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

2. Agenda
Learning goals
Vocabulary
Lesson

3. Learning goals Compare the impact of issuing debt instead of equity
Account for bonds payable
Account for long-term notes payable
Account for lease
Explain and illustrate the methods for the presentation and analysis of long-term liabilities

4. Vocabulary Effective-interest method of amortization Bearer bonds
Mortgage note payable
Bond
Off-balance sheet financing
Face value
Bond certificate
Financial leverage
Operating lease
Capital lease
Fixed interest rate
Premium
Contractual interest rate
Floating interest rate
Present value
Convertible bonds
Interest coverage ratio
Redeemable bonds
Debenture bonds
Registered bonds
Lessee
Debt to total assets
Retractable bonds
Lessor
Discount (on bonds payable)
Secured bonds
Market interest rate
Serial bonds
EBIT
Maturity date
Term bonds
Unsecured bonds

5. Long-Term Liabilities
Long- term liability:
No likely to be paid within a year
Can not be paid for existing current assets
Long-term liability is also known as financial liability, because there is a contract between two or more parties to pay cash in the future
Long-term debt such as bonds, help to finance large deals like corporate buyout and major projects
As we have learned in ch 13 companies can issue shares that this is known as equity capital or they can issue bonds and that is know as debt capital

6. Long-Term Liabilities
Advantages of debt over equity
Shareholder control is not affected: debt holder do not have voting rights so shareholder can still keep control of the company
Income tax saving results: Interest expense is deductible for income tax purposes, dividends are not
Earnings per share may be higher: because no additional common share issued.
Return on equity may be higher:

8. Why not only issue debt capital?
HIGH RISK
Debt must be repaid
If the corporation fails to repay the debt or pay interest the creditors can force the company into liquidation
With shares the company doesn’t have to pay dividends. If they fail to pay dividends the shareholder cannot force the company into liquidation

9. Long-Term Liabilities
“Using other people’s money to make money”
Financial leverage: borrowing at one rate and investing at a different rate. Rate of borrowing should be lower than rate of investing.

10. Long-Term Liabilities
Bond: represent a promise to repay a principal amount at a specific maturity date
Common types:
Bonds payable
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
All of this information is included in bond certificate
Notes payable
Capital leases

11. Bonds Payable Bonds are traded on the stock exchange just like shares
Bond holders can sell the bond, at market price, at any time and receive cash for it
Issuer
Coupon
Maturity Date
Price
Yield
Bell CDA
6.100
2035-Mar-16
103.20
5.87
Bond prices are usually quoted in demonization of Meaning this price is %*1000 = $1032

12. 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

13. Determining the Market Value of Bonds
January 1, 2008, Candlestick issued $1million of 5% bonds due in five years, with interest payable semi-annually. The purchaser of the bonds would receive two cash inflows: (1) the principal of $1million to be paid at maturity and (2) ten $25,000 interest payment ($1,000,000*5%*6/12)

14. 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
Where n = number of interest periods I = interest rate
Use table 1 on page 786 for PV of principal payment
Use table 2 on page 786 for PV of interest payments

15. 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

16. Types of Bonds Secured versus unsecured (debentures)
Specific assets are pledged as collateral for the bond versus no specific collateral
Term versus serial
Mature on a single date versus in instalments
Registered versus bearer (or coupon)
Registered: Issued with the name of the owner, interest payments on registered bonds are made by cheque or direct deposit to registered bondholders
Bearer: doesn’t have the name of the owner and the holder of the bond must send in coupons to receive interest payments

17. Types of Bonds Convertible Redeemable versus retractable
Can be converted into shares by bondholder
Can receive interest until the bond is converted
Redeemable versus retractable
Redeemable: just like shares can be bought back by the issuer at a stated dollar amount before they mature
Retractable: just like share can be sold back by the buyer to the issuers at a stated dollar amount before they mature

18. 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

19. 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

20. Issuing Bonds at a Discount 2
Entry to record bonds issued at a discount:
Discount on Bonds Payable is a contra liability account
Deducted from face value of bonds payable on balance sheet
An additional cost of borrowing that must be recognized
Allocated to interest expense (amortized 15A) over the term of the bond, using the effective interest method:

21. 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

22. Issuing Bonds at a Premium 2
Entry to record bonds issued at a premium:
Premium on Bonds Payable is added to the face value of bonds payable reported on balance sheet
A reduction in the cost of borrowing that is recognized
Allocated to interest expense (amortized) over the term of the bond, using the effective interest method:

23. Bond Retirements: Redeeming Bonds at Maturity
A bond may be retired:
Maturity
When it is bought back by the issuer
Carrying value 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

24. Bond Retirements: Redeeming Bonds before Maturity
Why would a company want to have the option to retire its bond early?
Interest rate drop, so it can purchase it and reissue a new with lower rate
Company has the financial ability to pay it back
To entice investors to sell the bonds the issue pays a few % above the market price.

