CHAPTER 11

Long-Term Liabilities: Notes, Bonds, and Leases

SYNOPSIS

In this chapter, the author discusses accounting issues surrounding long-term

liabilities. The specific issues discussed are (1) accounting for long-term notes
payable; (2) accounting for bonds payable; (3) the differences between, and
accounting for, operating and capital leases; (4) financial instruments and off-
balance-sheet risks; and (5) the economic consequences faced by managers
whose companies have long-term debt. The author discusses factors affecting
bond prices in Appendix 11A. Investing in bonds is covered in Appendix 11B.
Appendix 11C is about interest rate swaps and hedging.

The ethics vignette considers companies that structure their leasing contracts in
a manner that allows them to avoid reporting their lease obligations as debts on
their balance sheets.

The Internet research exercise examines current financial reports for Macy’s Inc.
It looks at the Bank Credit Agreements and how Macy’s Inc. is managing its debt
covenants.

The following key points are emphasized in Chapter 11:

1. Long-term notes payable, bonds payable, and leasehold obligations, and

how companies use these instruments as important sources of financing.

2. Economic consequences created by borrowing.

3. Different forms of contractual obligations.

4. The effective interest rate and how it is determined for contractual

obligations.

5. The effective interest method.

6. How changes in market interest rates can lead to misstated balance sheet
values for long-term liabilities.

7. Operating leases, capital leases, and off-balance-sheet financing.

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TEXT/LECTURE OUTLINE

Long-term liabilities: notes, bonds, and leases.

I. Long-term liabilities are probable future sacrifices of economic benefits

from present obligations of a particular entity to transfer assets or to
provide services to other entities in the future as a result of past
transactions or events. The obligation will require the disbursement of
assets outside the time frame of current assets.

II. Economic consequences of reporting long-term liabilities.

A. Credit ratings.

B. Debt covenants.

1. Debt covenants can limit a company's operating, investing, and

financing activities.

2. If a company violates a debt covenant, the borrower can require one of

the following:

a) The immediate repayment of the debt.

b) Renegotiation of the debt at terms that are more costly to the

borrower (i.e., higher interest rate or additional collateral).
C. Effects of "merger mania."

III. Basic definitions and different contractual forms.

A. Notes, bonds, and leases are supported by contracts.

1. The timing and magnitude of future cash outflows are specified in the
contracts.

2. Types of contractual forms.

a) Interest-bearing obligations require the following:

(1) Periodic cash payments (interest) calculated as a stated
percentage of the obligation's face value (principal or
maturity value). The stated percentage is given in the debt
contract, and the stated percentage is called the stated
interest rate.

(2) Payment of the face value at the end of the contract period.

b) Non-interest-bearing obligations do not require periodic interest

payments. Instead, they require only the payment of the face
value at the end of the contract period.
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c) Installment obligations require periodic payments throughout the

obligation's life, and the periodic payments include both principal
and interest.
3. The contracts may specify the following:

a) Collateral.

b) Restrictions (i.e., debt covenants).

B. Types of long-term liabilities.

1. Long-term notes payable.

2. Bonds payable.

a) Bonds are issued to raise large amounts of capital (usually from

multiple creditors) to finance long-term projects.

b) Secured bonds versus debentures.

c) Interest is usually paid semiannually on bonds.

3. Leases.

IV. Effective interest rate.

A. The effective interest rate is the interest rate that a company actually incurs
on an obligation.

B. The effective interest rate is the rate that equates the undiscounted future
cash flows of an obligation (e.g., periodic interest payments and the face
value for interest-bearing obligations) with the present value of the
obligation. That is, the effective interest rate is the rate used to discount the
future cash flows of an obligation so that the present value of the future
cash flows equals the fair market value of that which is received in the
exchange.

C. Relation of stated and effective interest rate for notes and bonds.

1. Stated rate equals effective rate. The present value of future cash
flows equals the face value of the debt; the note or bond is issued at
face value.

2. Effective rate exceeds stated rate. The present value of future cash
flows is less than the face value, thereby resulting in a discount; the
note or bond is issued for less than its face value. Discounts represent
future interest expense.
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3. Stated rate exceeds effective rate. The present value of future cash
flows is greater than the face value, thereby resulting in a premium; the
note or bond is issued for more than its face value.

