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Noncurrent LiabilitiesNoncurrent Liabilities
Chapter 9
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Noncurrent Liabilities Noncurrent Liabilities
• Noncurrent liabilities represent obligations of the firm that generally are due more than one year after the balance sheet date.
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Noncurrent Liabilities Noncurrent Liabilities
• The major portion of these liabilities consists of notes payable and bonds payable.
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Long-Term Notes PayableLong-Term Notes Payable
• Long-term notes payable can be either interest-bearing or discounted.
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Interest-Bearing NotesInterest-Bearing Notes
• With an interest-bearing note, the bank will loan the principal of the note for a specified period.
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Interest-Bearing NotesInterest-Bearing Notes
• The borrower will pay interest periodically and will repay the principal at the maturity date.
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Interest-Bearing NotesInterest-Bearing Notes
• Interest expense, of course, reduces Retained Earnings, as do all expenses.
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Interest-Bearing NotesInterest-Bearing Notes
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Interest-Bearing NotesInterest-Bearing Notes
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Interest-Bearing NotesInterest-Bearing Notes
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Discounted NotesDiscounted Notes
• Discounted notes do not require periodic payments of interest.
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Discounted NotesDiscounted Notes
• All long-term financing agreements involve interest, regardless of whether it is separately identified.
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Discounted NotesDiscounted Notes
• If a company borrows $10 million for 2 years and, because of the terms of the note, will not make periodic interest payments, then the lender will be unwilling to provide the borrower the full $10 million face amount of the note.
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Discounted NotesDiscounted Notes
• In this case, the note must be discounted, and the lender will lend the present value of the note, as computed by using the compound interest tables.
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Discounted NotesDiscounted Notes
• Assuming an interest rate of 12%, a factor of 0.797 is pulled from the Present Value of $1 table.
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Discounted NotesDiscounted Notes
• Multiplying $10 million by the factor, the present value (the amount which the borrower will receive in cash) is computed as $7,970,000.
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Discounted NotesDiscounted Notes
• The difference, $2,030,000, is the discount, which represents the interest that is associated with the transaction.
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Discounted NotesDiscounted Notes
• It will be recognized as Interest Expense by the borrower over the two-year period of the note.
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Discounted NotesDiscounted Notes
• At the maturity date, the borrower will repay $10 million to the lender.
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Discounted NotesDiscounted Notes
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Discounted NotesDiscounted Notes
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BondsBonds
• Bonds are individual notes, sold to individual investors as well as to financial institutions.
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Bonds have several advantages:Bonds have several advantages:
• The sale of bonds provides access to a large pool of lenders.
• For some firms, selling bonds may be less expensive than other forms of borrowing.
• Bond financing may offer managers greater flexibility in the future.
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Bonds Payable Bonds Payable
• Bonds payable represent a major source of borrowed capital for U.S. companies.
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Bonds Payable Bonds Payable
• Bonds involve the periodic payment of interest (usually every six months) and the repayment of the principal amount.
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Bonds Payable Bonds Payable
• The predicted interest rate usually becomes the coupon or face or nominal rate.
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Bonds Payable Bonds Payable
• It sets the cash interest payments the company will have to make.
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Bonds Payable Bonds Payable
• The market rate of interest will be known only when the bonds are sold.
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Bonds PayableBonds Payable
• Because interest rates change constantly, it is rare that a bond coupon rate will equal the market rate when the bond is sold.
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Bonds Payable Bonds Payable
• If the principal of a bond is $500,000 and the coupon rate is 12%, then the company will pay $60,000 ($500,000 X 12%) cash interest each year, or $30,000 every six months.
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Bonds PayableBonds Payable
• When interest is paid each six months, the interest rate is said to be compounded semiannually.
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Bonds PayableBonds Payable
• Since the bonds pay interest twice a year, the interest rate must be halved (10% per year is 5% each six months) and the number of years must be doubled.
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Bonds PayableBonds Payable
• A 6-year bond pays interest 12 times over the life of the bond.
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Bonds Sold at ParBonds Sold at Par
• Bonds sell at par or face value when the coupon rate equals the market rate of interest on the date of sale.
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Bonds Sold at ParBonds Sold at Par
• For a bond sold at par, on the date of sale, both Cash and Bonds Payable will increase by $100 million.
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Bonds Sold at ParBonds Sold at Par
• On each of the two annual interest payment dates, Interest Expense will increase and Cash will decrease by $6 million.
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Bonds Sold at ParBonds Sold at Par
• On the maturity date, both Cash and Bonds Payable will decrease by $100 million.
