1. Long-Term Liabilities
Chapter 10
Long-Term Liabilities

2. Learning Objectives
LO1 Identify the components of the Long-Term Liability category of the balance sheet. LO2 Define the important characteristics of bonds payable. LO3 Determine the issue price of a bond using compound interest techniques. LO4 Show that you understand the effect on the balance sheet of the issuance of bonds. LO5 Find the amortization of premium or discount using the effective interest method. LO6 Find the gain or loss on retirement of bonds.

3. Learning Objectives (continued)
LO7 Determine whether a lease agreement must be reported as a liability on the balance sheet.
LO8 Explain how investors use ratios to evaluate long term liabilities.
LO9 Explain the effects that transactions involving long term liabilities have on the statement of cash flows.
LO10 Explain deferred taxes and calculate the deferred tax liability.

4. Module 1 Long-Term Liabilities Including Bonds Payable
Long-term liabilities appear on the balance sheet
Companies account for the issuance of bonds payable using compound interest techniques
Module 1

5. Long-Term Liabilities
Long-term liability: obligation that will not be satisfied within one year or the current operating cycle
Components:
Bonds or notes payable
Leases
Deferred taxes
Module 1: LO 1

6. Exhibit 10-1—PepsiCo’s Balance Sheet
Module 1: LO 1

7. Bonds Payable
A bond is a security or financial instrument that allows firms to borrow large sums of money and repay the loan over a long period of time
Module 1: LO 2

8. Bonds Payable (continued)
Bonds are sold (issued) to investors who want a return on their investment
The borrower (issuing firm) promises to:
pay interest on specified dates
repay the principal on a specified date (due date or maturity date)
Module 1: LO 2

9. Bonds Payable: Characteristics
Face value or par value: the principal amount of the bond as stated on the bond certificate
Features that appear in the bond certificate are:
Collateral
represents assets that back the bonds in case the issuer must default on the loan
Due Date
date that the bond principal must be repaid
Other Features
Convertible bonds
Callable bonds
Module 1: LO 2

10. Bonds Payable: Characteristics (continued)
Debenture bonds: are not backed by specific collateral
Serial bonds: a portion of the bonds comes due each time period
Convertible bonds: can be converted into common stock at a future time
Callable bonds: can be redeemed or retired before their specified due date
Module 1: LO 2

11. Exhibit 10-2—Bond Certificate
Module 1: LO 2

12. Factors Affecting Bond Price
Face rate of interest: also called stated rate, nominal rate, contract rate, coupon rate
The rate of interest on the bond certificate
Market rate of interest: also called effective rate, bond yield
The rate that investors could obtain by investing in other bonds
Bond issue price: the present value of the annuity of interest payments plus the present value of the principal
Module 1: LO 3

13. Example 10-1— Calculating Bond Issuance at a Discount
Suppose that on January 1, 2016, Discount Firm wants to issue bonds with a face value of $10,000 at an 8% rate of interest and with interest paid annually for four years when the bonds come due
Assume that the market rate of interest for other similar bonds is currently 10%
Calculate the amount that will be obtained from the issuance of Discount Firm’s bonds
Module 1: LO 3

14. Example 10-1— Calculating Bond Issuance at a Discount (continued)
Discount’s bond will produce two sets of cash flows for the investor:
An annual interest payment of $800 ($10,000 x 8%) per year for four years
Repayment of the principal of $10,000 at the end of the fourth year
To calculate the issue price, calculate the present value of the two sets of cash flows as follows:
Present Value of Annuity of $1 $800 x $2,536
Present Value of $1 $10, ,830
Issue price $9,366
Module 1: LO 3

15. Exhibit 10-3—Listing of Bonds on the Bond Market
Module 1: LO 3

16. Premium or Discount on Bonds
Premium: excess of the issue price over the face value of the bonds
Premium = Issue Price – Face Value
Discount: excess of the face value of bonds over the issue price
Discount = Face Value – Issue Price
Module 1: LO 4

17. Recording Bond Issuance at Discount
Discount Firm would record both the discount and the issuance of the bonds in the following journal entry:
Module 1: LO 4

18. Recording Bond Issuance at Discount
Long-term liabilities category of the balance sheet:
Long-term liabilities:
Bonds payable $10,000
Discount on bonds payable
$ 9,366
Module 1: LO 4

19. Example 10-2— Calculating Bond Issuance at a Premium
Suppose that on January 1, 2016, Premium Firm wants to issue bonds with a face value of $10,000 at an 8% rate of interest and with interest paid annually for four years when the bonds come due
Assume that the market rate of interest for other similar bonds is currently 6%
Calculate the amount that will be obtained from the issuance of Discount Firm’s bonds
Module 1: LO 4

