CHAPTER 10
Non-Current (Long-Term) Liabilities

Learning Outcomes

After completing this chapter, you will be able to do the following:

• determine the initial recognition, initial measurement, and subsequent measurement of bonds;
• describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments;
• explain the derecognition of debt;
• describe the role of debt covenants in protecting creditors;
• describe the financial statement presentation of and disclosures relating to debt;
• explain motivations for leasing assets instead of purchasing them;
• explain the financial reporting of leases from a lessee’s perspective;
• explain the financial reporting of leases from a lessor’s perspective;
• compare the presentation and disclosure of defined contribution and defined benefit pension plans;
• calculate and interpret leverage and coverage ratios.

Summary Overview

Non-current liabilities arise from different sources of financing and different types of creditors. Bonds are a common source of financing from debt markets. Key points in accounting and reporting of non-current liabilities include the following:

• 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 the 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.
• Beginning with fiscal year 2019, lessees report a right-of-use asset and a lease liability for all leases longer than one year. An exception under IFRS exists for leases when the underlying asset is of low value.
  • Subsequent to lease inception, the lessee’s income statement will include both a depreciation expense on the right-of-use asset and an interest expense on the lease liability for all leases under IFRS and, under US GAAP for finance leases.
  • For lessee accounting, the distinction between finance leases and operating leases exists in US GAAP but not in IFRS. For operating leases under US GAAP, the lessee’s income statement will show a single lease expense.
  • Under IFRS, a lessor classifies each lease as either a finance lease or an operating lease. A lease is classified as a finance lease if it “transfers substantially all the risks and rewards incidental to ownership of an underlying asset” and otherwise as an operating lease. For finance leases, but not for operating leases, the lessor derecognizes the underlying leased asset, and recognizes a lease receivable, and recognizes selling profit where applicable. For operating leases, the lessor does not derecognize the underlying asset and recognizes lease receipts as income.
  • Under US GAAP, a lessor classifies a lease in one of three categories: sales-type, direct financing, or operating. The lessor’s classification and accounting for operating leases under US GAAP is similar to that under IFRS. For both sales-type and direct financing leases, the lessor derecognizes the underlying asset and recognizes a lease receivable; however, the lessor recognizes selling profit only if the lease is considered a sales-type lease.
• Two types of pension plans are defined contribution plans and defined benefits plans. In a defined contribution plan, the amount of contribution into the plan is specified (i.e., defined), and the amount of pension that is ultimately paid by the plan (received by the retiree) depends on the performance of the plan’s assets. In a defined benefit plan, the amount of pension that is ultimately paid by the plan (received by the retiree) is defined, usually according to a benefit formula.
• Under a defined contribution pension plan, the cash payment made into the plan is recognised as pension expense.
• Under both IFRS and US GAAP, companies must report the difference between the defined benefit pension obligation and the pension assets as an asset or liability on the balance sheet. An underfunded defined benefit pension plan is shown as a non-current liability.
• Under IFRS, the change in the defined benefit plan net asset or liability is recognized as a cost of the period, with two components of the change (service cost and net interest expense or income) recognized in profit and loss and one component (remeasurements) of the change recognized in other comprehensive income.
• Under US GAAP, the change in the defined benefit plan net asset or liability is also recognised as a cost of the period with three components of the change (current service costs, interest expense on the beginning pension obligation, and expected return on plan assets) recognized in profit and loss and two components (past service costs and actuarial gains and losses) typically recognized in other comprehensive income.
• 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.