V. Accounting for long-term obligations: the effective interest method.

A. The effective interest method results in a constant percentage of the

carrying value being charged to interest expense over the life of the debt
and is the preferred amortization method.

B. Relationships under the effective interest method.

1. Book value (or carrying value) of the debt equals the debt's face value
plus associated premium balance or it equals the debt's face value less
associated discount balance.

2. Interest expense equals debt's book value at the start of the period
times the effective interest rate.

3. Periodic interest payments equal debt's face value times the stated
interest rate.

4. The amount of the discount amortized equals interest expense less the
interest payment.

5. The amount of the premium amortized equals the interest payment

less interest expense.
C. Journal entries need to be prepared to record interest expense incurred and
discount/premium amortized on every interest payment date and at the end
of the accounting period (i.e., an adjusting journal entry) if an interest
payment date does not fall on the last day of the accounting period.

VI. Accounting for long-term notes and bonds payable.

A. Bond terminology.
1. Life: the time period from the date of issuance to the maturity date.

2. Maturity date: the end of a bond’s life, when the maturity value
(which is usually equal to the principal value, par value, and face
value) is paid to the bondholder

3. Interest payment:: the amount paid to the bondholders on

semiannual payment (coupon) dates

4. Proceeds: the amount collected when the bonds are issued.

5. Covenants: restrictions imposed on management by bondholders.

6. Unsecured bonds: bonds with no assets backing them

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7. Debentures: bonds with no assets backing them

8. Call provision: a right granted to the issuing corporation to

repurchase the outstanding bonds on or after a designated date for
a specified price

B. The price of a bond: See Appendix 11A

C. The effective rate and the stated rate:

If Effective rate is Then price is

Equal to Stated rate Par
More than Stated rate Par less discount
Less than Stated rate Par plus premium t

If Stated rate is Then price is

Equal to Effective rate Par
More than Effective rate Par plus premium
Less than Effective rate Par less discount

D. Accounting for bonds payable – the effective interest method

1. Issued at par

2. Issued at discount.

3. Issued at premium.

E. The effective interest method and changing interest rates.

F. Bond redemptions.

1. At maturity.

2. Before maturity.

a) Call provisions grant the issuing company the right to

repurchase bonds prior to the maturity date.

b) Calling bonds normally gives rise to gains or losses. If the gain

or loss is material, it should be reported on the income
statement as an extraordinary item.

VII. Financial instruments, fair market values, and off-balance-sheet risks.

Disclosure of market values required for certain financial instruments, whether or
not they are recognized in the financial statements.

A. Short-term investments in equity securities (Chapter 8).

B. Notes receivable and investments in debt securities.

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C. For long-term debts, the market value approximates the present value
of future cash outflows associated with the debt, discounted at the
current market rate of interest for similar obligations.

D. Other financial instruments not listed on the balance sheet, such as

guarantees of the credit of third parties, commitments to provide
financing, and derivatives.

VIII. Leases.

A. A contract granting use or occupation of property during a specified period

of time in exchange for rent payments. Leases allow companies to use or
occupy property without many of the associated costs and risks of
ownership.

B. Types of leases.

1. Operating leases.

a) The lessor (i.e., the owner) temporarily transfers the right to use
the property to the lessee for a specified period of time in
exchange for periodic payments. The lessor is normally
responsible for the normal maintenance of the property over the
life of the lease. The right to use the property reverts to the lessor
at the end of the lease.

b) The property is reported as an asset on the lessor's books. The

periodic rental payments are reported on the lessor's books as
Rent Revenue; the periodic rental payments are reported on the
lessee's books as Rent Expense.

2. Capital leases.

a) Leases that, in substance, transfer the rights and risks of

ownership to the lessee.

b) Criteria for a lease to be classified as a capital lease—if a lease

meets one of the following criteria, the property is considered
purchased rather than leased.
(1) The leased property's fair market value approximately equals
the present value of the lease payments.

(2) The term of the lease is 75 percent or more of the leased

property's useful life.