20. Example 10-2— Calculating Bond Issuance at a Premium
Premium’s bond will produce two sets of cash flows for the investor:
An annual interest payment of $800 ($10,000 x 8%) per year for four years
Repayment of the principal of $10,000 at the end of the fourth year
To calculate the issue price, calculate the present value of the two sets of cash flows as follows:
Present Value of Annuity of $1 $800 x $ 2,772
Present Value of $1 $10, ,921
Issue price $10,693
Module 1: LO 4

21. Example 10-2— Calculating Bond Issuance at a Premium (continued)
The premium is recorded at the time of bond issuance in the following entry:
Module 1: LO 4

22. Example 10-2— Calculating Bond Issuance at a Premium (continued)
Long-term liabilities category of the balance sheet:
Long-term liabilities:
Bonds payable $10,000
Premium on bonds payable
$ 10,693
Module 1: LO 4

23. Premium and Discount
To determine whether a bond will sell at a premium or a discount:
If Market Rate = Face Rate, THEN bonds are issued at face value amount
If Market Rate > Face Rate, THEN bonds are issued at a discount
If Market Rate < Face Rate, THEN bonds are issued at a premium
Module 1: LO 4

24. Premium and Discount (continued)
The relationship between interest rates and bond prices is always inverse:
As interest rates decrease, prices on the bond markets increase
As interest rates increase, prices on the bond markets decrease
Module 1: LO 4

25. Module 2 Bond Amortization and Bond Retirement
A company amortizes the premium or discount on bonds payable and accounts for the retirement of bonds
Module 2

26. Bond Amortization
Process of transferring an amount from the discount or premium account to interest expense each time period
This method results in a constant effective interest rate
Module 2: LO 5

27. Bond Amortization (continued)
Effective interest method of amortization: produces a constant effective interest rate from period to period
Effective Rate = Annual Interest Expense/Carrying Value
Carrying value: the face value of a bond plus the amount of unamortized premium or minus the amount of unamortized discount
Carrying Value = Face Value - Unamortized Discount
Carrying Value = Face Value + Unamortized Premium
Module 2: LO 5

28. Exhibit 10-4—Discount Amortization: Effective Interest Method of Amortization
Module 2: LO 5

29. Example 10-3—Recording Amortization of Discount
Discount Firm would record an entry for amortization for 2016 as follows:
Module 2: LO 5

30. Exhibit 10-5—Premium Amortization: Effective Interest Method of Amortization
Module 2: LO 5

31. Example 10-4—Recording Amortization of a Premium
Premium Firm would record an entry for amortization for 2016 as follows:
Module 2: LO 5

32. Redemption of Bonds Retirement of bonds by repayment of the principal
If redeemed at maturity, no gain or loss occurs
If retired before maturity, a gain or loss occurs
The gain or loss on bond redemption is shown on the income statement
Module 2: LO 6

33. Retired Early at a Gain or a Loss
Gain or loss on redemption: Difference between the carrying value and the redemption price at the time bonds are redeemed
Gain = Carrying Value - Redemption Price
Loss = Redemption Price - Carrying Value
Module 2: LO 6

34. Example 10-5—Recording Amortization of a Premium
Assume that on December 31, 2016, Premium Firm wants to retire its bonds due in 2019
Assume that the bonds were issued at a premium of $692 at the beginning of 2016
Premium Firm has used the effective interest method of amortization and has recorded the interest and amortization entries for the year
This has resulted in a balance of $535 in the Premium on Bonds Payable account as of December 31, 2016
Also, assume that Premium Firm’s bond certificates indicate that the bonds may be retired early at a call price of 102 (meaning 102% of face value)
Thus, the redemption price is 102% of $10,000, or $10,200
Module 2: LO 6

35. Example 10-5—Recording Amortization of a Premium (continued)
Premium Firm’s retirement of bonds would result in a gain which can be calculated using two steps:
The carrying value of Premium Firm’s bonds at that date is calculated as follows:
Carrying Value = Face Value + Unamortized Premium
= $10,000 + $535
= $10,535
Calculate the gain:
Gain = Carrying Value - Redemption Price
= $10,535 - ($10,000 x 1.02)
= $10,535 - $10,200
= $335
Module 2: LO 6

36. Example 10-6—Calculating a Loss on Bond Redemption
Assume that Premium Firm retires bonds at December 31, 2016, however, assume that the call price for the bonds is 107
The calculations can be performed in two steps:
Carrying Value = Face Value + Unamortized Premium
= $10,000 + $535
= $10,535
Calculate the loss:
Loss = Redemption Price - Carrying Value
= ($10,000 x 1.07) - $10,535
= $10,700 - $10,535
= $165
Module 2: LO 6

37. Module 3 Liability for Leases
Financial arrangements such as leases as a means of financing a company are important
Module 3

