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IFT Notes for Level I CFA® Program

R28 Non-current (Long-Term) Liabilities

Part 1



1.  Introduction

Non-current liabilities are long-term liabilities that are due after one year or more in the future. They are on the right-hand side of the balance sheet. Common non-current liabilities include bonds payable, notes payable, leases, pension liabilities, and deferred tax liabilities. This reading focuses on bonds payable and leases.

2.  Bonds Payable

2.1.     Accounting for Bond Issuance

Bonds are contractual promises made by an entity to pay cash in the future to its lenders (bondholders) in exchange for receiving cash in the present. In simple terms, bonds are a form of long-term borrowing. The terms of a bond contract are defined in a document called an indenture. Bonds usually make two types of payments: principal repayment (face value) and periodic interest payments.

Some of the common terms associated with a bond are described below:

  • Face value or par value: This is the amount of cash payable by the bond-issuing entity to the bondholders when the bond matures.
  • Coupon rate: This is the interest rate promised in the contract based on which periodic interest payments are calculated.
  • Coupon payment: The periodic interest payment is known as the coupon payment. The coupon amount is based on the face value and the coupon rate. Consider a bond with a face value of 1,000 which makes annual payments. If the coupon rate is 10%, the annual coupon amount will be 10% of 1,000 = 100.
  • Effective interest rate: It is the market interest rate (or the rate demanded by investors) when a bond is issued. This rate is not documented on the bond indenture. If the effective interest rate is equal to the coupon rate, a bond is issued at par value. This scenario is illustrated below.

Relationship between coupon rate and effective interest rate

  • A bond is issued at face value when coupon rate = effective interest rate.
  • A bond is issued at a discount if coupon rate < effective interest rate.
  • A bond is issued at a premium if coupon rate > effective interest rate.

We will now look at examples for each of the three cases.

Example (Bonds issued at face value)

The terms of a bond (issuer’s obligations) are given below:

Face value (par value) = 100

Issue Date = 1 January, 2016

Maturity Date = 31 December, 2018

Coupon rate = 10% paid annually

If the investor’s required return at issuance (effective interest rate) is 10%, then calculate the sales proceeds. State how the bond issuance is reflected in the financial statements.

Solution:

Let us start with the cash flow which is illustrated below throughout the bond’s life:

image 15

The bond’s tenure is 3 years. The effective interest rate or the market interest rate is 10%. The cash flow at the end of Year 1 is calculated as coupon rate * face value = 0.1 * 100 = 10. Similarly, the cash flow at the end of Year 2 and Year 3 is also 10. At the end of Year 3 (bond’s life), there is an additional cash flow of 100 equal to the face value of the bond.

To calculate the amount the investor pays now, the cash flows at the end of each period are discounted at the required rate of return (effective interest rate) of 10%. Using a financial calculator, calculate the present value as:

N = 3; I = 10; PMT = 10; FV = 100; CPT PV = 100.

I = 10 is the required rate of return. In this case, coupon rate = required rate of return.

The investor must pay the company 100 to earn 10% on the bond over 3 years.

Effect of bond issuance on the financial statements:

Balance sheet: Cash goes up by 100; Bond payable goes up by 100.

Cash flow statement: Issuance of the bond is shown as cash flow from financing.

Income statement: Initially, there is no effect on the income statement.

Example (Bonds issued at a discount)

The terms of a bond (issuer’s obligations) are given below:

Face value (par value) = 100

Issue date = 1 January, 2016

Maturity Date = 31 December, 2018

Coupon rate = 10% paid annually

When the bond is issued, the investor’s required return is 11%. What are the sales proceeds? How is the issuance reflected in the financial statements?

Solution:

Let us understand why investors require a return of 11% here, which is higher than the coupon rate. Investors demand a higher return if they perceive the company to be risky. The cash flows are the same as in the previous example.

image 15

The present value can be calculated as:

N = 3; I = 11; PMT = 10; FV = 100; CPT PV = 97.56.

In order to receive a higher return, an investor pays less than the face value, in this case 97.56 compared to 100, to earn 11% return.

Effect of bond issuance on the financial statements:

Balance sheet: Cash goes up by 97.56; Bond payable goes up by 97.56.

Cash flow statement: Cash inflow of 97.56. Issuance of the bond is shown as cash flow from financing.

Income statement: Initially, there is no effect on the income statement.

Example (Bonds issued at a premium)

The terms of a bond (issuer’s obligations) are given below:

Face value (par value) = 100

Issue Date = 1 January, 2016

Maturity Date = 31 December, 2018

Coupon rate = 10% paid annually

When the bond is issued, the investor’s required return is 9%. What are the sales proceeds? How is the issuance reflected in the financial statements?

Solution:

The cash flow is the same as in the previous two cases. Investors earn coupon amount based on coupon rate.  Since investors will receive a higher rate of return than the market rate, they are willing to pay more.

The present value can be calculated as:

N = 3; I = 9; PMT = 10; FV = 100; CPT PV = 102.53

Effect of bond issuance on the financial statements:

Balance sheet: Cash goes up by 102.53; Bond payable goes up by 102.53.

Cash flow statement: Cash inflow of 102.53. Issuance of the bond is shown as cash flow from financing.

Income statement: Initially, there is no effect on the income statement.

2.2.     Accounting for Bond Amortization, Interest Expense, and Interest Payments

In this section, we look at how the bond is shown on the balance sheet, and how the coupon payments are accounted for.

