CHAPTER 12
NONCURRENT (LONG-TERM) LIABILITIES
After completing this chapter, you will be able to do the following:
- Determine the initial recognition and measurement and subsequent measurement of bonds.
- Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.
- Discuss the derecognition of debt.
- Explain the role of debt covenants in protecting creditors.
- Discuss the financial statement presentation of and disclosures relating to debt.
- Discuss the motivations for leasing assets instead of purchasing them.
- Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.
- Determine the initial recognition and measurement and subsequent measurement of finance leases.
- Compare and contrast the disclosures relating to finance and operating leases.
- Describe defined contribution and defined benefit pension plans.
- Compare and contrast the presentation and disclosure of defined contribution and defined benefit pension plans.
- Calculate and interpret leverage and coverage ratios.
- The sales proceeds of a bond issue are determined by discounting future cash payments using the market rate of interest at the time of issuance (effective interest rate). The reported interest expense on bonds is based on the effective interest rate.
- Future cash payments on bonds usually include periodic interest payments (made at the stated interest rate or coupon rate) and the principal amount at maturity.
- When the market rate of interest equals the coupon rate for the bonds, the bonds will sell at par (i.e., at a price equal to the face value). When the market rate of interest is higher than the bonds’ coupon rate, the bonds will sell at a discount. When the market rate of interest is lower than the bonds’ coupon rate, the bonds will sell at a premium.
- An issuer amortizes any issuance discount or premium on bonds over the life of the bonds.
- If a company redeems bonds before maturity, it reports a gain or loss on debt extinguishment computed as the net carrying amount of the bonds (including bond issuance costs under IFRS) less the amount required to redeem the bonds.
- Debt covenants impose restrictions on borrowers, such as limitations on future borrowing or requirements to maintain a minimum debt-to-equity ratio.
- The carrying amount of bonds is typically amortized historical cost, which can differ from their fair value.
- Companies are required to disclose the fair value of financial liabilities, including debt. Although permitted to do so, few companies opt to report debt at fair values on the balance sheet.
- Accounting standards require leases to be classified as either operating leases or finance (capital) leases. Leases are classified as finance leases when substantially all the risks and rewards of legal ownership are transferred to the lessee.
- When a lessee reports a lease as an operating lease rather than a finance lease, the lessee usually appears more profitable in the early years of the lease and less so later, and it appears more solvent over the whole period.
- When a lessor reports a lease as a finance lease rather than an operating lease, the lessor usually appears more profitable in the early years of the lease.
- In a finance lease where the present value of lease payments equals the carrying amount of the leased asset, a lessor earns only interest revenue. In a finance lease where the present value of lease payments exceeds the carrying amount of the leased asset, a lessor earns both interest revenue and a profit (or loss) on the sale of the leased asset.
- Two types of pension plans are defined contribution plans and defined benefits plans. Under a defined contribution plan, the cash payment made into the plan is recognized as pension expense. Pension expense under the defined benefit plan typically includes five components: (a) service costs incurred during the period; (b) interest expense accrued on the beginning pension obligation; (c) actuarial gains and losses; (d) changes to the terms of a pension plan that increase the benefit obligation applicable to employees’ service during previous periods (past service cost); and (e) expected return on plan assets.
- Under IFRS, companies have a choice between reporting the net pension liability (or asset) as either the full amount of the pension obligation less plan assets or excluding any cumulative actuarial gains or losses or past service costs from the balance sheet. Under U.S. GAAP, companies must report the difference between the pension obligation and the pension assets as an asset or liability on the balance sheet.
- Solvency refers to a company’s ability to meet its long-term debt obligations.
- In evaluating solvency, leverage ratios focus on the balance sheet and measure the amount of debt financing relative to equity financing.
- In evaluating solvency, coverage ratios focus on the income statement and cash flows and measure the ability of a company to cover its interest payments.
