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LongTerm Liabilities

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Potential loss if asset becomes obsolete. Ties up capital that might be used in other projects. ... Long-Term Liabilities. Pensions: ... – PowerPoint PPT presentation

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Title: LongTerm Liabilities


1
Long-Term Liabilities
  • Overview
  • Accounting for Leases
  • Pensions Statement Analysis

2
Long-Term Liabilities
  • Leasing
  • To use an asset, a co. can purchase outright or
    enter into a lease agreement with another co.
    that owns an asset it wishes to use.
  • The co.,(as lessee), makes periodic payments to
    the other co. (the lessor) in exchange for use of
    the asset over the length of the lease agreement
    (lease term).

3
Leasing
  • Benefits of Ownership (i.e. vs. leasing)
  • Co. can amortize the asset for tax purposes.
  • An investment tax credit (ITC) (provided by the
    CRA to encourage investment in certain types of
    assets - new equip.) might be applicable.
  • Profit if value of asset appreciates.

4
Long-Term Liabilities
  • Leasing Disadvantages of Ownership (vs. leasing)
  • Potential loss if asset becomes obsolete.
  • Ties up capital that might be used in other
    projects.
  • The co.s debt/equity ratio and interest coverage
    ratios will change, possibly dramatically, if the
    co. borrows to buy.

5
Long-Term Liabilities
  • Leasing Benefits of Leasing
  • Lessee
  • doesnt have to invest own capital to buy an
    asset.
  • doesnt have to borrow - leaves debt/equity and
    interest coverage ratios unchanged.
  • transfers risk of obsolescence to lessor.
  • If lessee has little taxable income, there may be
    limited tax advantage to amortizing and to
    claiming an ITC. If the lessor can claim CCA,
    then savings may be passed on.
  • If lessee does not intend to keep the asset for
    its full useful life, risk of resale value
    resides with the lessor

6
Long-Term Liabilities
  • Leasing Operating Leases vs. Capital Leases
  • If an asset is leased for a short period of time
    (vs. its useful life) and there is no intent to
    buy it Operating Lease --gt recorded as a rent
    expense by lessee.
  • If the essence of the agreement is the lessee
    paying for the asset in instalments over its
    useful life and taking title to it at the end of
    the agreement, generally Capital Lease
    --gtconsidered no different than borrowing the
    money and buying the asset for cash.

7
Long-Term Liabilities
  • Leasing Operating Leases vs. Capital Leases
  • A corporation, generally would prefer to treat as
    an operating lease --gt no effect on debt/equity
    and interest coverage ratios.

8
Long-Term Liabilities
  • Leasing Operating Leases vs. Capital Leases
  • Under GAAP, Capital Lease Criteria
  • 1. Title to the asset passes to the lessee by the
    end of the lease term.
  • 2. Lease term is or gt 75 of the assets useful
    life.
  • 3. PV of the minimum lease payments is gt
    90 of the fair value of the asset.
  • If any of the above criteria are met,
    its a capital lease.
  • If a purchase option is provided to work around
    criteria 1 and the purchase price is a bargain,
    criteria 1 is considered met.

9
Long-Term Liabilities
  • Leasing Example Operating Lease vs.
    Capital Lease
  • Given Term 5 years Payment 2,000
    quarterly Payable in Advance
    Interest Rate 12 Title does not
    pass at end of lease. No purchase
    option.

10
Long-Term Liabilities
  • Leasing Example Operating Lease vs.
    Capital Lease
  • If an operating lease, only rent expense would be
    recorded quarterlyDr/ Rent Expense
    2,000 Cr/ Cash
    2,000

11
Long-Term Liabilities
  • Leasing Example Operating Lease vs.
    Capital Lease
  • If a capital lease, must be recorded as an asset
    and a corresponding debt obligation.
  • The value of the asset and the obligation are
    obtained by calculating the PV of the lease
    payments. Since this agreement requires payment
    in advance, this transaction is an annuity in
    advance. (i.e. The first payment is made
    immediately then 19 more payments)- Use PV of
    an Annuity in Arrears Table Table 4 in
    Appendix, Chptr. 10

