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

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

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

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

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)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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%

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

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

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

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

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

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