1. A company issues €1 million of bonds at face value. When the bonds are issued, the company will record a:
A. cash inflow from investing activities.
B. cash inflow from financing activities.
C. cash inflow from operating activities.
2. At the time of issue of 4.50% coupon bonds, the effective interest rate was 5.00%. The bonds were most likely issued at:
A. par.
B. a discount.
C. a premium.
3. Oil Exploration LLC paid $45,000 in printing, legal fees, commissions, and other costs associated with its recent bond issue. It is most likely to record these costs on its financial statements as:
A. an asset under U.S. GAAP and reduction of the carrying value of the debt under IFRS.
B. a liability under U.S. GAAP and reduction of the carrying value of the debt under IFRS.
C. a cash outflow from investing activities under both U.S. GAAP and IFRS.
4. On 1 January 2010, Elegant Fragrances Company issues £1,000,000 face value, five-year bonds with annual interest payments of £55,000 to be paid each 31 December. The market interest rate is 6.0 percent. Using the effective interest rate method of amortization, Elegant Fragrances is most likely to record:
A. an interest expense of £55,000 on its 2010 income statement.
B. a liability of £982,674 on the 31 December 2010 balance sheet.
C. a £58,736 cash outflow from operating activity on the 2010 statement of cash flows.
5. Consolidated Enterprises issues €10 million face value, five-year bonds with a coupon rate of 6.5 percent. At the time of issuance, the market interest rate is 6.0 percent. Using the effective interest rate method of amortization, the carrying value after one year will be closest to:
A. €10.17 million.
B. €10.21 million.
C. €10.28 million.
6. The management of Bank EZ repurchases its own bonds in the open market. They pay €6.5 million for bonds with a face value of €10.0 million and a carrying value of €9.8 million. The bank will most likely report:
A. other comprehensive income of €3.3 million.
B. other comprehensive income of €3.5 million.
C. a gain of €3.3 million on the income statement.
7. Innovative Inventions, Inc. needs to raise €10 million. If the company chooses to issue zero-coupon bonds, its debt-to-equity ratio will most likely:
A. rise as the maturity date approaches.
B. decline as the maturity date approaches.
C. remain constant throughout the life of the bond.
8. Fairmont Golf issued fixed rate debt when interest rates were 6 percent. Rates have since risen to 7 percent. Using only the carrying amount (based on historical cost) reported on the balance sheet to analyze the company’s financial position would most likely cause an analyst to:
A. overestimate Fairmont’s economic liabilities.
B. underestimate Fairmont’s economic liabilities.
C. underestimate Fairmont’s interest coverage ratio.
9. Debt covenants are least likely to place restrictions on the issuer’s ability to:
A. pay dividends.
B. issue additional debt.
C. issue additional equity.
10. Compared to using a finance lease, a lessee that makes use of an operating lease will most likely report higher:
A. debt.
B. rent expense.
C. cash flow from operating activity.
11. Which of the following is most likely a lessee’s disclosure about operating leases?
A. Lease liabilities
B. Future obligations by maturity
C. Net carrying amounts of leased assets
12. For a lessor, the leased asset appears on the balance sheet and continues to be depreciated when the lease is classified as:
A. a sales-type lease.
B. an operating lease.
C. a financing lease.
13. Under U.S. GAAP, a lessor’s reported revenues at lease inception will be highest if the lease is classified as:
A. a sales-type lease.
B. an operating lease.
C. a direct financing lease.
14. A lessor will record interest income if a lease is classified as:
A. a capital lease.
B. an operating lease.
C. either a capital or an operating lease.
15. Cavalier Copper Mines has $840 million in total liabilities and $520 million in shareholders’ equity. It discloses operating lease commitments over the next five years with a present value of $100 million. If the lease commitments are treated as debt, the debt-to-total-capital ratio is closest to:
A. 0.58.
B. 0.62.
C. 0.64.
16. Penben Corporation has a defined benefit pension plan. At 31 December, its pension obligation is €10 million and pension assets are €9 million. If Penben chooses to report under a method consistent with both IFRS and U.S. GAAP, the reporting on the balance sheet would be closest to which of the following?
A. €10 million is shown as a liability, and €9 million appears as an asset.
B. €1 million is shown as a net pension obligation.
C. There is no choice that reports pension assets and obligations on the balance sheet consistently under IFRS and U.S. GAAP.