1. Non-Current Liabilities RCJ Chapter 11 (except 583-601)

2. Paul Zarowin2 Key Issues  Effective interest method  Types of non-current liabilities  Understanding the financials  Early retirement/swap  Earnings management  Footnote disclosures

3. Paul Zarowin3 Effective Interest Method 2 implications: 1)the net book value (NBV) of the liability = present value of the future cash flows discounted at the effective (market required rate) rate in effect at the liability issuance [i.e., any subsequent changes in interest rates are ignored] 2)interest expense = Ex. P11-11, P11-12 except #3 beginning of period NBV x the effective market rate

4. Paul Zarowin4 Effective Interest Method (cont’d) effective market rate (r%) can be > = < coupon rate (C%) cash payment can be > = < interest expense par bond:effective rate______coupon rate Discount bond:effective rate______coupon rate Premium bond:effective rate______coupon rate par bond:cash payment______interest expense Discount bond:cash payment______interest expense Premium bond:cash payment______interest expense

5. Paul Zarowin5 Liability Spectrum all cash as principal Combination of periodic + principal all cash as periodic Zero Coupon Bond Par Bond Lease (Mortgage) Where on the spectrum do premium and discount bonds go?

6. Paul Zarowin6 Liability Spectrum (cont’d)  For a constant principal (cash borrowed), which liability has least? most? total CF  For a constant Total CF, which liability yields least? most? cash at inception (higher principal)  Is any liability a better? worse? deal than any other all cash as principal Combination of periodic + principal all cash as periodic Zero Coupon Bond Par Bond Lease (Mortgage) Discount Bond Premium Bond

7. Paul Zarowin7 Example We will show the accounting for each of the 5 examples, by using an amortization schedule (amortization table same as JE). In each case, the liability has a 5 year life, a 10% effective market rate, and a $1000 present value at inception. Only the pattern of (and total) future cash outflows differs.  Key: effective interest method

8. Paul Zarowin8 1. Zero Coupon Bond The inception j.e. is: DRCash 1,000 CRLiability1,000 The periodic j.e.’s are: PeriodBeg. Liab.Interest Expense - DRLiability - CRCash - CREndLiab 11,000100 01,100 2 110 01,210 3 121 01,331 4 133 01,464 5 146 01,610 End1,61001610 DR16100 Total cash outflows = 1610 (note: 1610 = 1000 x 1.10 5 ) Ex. E11-11

9. 9 2. Discount Bond (5% coupons=$50) The inception j.e. is: DRCash 1,000 CRLiability1,000 The periodic j.e.’s are: PeriodBeg. Liab.Interest Expense - DRLiability - CRCash - CREndLiab 11,00010050 1,050 2 10555501,105 3 11060501,165 4 11767501,232 5 12373501,305 End1,30501305 0 Total cash outflows = (5 x 50) + 1305 = 1555 PV of coupons = 50 x 3.791(5 yr,10% annuity factor)=190 PV of principal = 810(810x1.10 5 = 1305)

10. Paul Zarowin10 3. Par Bond The inception j.e. is: DRCash 1,000 CRLiability1,000 The periodic j.e.’s are: PeriodBeg. Liab.Interest Expense - DRLiability - CRCash - CREndLiab 11,0001000 1,000 2 1000 1,000 3 1000 1,000 4 1000 1,000 5 1000 1,000 End1,0001001000 DR1000 CR0 Total cash outflows = (5 x 100) + 1000 = 1500 PV of coupons=100 x 3.791 = 379; PV of principal = 621 (621 x 1.10 5 = 1000)

11. Paul Zarowin11 4. Premium Bond (15% coupons = $150) The inception j.e. is: DRCash 1,000 CRLiability1,000 The periodic j.e.’s are: PeriodBeg. Liab.Interest Expense - DRLiability - DRCash - DREndLiab 11,00010050150950 2 9555150895 3 9060150835 4 8466150769 5 7773150696 End6960 0 Total cash outflows = (5 x 150) + 696 = 1446 PV of coupons = 150 x 3.791 = 569; PV of principal = 431 (4311 x 1.10 5 = 696)

12. Paul Zarowin12 5. Lease (Mortgage) The inception j.e. is: DRCash 1,000 CRLiability1,000 The periodic j.e.’s are: PeriodBeg. Liab.Interest Expense - DRLiability - CRCash – CR EndLiab 11,000100164264836 2 84180264656 356566198264458 4 46218264240 5 242402640 Total cash outflows = 5 x 264 = 1320 PV of coupons = 264 x 3.791 = 1000

13. Paul Zarowin13 Example (cont ’ d) 1.Zero Coupon = 1610 2.Discount Bond = 1555 3.Par Bond = 1500 4.Premium Bond = 1446 5.Lease(mortgage) = 1320 Ranking of total cashflows: despite the fact that all PV = s are $1000, the later the liability is paid back (the longer the liability is outstanding), the greater the total cash outflows.

