Chapter 10 – Long-Term Liabilities

Balance Sheet Presentation of Long-Term Liabilities

• The balance sheet generally presents two categories of liabilities: current and long term.
• Long-term liability: an obligation that will not be satisfied within one year or the current operating
cycle.
• On the balance sheet, long-term liabilities are written after the current liabilities.
• Examples of long-term liabilities: bonds/notes, leases, deferred taxes & long-term debt.

Bonds Payable: Characteristics

• A bond is a security or financial instrument that allows firms to borrow money and repay the loan
over a long period of time.
• The bonds are sold, or issued, to investors who have amounts to invest and want a return on their
investment.
• The borrower (issuing firm) promises to pay interest on specified dates, usually annually or
semiannually.
• The borrower also promises to repay the principal on a specified date, the due date or maturity
date.
• A bond certificate is issued at the time of purchase and indicates the terms of the bond.
• Face value: the principal amount of the bond as stated on the bond certificate (also: Par value).
• After bonds are issued, they may be traded on a bond exchange in the same way that stocks are
sold on the stock exchanges.
• Bonds are not always held until maturity by the initial investor but may change hands several times
before their eventual due date.
• Investors in bonds may want to sell them if interest rates paid by competing investments become
more attractive or if the issuer becomes less creditworthy. Buyers of these bonds may be betting
that interest rates will reverse course or that the company will get back on its feet.
• Trading in the secondary market does not affect the financial statements of the issuing company
• All bonds do not have the same terms and features.

Some Important Features in Bond Certificate

1. Collateral
• The bond certificate should indicate the collateral of the loan.
• Collateral represents the assets that back the bonds in case the issuer cannot make the interest
and principal payments and must default on the loan.
• Debenture bonds: bonds that are not backed by specific collateral (investor must examine the
general creditworthiness of the issuer).

2. Due Date
• The bond certificate specifies the date that the bond principal must be repaid.
• Normally, bonds are term bonds, meaning that the entire principal amount is due on a single date.
• Serial bonds: bonds that do not all have the same due date; a portion of the bonds comes due
each time period.
• Issuing fi rms may prefer serial bonds because a fi rm does not need to accumulate the entire
amount for principal repayment at one time.
3. Other Features
• Some bonds are issued as convertible or callable bonds.
• Convertible bonds can be converted into common stock at a future time if the issuing firm is
growing and profitable.
• The conversion feature is also advantageous to the issuing firm because convertible bonds
normally carry a lower rate of interest.
• Callable bonds: bonds that may be redeemed or retired before their specified due date (refers to
the issuer’s right to retire the bonds).
• If the buyer or investor has the right to retire the bonds, they are referred to as redeemable bonds.
• Callable bonds stipulate the price to be paid at redemption; this price is referred to as the
redemption price or the reacquisition price.

Issuance of Bonds
Factors Affecting Bond Price
• With bonds payable, two interest rates are always involved: the face rate and the market rate.
• Face rate of interest: the rate of interest on the bond certificate (also: stated rate, nominal rate,
contract rate, coupon rate). It is the amount of interest that will be paid each interest period.
• Market rate of interest: the rate that investors could obtain by investing in other bonds that are
similar to the issuing firm’s bonds (also: effective rate, bond yield).
• The issuing firm does not set the market rate of interest. That rate is determined by the bond
market on the basis of many transactions for similar bonds.
• Both the face rate and the market rate of interest must be known to calculate the issue price of a
bond.
• Bond issue price: the present value of the annuity of interest payments plus the present value of
the principal.
• Bonds produce two types of cash flows for the investor: interest receipts & repayment of principal
(face value).
• The interest receipts constitute an annuity of payments each interest period over the life of the
bonds.
• The repayment of principal (face value) is a one-time receipt that occurs at the end of the term of
the bonds.
• The issue price of a bond is always calculated using the market rate of interest. The face rate of
interest determines the amount of the interest payments, but the market rate determines the
present value of the payments and the present value of the principal (and therefore the issue
price).

