1. FINANCIAL ACCOUNTING a user perspective Sixth Canadian Edition Prepared by: Lynn de Grace C.A. Chapter 10 Long-Term Liabilities

2. User Relevance WHAT ARE THE KEY ISSUES? 1.Maturity dates and interest rates of debt: - cash flows must be planned to meet maturity dates and interest payments - companies commonly replace old debt with new debt; - high interest rates are detrimental to profitability ratios. 2.Existence of Debt Covenants: - These are special conditions attached to the debt, such as a requirement to maintain a certain ratio of debt to equity or level of retained earnings; - failure to comply may result in debt becoming due immediately. John Wiley & Sons Canada, Ltd. ©2011 2

3. User Relevance 3. Proportion of debt to equity - Higher debt means greater risk – cash flows must be used at maturity, - Replacing old debt with new debt may only be possible at higher interest rates; - Can make lenders reluctant to extend further debt; - Too much debt results in lower financial leverage and ultimately less shareholder wealth. 4.Is the company using leverage to the advantage of its shareholders ? - This means earning a rate of return on investment that is higher than the cost of debt? John Wiley & Sons Canada, Ltd. ©2011 3

4. Long-Term Notes & Mortgages  Various markets from which a company can obtain long term financing  Examples: Commercial bank loans often contain conditions or restrictions known as covenants Commercial paper – a promissory note sold to another business only used by companies with high credit ratings John Wiley & Sons Canada, Ltd. ©2011 4

5. Long-Term Notes & Mortgages  Long-term loans with equal blended monthly payments : Mortgage loans – capital asset is pledged as collateral Usually structured as instalment loans Payments are blended – consisting of both interest and principal Loan amortization table is usually prepared showing the allocation of interest and principal payments for the duration of the loan. John Wiley & Sons Canada, Ltd. ©2011 5

6. Long-Term Notes & Mortgages Long-term loans with equal blended monthly payments: EXAMPLE: A company that takes out a three-year, $100,000 mortgage on September 30. The interest rate on the loan is 6% per year, and equal blended payments of $3,042.19 are to be made at the end of each month. Sept 30 Cash100,000 Mortgage payable100,000 John Wiley & Sons Canada, Ltd. ©2011 6

7. Long-Term Notes & Mortgages Long-term loans with equal blended monthly payments: To record the first three payments: Oct 31 Interest expense 500.00 Mortgage payable 2,542.19 Cash3042.19 Nov 30 Interest expense 487.29 Mortgage payable 2,554.90 Cash3042.19 Dec 31 Interest expense 474.51 Mortgage payable 2,567.68 Cash3042.19 John Wiley & Sons Canada, Ltd. ©2011 7

8. Long-Term Notes & Mortgages Long-term loans with interest only monthly payments: Oct 31 Cash100,000.00 Mortgage payable100,000.00 Oct 31 Interest expense 500.00 Cash500.00 Nov 30 Interest expense 500.00 Cash500.00 Dec 31 Interest expense 500.00 Cash500.00 John Wiley & Sons Canada, Ltd. ©2011 8

9. Bonds John Wiley & Sons Canada, Ltd. ©2011  Companies may raise long-term funds through either: Equity (stock) market OR Debt market Borrow money from a commercial bank Sell bonds to investors 9

10. Bond Characteristics John Wiley & Sons Canada, Ltd. ©2011  Formal agreement called an indenture agreement.  Specifies How the money is to be paid back Conditions that must be met during the period of the loan Stated in the indenture agreement May specify restrictions (debt covenants) 10

11. Bond Characteristics John Wiley & Sons Canada, Ltd. ©2011  Bonds traded in public markets are standardized, stating: Face value: $1,000 per bond Specifies the cash payment to be made at the maturity date of the bond Usually semi-annual interest payments Bond interest rate Stated as an annual percentage 11