(3) The lessee has the right to purchase the property from the
lessor for less than what the property is actually worth, called
a bargain purchase price.
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(4) Ownership is transferred to the lessee by the end of the

lease term.

c) Accounting for capital leases on the lessee's books.

(1) At the inception of the lease agreement, the lessee records
an asset and a liability equal to the present value of the
future lease payments.

(2) The asset should be depreciated, if appropriate, over its

useful life.

(3) The periodic rental payments serve to reduce the lease

liability and to recognize interest expense. Interest expense
is computed using the effective interest method.

IX. International perspective: The importance of debt financing in other countries

X. ROE exercise: managing long-term debt

XI. Appendix 11A: The determination of bond prices.

A. Risk-free return—the annual return that an individual would earn by

investing in a riskless security such as a treasury note. Factors increasing
the risk-free rate tend to decrease bond prices, while factors decreasing the
risk-free rate tend to increase bond prices.

B. Risk premium—the interest rate over and above the risk-free rate to cover
the issuing company's default risk. Factors increasing a company's
riskiness tend to decrease bond prices, while factors decreasing a
company's riskiness tend to increase bond prices.

XII. Appendix 11B: Investing in bonds.

XIII. Appendix 11C: Interest rate swaps and hedging

XIV. Review problem

XV. Ethics in the real world.

XVI. Internet research exercise.

LECTURE TIPS

1. The concept of effective interest rates is sometimes troublesome, especially in

cases where these rates are imputed for notes (i.e., when no market exists to
establish the effective interest rate). Further, many students do not understand how
the effective and stated interest rates could be different. It should be stressed that
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the stated interest rate is simply a device to structure the future cash flows; it does
not have to approximate the rate that a company should actually be paying.

In addition, discounts or premiums are often viewed as something inherently

positive or negative. An approach that may help address this problem is to offer
students the opportunity to "invest" in several different notes or bonds—all with the
same effective interest rates, the same present values and maturity dates, but with
different face values and stated rates. This should drive home the point that
discounts and premiums arise because of the way the future cash flows are
structured.

Many students find time lines showing the future cash flows and the change in the
debt's carrying value over the life of the debt to be useful in understanding the
relation between discounts/premiums and interest expense.

Figures 11–7 and 11–10, end-of-chapter exercises 11–3 through 11–8, and problem
11–5 are all useful for demonstrating the points involved.

2. Calculating the present value of the future cash flows, particularly for bonds, is
sometimes troublesome. The most common mistake is not adjusting the annual
effective and stated interest rates to semi-annual interest rates. It should be
stressed that present value techniques rely on the compounding period. Since
bonds usually pay interest every six months, the appropriate compounding period is
six months. End-of-chapter exercise 11–2 emphasizes the concept of compounding.

3. End-of-chapter problems 11–13 to 11-15 and issues for discussion 11–3 and 11–7
are useful for considering the financial statement effects of accounting for leases.
The economic differences between capital and operating leases should be
discussed as the basis for accounting for each. The lease agreement's economic
substance should be stressed over its legal form.

OUTSIDE ASSIGNMENT OPPORTUNITIES

Group study of long-term debt and off-balance-sheet risks both across time and within
and across industries (continuing assignment for Chapters 6–14)

1. Using the most recent annual report of a major public company in one of the four
general industry groupings, identify or compute the items listed below for the two
most recent years. Compare the items across time. Relate your findings to the
economic characteristics and current conditions in the industry and the company’s
strategy for competing. Prepare a written summary of your findings. Report findings
in a class discussion session in which comparisons will be made both across time
and within and across industries.
Captions and amounts for components of long-term liabilities:
long-term debt, including capitalized lease obligations,
employee benefits, deferred income taxes, and others
Footnote disclosures for long-term liabilities
Total long-term liabilities as a percentage of total assets
Total long-term liabilities as a percentage of total liabilities
Total long-term liabilities as a percentage of shareholders’ equity
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Nature of and aggregate commitments for operating leases

Disclosures of off-balance-sheet commitments and their associated risks,
such as commitments to extend credit, guarantees of debt, interest
rate agreements, and foreign exchange contracts

Recalculation of ratios based on constructive capitalization of operating leases

2. Obtain the most recent annual report for a company in an industry likely to have
significant operating leases (such as JCPenney) in the retail field. Calculate key
financial ratios, especially those for return on assets and debt/equity. Obtain and
read the Imhoff article (referenced below1) on constructive capitalization of operating
leases. Use the method discussed in the article to constructively capitalize the
selected company’s operating lease commitments. Recalculate key financial
statement ratios. Evaluate the results.

