1. Chapter 15 Long-Term Liabilities
Prepared by:
Debbie Musil
Kwantlen Polytechnic University

2. Long-Term Liabilities
Bonds payable
Bond basics
Accounting for bond issues and retirements
Notes payable
Fixed principal payments
Blended payments
Lease liabilities
Finance and operating leases
Statement presentation and analysis

3. Long-Term Liabilities
Debt that is not current is a long-term liability:
Current if settled within one year or normal operating cycle of company
Common types:
Bonds payable
Notes payable
Finance leases
Referred to as financial liabilities

4. Advantages of Debt over Equity
Shareholder control is not affected
Debt holders have no voting rights
Income tax savings
Interest expense deductible; dividends are not
Earnings per share may be higher
No common shares are issued
Return on equity may be higher
Lower net income and shareholders’ equity

5. Bond Basics Board of directors approve issuing bonds
Face value: principal amount due at maturity
Contractual interest rate (coupon rate): rate used to calculate amount of interest on bond
Usually an annual rate but paid semi-annually
Maturity date: date when final payment is due
Details are included in the bond certificate
Once issued, bonds are traded on organized securities exchanges
Usually issued in small denominations ($1,000)

6. Determining the Market Value of Bonds
Market value (present value) depends on three factors:
Dollar amounts to be received
Length of time (n) until the amounts are received
Market (effective) rate of interest (i), which investors demand for loaning funds to the corporation
Present value tables or formulas are used to determine present value

7. Determining the Market Value of Bonds 2
Market value of a bond = the present value of all future cash payments promised by the bond:
Periodic interest payments
Repayment of principal when bond matures
Market rates change daily and can therefore differ from contractual interest rate

8. Determining the Market Value of Bonds 3
Bonds may be issued at face value, a discount (< face value), or a premium (> face value)
Due to contractual rate being higher or lower than market interest rate:
Discount
Premium
Face Value 6% 4% 5%
Bond Contractual Interest Rate 5%
Issued when
Market Interest Rate
Bonds Sell at

9. Types of Bonds Secured versus unsecured (debentures)
Specific assets are pledged as collateral versus no specific collateral
Term versus serial
Mature on a single date versus in instalments
Registered versus bearer (or coupon)
Issued with the name of the borrower versus not registered
Convertible
Can be converted into shares by bondholder
Redeemable versus retractable
Redeemed by issuer versus redeemed by bondholder

10. Issuing Bonds at Face Value
If market interest rate = contractual rate, bonds are issued at face value:
Semi-annual interest payments ($1,000,000 x 5% x 6/12 = $25,000) are recorded as follows
Bonds payable are reported as a long-term liability if maturity date is more than one year away

11. Issuing Bonds at a Discount
If market interest rate > contractual rate, bonds are issued at a discount
Selling price is determined as follows:
Difference between selling price and face value of bonds is the amount of the discount
= $1,000,000 face value - $957,345 selling price = $42,655 discount

12. Issuing Bonds at a Discount 2
Entry to record bonds issued at a discount:
Discount is an additional cost of borrowing
Deducted from face value of bonds payable on balance sheet
Allocated to interest expense (amortized) over the life of the bonds

13. Issuing Bonds at a Premium
If market interest rate < contractual rate, bonds are issued at a premium
Selling price is determined as follows:
Difference between selling price and face value of bonds is the amount of the premium
= $1,044,915 selling price - $1,000,000 face value = $44,915 premium

14. Issuing Bonds at a Premium 2
Entry to record bonds issued at a premium:
Premium reduces the cost of borrowing
Added to face value of bonds payable reported on balance sheet
Allocated to interest expense (amortized) over the term of the bonds

15. Bond Retirements: Redeeming Bonds at Maturity
Amortized cost of bonds at maturity will equal their face value
Regardless of the issue price of bonds
Entry to record redemption of bonds at maturity:
After last interest payment has been recorded

