Long-Term Liabilities Chapter 10 Long-Term Liabilities 1,000 Financial Accounting, Alternate 4e by Porter and Norton 1

Balance Sheet Classifications 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 Current Liabilities: Long-Term Liabilities: due within one year of the balance sheet date due beyond one year

Long-Term Liabilities Bonds Payable Notes Payable Leases Deferred Taxes Pensions Other Postretirement Benefits

Bonds 1,000 Investor Borrower Long-term borrowing arrangement Due 2019 Investor Borrower Interest for Investor Borrower Long-term borrowing arrangement Interest paid at stated rate and times Principal repaid at maturity date

Bond Features Collateralized - backed by specific assets in event of default Debentures - backed only by general credit- worthiness of issuer

Bond Features Term - Entire principal due on a specific single date Serial - Principal repaid in installments over time 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27

Bond Features Convertible - into common stock Callable / Redeemable - may be retired before maturity date Common Stock 1,000

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 Paycheck for Date Dept.. of Treasurer Jane Doe 8% Return

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) > MARKET RATE = MARKET RATE < MARKET RATE

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

Relationship of Interest Rates and Bond Prices Market Interest Rates Bond Prices Market Interest Rates Bond Prices

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 = ? 1

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.

Interest is always paid at rate stated on bonds Calculating Bond Prices (1) Interest Payments (4 payments @ $800) 2004 2005 2006 2007 PV = ? $800 $800 $800 $800 Interest is always paid at rate stated on bonds ($10,000 @ 8%) 14 1

Calculating Bond Prices (1) Interest Payments (4 payments @ $800) 2004 2005 2006 2007 PV = ? $800 $800 $800 $800 (2) Principal of $10,000 due at end of 2007 2007 $10,000 PV = ? 15 1

payment at stated rate (i.e. 8%) ... Example of Price Calculation Compute interest payment at stated rate (i.e. 8%) ... Present value: interest payments - $ 800 x 3.170 = $ 2,536 (PV; n=4; i = 10%) principal payment - $ 10,000 x 0.683 = 6,830 Bond issue price: $ 9,366 …but discount @ market rate 2

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)

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

Determining Bond Prices Assume Premium Firm sells the same $10,000; 8% bonds when the market rate on similar bonds is 6%.

payment at stated rate (i.e. 8%) ... Example of Price Calculation Compute interest payment at stated rate (i.e. 8%) ... Present value: interest payments - $ 800 x 3.465 = $ 2,772 (PV; n=4; i = 6%) principal payment - $ 10,000 x 0.792 = 7,920 Bond issue price: $10,692 …but discount @ market rate 2

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

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

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

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 13

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 13

Redemption of Bonds Reasons for early redemption: Excess cash Changing interest rates Gain = Carrying Value - Redemption Price (Loss) = Redemption Price - Carrying Value

Leases Lessor Lessee Contractual arrangement Grants right to use asset in exchange for payment Form of financing Lessor Lessee Rights

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

Criteria for Lease Capitalization Lease meets one or more: Title Transfers ownership of property Contains bargain purchase option Term is > 75% of property’s life PV of payments > 90% of property FMV 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 Paycheck for Date Dept. of Treasurer Jane Doe

Operating Leases Record as rent (lease) expense each period Disclose future lease obligations in footnotes OFFICE SPACE FOR LEASE

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

Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed as compared to owners?

Accounting Tools: Other Liabilities Appendix Accounting Tools: Other Liabilities

Deferred Taxes Reflects temporary differences between book and tax accounting methods Book tax expense Cash paid to IRS = Income Statement Expense Tax Return Liability Pay to the order of: IRS ABC Co.

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

Deferred Income Taxes Income tax Book Tax $1,400 $ 800 $ 600 $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

Pensions Pays benefits Employer to retired contributes Pension employees Employer contributes to Pension Fund Date Dept. of Treasurer Pension Fund XYZ Corp. Paycheck for Date Dept. of Treasurer Jane Doe

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

Pensions on the Balance Sheet ASSETS Prepaid Pension Cost $$ LIABILITIES Accrued Pension Cost $$ Funding > Expense Expense > Funding

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

End of Chapter 10 1,000