12. Bond Characteristics John Wiley & Sons Canada, Ltd. ©2011  Mortgage bond Has real property as collateral  Collateral trust bond Provides shares and bonds of other companies as collateral  Debenture bond Carries no specific collateral Senior debenture bonds Subordinated debenture bonds 12

13. Bond Characteristics John Wiley & Sons Canada, Ltd. ©2011  Some bonds have special provisions Convertible bonds Can be converted to a specified number of common shares; Usually based on the occurrence of a specific event or a specified period of time. 13

14. Bond Pricing John Wiley & Sons Canada, Ltd. ©2011  Market price of bonds is determined by discounting two sources of future cash flows: Repayment of principal – present value of a single sum PLUS Periodic interest payments – present value of a series of payments 14

15. Bond Pricing John Wiley & Sons Canada, Ltd. ©2011 Example:  On December 31, 2011 a company issues bonds with a total face value of $100,000, a bond interest rate of 8%, maturing on December 31, 2014.  The company expects the investor to demand a return of 10% (the risk-adjusted market rate) compounded semi- annually from this type of investment. AT WHAT PRICE WILL THE BONDS BE ISSUED ? 15

16. Bond Pricing Preliminary calculation:  The cash flows must be discounted using the yield rate* of 10% *Often called the discount rate or market rate Number of periods= Time to maturity x 2 = 3 years x 2 = 6 periods Yield rate per period = Yield rate ÷ 2 = 10% ÷ 2 = 5% per period Interest payments = Face amount x coupon rate x 6/12 = $100,000 x 8% x 6/12 = $4,000 John Wiley & Sons Canada, Ltd. ©2011 16

17. Bond Pricing  Summary of key data: Face value 100,000 Bond interest rate* 8% Time to maturity 3 years Yield rate 10% Semi-annual yield rate5% Semi-annual interest payments$4,000 Number of semi-annual periods6 *often referred to as the coupon rate John Wiley & Sons Canada, Ltd. ©2011 17

18. Bond Pricing Calculation: Present value of the interest payments (an annuity): $4,000 x 5.07569* = 20,302.76 *present value interest factor of an annuity in arrears for 6 periods at 5% PLUS Present value of the principal sum: ($100,000 x 0.74622) = 74,622.00 = $20,302.76 + $74,622.00 = $94,924.76 = $94,924.76 Bond is issued at a discount John Wiley & Sons Canada, Ltd. ©2011 18

19. Bond Pricing WHAT IF THE COMPETITIVE INTEREST RATE IN THE MARKET IS 6% ?  If the buyers demand a 6% return on their investment: PV of bond = PV of interest payments + PV of maturity payment = PV of annuity of $4,000 for 6 periods at 3% + PV of $100,000 for 6 periods at 3% = ($4,000 x 5.41719) + ($100,000 x 0.83748) = $105,416.76 Bond is issued at a premium. John Wiley & Sons Canada, Ltd. ©2011 19

20. Bond Price Relationship John Wiley & Sons Canada, Ltd. ©2011 Coupon RateBonds Issued at: Higher than expected yieldPremium Lower than expected rateDiscount Equal to expected yield Par 20

21. Bond Price Relationship Yield Rates Coupon Rates 6%8%10%12% 6%$1,000.00$963.70$929.08$896.05 8%$1,037.17$1,000.00$964.54$930.70 10%$1,074.34$1,036.30$1,000.00$965.35 12%$1,111.51$1,072.60$1,035.46$1,000.00 John Wiley & Sons Canada, Ltd. ©2011

22. Bonds Issued at Par John Wiley & Sons Canada, Ltd. ©2011 Bonds issued at par are said to be issued at 100. Cash (A) 1,000 Bonds Payable (L) 1,000  Because interest accrues as time passes, no interest is recognized on the date of issuance 22

23. Accounting for Bonds John Wiley & Sons Canada, Ltd. ©2011  Interest expense versus Interest Payment Actual interest payment is based on the bond coupon rate Company nets any discount or premium against the bonds payable account. Interest expense for accounting purposes will include both the actual interest payment and a portion of the discount or premium, if any. This is accomplished by calculating interest expense based on the Yield Rate x Bond Carrying Value. 23

