation
Net pension asset
Firm must estimate PV of pension obligations based on future compensation levels, employee turnover, average retirement age, mortality rates, appropriate discount rate
Fund status = asset - estimate obligation
income statement
manufacturing companies allocate pension expense
inventory or CoGS for employees who provide direct labor to production
Salary and Administrative Expense for other employees
Pension expense details are disclosed in the financial statement notes