ANSWERS TO IN-TEXT DISCUSSION QUESTIONS

448. Cash increased and long-term debt increased by the amount of proceeds from
new debt issued in excess of repayments during 2010, 2011 and 2012.

448. Profile 1 would be the Bank of New York Mellon. Banks balance sheets consist
mostly of financial assets (loans and investments). Banks have little in the way
of fixed assets relative to total assets. Liabilities of banks are mostly current
rather than long-term, represented by deposit liabilities to customers.

Profile 2 would be 3M. Manufacturing companies such as 3M have extensive

infrastructure, which in turn would support a fair amount of long-term debt in the
capital structure. Also, companies with a large base of fixed assets usually have
associated deferred tax liabilities. Current liabilities would reflect accounts
payable, accruals and taxes, as well as the current portion of long-term liabilities.

Profile 3 would be Google. Internet companies do not have much in the way of
fixed assets, and correspondingly rely primarily on equity financing, rather than
debt, to capitalize the business. Current liabilities would reflect payables and
accruals for goods and services.

449. The downgrade by S&P has no direct impact on the financial statements of Sun
Microsystems. The downgrade may have an effect on Sun’s ability to raise funds
by way of issuing debt in the future. The risks of holding debt in this company
have increased so the risk premium that debt investors require is likely to
increase and Sun’s financing (interest) costs for future debt issuances are likely
to rise. S&P would have reached their conclusions by analyzing Sun’s financial
statements using the ratios discussed in Chapter 5 to assess earning power and
solvency.

The downgrade may have a significant impact on the market value of the bonds.
By lowering Sun’s credit rating, S&P is giving the marketplace an indication that
the risks of holding Sun’s debt instruments have increased. This would cause
the re-sale market value of Sun’s bonds and notes payable to decline.
1
Eugene A. Imhoff Jr., Robert C. Lipe, and David W. Wright, “Operating Leases: Impact of
Constructive Capitalization,” Accounting Horizons, March 1991, pp. 51–63.
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450. Financial instruments are defined as cash, an ownership interest, or a contractual

right to receive or obligation to deliver cash or another financial instrument.
Financial instruments include routine things such as cash, investments,
receivables, and payables, as well as more exotic instruments such as derivative
financial instruments employed to manage currency and interest rate risks. The
terms of financial instruments can have a significant potential impact on the
future operations, cash flows, and financial position of a company, which is not
captured in the dollar amounts in the financial statements. Accordingly,
accounting standards require additional disclosures to help the user evaluate the
associated risks and assess their possible impact on the financial statements.

451. Home Depot's leases require monthly or annual payments, probably in equal
amounts but may have percentage of sales provisions requiring additional
payments to be made. Many leases also require payments for property taxes,
insurance and other executory costs.

Nike's bond is a written legal obligation to pay a certain amount (or amounts) at a
certain time (or times). For most bonds there are periodic interest payments for a
term of years, with a final payment of principal upon maturity.

The Foothill/Eastern Transportation Corridor Agency zero coupon bond is a debt

security issued by an entity to investors in exchange for cash. The entity that
issues a zero coupon bonds and receives the cash normally agrees to make a
single large principal payment whereupon the obligation is terminated.

451. A lease is a contract granting use of property for a specified period of time in
exchange for payment(s).

A note is a written legal obligation to pay a certain amount (or amounts) at a

certain time (or times).

A bond is a debt security issued by an entity to investors in exchange for cash.

The entity that issues the bonds and receives the cash normally agrees to make
cash interest payments to the bondholders until a specific future date called
maturity whereupon a large principal payment is made and the obligation is
terminated.

452. The interest rates disclosed by Hewett Packard appear to be effective rates.
Leases usually don’t have stated rates, only effective rates. It is impossible to tell
from this disclosure if these debts are interest-bearing or not.