12
Long-Term Liabilities
  • Leasing Example Operating Lease (see pg. 574
    of text) vs. Capital Lease
  • Capital Lease Entry (at signing date)Dr/ Asset
    under Lease 30,647.60 Cr/ Lease
    Obligation 30,647.60
  • Capital Lease Expense Entry (at end of qtr.)Dr/
    Amortization Expense 1,532.38 Cr/
    Accumulated Amortization 1,532.38Since
    title doesnt pass at the end, useful life
    lease term and residual value 0. Therefore,
    assuming straight-line amortn., qrtrly amortn.
    (30,647,60 / 20 quarters)

13
Long-Term Liabilities
  • Leasing Example Operating Lease vs.
    Capital Lease
  • Capital Lease Payment Entry (1st day of qtr.)Dr/
    Lease Obligation 2,000.00 Cr/
    Cash
    2,000.00
  • Capital Lease Expense Entry (_at_ end of 1st
    qtr.)Dr/ Interest Expense
    859.43 Cr/ Lease Obligation
    859.43 (30,647.60 - 2,000) x 12 x
    3/12 28,647.60 x 3

14
Long-Term Liabilities
  • Leasing Example Operating Lease vs.
    Capital Lease
  • Capital Lease Expense Entry (_at_ end of 2nd
    qtr.)Dr/ Interest Expense
    825.21 Cr/ Lease Obligation
    825.21 ( 28,647.60 859.43 - 2,000) x
    12 x 3/12 27,507.03 x 3
  • By the end of the lease term, the lease
    obligation will be 0.
  • For a lease, interest is added directly to the
    lease obligation account and cash payments
    directly reduce the balance.

15
Long-Term Liabilities
  • Leasing Example Operating Lease vs.
    Capital Lease
  • Effects of capital lease on financial stmts.
  • assets and liabilities will be higher by
    30,647.60
  • on the income stmt., both amortization expense
    and interest expense are reported vs. only rent
    expense.
  • total expense over the life of the lease is equal
    under both leases (i.e. 40,000) but the capital
    lease creates greater expense early in the lease.
    (see exhib. 10-10, pg.
    576)

16
Long-Term Liabilities
  • Leasing GAAP Disclosure
  • co.s with capital leases and with significant
    operating leases are required to disclose future
    lease payments in total and for each of the next
    5 years.
  • disclosure is in the form of a note to the
    financial statements under long-term debts,
    commitments, or contingencies.

17
Long-Term Liabilities
  • Leasing Lessor Accounting
  • for capital leases
  • The asset is provided to the lessee. Therefore,
    the capital asset is replaced (credited) and a
    receivable asset is set up on the lessors
    balance sheet.
  • for operating leases
  • The lessor retains the asset as owner.
  • Lease revenue is recorded.

18
Long-Term Liabilities
  • Pensions
  • Agreements between employers and employees that
    provide employees with specified benefits
    (income) upon retirement.
  • Represent a future obligation.
  • 2 types - Defined Contribution Plans
    - Defined Benefit Plans
  • Vested - if there is a provision that benefits
    belong to employees whether they remain employed
    by the co. or not.

19
Long-Term Liabilities
  • Pensions Defined Contribution Plans
  • Employer agrees to contribute a set (defined)
    amount (usually a of salary) to the employees
    retirement fund. The employees may also make
    contributions in some plans.
  • The employers obligation is satisfied upon
    payment into the fund.
  • Usually managed by a trustee. Assets are kept
    separate from the assets of the co. Therefore,
    not reported on the balance sheet.

20
Long-Term Liabilities
  • Pensions Defined Contribution Plans
  • Co.s record pension expense and normally pay the
    obligation promptly. Only payments are
    recognized as expense for tax purposes.
  • Accrual Entry
  • Dr/ Pension Expense xxxx Cr/
    Pension Obligation xxxx
  • Funding Entry
  • Dr/ Pension Obligation xxxx Cr/
    Cash xxxx

21
Long-Term Liabilities
  • Pensions Defined Benefit Plans
  • Guarantees to pay a certain amount of money
    during each retirement year to an employee.
  • Payment s usually take into consideration - an
    employees length of employment as well as
    highest salaries (or ave. of highest
    salaries).(e.g. ave. highest salaries x factor
    x of years) 60,000 x 3 x 20 years
    36,000/year

22
Long-Term Liabilities
  • Pensions Defined Benefit Plans
  • To estimate present value, factors, (normally
    based on the average employee), to be considered
    are
  • Projections of length of employee service.
  • Age at retirement.
  • Average salary at retirement.
  • Length of life after retirement.
  • Whether will remain employed with co.
  • Appropriate interest rate for NPV calculation.
  • An Actuary (trained in statistical procedures) is
    usually retained by a co. to make pension
    calculations.