14. Paul Zarowin14 Implication of Effective Interest Method: Early Bond Retirement/ Debt-Equity Swap DROld B/P NBV DRLoss (plug) CRNew B/P or C/S or cashFMV CRGain (plug) gain/loss = NBV - FMV, due to change in interest rates Ex. E11-5, E11-9, P11-22 Increase in r%:NBV____FMV Decrease in r%:NBV____FMV or

15. Paul Zarowin15 Earnings Management and Bond Retirement/Swap  firms continually issue bonds  they have many vintages of B/P outstanding  some have risen in value  some have fallen in value  firms pick which bonds to retire  manage income by choosing to recognize gains or losses  gains or losses on early debt redemption were extraordinary items (pre 2002)

16. Paul Zarowin16 Bond Footnote Disclosures  FMV of outstanding B/P ’ s  annual (cash) principal repayments for next 5 years  cash interest paid for the year (not necessarily = interest expense) C11-3, except #6, C11-4

17. Paul Zarowin17 Analyzing Long-Term Debt Will projected cash flows be adequate to service debt? 1.Principal payments 2. 3.Future cash interest payments over the next 5 years= effective cash interest % * debt outstanding each year (remember to subtract the debt that will be redeemed) 4.compare to cash flow forecasts for the firm: will projected cash flows be adequate to service interest and principle payments? C11-5, except #7

18. Paul Zarowin18 Bond Correction JE Put bonds on B/S at FMV (i.e., replace NBV with FMV) DRB/PNBV DRR/E CRB/PFMV DRR/E DR or CR to R/E is a plug for cumulative unrecognized gain or loss, from not marking to mkt

19. Paul Zarowin19 Loss Contingencies An event which raises the possibility of future loss is a loss contingency (the actual loss is yet to occur). Examples: Legal suit against the company. Company is the guarantor for another entity ’ s debt. The way loss contingencies are disclosed depends on: how high the probability of their occurrence; and whether of not they are measurable.

20. Paul Zarowin20 Loss Contingencies (cont ’ d) 3 probability degrees of future loss: probable, reasonably possible and remote. A loss should only be recorded if: (1) the liability is probable; and (2) the amount of the loss can be reasonably estimated. DR loss(I/S) CRloss contingency(B/S) If either (or both) condition is not met the liability should be disclosed only in a footnote. When the probability of a future loss is remote, it will be disclosed in a footnote only under certain circumstances.

21. Paul Zarowin21 Example of Loss Contingency: Adelphia Case Adelphia is one of the biggest cable companies in the US, and is controlled by the Rigas Family. The Rigas Family took a private loan of 3.1 billion dollars private loan, and Adelphia provided the collateral for this loan. How should have Adelphia reported this collateral in its financial reports?

22. Paul Zarowin22 Adelphia case (cont ’ d) In case the Rigases won ’ t pay the loan, Adelphia as the grantor will have to step in and pay back the loan. The fact that the company guarantied $3.1 billion loans of the Rigas family, was not disclosed under "contingent liabilities" in the company's 2000 financial statements. In case this contingent liability would have been disclosed, what could have been the impact on Adelphia ’ s share price?

23. Paul Zarowin23 Fair Value (FV) Accounting 3 features of FV accounting: 1.FV on B/S 2.recognize on I/S UHG and UHL (should be separate line from interest) 3.FV Interest expense = wt. Avg. current period FV x wt. Avg. current period r% UHG/UHL = FV – NBV Note: 2 and 3 may be difficult to separate, so aggregate

24. Paul Zarowin24 FV is better than amortized cost (AC) Because: 1.AC uses old info 2.AC causes non-comparability of instruments issued at different times 3.AC allows income manipulation via realized G/L ’ s (gains trading) 4.AC recognizes G/L ’ s gradually over instrument ’ s remaining life, via misstated interest (interest is not same as G/L) 5.Current prices and rates based on new info are better predictors of future prices/rates than old prices and rates based on old info

25. Paul Zarowin25 Adjusting for FV Solution: adjust financial statements for FV ’ s, to create a more accurate picture of profitability, solvency,etc. Adjustment to B/S: write liabilities up or down to FV 1. recognize UHG DR CR if r%  liability UHG (R/E) 2. recognize UHL DR CR if r%  UHL (R/E) liability

26. Paul Zarowin26 Adjusting for FV (cont ’ d) Adjustment to I/S: recognize change (from BOY to EOY) in UHG/UHL on I/S change in UHG/UHL is current year ’ s UHG/UHL

27. Paul Zarowin27 Problems/Limitations of FV 1.measurement error if market is not liquid – key is disclosure of estimation assumptions and sensitivity of FV ’ s to these assumptions 2.mismatching of assets (not FV) vs liabilities (FV) 3.problem if  r% is due to firm specific  risk; a.ex. r% rises due to financial difficulty – write-down of bonds (gain) implies success (eg, D/E falls) b.ex. r% falls due to financial success – write-up of bonds (loss) implies problem (eg, D/E rises)