38. Leases Contractual arrangement between two parties
Allows the lessee the right to use an asset in exchange for making payments to its owner, the lessor
Module 3: LO 7

39. Lease Criteria Operating lease: off-balance-sheet financing
The lessee acquires the right to use an asset for a limited period of time
The lessee is not required to record the right to use the property as an asset
Or record the obligation for payments as a liability
Capital lease
Recorded as an asset by the lessee
The lessee has the right of ownership and control
Module 3: LO 7

40. Criteria for Lease Capitalization
One or more of the following criteria must be met:
Transfer of ownership of property to the lessee at the end of the lease term
Contains a bargain-purchase option to purchase the asset for lower than its fair market value
The lease term is 75% or more of property’s economic life
The present value of payments is 90% or more of property’s fair market value at the inception of the lease
Module 3: LO 7

41. Exhibit 10-6—Target’s Note Disclosure of Leases, February 1, 2014
Although operating leases are not recorded on the balance sheet, FASB requires note disclosure
Module 3: LO 7

42. Example 10-7—Recording an Operating Lease
Suppose that Lessee Firm wants to lease a car for a new salesperson
A lease agreement is signed with Lessor Dealer on January 1, 2016, to lease a car for the year for $4,000, payable on December 31, 2016
Typically, a car lease does not transfer title at the end of the term, does not include a bargain-purchase price, and does not last for more than 75% of the car’s life
In addition, the present value of the lease payments is not 90% of the car’s value
Because the lease does not meet any of the specified criteria, it should be presented as an operating lease
Lessee Firm would simply record lease expense (or rent expense) of $4,000 for the year
Module 3: LO 7

43. Example 10-8—Lease Amortization: Effective Interest Method of Amortization
Assume that on January 1, 2016, Lessee signs a lease agreement with Lessor Dealer and the terms of the agreement specify that Lessee will make annual lease payments of $4,000 per year for five years, payable each December 31
Also, assume that the lease specifies that at the end of the lease agreement, the title to the car is transferred to Lessee Firm
The lease should be treated as a capital lease by Lessee because it meets at least one of the four criteria
A capital lease must be recorded at its present value by Lessee as an asset and as an obligation
Assume an interest rate of 8%
As of January 1, 2016, the present value of the annual payments is $15,972 ($4,000 x an annuity factor of )
Module 3: LO 7

44. Example 10-8—Lease Amortization: Effective Interest Method of Amortization (continued)
The first entry is made on the basis of the present value as follows:
Module 3: LO 7

45. Example 10-8—Lease Amortization: Effective Interest Method of Amortization (continued)
On December 31, 2016, Lessee records depreciation of $3,194 ($15,972/5 years), assuming that the straight-line method is adopted:
Module 3: LO 7

46. Exhibit 10-7—Lease Amortization: Effective Interest Method of Amortization
Module 3: LO 7

47. Example 10-8—Lease Amortization: Effective Interest Method of Amortization (continued)
The $4,000 payment in 2016 is interest of $1,278 (8% of $15,972) and reduction of principal of $2,722
On December 31, 2016, Lessee Firm records the following entry for the annual payment:
Module 3: LO 7

48. IFRS and Leasing U.S. accounting standards: rule based
If lease meets any of the criteria—capital lease
Does not meet any criteria—operating lease
IFRS: criteria are used as ‘‘guidelines’’ rather than rigid rules
More flexibility in applying the lease standards
Module 3: LO 7

49. Module 4 Analysis of Long-Term Liabilities and Cash Flow Issues
Financial arrangements such as leases are a means of financing a company and long-term liabilities affect a company’s cash flows
Module 4

50. Debt-to-Equity Ratio
Measures the proportion of a company’s debt to its equity
Debt-to-Equity Ratio = Total Liabilities
Total Stockholders’ Equity
Module 4: LO 8

51. Times Interest Earned Ratio
Measures a company’s ability to meet interest obligations as they come due
Times Interest Earned Ratio = Income Before Interest and Tax
Interest Expense
Module 4: LO 8

52. The Ratio Analysis Model
What is the amount of debt in relation to the total equity of a company? Will the company be able to meet its obligations?
Gather the information about total debt and total equity, income before interest and tax, and interest expense
Calculate debt-to-equity ratio and times interest earned ratio
Compare the ratio with prior years and with competitors
Interpret the results
Module 4: LO 8

53. Calculate the Ratio Analysis
Module 4: LO 8

54. Calculate the Ratio Analysis (continued)
Module 4: LO 8

55. The Business Decision Model
If you were a lender, would you be willing to lend money to a company?
Gather information from the financial statements and other sources
Compare the company's ratios with industry averages and look at trends
Lend money or find an alternative use for the money
Monitor your investment periodically
Module 4: LO 8

