Back to Basics, Part 6
Having reviewed current liabilities last week, we'll turn our focus
tonight to those obligations that a company must pay beyond one year
of the date on the balance sheet. Noncurrent liabilities are listed
at their present value, meaning this is the amount that would be paid
to settle the obligation. The exception is future interest payments
that are not yet due.
Most noncurrent liabilities do require periodic payments of principal
and interest, but as we discussed last week, the portion of those payments due
within one year are -- in the case of future interest payments -- listed under
current liabilities, rather than noncurrent liabilities.
The key to fully understanding noncurrent liabilities is in the footnotes. Many
of the obligations carry with them covenants, which are requirements and restrictions
placed on the borrowing company. An example of a covenant might be a debt-total
capital ratio of 0.5 or less. If a covenant is breached the company is technically
in default of its long-term obligation and it can be called at any time. Be sure
to seek out the footnotes for a high-definition widescreen look at long-term
There are roughly six main categories of noncurrent liabilities:
Long-Term Debt, also known as Funded Debt, are the loans and
notes with a maturity greater than one year. Too much long-term debt will restrict
the growth and ability to adapt to the changing climate of business, as well
as increase the fixed charges against income each quarter. High levels of long-term
debt will also make creditors wary. As debt increases, funds available to a company
will decrease or carry a very high interest rate.
Sometimes companies will settle their debt obligations before they are due. This
will result in a loss if the settlement is greater than the principal listed
on the balance sheet and a gain if the settlement is less than the principal.
The gain or loss as a result of an early settlement will appear on the income
If a company encounters difficulty in meeting its debt obligations, sometimes
a creditor will grant an allowance known as a Troubled Debt Restructuring .
Troubled debt restructuring generally comes in the form of transferring noncash
assets or stock to the creditor, or sometimes merely changing the terms of the
Bonds Payable are a form of debt issued for a period of more
than one year. When an investor buys bonds, he or she is lending the company
money. The seller of the bond agrees to repay the principal amount of the loan
at a specified time, plus interest. The interest rate, date of maturity (when
the principal is returned to the lender), and interest payment schedule are
all incorporated into the bond.
Bonds may be backed by collateral or unsecured. Unsecured bonds are known as Debentures .
Bonds can either come to maturity all at once or staggered over time. Those that
mature in increments are known as Serial Bonds .
Sometimes, due to changing market interest rates, bonds are sold at a discount
or a premium to their principal value. These discounts and premiums will be listed
just below the bonds payable listing on the balance sheet.
Obligations Under Capital Lease arise from businesses leasing
properties rather than buying outright. As we discussed in the current assets
portion of this series, there are two kinds of leases under GAAP accounting,
operating and capital.
Operating Leases are generally short-term leases for which rental payments are
made by the lessee and full ownership rights are kept by the lessor. Operating
leases are not recorded on the balance sheet.
Capital Leases are long-term leases that represent a purchase of the asset by
the company because the company will control the asset for nearly all of its
useful life. A lease qualifies as capital if any of the following is true:
- The lease payments will total 90% or more of the fair market value
of the property.
- The ownership of leased property converts to the lessee at the
conclusion of the lease.
- The lease contains an option to purchase the property.
- The term of the lease is equal to or greater than 75% of the estimated
useful life of the property.
Accounting rules require that the leased asset and the present value
of the lease payments be recorded on the lessee's balance sheet.
Deferred Tax Liability will originate when the current deduction
under GAAP accounting is less than the deduction as determined by the IRS.
The company will defer the difference, temporarily saving on its tax liability.
Pension Liability stems from the company's promise to pay
retirement benefits to employees. There are two types of pension plans, defined
contribution plans and defined benefit plans.
Defined Contribution Plans require the company to contribute a fixed dollar
amount to the plan in the present, with several investment options available
to the employee for those funds. Typical defined contribution plans are 401(k)
and 403(b) plans. Since the obligation to these plans are paid in the present,
they are not listed under noncurrent liabilities.
With a Defined Benefits Plan, the company takes on an obligation to pay the
employee a set amount each year upon retirement. In order for the company to
meet its pension obligations down the road, it must contribute now and invest
that money in such a manner that it will meet the defined pension benefits.
The company's pension liability is the difference between its current value
and what it is obligated to pay out in benefits.
Mortgages Payable are self-explanatory.
Again, the key to clearly understanding noncurrent liabilities is to examine
the footnotes closely, where the terms and conditions of future obligations
will be spelled out.
>> Finishing the Balance Sheet >>