1 Chapter 11 Long-Term Liabilities 1,000 Adapted from Financial Accounting 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 Interest for Investor Borrower Bonds $10,000 9% Bond Due 2019  Long-term borrowing arrangement  Interest paid at stated rate and times  Principal repaid at maturity date 1,000 Investor Borrower

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 Common Stock 1,000

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

9 Interest Rates and Bond Prices Above face value (at a premium) At face value Below face value (at a discount) = MARKET RATE BONDS ISSUED:IF STATED RATE: > MARKET RATE < MARKET RATE

10 Bonds Sold at Face Value Cash 10,000 Bonds Payable10,000 To record issuance of bonds at face value. Face Value of Bonds = Sales Price

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

12 PV = ? Calculating Bond Prices - two sets of cash flows $$ ( 2 ) Principal due at maturity(single sum) PV = ? $$$$$ ( 1 ) Interest Payments made each period (annuity) etc. $$

13 Determining Bond Prices 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. Example:

PV = ? Calculating Bond Prices $800 ( 1 ) Interest Payments (4 $800) $800 Interest is always paid at rate stated on bonds 8%) 14

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

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

17 Recording Bond Discounts Cash 9,366 Discount on Bonds Payable 634 Bonds Payable 10,000 To record the issuance of bonds at a discount. Assets=Liabilities + Owners’ Equity + 9, ,

18 Balance Sheet Presentation of Bond Discount Long-term Liabilities: Bonds Payable$10,000$10,000 Less: Discount on Bonds Payable (634) $ 9,366$10,000 At DateUpon of SaleMaturity 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 Present value: interest payments - $ 800 x = $ 2,772 (PV; n=4; i = 6%) principal payment - $ 10,000 x = 7,920 (PV; n=4; i = 6%) Bond issue price:$10,692 Example of Price Calculation …but market rate Compute interest payment at stated rate (i.e. 8%)...

21 Recording Bond Premiums Cash10,692 Bonds Payable 10,000 Premium on Bonds Payable 692 To record the issuance of bonds at a premium. Assets=Liabilities + Owners’ Equity +10, ,

22 Balance Sheet Presentation of Bond Premium Long-term Liabilities: Bonds Payable$10,000$10,000 Plus: Premium on Bonds Payable $10,692$10,000 At DateUpon of SaleMaturity 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 Discount increases interest expense Premium reduces interest expense

Amortization Schedule - Discount Cash Interest DiscountCarrying Date Interest Expense Amortized Value 1/1/04 – – – $ 9,366 12/31/04 $ 800 $ 937 $ 137 9,503 12/31/ ,653 12/31/ ,818 12/31/ ,000 (rounded) 24

Amortization Schedule - Premium Cash Interest PremiumCarrying Date Interest Expense Amortized Value 1/1/04 – – – $ 10,692 12/31/04 $ 800 $ 642 $ ,534 12/31/ ,366 12/31/ ,188 12/31/ ,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 Rights Lessee Lessor

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  Transfers ownership of property  Contains bargain purchase option  Term is > 75% of property’s life  PV of payments > 90% of property FMV Title Lease meets one or more: Paycheck for Date Dept. of Treasurer Jane Doe

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

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

Long-Term Liabilities on the Statement of Cash Flows Operating Activities Net incomexxx Increase in current liability + Decrease in current liability - Investing Activities Financing Activities Increase in long-term liability + Decrease in long-term liability - 32

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 Income Statement Expense Pay to the order of: IRS ABC Co.

35 Deferred Income Taxes Sales Depreciation expense Income before tax Tax rate Income tax BookTax$6,000 2,500 4,000 3,500 2,000 40% $1,400$ 800 $ 600 Difference recorded as deferred tax

36 Deferred Income Taxes Income tax Book Tax $1,400$ 800 Journal Entry:Dr. Cr. Tax Expense 1,400 Tax Payable 800 Deferred Tax 600 $ 600

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

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 > Expense > 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 11 1,000