Understanding NonCurrent Liabilities
Back to Basics, Part 6

By Vince Hanks

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 liabilities.

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 statement.

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 loan.

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.

 

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