24. Bond Amortization Table John Wiley & Sons Canada, Ltd. ©2011 24

25. Accounting for Bonds John Wiley & Sons Canada, Ltd. ©2011  Case 1 Bonds Issued at a Discount: Issue date: Cash (A)94,924.76 Bond liability (L)94,924.76 First interest payment: Interest expense (SE) 4,746.24 Bond liability (L)746.24 Interest payable (L) 4,000.00 Second interest payment: Interest expense (SE) 4,783.55 Bond liability (L)783.55 Interest payable (L) 4,000.00 25

26. Bond Amortization Table John Wiley & Sons Canada, Ltd. ©2011 26

27. Accounting for Bonds John Wiley & Sons Canada, Ltd. ©2011  Case 2 Bonds Issued at a Premium: Issue date: Cash (A)105,416.76 Bond liability (L)105,416.76 First interest payment: Interest expense (SE) 3,162.50 Bond liability (L)837.50 Interest payable (L) 4,000.00 Second interest payment*: Interest expense (SE) 3,137.38 Bond liability (L)783.55 Interest payable (L) 4,000.00 (*Difference due to rounding) 27

28. Accounting for Bonds Issued at Par John Wiley & Sons Canada, Ltd. ©2011  Interest expense and Interest payable amount will be the same in all six interest periods over the life of the bond. 28

29. Early Retirement of Debt  Sometimes makes sense to pay off debt early  Callable bonds – a feature that allows the company to buy them back at a predetermined price before maturity  Usually a gain or loss will arise because the price paid to retire the bonds differs from their carrying value. John Wiley & Sons Canada, Ltd. ©2011 29 WestJet Long Term Debt Note

30. Long Term Debt with No Explicit Interest  Often, long term assets are purchased under arrangements whereby interest expense is not explicitly stated in the loan agreement.  Loan agreement specifies the amounts and timing of the payments  If payment is not due until a later period, more appropriate to record the initial debt at present value.  Present value represents the true value of the asset at the time of purchase if the company does not have to pay for it until later.  The appropriate discount rate should be the rate at which the company would have to borrow to buy the asset.  Interest expense is calculated each period using the discount rate times the carrying value of the debt. John Wiley & Sons Canada, Ltd. ©2011 30

31. Long Term Debt with No Explicit Interest EXAMPLE: A company negotiates the purchase of some equipment for $100,000, which is to be paid at the end of three years with no interest added. The company would normally have been charged an interest rate of 6% annually for a three-year loan. PVIF 6%, 3 = 0.83962 Purchase Date: Equipment83,962 Long term note payable 83,962 First year’s interest expense: Interest expense5,038 Long term note payable 5,038 [$83,962 x 6% = 5,038] John Wiley & Sons Canada, Ltd. ©2011 31

32. Leases John Wiley & Sons Canada, Ltd. ©2011 What is a lease agreement? One party (the lessor) buys the asset and the second party (the lessee) makes periodic payments in exchange for the use of the asset over the lease term. 32

33. Owning Versus Leasing John Wiley & Sons Canada, Ltd. ©2011 Ownership pros:  Company can use the CCA to reduce income taxes. Investment tax credits may also be available  Benefits from the increase in value of the asset Ownership cons:  Ties up capital that could have been used for something else  Financing the assets will negatively impact debt ratios and interest coverage ratios. 33

34. Owning Versus Leasing John Wiley & Sons Canada, Ltd. ©2011 Leasing:  Favourable terms can mean a low cost form of financing  Frees up capital for other purposes  Not necessary to incur debt – less impact on debt ratios  Lowers lessee’s risk that the asset will become obsolete  Lessee may opt to use the asset for less than its useful life. 34