Premium or Discount on Bonds

• Premium: the excess of the issue price over the face value of the bonds.
Premium = Issue Price – Face Value
• Discount: the excess of the face value of bonds over the issue price.
Discount = Face Value – Issue Price
• The Discount on Bonds Payable account is shown as a contra liability on the balance sheet in
conjunction with the Bonds Payable account and is a deduction from that account.
• The Premium on Bonds Payable account is shown as a contra liability on the balance sheet in
conjunction with the Bonds Payable account and is an addition to that account.
• If Discount Firm prepared a balance sheet immediately after the bond issuance, the following
would appear in the Long-Term Liabilities category of the balance sheet:
Long-term liabilities:
Bonds payable $10,000
Less: Discount on bonds payable 634
$ 9,366
• If Premium Firm presented a balance sheet immediately after the bond issuance, the Long-Term
Liabilities category of the balance sheet would appear as follows:
Long-term liabilities:
Bonds payable $10,000
Plus: Premium on bonds payable 692
$10,692
• When interest rates increase, present values decrease.
• 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.

Bond Amortization
Purpose of Amortization
• Amortization refers to the process of transferring an amount from the discount or premium
account to interest expense each time period to adjust interest expense.
• Interest expense is made up of two components: cash interest and amortization.
Effective Interest Method: Impact on Expense
• Effective interest method of amortization: the process of transferring a portion of the premium or
discount to interest expense; this method results in a constant effective interest rate (also: interest
method).
• Carrying value: the face value of a bond plus the amount of unamortized premium or minus the
amount of unamortized discount (also: book value).
Carrying Value = Face Value – Unamortized Discount
Carrying Value = Face Value + Unamortized Premium
Effective Rate = Annual Interest Expense/Carrying Value

Effective Interest Method

Cash Interest = Bond Face Value x Face Rate
Interest Expense = Carrying Value x Effective Rate
Discount Amortized = Interest Expense – Cash Interest
Premium Amortized = Cash Interest – Interest Expense
• The amount of interest expense changes each year because the carrying value changes as discount
is amortized.
• When bonds are issued at a discount, the carrying value starts at an amount less than face value
and increases each period until it reaches the face value amount.
• The carrying value at the end of each year is the carrying value at the beginning of the period
minus the premium amortized for that year.
Redemption of Bonds
Redemption at Maturity
• The term redemption refers to retirement of bonds by repayment of the principal.
• If the Firm retires its bonds on the due date, it must repay the principal and Cash is reduced by the
principal amount.

Retired Early at a Gain

• Early retirement of callable bonds is always a possibility that must be anticipated.
• Bond terms generally specify that if bonds are retired before their due date, they are not retired
at the face value amount, but at a call price or redemption price indicated on the bond certificate.
• Gain or loss on redemption: the 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
• The issuing firm must calculate the carrying value of the bonds at the time of redemption and
compare it with the total redemption price.
• If the carrying value > redemption price, the issuing firm must record a gain.
• If the carrying value < redemption price, the issuing firm must record a loss.

Financial Statement Presentation of Gain or Loss

• The accounts Gain on Bond Redemption and Loss on Bond Redemption are income statement
accounts.
• A gain on bond redemption increases Premium Firm’s income; a loss decreases its income.

Liability for Leases

• Long-term bonds and notes payable are important sources of financing for many large
corporations and are quite prominent in the Long-Term Liability category of the balance sheet for
many firms.
• Other liabilities include leases and deferred taxes.

Leases
• A lease, a contractual arrangement between two parties, allows one party, the lessee, the right to
use an asset in exchange for making payments to its owner, the lessor.
• Lease agreements are a form of financing.
• Lease arrangements are popular because of their flexibility.
• The answers are that some leases should be reported as an asset and a liability by the lessee and
some should not, depending on an established set of criteria.
• From the viewpoint of the lessee, there are two types of lease agreements: operating and capital.
• Operating lease: a lease that does not meet any of the four criteria and is not recorded as an asset
by the lessee (off-balance sheet financing). The lessee acquires the right to use an asset for a
limited period of time.
• Although operating leases are not recorded on the balance sheet by the lessee, they are
mentioned in financial statement notes (required by FASB).
• Capital lease: a lease that is recorded as an asset by the lessee. The lessee has acquired sufficient
rights of ownership and control of the property to be considered its owner.
• Capital leases are presented as assets and liabilities on the balance sheet.
• A lease should be considered a capital lease by the lessee when one or more of the following
criteria are met:
1. The lease transfers ownership of the property to the lessee at the end of the lease term.
2. The lease contains a bargain-purchase option to purchase the asset at an amount lower than its
fair market value.
3. The lease term is 75% or more of the property’s economic life.
4. The present value of the minimum lease payments is 90% or more of the fair market value of
the property at the inception of the lease.