56. Exhibit 10-8—Long-Term Liabilities on the Statement of Cash Flows
Module 4: LO 9

57. Exhibit 10-9—The Coca-Cola Company and Subsidiaries’ 2014 Consolidated Statements of Cash Flows
Module 4: LO 9

58. Module 5 Deferred Tax
Deferred Tax Account: reflected in the Operating Activities category
Module 5

59. Other Liabilities—Deferred Tax
Reconciles the differences between the accounting done for financial reporting purposes and tax purposes
Reconcile the difference between the income tax expense and income tax payable
Permanent difference: affects the tax records and not the accounting records, or vice versa
Temporary difference: affects both book and tax records but not in the same time period
Module 5: LO 10

60. Example 10-9—Calculation and Reporting Deferred Tax
Assume that Startup Firm begins business on January 1, 2016
During 2016, the firm has sales of $6,000 and has no expenses other than depreciation and income tax at the rate of 40%
Startup has depreciation on only one asset which was purchased on January 1, 2016, for $10,000 and has a four-year life
Startup has decided to use the straight-line depreciation method for financial reporting purposes
Startup’s accountants have chosen to use MACRS for tax purposes, however, resulting in $4,000 depreciation in 2016 and a decline of $1,000 per year thereafter
Module 5: LO 10

61. Example 10-9—Calculation and Reporting Deferred Tax (continued)
The depreciation amounts for each of the four years for Startup’s asset are as follows:
Module 5: LO 10

62. Example 10-9—Calculation and Reporting Deferred Tax (continued)
Startup’s tax calculation for 2016 is based on the accelerated depreciation of $4,000, as follows:
Sales $ 6,000
Depreciation expense 4,000
Taxable income $ 2,000
Tax rate x 40%
Tax payable to IRS $
Module 5: LO 10

63. Example 10-9—Calculation and Reporting Deferred Tax (continued)
Startup’s income statement for 2016 appears as follows:
Sales $6,000
Depreciation expense 2,500
Income before tax $3,500
Tax expense (40%) 1,400
Net income $2,100
Module 5: LO 10

64. Example 10-9—Calculation and Reporting Deferred Tax (continued)
Startup must make the following accounting entry to record the amount of tax expense and tax payable for 2016:
Module 5: LO 10

65. Review
LO1 Identify the components of the Long-Term Liability category of the balance sheet.
Generally, long-term liabilities are obligations of a company that will not be satisfied within one year. On the balance sheet, they are listed after current liabilities.
LO2 Define the important characteristics of bonds payable.
Important characteristics of bonds payable include par value, due date, interest rate, an indication of whether the bonds are convertible or callable, and any property collateralizing the bonds.
LO3 Determine the issue price of a bond using compound interest techniques.
Bonds are issued at a price that reflects the market rate of interest on the day the bond is purchased. The actual issue price of a bond represents the present value of all future cash flows related to the bond.

66. Review
LO4 Show that you understand the effect on the balance sheet of the issuance of bonds.
Bonds are recorded on the balance sheet at an amount that takes into account the premium or discount associated with bonds on the date they are issued.
LO5 Find the amortization of premium or discount using the effective interest method.
The premium or discount on bonds must be amortized over the life of the bond to accurately reflect the interest expense.
The effective interest method amortizes discounts or premiums in a way that produces a constant interest rate from one period to the next.

67. Review LO6 Find the gain or loss on retirement of bonds.
Bonds are retired for various reasons, and if they are retired before their due date, the amount is different from the face value. Unamortized bond premiums or discounts may result in a gain or loss.
When the redemption price is less than the carrying value, a gain results. When the redemption price is greater than the carrying value, a loss results.
LO7 Determine whether a lease agreement must be reported as a liability on the balance sheet.
Leases can be classified as two types: operating leases and capital leases. Capital leases imply more rights of ownership. The accounting for these two types of leases is as follows:
Under an operating lease, the lessee does not record the right to use the leased asset or any related obligation to make lease payments on the balance sheet.
Under a capital lease, the lessee records the right to use the property and the lease payments that are obligated to be paid on the balance sheet.

68. Review
LO8 Explain how investors use ratios to evaluate long term liabilities.
Investors use the debt-to-equity ratio and the times interest earned ratio as measures of a company’s abilities to meet its long-term obligations.
LO9 Explain the effects that transactions involving long term liabilities have on the statement of cash flows.
Cash flows related to long-term liabilities are generally related to a firm’s financing activities.

69. Review
LO10 Explain deferred taxes and calculate the deferred tax liability.
Differences arise between the tax treatment of revenue and expense items for financial accounting (book) and tax accounting methods. Deferred taxes are those amounts that reconcile these differences.
Permanent differences occur when an item is included for tax purposes but not book, or vice versa.
Temporary differences occur when there are differences between the time an item is recognized for tax purposes and the time it is recognized for book purposes.

70. End of Chapter 10