35. Classification of Leases John Wiley & Sons Canada, Ltd. ©2011  OPERATING LEASE: If the lease term is a relatively short period of time compared to the life of the assets, then: Lessee is not buying, but renting the asset Payments are recorded as rent expense  CAPITAL/FINANCE LEASE: Lease is for a major part of the asset’s useful life Lease is effectively a financing arrangement with installments Asset is recorded at its cost – measured at the present value of the future lease payments; Obligation to the lessor is recorded as a non-current liability and interest is recognized over the term of the lease. 35

36. Classification of Leases John Wiley & Sons Canada, Ltd. ©2011 A lease qualifies as a capital/finance lease if any one of the following criteria is met : 1.The lease transfers ownership of the asset to the lessee by the end of the lease term; 2.The lessee has a “bargain purchase” and it is reasonably certain that this “bargain purchase option” will be exercised; 3.The lease term is for the major part of the asset’s economic life; 4.The present value of the minimum lease payments is equal to substantially all of the fair value of the asset; 5.The leased asset is of such a specialized nature that, without major modifications, only the lessee can use it. 36

37. Accounting For Leases John Wiley & Sons Canada, Ltd. ©2011  Example: Asset is leased for 3 years Monthly lease payments of $1,000, payable at the end of each month Interest rate is 12% Under an operating lease, the monthly journal entry is: Equipment rental/lease expense (SE)1,000 Cash (A)1,000 37

38. Accounting For Leases John Wiley & Sons Canada, Ltd. ©2011  Under a capital/finance lease: Asset and liability are recorded at present value  Key data: 36 periods, 1% per period PVIFA 1%, 36 = 30.10751 Journal entry to record lease transaction: Leased equipment (A)30,107.51 Lease obligation (L)30,107.51 38

39. Accounting For Leases John Wiley & Sons Canada, Ltd. ©2011 Capital/finance lease (cont’d):  At the end of the first month: Interest expense (SE)301.08 Lease obligation (L) 698.92 Cash (A) 1,000.00 [Interest = 1% x 30,107.51]  At the end of the second month: Interest expense (SE)294.09 Lease obligation (L) 705.91 Cash (A) 1,000.00 [Interest = 1% x (30,107.51-698.92)] 39

40. Accounting For Leases John Wiley & Sons Canada, Ltd. ©2011 Capital/finance lease (cont’d):  Assuming straight-line amortization over 36 months  At the end of each month: Depreciation expense (SE) 836.32 Accumulated depreciation (XA) 836.32 - leased equipment 40

41. Pensions John Wiley & Sons Canada, Ltd. ©2011  Agreements between employers and employees that provide employees with specified benefits (income) upon retirement  Represents an estimated future obligation for the services that the employee is rendering to the company presently,  Makes sense to include the costs of this obligation in the same period as the benefits received 41

42. Pensions John Wiley & Sons Canada, Ltd. ©2011  Defined contribution pension plans: Employer agrees to make a pre-defined contribution to a retirement fund for the employee. Risk of increases or decreases to the plan’s market value is borne by the employee. Pension expense is generally equal to the contribution. 42

43. Pensions John Wiley & Sons Canada, Ltd. ©2011  Defined benefit pension plans: Employee is guaranteed a certain amount of money during each year of retirement. Risk of increases or decreases to the plan’s market value is borne by the employer. Employer must continually assess plan assets to determine if the current contributions to the plan will be sufficient to meet the future obligation. Pension obligation is determined as the present value of the future obligation. Pension expense consists of both the current pension expense (determined by an actuary) plus/minus any adjustments or contributions required to fund plan assets in order to meet the present value of the future obligation. 43

44. Pension Plan Disclosure  For a defined contribution plan, the contributed amounts must be disclosed.  For a defined benefit plan disclosure is usually extensive and can be complex. Generally, in order to determine whether the pension plan is underfunded, overfunded, or fully funded, it is necessary to read the notes to the financial statements John Wiley & Sons Canada, Ltd. ©2011 44