Amortization of a Bond

When a bond is issued, most companies report the historical cost and amortize the discount/premium over the life of the bond. The amortized cost is reported on the balance sheet, which is the historical cost plus or minus the cumulative amortization.

Accounting Treatment for Bonds at Issuance

Initially, bonds are reported as a liability on the balance sheet. This amount on the balance sheet is known as the carrying value or book value of the bond.

Under both IFRS and US GAAP the amount of sales proceeds minus issuance costs is reported on the balance sheet.

Example (Amortizing a bond discount)

Terms of the bond are given below:

Face value (par value) = 100

Issue Date = 1 January, 2016

Maturity Date = 31 December, 2018

Coupon rate = 10% paid annually

When the bond is issued, investors require a return of 11%. Show the following:

  1. Interest Payments
  2. Interest Expense
  3. Reported Bond Value

How are the above numbers reflected in the financial statements?

Solution:

To identify if a bond was sold at par, premium, or discount, one needs to know the prevailing market interest rate when the bond was issued. Since the market interest rate/required return 11% is greater than the coupon rate, the bond was sold at a discount. Let us see how the values for each item are arrived at for 2016:

Carrying amount = Present value of the bond or the amount the investor pays initially. We calculated this to be 97.56 in the earlier example.

Interest expense = Carrying amount * required return = 97.56 * 0.11 = 10.73

Interest payment = Face value * coupon rate = 100 * 0.1 = 10

Amortization of discount = Interest expense – interest payment = 10.73 – 10 = 0.73

Carrying amount (end) = Beginning carrying amount + amortization of discount = 97.56 + 0.73 = 98.29

Year Carrying Amount (Begin) Interest

Expense

Interest

Payment

Amortization of Discount Carrying Amount (End)
2016 97.56 10.73 10 0.73 98.29
2017 98.29 10.81 10 0.81 99.10
2018 99.10 10.90 10 0.90 100.00

Effect on financial statements:

Balance Sheet: The carrying amount in the beginning for the bond is 97.56. At the end of Year 1, the liability is 98.29, 99.10 at the end of Year 2 and 100.00 at the end of Year 3.

Income Statement: The interest expense is shown in the income statement which is 10.73 for Year 1, and 10.81 and 10.90 for the subsequent years. Though the actual interest paid is only 10, the required return of 11% should be shown on the income statement.

Cash Flow Statement: The actual cash flow for each year is 10. Under US GAAP, interest paid must be classified as CFO. IFRS allows interest paid to be treated as either CFO or CFF. Amortization of discount is a non-cash item. It only affects the taxable income.

Example (Amortizing a bond premium)

Terms of the bond are given below:

Face value (par value) = 100

Issue Date = 1 January, 2016

Maturity Date = 31 December, 2018

Coupon rate = 10% paid annually

When the bond is issued, investors require a return of 9%. Show the following:

  1. Interest Payments
  2. Interest Expense
  3. Reported Bond Value

How are the above numbers reflected in the financial statements?

Solution:

Since the required return is less than the coupon rate, the bond is sold at a premium. The individual items are calculated the same way as for a discount bond.

Year Carrying Amount (Begin) Interest

Expense

Interest

Payment

Amortization of Premium Carrying Amount (End)
2016 102.53 9.23 10 -0.77 101.76
2017 101.76 9.16 10 -0.84 100.92
2018 100.92 9.08 10 -0.92 100.00

Based on the above example, we can infer the following points:

Bonds Issued at Par:

  • Periodic interest expense is equal to the periodic interest payment to bondholders.

Bonds Issued at a Premium:

  • Initially, the carrying amount of the bonds is greater than the face value and as the premium is amortized, the carrying amount decreases to the face value.
  • Interest expense will be less than the coupon payment.
  • Interest expense = interest payment – amortization of premium

Bonds issued at a Discount:

  • Initially, the carrying amount of the bonds is less than the face value and as the discount is amortized, the carrying amount increases to the face value.
  • Interest expense will be higher than the coupon payment.
  • Interest expense = interest payment + amortization of discount

Amortization of a Zero-Coupon Bond

A zero-coupon bond is a type of a discount bond that does not make any coupon or periodic interest payments. A lump sum amount is paid on maturity which includes principal and the accrued interest payments. Zero-coupon bonds are always issued at a discount to face value i.e. at a price much lower than the par/face value of the bond.

Example (Amortizing a zero-coupon bond)

Terms of the bond are described below:

Face value (par value) = 100

Issue Date = 1 January, 2016

Maturity Date = 31 December, 2018

No coupon payments are made.

When the bond is issued, investors require a return of 10%. Show the following:

  1. Reported Bond Value.
  2. Interest Expense.

How are the above numbers reflected in the financial statements?

Solution:

The present value can be calculated as:

N = 3; I = 10; PMT = 0; FV = 100; CPT PV = 75.13

Year Carrying Amount (Begin) Interest

Expense

Interest

Payment

Amortization of Discount Carrying Amount (End)
2016 75.13 7.51 0 7.51 82.64
2017 82.64 8.26 0 8.26 90.91
2018 90.91 9.09 0 9.09 100.00

Effect on financial statements:

Balance Sheet: The carrying amount is shown on the balance sheet.

Income Statement: The interest expense is shown on the income statement which is 7.51 for year 1, and 8.26 and 9.09 for the subsequent years.


FRA Non-Current (Long-Term) Liabilities Part 1