25. Bond Retirements: Redeeming Bonds before Maturity
To record redemption of bonds:
Update any unrecorded interest
If redeemed between semi-annual interest payment dates
Eliminate carrying value 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 < (>) carrying value of bonds

26. Bond Retirements: Redeeming Bonds before Maturity
Assume that Candlestick sells its bonds at a premium as described in the last section. It retires its bonds at 103 at the end of the fourth year (8 periods) after paying the semi-annual interest. Assume also that the carrying value of the bonds at the redemption date is $1,009,709. That is, the face value of the bands is $1,000,000 and the unamortized premium is $9,709.

27. Bond Retirements: Redeeming Bonds before Maturity
When you sell assets, you gain when the cash received is greater than the carrying value.
When you retire a liability, you gain when the cash paid is less than the carrying value

28. Check for understanding
On January 1, 2015, R&B Inc, issues $500,000 of 10 year, 4% bonds at Interest is paid semi-annually on January 1 and July 1. On July 1, 2009, the company records the semi-annual interest and amortization(the semi-annual amortization amount for this period is $1,859. On this same date, the company redeems the bond at 99. The carrying value of the bond is $476,214 on this date. Prepare the entry to record (a) the issue of the bonds on January 1, 2005 (b) the payment of interest and amortization of any bond discount or premium on July 1, and (c) the redemption of the bond on July 1, 2009 (p 771)

29. Practice questions Self study questions: 1-5 Questions 2, 3, 7
BE 15-1  6
E 15-15

30. 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

31. Long-term Notes Payable
Each payment on a note payable consists of
Part payment of interest
Part is put towards repaying the principle of the loan
The payment could be either
Fixed principal payments plus interest, or
Blended principal and interest payments

32. 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
January 1, 2008, Belanger Ltee issues a $120,000 5-year, 7% note payable to finance a new research laboratory.

33. Notes Payable: Fixed Principal Payments
The terms of the note provide for equal monthly instalment payments of $2,000 (120,000/60 monthly periods) on the firs of each month, plus interest of 7% on the outstanding principal balance by the interest rate

34. Notes Payable: Fixed Principal Payments

35. 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
To illustrate assume that instead of fixed principal payment, Belanger Ltee repays its $120,000 notes payable in blended payment of $2,376 each month.

36. Notes Payable: Blended Payments

37. Check for understanding
On December 31, 2007, Tian Inc, issued a $500,000 , 15-year 8% mortgage note payable. The terms provide for semi-annual blended payment of $28,915, on June 30 and December 31. (a) Prepare instalment payment schedule for the first two years of the note (b) Prepare the journal entries required to record the issue of the note on December 31, 2007, and the first two instalment payment (c) Show the presentation of the liability on the balance sheet at December 31, 2008 (p 775)

38. Practice questions Self study questions: 6 + 7 Questions 11+12
BE 15-79
E 15-68

39. 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 (asset becomes out of date before it wears out)
100-percent financing: do not need to borrow large sum of money to buy the asset
Income tax advantages: can deduct the whole amount of lease payment which is larger than amortization expense
Two types of leases: operating and capital

40. Lease Liabilities: Operating Leases
Characteristics:
Lessee has temporary use of asset only
Lessor continues to own asset
The lease payment are recorded as an expense by the lessee.
Western Inc. leases a car from Hertz Car Rental at the airport on July 17. Hertz charges a total of $275.

41. Lease Liabilities: Operating Leases
Operating lease that cover a long period of time are sometimes seen as:
Known as off-balance sheet financing (operating lease)
But detailed disclosure in notes to financial statements is required

42. Lease Liabilities: Capital Leases
Benefits and risks of ownership are transferred from lessor to lessee
One of the following conditions must be met:
Ownership of property is transferred to lessee at the end of the term
Lessee has the option to purchase the item during the term
Lease term is ≥ 75% of economic life of leased property
Present value of lease payments ≥ 90% of fair market value of leased property
Leased asset is recorded as an asset; lease obligation is recorded as a liability

43. Lease Liabilities: Capital Leases
Fortune Ltd. Decides to lease new equipment on November 27. The lease period is four years and the economic life of the leased equipment is estimated to five years. The present value of the lease payment is $190,000 and the fair market value of the equipment is $200,000. There is no transfer of ownership during the lease term Condition have been meet for capital lease.

44. Check for understanding
The Alert Company has the following two leasing options to acquire a new machine: (778-9)
Lease Option 1
Lease Option 2
Transfer of ownership No
Bargain purchase option
Lease term
4 years
3 years
Estimated useful life
5 years
Fair market value
$20,000
Present value
$15,000

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

46. 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

47. Analysis: Return on Equity
Also called return on investment
Considered to be the most important measure of a firm’s profitability
It evaluates how many dollars are earned for each dollar invested by shareholders
Average Shareholders’ Equity ÷ =
Net income
Return on Equity

48. 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

49. Practice questions Self-study questions: 8+9 Questions: 16+17
BE 15-1013
E 15-9,10,12