Problems

1. A company issues €1 million of bonds at face value. When the bonds are issued, the company will record a:
   1. cash inflow from investing activities.
   2. cash inflow from financing activities.
   3. 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:
   1. par.
   2. a discount.
   3. 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:
   1. an asset under US GAAP and reduction of the carrying value of the debt under IFRS.
   2. a liability under US GAAP and reduction of the carrying value of the debt under IFRS.
   3. a cash outflow from investing activities under both US GAAP and IFRS.
4. A company issues $1,000,000 face value of 10-year bonds on January 1, 2015 when the market interest rate on bonds of comparable risk and terms is 5%. The bonds pay 6% interest annually on December 31. At the time of issue, the bonds payable reflected on the balance sheet is closest to:
   1. $926,399.
   2. $1,000,000.
   3. $1,077,217.
5. Midland Brands issues three-year bonds dated January 1, 2015 with a face value of $5,000,000. The market interest rate on bonds of comparable risk and term is 3%. If the bonds pay 2.5% annually on December 31, bonds payable when issued are most likely reported as closest to:
   1. $4,929,285.
   2. $5,000,000.
   3. $5,071,401.
6. A firm issues a bond with a coupon rate of 5.00% when the market interest rate is 5.50% on bonds of comparable risk and terms. One year later, the market interest rate increases to 6.00%. Based on this information, the effective interest rate is:
   1. 5.00%.
   2. 5.50%.
   3. 6.00%.
7. On January 1, 2010, Elegant Fragrances Company issues £1,000,000 face value, five-year bonds with annual interest payments of £55,000 to be paid each December 31. The market interest rate is 6.0 percent. Using the effective interest rate method of amortization, Elegant Fragrances is most likely to record:
   1. an interest expense of £55,000 on its 2010 income statement.
   2. a liability of £982,674 on the December 31, 2010 balance sheet.
   3. a £58,736 cash outflow from operating activity on the 2010 statement of cash flows.
8. 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:
   1. €10.17 million.
   2. €10.21 million.
   3. €10.28 million.
9. A company issues €10,000,000 face value of 10-year bonds dated January 1, 2015 when the market interest rate on bonds of comparable risk and terms is 6%. The bonds pay 7% interest annually on December 31. Based on the effective interest rate method, the interest expense on December 31, 2015 is closest to:
   1. €644,161.
   2. €700,000.
   3. €751,521.
10. A company issues $30,000,000 face value of five-year bonds dated January 1, 2015 when the market interest rate on bonds of comparable risk and terms is 5%. The bonds pay 4% interest annually on December 31. Based on the effective interest rate method, the carrying amount of the bonds on December 31, 2015 is closest to:
    1. $28,466,099.
    2. $28,800,000.
    3. $28,936,215.
11. Lesp Industries issues five-year bonds dated January 1, 2015 with a face value of $2,000, 000 and 3% coupon rate paid annually on December 31. The market interest rate on bonds of comparable risk and term is 4%. The sales proceeds of the bonds are $1,910,964. Under the effective interest rate method, the interest expense in 2017 is closest to:
    1. $77,096.
    2. $77,780.
    3. $77,807.
12. For a bond issued at a premium, using the effective interest rate method, the:
    1. carrying amount increases each year.
    2. amortization of the premium increases each year.
    3. premium is evenly amortized over the life of the bond.
13. Comte Industries issues $3,000,000 worth of three-year bonds dated January 1, 2015. The bonds pay interest of 5.5% annually on December 31. The market interest rate on bonds of comparable risk and term is 5%. The sales proceeds of the bonds are $3,040,849. Under the straight-line method, the interest expense in the first year is closest to:
    1. $150,000.
    2. $151,384.
    3. $152,042.
14. 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:
    1. other comprehensive income of €3.3 million.
    2. other comprehensive income of €3.5 million.
    3. a gain of €3.3 million on the income statement.
15. A company redeems $1,000,000 face value bonds with a carrying value of $990,000. If the call price is 104 the company will:
    1. reduce bonds payable by $1,000,000.
    2. recognize a loss on the extinguishment of debt of $50,000.
    3. recognize a gain on the extinguishment of debt of $10,000.
16. 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:
    1. rise as the maturity date approaches.
    2. decline as the maturity date approaches.
    3. remain constant throughout the life of the bond.
17. 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:
    1. overestimate Fairmont’s economic liabilities.
    2. underestimate Fairmont’s economic liabilities.
    3. underestimate Fairmont’s interest coverage ratio.
18. Which of the following is an example of an affirmative debt covenant? The borrower is:
    1. prohibited from entering into mergers.
    2. prevented from issuing excessive additional debt.
    3. required to perform regular maintenance on equipment pledged as collateral.
19. Debt covenants are least likely to place restrictions on the issuer’s ability to:
    1. pay dividends.
    2. issue additional debt.
    3. issue additional equity.
20. Regarding a company’s debt obligations, which of the following is most likely presented on the balance sheet?
    1. Effective interest rate.
    2. Maturity dates for debt obligations.
    3. The portion of long-term debt due in the next 12 months.
21. Compared to using a finance lease, a lessee that makes use of an operating lease will most likely report higher:
    1. debt.
    2. rent expense.
    3. cash flow from operating activity.
22. Which of the following is most likely a lessee’s disclosure about operating leases?
    1. Lease liabilities.
    2. Future obligations by maturity.
    3. Net carrying amounts of leased assets.
23. For a lessor, the leased asset appears on the balance sheet and continues to be depreciated when the lease is classified as:
    1. a sales-type lease.
    2. an operating lease.
    3. a financing lease.
24. Under US GAAP, a lessor’s reported revenues at lease inception will be highest if the lease is classified as:
    1. a sales-type lease.
    2. an operating lease.
    3. a direct financing lease.
25. A lessor will record interest income if a lease is classified as:
    1. a capital lease.
    2. an operating lease.
    3. either a capital or an operating lease.
26. Compared with a finance lease, an operating lease:
    1. is similar to renting an asset.
    2. is equivalent to the purchase of an asset.
    3. term is for the majority of the economic life of the asset.
27. Under US GAAP, which of the following would require the lessee to classify a lease as a capital lease?
    1. The term is 60% of the useful life of the asset.
    2. The lease contains an option to purchase the asset at fair value.
    3. The present value of the lease payments is 95% of the fair value.
28. A lessee that enters into a finance lease will report the:
    1. lease payable on its balance sheet.
    2. full lease payment on its income statement.
    3. full lease payment as an operating cash flow.
29. A company enters into a finance lease agreement to acquire the use of an asset for three years with lease payments of €19,000,000 starting next year. The leased asset has a fair market value of €49,000,000, and the present value of the lease payments is €47,250,188. Based on this information, the value of the lease payable reported on the company’s balance sheet is closest to:
    1. €47,250,188.
    2. €49,000,000.
    3. €57,000,000.
30. Which of the following best describes reporting and disclosure requirements for a company that enters into an operating lease as the lessee? The operating lease obligation is:
    1. reported as a receivable on the balance sheet.
    2. disclosed in notes to the financial statements.
    3. reported as a component of debt on the balance sheet.
31. 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:
    1. 0.58.
    2. 0.62.
    3. 0.64.
32. The following presents selected financial information for a company:

