Chapter 10 Long-Term Liabilities Using Financial Accounting Information: The Alternative to Debits and Credits, 6/e by Gary A. Porter and Curtis L. Norton Copyright © 2009 South-Western, a part of Cengage Learning

Balance Sheet Classifications Current liabilities: Long-term liabilities: Due within one year of the balance sheet date Due beyond one year LO1

Long-Term Liabilities  Bonds payable  Notes payable  Leases  Deferred taxes

Bonds  Long-term borrowing arrangement  Interest paid at stated rate and times  Principal repaid at maturity date InvestorBorrower LO2

Bond Features Collateralized backed by specific assets in event of default Term: entire principal due on a specific single date Debentures backed only by general creditworthiness of issue Serial: principal repaid in installments over time

Bond Features Convertible into common stock Callable / Redeemable may be retired before maturity date

Bonds Sold at Face Value To record issuance of bonds at face value: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues – Expenses Equity Cash Bonds 10,000 = Payable 10,000 Face value of bonds = Sales price

Bond Interest Rates Face rate the rate specified on the bond certificate Market rate the rate that investors could obtain by investing in other bonds similar to the issuing firm’s bonds LO3

Two sets of cash flows PV = ? Calculating Bond Prices $$ ( 2 ) Principal due at maturity PV = ? $$$$$ ( 1 ) Interest payments made each period etc. $$

Determining Bond Prices On 1/1/08, Discount Firm issues:  $10,000, 8% bonds  Due December 31, 2011  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%) $800

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

Present value: Interest payments: $800 × = $2,536 (PV; n = 4; i = 10%) Principal payment: $10,000 × = 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%)...

Recording Bond Discounts To record the issuance of bonds payable: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Cash 9,366 = Bonds Payable 10,000 Discount on Bonds Payable (634) LO4

Balance Sheet Presentation of Bond Discount Long-term liabilities: Bonds payable $10,000 Less: Discount on bonds payable 634 $ 9,366

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

Present value: Interest payments: $800 × = $ 2,772 (PV; n = 4; i = 6%) Principal payment: $10,000 × = 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%)...

Recording Bond Premiums To record the issuance of bonds payable: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues – Expenses Equity Cash = Bonds Payable 10,692 10,000 Premium on Bonds Payable 692

Balance Sheet Presentation of Bond Premium Long-term liabilities: Bonds payable $10,000 Plus: Premium on bonds payable 692 $10,692

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

Amortization of Bond Premiums and Discounts Transferring an amount from the discount or premium account to interest expense over the life of the bond using the effective interest method Discount increases interest expense Premium reduces interest expense LO5

Amortization Schedule – Discount Cash Interest DiscountCarrying Date Interest Expense Amortized Value 1/01/08 — — — $ 9,366 12/31/08 $800 $937 $137 9,503 12/31/ ,653 12/31/ ,818 12/31/ ,000 (rounded)

Amortization Schedule – Premium Cash Interest DiscountCarrying Date Interest Expense Amortized Value 1/1/07 — — — $10,692 12/31/07 $800 $642 $158 10,534 12/31/ ,366 12/31/ ,188 12/31/ ,000 (rounded)

Redemption of Bonds  Reasons for early redemption: Excess cash Changing interest rates Gain = Carrying Value – Redemption Price Loss = Redemption Price – Carrying Value LO6

Leases  Contractual arrangement  Grants right to use asset in exchange for payments  Form of financing LesseeLessor LO7

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  Transfers ownership of property  Contains a bargain-purchase option  Term is > 75% of property’s life  Present value of payments is > 90% of property’s fair market value Lease meets one or more:

Operating Leases  Record as rent (lease) expense each period  Disclose future lease obligations in financial statement notes OFFICE SPACE FOR LEASE

Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed as compared to owners? LO8

Times Interest Earned Ratio Income Before Interest and Tax Interest Expense Will they be able to pay the interest on their debt?

Debt Service Coverage Ratio Cash Flow from Operations Before Interest and Tax Interest and Principal Payments Will they be able to repay the principal on their loan?

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 – LO9

Appendix Accounting Tools: Other Liabilities

Deferred Tax  Used to reconcile the differences between the accounting for book purposes and for tax purposes  Should reflect temporary differences but not permanent differences LO9 Permanent difference – affects the tax records but not the accounting records, or vice versa Temporary difference – affects both book and tax records but not in same period

Deferred Income Taxes Sales Depreciation Expense (2008) Taxable Income × Tax Rate Tax Payable to IRS Book Tax$6,000 2,500 4,000 3,500 2,000 40% 40% $1,400$ 800 $ 600 Difference recorded as deferred tax

Deferred Income Taxes Income tax Book Tax $1,400$ 800 To record income tax for the year: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues – Expenses Equity Taxes Payable 800 Tax Expense 1,400 Deferred Taxes 600 $ 600

End of Chapter 10