45. Deferred Income Taxes  Basic Concepts: Income tax expense is an accrual accounting concept since it is based on accounting income from the income statement Income taxes payable must be calculated according to the rules established by Canada Revenue Agency (CRA) Difference is deferred income tax – it can be either an asset or a liability, depending on the cause of the difference.  Canadian practice uses the liability method to account for these differences. 45 John Wiley & Sons Canada, Ltd. ©2011

46. Deferred Income Tax - Liability Method  A calculation of the income tax that will be payable in the future or deductible in the future, based on the temporary differences (the differences between the accounting records and the tax records) that exist in the current period. 46 John Wiley & Sons Canada, Ltd. ©2011

47. Deferred Income Tax - Liability Method EXAMPLE - Warranties  For accounting purposes, the company estimates the probable costs associated with the warranty and records the total amount as warranty expense in the year of the sale, as well as a liability (warranty obligation). For tax purposes, the CRA does not permit a company to deduct the estimated warranty expense in calculating its taxable income; the company can only claim a tax deduction for the actual costs that it incurs each year to settle claims under the warranty. 47 John Wiley & Sons Canada, Ltd. ©2011

48. Deferred Income Tax - Liability Method Example :  Assumptions Income before tax and warranties: $10,000 Estimated warranty expense (for accounting purposes) Year 1: $ 500 Actual warranty costs incurred: Year 1: $ 125 Year 2: $ 175 Year 3: $ 200 Tax rate (same in year 1, year 2, and year 3): 40% 48 John Wiley & Sons Canada, Ltd. ©2011

49. Deferred Income Tax - Liability Method Year 1Year 2Year 3 Income before warranty expense & income taxes 10,000 Actual warranty costs incurred (125)(175)(200) Taxable income9,8759,8259,800 40% Taxes payable$3,950$3,930$3,920 Income tax currently payable: John Wiley & Sons Canada, Ltd. ©2011 49

50. Deferred Income Tax - Liability Method Year 1Year 2Year 3 Beginning warranty obligation $ 500$ 375$ 200 Actual warranty costs incurred 125 175 200 Ending warranty obligation (Temporary difference) $ 375$ 200$ -0- Tax rate 40% Deferred tax asset$ 150$ 80$ -0- Increase (decrease) in deferred tax asset $ 150 ( $70)( $80) Calculation of deferred income taxes: John Wiley & Sons Canada, Ltd. ©2011 50

51. Deferred Income Tax - Liability Method Year 1Year 2Year 3 Income taxes payable(3,950)(3,930)(3,920) Future income taxes150(70)(80) Income tax expense$3,800$4,000 Calculation of income tax expense: 51 John Wiley & Sons Canada, Ltd. ©2011

52. Income Tax Disclosures  Reconciliation of the difference between the tax expense reported on the income statement and the amount that would have been reported if all revenues, expenses, gains, and losses were subject to tax at the stated tax rates  Summary of the temporary differences creating the deferred income tax amounts  Breakdown of the taxes into the amounts that are currently payable and the amounts that are deferred to the future 52 John Wiley & Sons Canada, Ltd. ©2011 West Timber Lumber Co. Income Tax Note

53. Statement Analysis John Wiley & Sons Canada, Ltd. ©2011 Debt/Equity Ratio = Total Liabilities Total liabilities + Shareholder’s Equity 53 WestJet Balance Sheet

54. Statement Analysis John Wiley & Sons Canada, Ltd. ©2011 54 WestJet Debt to Equity Ratio:

55. Times-Interest-Earned Ratio John Wiley & Sons Canada, Ltd. ©2011 Times- interest- earned Income before interest and taxes Interest = = Net income + Taxes + Interest Interest 55 WestJet Income Statement

56. Times-Interest-Earned Ratio John Wiley & Sons Canada, Ltd. ©2011 56 WestJet Times Interest Earned Ratio:

57. Copyright © 2011 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright 57