Professor Paul Zarowin - NYU Stern School of Business



Professor Paul Zarowin - NYU Stern School of Business

Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes

Accounting for non-current liabilities

υ effective interest method

υ coupon vs effective rate

υ cash payment vs interest expense

υ market vs book value

υ amortization schedule

υ liability spectrum

υ early bond retirement/debt-equity swap

υ bond disclosures

υ contingent liabilities

υ keeping debt off of the Balance Sheet (investments, joint ventures)

υ Equity Method

υ Partial (vs full) Consolidation

Accounting for non-current liabilities: general principles

Accounting for all non current liabilities is based on the effective interest method. There are two key implications of this method: (1) the net book value (NBV) of the liability at any point in time is the discounted present value of the remaining cash flows, discounted at the effective (market required rate) rate in effect at the liabilities issuance [i.e., any subsequent changes in interest rates are ignored]; and thus, (2) interest expense each period equals the beginning of period NBV times the effective market rate. This principle applies regardless of the pattern of future cash outflows, i.e., how the liability is paid back over time. Note that the effective market rate need not be the same as the coupon rate [the annual cash coupons)liability principal (par) amount].

We can think of all non-current liabilities as fitting on a spectrum that depends on the pattern of future cash outflows (what portion is paid back periodicially vs at the end). At one extreme, the liability is paid back in one lump sum at the end of its life, with no periodic cash payments (zero coupon bond). At the other extreme, the liability is fully paid back by periodic cash payments, with no lump sum at the end (lease, mortgage). In between, the liability is paid back by both periodic cash payments and a final lump sum (conventional coupon bond). Can you figure out where on the spectrum a discount coupon bond and a premium coupon bond go (See below)?

Liability Spectrum

ZeroCouponBond DiscountBond ParBond PremiumBond Lease(Mortgage)

We will show the accounting for each of the 5 examples, by using an amortization schedule. 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.

1. Zero coupon bond: The inception je is: DR CR

cash 1000

Liability 1000

The periodic je=s are:

period Beg.Liab. InterestExpense-DR Liability-CR Cash-CR EndLiab.

1 1000 100 100 0 1100

2 1100 110 110 0 1210

3 1210 121 121 0 1331

4 1331 133 133 0 1464

5 1464 146 146 0 1610

End 1610 0 1610 DR 1610 0

Total cash outflows = 1610 (note: 1610 = 1000 x 1.105)

2. Discount Bond (5% coupons=$50): The inception je is: DR CR cash 1000

Liability 1000

The periodic je=s are:

period Beg.Liab. InterestExpense-DR Liability-CR Cash-CR EndLiab.

1 1000 100 50 50 1050

2 1050 105 55 50 1105

3 1105 110 60 50 1165

4 1165 117 67 50 1232

5 1232 123 73 50 1305

End 1305 0 1305 1305 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(810x1.105= 1305)

3. Par Bond: The inception je is: DR CR

cash 1000

Liability 1000

The periodic je=s are:

period Beg.Liab. InterestExpense-DR Liability-CR Cash-CR EndLiab.

1 1000 100 0 100 1000

2 1000 100 0 100 1000

3 1000 100 0 100 1000

4 1000 100 0 100 1000

5 1000 100 0 100 1000

end 1000 0 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)

4. Premium Bond (15% coupons = $150)The inception je is: DR CR cash 1000

Liability 1000

The periodic je=s are:

period Beg.Liab. InterestExpense-DR Liability-DR Cash-CR EndLiab.

1 1000 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)

5. Lease (Mortgage): The inception je is: DR CR

cash 1000

Liability 1000

The periodic je=s are:

period Beg.Liab. InterestExpense-DR Liability-CR Cash-CR EndLiab.

1 1000 100 164 264 836

2 836 84 180 264 656

3 656 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

Note the ranking of total cash flows. 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. Zero Coupon = 1610

2. Discount Bond = 1555

3. Par Bond = 1500

4. Premium Bond = 1446

5. Lease(mortgage) = 1320

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