454. The interest expense reported during each period is computed by multiplying the
effective interest rate by the balance sheet value of the obligation as of the
beginning of the period. For Sherwin Williams 2008 interest expense would be
2.87 percent of $1.632 million, or $46.84 million.

456. The present value of the future cash payments associated with these debts
would be equal to the $51.7 billion liability net of the $228 million unamortized
discount, or $51,472 million. The discount is the excess of the face value of the
bonds over the price received upon issuance. The discount indicates that the
 Chapter 11

stated interest rate on the bonds was lower than the effective rate at the time the
bonds were issued. The bond discount is amortized over the term of the bonds,
and is reduced annually. The unamortized discount would be equal to the original
discount (determined at the time of issuance) less the cumulative amounts of
amortization recognized annually during prior years. The discount is amortized
using the effective interest method. By using this method of amortization, the net
amount of the liability for the bonds (ie. the bond principal less the unamortized
discount) will always equal the present value of the future cash payments
associated with these debts.

458. CBS would want an option to redeem long-term debt, especially debt such as the
debentures mentioned which are scheduled for repayment over 20 years from
now, to protect itself in the event interest rates and other economic conditions
change. For instance, if interest rates drop, CBS could lower its interest cost by
redeeming the debentures and replacing them with bonds bearing a lower
interest rate.

458. Debentures are unsecured bonds. Bonds are issued at a premium when the
market or effective rate of interest at the time of issuing the bonds is less than the
stated or coupon rate specified in the bond contract.

459. If the effective rate of the Exxon Mobil debentures was 4.9 percent and the
debentures were issued at a premium, it means that the stated rate was higher
than 5 percent. The stated rate in the bond contract specifies the fixed amount of
interest to be paid. If the effective rate is lower, it means the market demands
less of a return than what is being offered in interest payment, and therefore
would price the bond at a higher amount, based on the present value of the
future interest and principal payments using the effective or market rate.

463. Proceeds received on January 1 from the bonds were as follows:

PV of semi-annual interest (PV of annuity: n=20, i=2.75%)

plus
PV of face value (PV lump sum: n=20, i=2.75%)

(.0525 x $50,000,000)/2 x 15.24596

plus
$50,000,000 x .58350

(present value factors for fractional percentages were interpolated from the
tables in Appendix B and are inexact)

$20,010,323
plus
$29,175,000

$49,185,323

Interest for the first year, would be as follows:

First six months:

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Original proceeds of $49,185,323

x [effective rate of interest (5.5%)/2] = $1,352,596

Second six months:

Present value at the end of the first six months

x [effective rate of interest (5.5%)/2]

($49,185,323 + 1,352,596 – 1,312,500)

x .02.75 $1,353,699

TOTAL INTEREST EXPENSE FOR YEAR 1 $2,706,295

463. Washington Post Company’s long term debt has a higher fair value because the
fixed interest payments due on their debt exceeded the market interest rates.

464. Johnson and Johnson's long term debt has a higher fair value because the fixed
interest payments due on their debt exceeded the market interest rates. An
investor is interesting in both the book value and fair value of long-term debt so
they can understand the market holdings of J&J of long-term debt. In this case,
the higher value indicates that a better than market interest payment is being
received and the company could sell for more than the book value if they would
choose to do so.

465. When interest rates go down, bond prices go up. This is because the fixed
interest payments promised in the bond contracts become more valuable when
market interest rates decline. Companies with outstanding long-term debt would
hope to repay debt with higher interest rates before maturity and get new debt
with lower interest rates and interest payments going forward.

466. Operating leases are treated as pure leasing or rental arrangements. The
property would be on the books of the lessor. JCPenney, as lessee, would not
recognize any asset or liability on its books, but simply record rent expense on
the income statement as the rent is paid or accrued.

468. Assets under capital leases of $335 million would be shown as an asset on the
balance sheet, and the capital lease obligation of $330 million would be shown
on the balance sheet as a liability. The asset value represents the present value
of the total of the future lease payments as of the inception of the lease, less
accumulated depreciation recognized through year-end fiscal 2012. The liability
represents the present value of the remaining payments under the lease as of
fiscal year-end 2012, computed using the effective interest rate determined as of
the inception of the lease.

