Long-Term Liabilities

1
Chapter 10

• Long-Term Liabilities

Financial Accounting, Alternate 4e by Porter and
Norton
2
Balance Sheet Classifications

• Current Liabilities
• Long-Term Liabilities

due within one year of the balance sheet date
due beyond one year
3
Long-Term Liabilities

• Bonds Payable
• Notes Payable
• Leases
• Deferred Taxes
• Pensions
• Other Postretirement Benefits

4
Bonds
Investor
Borrower

• Long-term borrowing arrangement
• Interest paid at stated rate and times
• Principal repaid at maturity date

5
Bond Features

• Collateralized - backed by specific assets in
  event of default

• Debentures -backed only by general
  credit-worthiness of issuer

6
Bond Features

• Term - Entire principal due on a specific single
  date

• Serial - Principal repaid in installments over
  time

7
Bond Features

• Convertible -
• into common stock

• Callable / Redeemable - may be retired before
  maturity date

8
Bond Interest Rates

• Face Rate -
• interest is paid at the rate specified on the bond

• Market Rate -
• the interest rate the bond will yield after
  selling at a discount or premium

9
Interest Rates and Bond Prices
BONDS ISSUED IF STATED RATE

• Above face value (at a premium)
• At face value
• Below face value (at a discount)

gt MARKET RATE
MARKET RATE
lt MARKET RATE
10
Bonds Sold at Face Value

• Issuance of bonds at face value
• Assets Liab. O/E Rev.
  Exp.
• Cash 10,000 Bonds Pay. 10,000

Face Value of Bonds Sales Price
11
Relationship of Interest Rates and Bond Prices

Market Interest Rates
Bond Prices
12
Calculating Bond Prices - two sets of cash flows
(1) Interest Payments made each period (annuity)
PV ?
etc.




(2) Principal due at maturity(single sum)

PV ?
13
Determining Bond Prices
Example

• On 1/1/04, Discount Firm issues
• 10,000 8 bonds.
• due December 31, 2007
• Interest payable annually
• Market rate of interest 10
• Calculate the issue price of the bonds.

14
Calculating Bond Prices
(1) Interest Payments (4 payments _at_ 800)
PV ?
800
800
800
800
Interest is always paid at rate stated on bonds
(10,000 _at_ 8)
14
15
Calculating Bond Prices
(1) Interest Payments (4 payments _at_ 800)
PV ?
800
800
800
800
(2) Principal of 10,000 due at end of 2007
2007
10,000
PV ?
15
16
Example of Price Calculation
Present value interest payments - 800
x 3.170 2,536 (PV n4 i
10) principal payment - 10,000 x
0.683 6,830 (PV n4 i 10) Bond
issue price 9,366
17
Recording Bond Discounts

• Issue bonds at a discount
• Assets Liab. O/E Rev.
  Exp.
• Cash 9,366 Bonds Pay. 10,000
• Discount on
• Bonds Pay. (634)

18
Balance Sheet Presentation of Bond Discount
At Date Upon of Sale Maturity

• Long-term Liabilities
• Bonds Payable 10,000 10,000
• Less Discount on
• Bonds Payable (634) - 0 -
• 9,366 10,000

amortize to Interest Expense over the life of
the bond
19
Determining Bond Prices

• Assume Premium Firm sells the same 10,000 8
  bonds when the market rate on similar bonds is 6.

20
Example of Price Calculation
Present value interest payments - 800
x 3.465 2,772 (PV n4 i
6) principal payment - 10,000 x
0.792 7,920 (PV n4 i 6) Bond
issue price 10,692
21
Recording Bond Premiums

• Issue bonds at a premium
• Assets Liab. O/E Rev.
  Exp.
• Cash 10,692 Bonds Pay. 10,000
• Discount on
• Bonds Pay. 692

22
Balance Sheet Presentation of Bond Premium
At Date Upon of Sale Maturity

• Long-term Liabilities
• Bonds Payable 10,000 10,000
• Plus Premium on
• Bonds Payable 692 - 0 -
• 10,692 10,000

amortize to Interest Expense over the life of
the bond
23
Amortization of Bond Premiums and Discounts

• Transfer to interest expense over the life of the
  bond using effective interest method

Premium reduces interest expense
Discount increases interest expense
24
Amortization Schedule - Discount

• Cash Interest Discount Carrying
• Date Interest Expense Amortized
  Value
• 8 10 Col. 2 - Col. 1
• 1/1/04 9,366
• 12/31/04 800 937 137 9,503
• 12/31/05 800 950 150
  9,653
• 12/31/06 800 965 165 9,818
• 12/31/07 800 982 182
  10,000
• (rounded)

24
25
Amortization Schedule - Premium
Cash Interest Premium Carrying Date
Interest Expense Amortized Value
8 6 Col. 1 - Col. 2 1/1/04
10,692 12/31/04 800
642 158 10,534 12/31/05
800 632 168
10,366 12/31/06 800 622 178
10,188 12/31/05 800 612
188 10,000 (rounded)

25
26
Redemption of Bonds

• Reasons for early redemption
• Excess cash
• Changing interest rates

Gain Carrying Value - Redemption Price (Loss)
Redemption Price - Carrying Value
27
Leases

• Contractual arrangement
• Grants right to use asset in exchange for payment
• Form of financing

Lessor
Lessee
28
Capital Lease

• Record as asset and corresponding liability (as
  if purchased through borrowings)
• Depreciate asset over lease term
• Separate payments into principal and interest
  components using the effective interest method

29
Criteria for Lease Capitalization
Lease meets one or more

• Transfers ownership of property
• Contains bargain purchase option
• Term is gt 75 of propertys life
• PV of payments gt 90 of property FMV

30
Operating Leases

• Record as rent (lease) expense each period
• Disclose future lease obligations in footnotes

31
Long-Term Liabilities on the Statement of Cash
Flows

• Operating Activities
• Net income xxx
• Increase in current liability
• Decrease in current liability
• Investing Activities
• Financing Activities
• Increase in long-term liability
• Decrease in long-term liability

31
32
Debt-to-Equity Ratio
Total Liabilities Total Stockholders Equity
How much have creditors contributed as compared
to owners?
33
Appendix

• Accounting Tools
• Other Liabilities

34
Deferred Taxes

• Reflects temporary differences between book and
  tax accounting methods
• Book tax expense Cash paid to IRS

Tax Return Liability
35
Deferred Income Taxes

• Sales
• Depreciation expense
• Income before tax
• Tax rate
• Income tax

• Book Tax
• 6,000 6,000
• 2,500 4,000
• 3,500 2,000
• 40 40
• 1,400 800

Difference recorded as deferred tax
600
36
Deferred Income Taxes

• Income tax

• Book Tax
• 1,400 800

600
Effect on financial statements Assets
Liab. O/E Rev. Exp.
Tax Pay. 800
Tax Exp. (1,400) Deferred Tax 600
Balance Sheet
Income Statement
37
Pensions
Pays benefits to retired employees
Employer contributes to
Pension Fund
38
Pensions

• Expense accrued in period employee earns benefits
  (regardless of when paid)
• Expense may amount funded

39
Pensions on the Balance Sheet

• ASSETS
• Prepaid Pension Cost

• LIABILITIES
• Accrued Pension Cost

Funding gt Expense
Expense gt Funding
40
Postretirement Benefits

• Benefits paid to employees after retirement
• e.g., health costs
• Record expense when employee earns benefits, not
  when paid (matching principle)

41
End of Chapter 10