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Bonds Sold at ParBonds Sold at Par
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Bonds Sold at ParBonds Sold at Par
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Bonds Sold at ParBonds Sold at Par
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Bonds Sold at DiscountBonds Sold at Discount
• If, on the date of sale, the coupon rate does not equal the market rate, the bonds will sell at their present value.
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Bonds Sold at DiscountBonds Sold at Discount
• If the coupon rate is below the market rate of interest on the date of sale, then the bonds will sell at a discount.
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Bonds Sold at DiscountBonds Sold at Discount
• An investor will not pay face amount for a bond which has an interest rate lower than that which the investor could find elsewhere.
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• On January 3 a company sells $100,000,000 of bonds with a coupon rate of interest of 12% while the market rate of interest is 16%.
• The bonds are 10-year bonds and pay interest twice a year
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• The present value of the bonds is calculated by adding the present value of the $10,000,000 to the present value of the annuity.
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• The present value of the bonds is calculated by adding the present value of the $10,000,000 to the present value of the annuity.
$100,000,000 x 0.215 = $ 21,500,000
$ 6,000,000 x 9.818 = 58,908,000
$ 80,408,000
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• The coupon rate of interest is used to compute the cash interest payments ($10,000,000 X .12 X 6/12) and to compare against the market rate of interest (12% versus 16%) to let you know that the bonds are selling at a discount.
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• After that, the present value computations and interest computations are driven by the market rate of interest.
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• Because the bonds are 10-year bonds paying interest twice a year, there are 20 interest payment periods, and the market rate of interest will be halved, to 9%.
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• Upon sale of the bonds, the company will increase Cash and net Bonds Payable by $80,408,000.
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An example of a bond sold at a discount:An example of a bond sold at a discount:
• The discount of $19,592,000 represents additional interest paid to bondholders.
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Bonds Sold at Discount Bonds Sold at Discount
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Amortization Amortization
• Periodic interest expense may differ from the periodic cash payments to the bondholders
• The reported value of the bonds will be adjusted for the difference through a process called amortization.
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Amortization Amortization
• For our bond, the first interest payment date will involve the following:
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Amortization Amortization
• For our bond, the first interest payment date will involve the following:– A decrease in Cash of $6,000,000 an
decrease in Interest Expense of $6,432,640 ($80,408,000 X 8%), and an increase in the reported value of Bonds Payable (because the discount is decreasing) of $432,640 ($6,432,640 - $6,000,000).
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AmortizationAmortization
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AmortizationAmortization
• For our bond, the first interest payment date will involve the following:
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AmortizationAmortization
• For our bond, the first interest payment date will involve the following:– The value of the bonds will continue
to rise toward $100,000,000 over the life of the bond, and the discount will be completely amortized by the maturity date.
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Bonds Sold at DiscountBonds Sold at Discount
• A bond is sold at a premium when the coupon rate of interest is higher than the market rate.
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An example of a bond sold at a premium: An example of a bond sold at a premium:
• On January 3 a company sells $100,000,000 of bonds with a coupon rate of interest of 12%, but now the market rate of interest is 8%.
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An example of a bond sold at a premium: An example of a bond sold at a premium:
• The bonds are 10-year bonds and pay interest twice a year.
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An example of a bond sold at a premium: An example of a bond sold at a premium:
• The present value of the bonds is calculated by adding the present value of the $100,000,000 to the present value of the annuity.
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An example of a bond sold at a premium: An example of a bond sold at a premium:
• Using the same bond as above, an example of a bond sold at a premium:
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An example of a bond sold at a premium: An example of a bond sold at a premium:
• Using the same bond as above, an example of a bond sold at a premium:
$100,000,000 x 0.456 = $ 45,600,000
$ 6,000,000 x 13.590 = 81,540,000
$127,140,000
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An example of a bond sold at a premium: An example of a bond sold at a premium:
• The premium of $27,140,000 represents a reduction in interest paid to bondholders to compensate for the fact that the coupon rate is too high.
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Bonds Sold at PremiumBonds Sold at Premium
• The reported value of the bonds will be adjusted for the difference between interest expense and cash interest payments through a process called amortization.
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Early Retirement of BondsEarly Retirement of Bonds
• Changes in market rates of interest may motivate firms to buy back their outstanding bonds prior to their scheduled maturity dates.
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Early Retirement of BondsEarly Retirement of Bonds
• Any difference between the reported value of the bonds and the repurchase price must be accounted for as either an extraordinary gain or loss.
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Early Retirement of BondsEarly Retirement of Bonds
• Extraordinary gains or losses are reported separately, net of tax, at the bottom of the income statement.
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Other Aspects of Borrowing AgreementsOther Aspects of Borrowing Agreements
• Borrowing agreements – indentures – can include other important provisions.
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Restrictive CovenantsRestrictive Covenants
• A lender may insist that a borrower agree to various restrictions in order that the lender be protected from possible default by the borrower.