470. Wal-Mart appears to be practicing off-balance-sheet financing more aggressively

than SUPERVALUE. Although both companies have higher minimum lease
payments under their operating leases than they do for their capital leases, the
proportion of total minimum lease payments under operating leases is higher for
Wal-Mart than for SUPERVALUE. Capital leases are reported on the balance
sheet as both a property right and a liability. Operating leases do not appear as
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liabilities on the balance sheet. Therefore operating leases are considered a

means of off-balance-sheet financing. To make the financial ratios of the two
companies more comparable, an analyst could make adjustments to the balance
sheets of the two companies to assume that all the leases were capitalized and
then use the adjusted balance sheets in the calculation of the relevant financial
ratios.

470. High debt levels can have an adverse effect the liquidity, cash flow, and earning
power of a company. Interest expense is a drain on operating income and cash
flow. It also has a negative effect on liquidity. The debt to equity ratio would
improve if Prada was successful in implementing the plan to reduce debt levels
and increase equity. Cash flows and operating profits would improve because of
the reduction in interest costs.

CHARACTERISTICS OF END-OF-CHAPTER ASSIGNMENTS

Item Difficulty Description

Brief exercises:
BE11–1 E Inferring debt transactions
BE11–2 E Zero Coupon Bond issuance
BE11–3 M Operating and capital leases

Exercises:
E11–1 M Disclosing debt and debt covenants
E11–2 M Annual or semi-annual interest payments?
E11–3 E Stated Rate vs. Effective Rate, and issuance price of a liability
E11–4 M Computing the proceeds from various notes
E11–5 M Notes issued at a discount and interest expense
E11–6 M Accounting for notes payable with various stated interest rates
E11–7 M Determining the effective interest rate
E11–8 M Financing asset purchases with notes payable
E11–9 M Inferring an effective interest rate from the financial statements
E11–10 M Bond discounts
E11–11 M Computing bond issuance proceeds, carrying value, interest
expense
E11–12 M Accounting for bonds issued at face value
E11–13 M Accounting for bonds issued at a discount
E11–14 M Accounting for bonds issued at a premium
E11–15 H Changing market interest rates/economic gains and losses
E11–16 M Redeeming bonds not originally issued at par
E11–17 M Refinancing debt
E11–18 M Refinancing debt
E11–19 M Updating amortization and retiring a bond issuance
E11–20 H Analyzing bond disclosures and market values
E11–21 H Analyzing bond disclosures and market values
E11–22 M Accounting for leases
E11–23 H Accounting for leases and the financial statements
E11–24 H Financing asset purchases
E11–25 H Inferring the effective rate of interest
E11–26 M The decision to purchase a bond
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E11–27 H Managing interest rate risk

Problems:
P11–1 M Computing the face value of a note payable
P11–2 M Bonds with an effective rate greater than the stated rate
P11–3 M Value of debt and the long-term debt/equity ratio
P11–4 M Accounting for notes issued at a discount and at face value
P11–5 M The effects of notes payable on the financial statements
P11–6 M Cash interest payments vs. interest expense
P11–7 M The effective interest method
P11–8 M The effective interest method: effects on the statements
P11–9 M The effective interest method vs. the straight-line method
P11–10 M Redemption and updating amortization
P11–11 M Call provisions and bond market prices
P11–12 H Tax deductible interest and the present value of cash outflows
P11–13 H Capital and operating leases
P11–14 H Accounting for a capital lease
P11–15 M Some economic effects of lease accounting
P11–16 M Financing asset purchases with notes (effective rate)
P11–17 M Determinants of bond market prices
P11–18 M Bond investments

Issues for discussion:

ID11–1 E Repurchasing outstanding debt
ID11–2 M Bonds with a stated interest rate of zero
ID11–3 H Buy or lease: financial statement effects
ID11–4 E Long term debt disclosures
ID11–5 M Bond prices and market rates
ID11–6 M Holding debt in times of recession
ID11–7 M Adjusting ratios for lease accounting
ID11–8 M Sub-prime mortgage problems
ID11–9 M Long-term debt and covenants
ID11–10 M Lease accounting revolution
ID11–11 M Risk premiums and bond prices in a recession
ID11–12 H Interest rate swaps
ID11–13 M The annual report of Google