23
Long-Term Liabilities
  • Pensions Defined Benefit Plans -Accounting
    Entries
  • Accrual and funding entries are the same as for
    defined contribution plans.
  • Many pension plan agreements require the co. to
    fund the pension obligation. However, there is
    no requirement that the s expensed the s
    funded.
  • If s expensed gt s funded, then a net pension
    obligation.
  • If s expensed lt s funded, then a net pension
    asset.

24
Long-Term Liabilities
  • Pensions Defined Benefit Plans - Funding
  • Pension funds are
  • Fully funded - if assets in the fund the PV of
    future pension obligations.
  • Overfunded - if assets in the fund gt the PV of
    future pension obligations.
  • Underfunded - if the PV of future pension
    obligations gt assets in the fund.
  • A trustee normally handles the fund and is
    responsible for investing the contributions to
    provide sufficient funds to pay benefits from the
    fund assets.
  • Contributions to a fund cannot be returned to an
    employer except under extraordinary
    circumstances.

25
Long-Term Liabilities
  • Pensions GAAP Annual Statement Disclosures
  • Defined contribution plans- simply contribution
    amounts for the period.
  • Defined benefit plans- disclosure is extensive
    (including PV of future obligations and
    fair value of pension fund assets).

26
Long-Term Liabilities
  • Other Employment Benefits
  • To date, health-care and life insurance costs,
    due to publicly funded health care in Canada,
    create limited exposure to co.s.
  • Therefore, in the past these were expensed as
    cash was paid out.
  • As of 2000, since limited exposure may not hold
    true into the future, companies are required to
    account for these items much the same way as
    pensions.

27
Liabilities
  • Statement Analysis Considerations
  • Major concern is the possibility of unrecorded
    liabilities or off-balance-sheet liabilities
    (e.g. operating leases).
  • Debt/equity ratio can be understated and times
    interest earned ratio can be overstated.
  • Therefore, understand the co. and the types of
    contracts it enters into.

28
Liabilities
  • Statement Analysis Considerations
  • Fluctuations in market interest rates cause
    differences between the book values of
    liabilities (as per GAAP, calculated at interest
    rates in effect when the debt was issued) and
    their current market values.
  • Fluctuations in foreign currency rates can cause
    increases or decreases in those liabilities
    expressed in Cdn. s.

29
Liabilities
  • Statement Analysis Considerations
  • Fluctuations in interest rates on debt agreements
    with floating (or variable) interest rates can
    cause significantly higher future interest
    payments.
  • Both the risk of currency and interest rate
    fluctuations can be minimized through through
    hedging techniques.
  • There is a guideline requiring co.s to disclose
    interest and currency transactions and their
    associated risks.

30
Liabilities
  • Statement Analysis
  • Both the Debt/Equity Ratio and the Times Interest
    Earned Ratio are used to evaluate a co.s ability
    to repay its obligations. (i.e. Long-term
    liquidity.) Debt/Equity Ratio (D/E)
    Total Liabilities
  • Total LiabilitiesShareholders Equity
  • Norm for non-financial corporations is between
    45 and 50. (see Exhib. 10-14 and
    Pgs. 584-586)

31
Liabilities
  • Statement Analysis
  • Times Interest Earned Ratio (TIE)
  • Income before interest
    and taxes
  • Interest
  • Net income Taxes
    Interest
  • Interest
  • Compares the amount of earnings available to pay
    interest to the level of interest expense.
    (i.e. measures the co.s ability to pay
    interest out of earnings). Low single digits
    might signal a warning.
  • Both ratios are used in trend analysis and/or
    comparison to other co.s in an industry.
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