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Restrictive CovenantsRestrictive Covenants
• Violations of these restrictive covenants constitute technical default on the debt and usually come with penalties for the borrower.
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Restrictive CovenantsRestrictive Covenants
• Analysts are always concerned with the existence of such covenants.
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CollateralCollateral
• Debt agreements sometimes require that specific assets of the borrower be pledged as security in the event of default by the borrower.
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CollateralCollateral
• If a lender is not happy with the assets to be pledged as collateral, then he may require that a sinking fund be established to secure the debt.
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CollateralCollateral
• Such a fund is segregated cash and/or investments, administered by a third party, dedicated to repayment of the debt.
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ConvertibilityConvertibility
• Sometimes bonds are convertible, meaning that the bondholder has the option to exchange the debt for a predetermined number of shares of stock.
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ConvertibilityConvertibility
• Investors usually view convertibility as a very attractive feature.
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Financial Reporting of Income TaxFinancial Reporting of Income Tax
• The objectives of income measures for financial reporting may differ from measures for income tax purposes.
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Financial Reporting of Income TaxFinancial Reporting of Income Tax
• Income measures for financial reporting purposes should help financial analysts to assess the firm's future ability to generate cash.
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Financial Reporting of Income TaxFinancial Reporting of Income Tax
• Income measures for income tax purposes must comply with the relevant provisions of the IRS tax code.
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Book and Tax DifferencesBook and Tax Differences
• Book measurements are used for financial reporting purposes, while tax measurements must comply with income tax laws.
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Book and Tax DifferencesBook and Tax Differences
• In most cases, differences between book and tax measurements are temporary in nature.
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Book and Tax DifferencesBook and Tax Differences
• Accounting standards for reporting income tax expenses and liabilities reflect a basic premise.
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Book and Tax DifferencesBook and Tax Differences
• All events that affect the tax impact of temporary differences should be recognized currently in the financial statements.
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Two types of events can affect expected tax impacts:Two types of events can affect expected tax impacts:
• A change in the amount of temporary differences between the book and the tax bases of a firm's assets (or liabilities).
• A change in tax rates that will apply to those temporary differences.
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DepreciationDepreciation
• A frequently occurring temporary difference appears in the area of depreciation.
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DepreciationDepreciation
• A company may use straight-line depreciation for the books but an accelerated method for tax depreciation.
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DepreciationDepreciation
• Use of the accelerated method will lower current net, and therefore taxable, income.
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DepreciationDepreciation
• The temporary difference simply allows a firm to postpone its tax payments to later years.
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DepreciationDepreciation
• The tax eventually must be paid.
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DepreciationDepreciation
• Accounting standards require that firms recognize a liability for such future income taxes.
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Deferred Income Tax LiabilityDeferred Income Tax Liability
• The liability for future income taxes is referred to as a deferred income tax liability.
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Deferred Income Tax LiabilityDeferred Income Tax Liability
• It is computed by multiplying the difference between the asset's book and tax bases by the appropriate income tax rate.
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Deferred Income Tax LiabilityDeferred Income Tax Liability
• An assets with a book basis of $7,000,000 and a tax basis of $5,000,000, gives a deferred income tax liability of $800,000 if the income tax rate is 40%.
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Deferred Income Tax LiabilityDeferred Income Tax Liability
• An assets with a book basis of $7,000,000 and a tax basis of $5,000,000, gives a deferred income tax liability of $800,000 if the income tax rate is 40%.
$7,000,000 – $5,000,000 = $2,000,000
$2,000,000 x 40% = $800,000
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Deferred Income Tax LiabilityDeferred Income Tax Liability
• Deferred tax accounting appears to provide a better matching of expenses on the income statement, at least when tax rates are expected to be stable over time.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• Others items causing temporary differences include revenue and expense measurements in areas such as leasing, warranties, debt refinancing, and exchanges of assets.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• Just as there are deferred tax liabilities, there are also deferred tax assets.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• These occur when the difference between book and tax measurements results in earlier recognition of taxable income.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• The reduction in income tax will occur in future years.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• To sum up, a deferred tax liability causes current taxable income to be lower than book income.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• The increase in income tax occurs in future years.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• A deferred tax asset causes current taxable income to be higher than book income.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• The benefit, the decrease in income tax, will occur in future years.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• Deferred tax obligations are classified as current or noncurrent based upon the current or noncurrent classification of the related asset.
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Other Aspects of Income Tax ReportingOther Aspects of Income Tax Reporting
• While long-term obligations are reported at their present values, deferred tax obligations are not discounted to their present values.
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Noncurrent LiabilitiesNoncurrent Liabilities
End of Chapter 9