Non-Current Liabilities
RCJ Chapter 11 (except 583-601)
Key Issues
1.
2.
3.
4.
5.
6.
Effective interest method
Types of non-current liabilities
Understanding the financials
Early retirement/swap
Earnings management
Footnote disclosures
Paul Zarowin
2
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 =
beginning of
period NBV
x
the effective market rate
annual cash coupons
coupon rate 
liability principal (par) amount
Ex. P11-11, P11-12 except #3
Paul Zarowin
3
Effective Interest Method (cont’d)
effective market rate (r%) can be > = < coupon rate (C%)
par bond:
Discount bond:
effective rate
effective rate
______ coupon rate
______ coupon rate
Premium bond: effective rate
______ coupon rate
cash payment can be > = < interest expense
par bond:
Discount bond:
cash payment ______
cash payment ______
interest expense
interest expense
Premium bond: cash payment ______
interest expense
Paul Zarowin
4
Liability Spectrum
all cash as
principal
Zero Coupon
Bond
Combination of
periodic + principal
Par Bond
all cash as
periodic
Lease
(Mortgage)
Where on the spectrum do premium and discount bonds go?
Paul Zarowin
5
Liability Spectrum (cont’d)
all cash as
principal
Zero Coupon
Bond
Combination of
periodic + principal
Par Bond
Discount
Bond
Premium
Bond
all cash as
periodic
Lease
(Mortgage)
Total CF  Principal  interest
 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
Paul Zarowin
6
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
Paul Zarowin
7
1. Zero Coupon Bond
The inception j.e. is:
DR
CR
Cash
Liability
The periodic j.e.’s are:
Period
1,000
1,000
Beg. Liab. Interest Expense - DR Liability - CR Cash - CR EndLiab
1
1,000
100
100
0
1,100
2
1,100
110
110
0
1,210
3
1,210
121
121
0
1,331
4
1,331
133
133
0
1,464
5
1,464
146
146
0
1,610
End
1,610
0
1610 DR
1610
0
Total cash outflows = 1610 (note: 1610 = 1000 x 1.105)
Ex. E11-11
Paul Zarowin
8
2. Discount Bond (5% coupons=$50)
The inception j.e. is:
DR
CR
Cash
Liability
The periodic j.e.’s are:
Period
1,000
1,000
Beg. Liab. Interest Expense - DR Liability - CR Cash - CR EndLiab
1
1,000
100
50
50
1,050
2
1,050
105
55
50
1,105
3
1,105
110
60
50
1,165
4
1,165
117
67
50
1,232
5
1,232
123
73
50
1,305
End
1,305
0
1305
1305
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(810x1.105= 1305)
0
9
3. Par Bond
The inception j.e. is:
DR
CR
Cash
Liability
The periodic j.e.’s are:
Period
1,000
1,000
Beg. Liab. Interest Expense - DR Liability - CR Cash - CR EndLiab
1
1,000
100
0
100
1,000
2
1,000
100
0
100
1,000
3
1,000
100
0
100
1,000
4
1,000
100
0
100
1,000
5
1,000
100
0
100
1,000
End
1,000
100
1000 DR
1000 CR
0
Total cash outflows = (5 x 100) + 1000 = 1500
PV of coupons=100 x 3.791 = 379; PV of principal = 621 (621 x 1.105 = 1000)
Paul Zarowin
10
4. Premium Bond (15% coupons = $150)
The inception j.e. is:
DR
CR
Cash
Liability
The periodic j.e.’s are:
Period
1,000
1,000
Beg. Liab. Interest Expense - DR Liability - DR Cash - DR EndLiab
1
1,000
100
50
150
950
2
950
95
55
150
895
3
895
90
60
150
835
4
835
84
66
150
769
5
769
77
73
150
696
End
696
0
696
696
0
Total cash outflows = (5 x 150) + 696 = 1446
PV of coupons = 150 x 3.791 = 569; PV of principal = 431 (4311 x 1.105 = 696)
Paul Zarowin
11
5. Lease (Mortgage)
The inception j.e. is:
DR
CR
Cash
Liability
1,000
The periodic j.e.’s are:
Period
1,000
Beg. Liab. Interest Expense - DR Liability - CR
Cash –
CR
EndLiab
1
1,000
100
164
264
836
2
836
84
180
264
656
3
565
66
198
264
458
4
458
46
218
264
240
5
240
24
240
264
0
Total cash outflows = 5 x 264 = 1320
PV of coupons = 264 x 3.791 = 1000
Paul Zarowin
12
Example (cont’d)
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.
1.
2.
3.
4.
5.
Zero Coupon
= 1610
Discount Bond = 1555
Par Bond
= 1500
Premium Bond = 1446
Lease(mortgage) = 1320
Paul Zarowin
13
Implication of Effective Interest Method:
Early Bond Retirement/ Debt-Equity Swap
DR Old B/P
NBV
DR Loss (plug)
or
CR
New B/P or C/S or cash
CR
Gain (plug)
FMV
gain/loss = NBV - FMV, due to change in interest rates
Increase in r%:
NBV ____ FMV
Decrease in r%:
NBV ____ FMV
Ex. E11-5, E11-9, P11-22
Paul Zarowin
14
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)
Paul Zarowin
15
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
Paul Zarowin
16
Analyzing Long-Term Debt
Will projected cash flows be adequate to service debt?
1. Principal payments
2. effective cash interest % 
cash interest
(beg. B/S debt  end. B/S debt) 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
Paul Zarowin
17
Bond Correction JE
Put bonds on B/S at FMV (i.e., replace NBV with FMV)
DR B/P NBV
DR R/E
CR
B/P FMV
DR
R/E
DR or CR to R/E is a plug for cumulative unrecognized
gain or loss, from not marking to mkt
Paul Zarowin
18
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.
Paul Zarowin
19
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)
CR


loss 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.
Paul Zarowin
20
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?
Paul Zarowin
21
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?
Paul Zarowin
22
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
Paul Zarowin
23
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
Paul Zarowin
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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
if r% 
DR
liability
CR
UHG (R/E)
2. recognize UHL
if r% 
DR
UHL (R/E)
CR
liability
Paul Zarowin
25
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
Paul Zarowin
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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)
Paul Zarowin
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