    	$ Millions
    Short-term borrowing	4,231
    Current portion of long-term interest-bearing debt	29
    Long-term interest-bearing debt	925
    Average shareholders’ equity	18,752
    Average total assets	45,981

    The financial leverage ratio is closest to:

    1. 0.113.
    2. 0.277.
    3. 2.452.
33. An analyst evaluating three industrial companies calculates the following ratios:

    	Company A	Company B	Company C
    Debt-to-Equity	23.5%	22.5%	52.5%
    Interest Coverage	15.6%	49.5%	45.5%

    The company with both the lowest financial leverage and the greatest ability to meet interest payments is:

    1. Company A.
    2. Company B.
    3. Company C.
34. An analyst evaluating a company’s solvency gathers the following information:

    	$ Millions
    Short-term interest-bearing debt	1,25800
    Long-term interest-bearing debt	32100
    Total shareholder’s equity	4,28500
    Total assets	8,75000
    EBIT	2,50400
    Interest payments	5200

    The company’s debt-to-assets ratio is closest to:

    1. 0.18.
    2. 0.27.
    3. 0.37.
35. Penben Corporation has a defined benefit pension plan. At December 31, its pension obligation is €10 million, and pension assets are €9 million. Under either IFRS or US GAAP, the reporting on the balance sheet would be closest to which of the following?
    1. €10 million is shown as a liability, and €9 million appears as an asset.
    2. €1 million is shown as a net pension obligation.
    3. Pension assets and obligations are not required to be shown on the balance sheet but only disclosed in footnotes.
36. The following information is associated with a company that offers its employees a defined benefit plan:

    Fair value of fund’s assets	$1,500,000,000
    Estimated pension obligations	$2,600,000,000
    Present value of estimated pension obligations	$1,200,000,000

    Based on this information, the company’s balance sheet will present a net pension:

    1. asset of $300,000,000.
    2. asset of $1,400,000,000.
    3. liability of $1,100,000,000.