• The Leased Asset account is a long-term asset similar to plant and equipment and represents the
fact that Lessee has acquired the right to use and retain the asset.
• Because the leased asset represents depreciable property, depreciation must be reported for each
of the years of asset use.
• Some firms refer to depreciation of leased assets as amortization.

• For a capital lease, Lessee Firm must record both an asset and a liability.
• The asset is reduced by the process of depreciation.
• The liability is reduced by reductions of principal using the effective interest method.
• The depreciated asset does not equal the present value of the lease obligation.
• Lessee Firm reports the following balances related to the lease obligation:
Assets:
Leased assets $15,972
Less: Accumulated depreciation 3,194
$12,778
Current liabilities:
Lease obligation $ 2,940
Long-term liabilities:
Lease obligation $10,310
IFRS and Leasing
• There is much more flexibility in applying the lease standards when using the international
standards, as compared to U.S. standards that are very rigid.
• While many consider this to be a positive aspect of international accounting, it also requires more
judgment by accountants in applying those standards.
• U.S. standards are often “rule-based” and international standards are “principles-based.”

Analyzing Debt to Assess a Firm’s Ability to Pay its Liabilities

• Long-term liabilities are a component of the “capital structure” of the company and are included
in the calculation of the debt-to-equity ratio:
Total Liabilities
Debt-to-Equity Ratio =
Total Stockholders’ Equity
• Most investors would prefer to see equity rather than debt on the balance sheet.
• Other ratios used to measure the degree of debt obligation include the times interest earned ratio
and the debt service coverage ratio:
Income Before Interest and Tax
Times Interest Earned Ratio =
Interest Expense
Cash Flow from Operations Before Interest and Tax
Debt Service Coverage Ratio =
Interest and Principal Payments
• Lenders want to be sure that borrowers can pay the interest and repay the principal on a loan.
Both of the preceding ratios reflect the degree to which a company can make its debt payment
out of current cash flow.
Deferred Tax
• Deferred tax: the account used to reconcile the difference between the amount recorded as
income tax expense and the amount that is payable as income tax.
• When differences between financial and tax reporting do occur, the differences can be classified
into two types: permanent and temporary.
• Permanent difference: a difference that affects the tax records but not the accounting records, or
vice versa.
• Temporary difference: a difference that affects both book and tax records but not in the same
time period (also: timing difference).
• A difference caused by depreciation methods is the most common type of temporary difference.
• The Deferred Tax account is used to reconcile the differences between the accounting for book
purposes and for tax purposes.
• The Deferred Tax account should reflect temporary differences but not items that are permanent
differences between book accounting and tax reporting.
• When you see a firm’s income statement, the amount listed as tax expense does not represent
the amount of cash paid to the government for taxes.
• When you see a firm’s balance sheet, the amount in the Deferred Tax account reflects all of the
temporary differences between the accounting methods chosen for tax and book purposes.

How Long-Term Liabilities Affect the Statement of Cash Flows

• The decrease in a long-term liability account indicates that cash has been used to pay the liability.
Therefore, in the statement of cash flows, a decrease in a long-term liability account should appear
as a subtraction, or reduction.
• The increase in a long-term liability account indicates that the fi rm has obtained additional cash
via a long-term obligation. Therefore, an increase in a long-term liability account should appear in
the statement of cash flows as an addition.
• Although most long-term liabilities are reflected in the Financing Activities category of the
statement of cash flows, there are exceptions, such as the Deferred Tax account being reflected
under Operating Activities category of cash flows.