16. Bond Retirements: Redeeming Bonds before Maturity
To record redemption of bonds:
Update any unrecorded interest
If redeemed between semi-annual interest payment dates
Eliminate amortized cost of bonds at redemption date
= face value of bonds - (+) unamortized discount (premium)
Record cash paid
Recognize gain or loss on redemption
Gain (loss) if cash paid < (>) amortized cost of bonds

17. Long-term Notes Payable
Similar to short-term notes payable except term exceeds one year
Interest rate can be fixed or variable (floating) over the term of the note
May be unsecured or secured by specific assets (collateral)
Secured notes are commonly known as mortgages
Repayable in a series of periodic payments, which consist of interest and principal, either:
Fixed principal payments plus interest, or
Blended principal and interest payments

18. Notes Payable: Fixed Principal Payments
Periodic payments vary due to change in interest owed:
Principal is repaid in equal periodic amounts
Interest is calculated on the outstanding principal balance

19. Notes Payable: Blended Payments
Equal periodic payments that include principal and interest:
Amount of interest and principal changes with each payment
Interest decreases and principal increases each period

20. Lease Liabilities Lease: contractual arrangement between two parties:
Lessor: owner of the asset
Lessee: allowed to use the asset in return for a series of periodic payments
Advantages of leasing:
Reduced risk of obsolescence
100-percent financing
Income tax advantages
Two types of leases: finance and operating

21. Lease Liabilities: Finance Leases
Benefits and risks of ownership are transferred from lessor to lessee
Any one of the following conditions must be met:
Ownership of property is transferred to lessee
Lease contains a bargain purchase option
Lease term covers major part of life of property
Present value of lease payments amount to substantially all of fair value of property
Specialized for use only by lessee
Leased asset is recorded as an asset; lease obligation is recorded as a liability

22. Lease Liabilities: Operating Leases
Benefits and risks of ownership are not transferred to lessee
Leases can be structured to avoid meeting criteria for a finance lease
Known as off-balance sheet financing
Detailed disclosure in notes to financial statements is required

23. Statement Presentation
Long-term liabilities are reported in a separate section of the balance sheet, immediately after current liabilities

24. Analysis: Debt to Total Assets
Measures the percentage of total assets financed by creditors (not shareholders)
Higher the percentage, greater the risk of company defaulting on its obligations
Debt to Total Assets ÷ =
Total Liabilities
Total Assets
$356,281
$689,460
52%

25. Analysis: Interest Coverage
Interest coverage ratio indicates company’s ability to meet interest payments as they come due
Uses EBIT: Earnings before interest and tax
= Net income + interest expense + income tax expense ÷ =
EBIT
Interest Expense
Interest Coverage
$29,325 + $5,175 + $14,989
$5,175
9.6 times

26. Appendix 15A: Effective-Interest Amortization
Three steps to calculate amortization:
1. Calculate bond interest paid
2. Calculate interest expense
3. Amortization amount is difference
Bond Interest Paid
Bond Interest Expense ÷ =
Amortization Amount
Face Value of Bonds
Contractual Interest Rate
Carrying Value of Bonds at Beginning of Period
Market Interest Rate x x

27. Amortizing Bond Discount
For the first interest period:
1. Calculate bond interest paid
= $1,000,000 x 5% x 6/12 = $25,000
2. Calculate interest expense
= $957,345 x 6% x 6/12 = $28,720
3. Determine amortization amount
= $25,000 - $28,720 = $3,720
Subsequent periods are calculated in a similar manner
Amortized cost of bond increases for each period based on amortization of discount

28. Amortizing Bond Premium
For the first interest period:
1. Calculate bond interest paid
= $1,000,000 x 5% x 6/12 = $25,000
2. Calculate interest expense
= $1,044,915 x 4% x 6/12 = $20,898
3. Determine amortization amount
= $25,000 - $20,898 = $4,102
Subsequent periods are calculated in a similar manner
Carrying value of bond decreases for each period based on amortization of premium

29. Summary of Differences
Interest payment is the same as it is based on face value of bond
Interest expense changes as amortized cost of bond changes
Discount: interest expense increases as amortized cost increases towards face value of bond
Premium: interest expense decreases as amortized cost declines towards face value of bond

30. COPYRIGHT
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