Chapter 10 Long-Term Liabilities

 Obligation that will not be satisfied within one year or the current operating cycle  Components:  Bonds or notes payable  Leases  Deferred taxes LO 1

Bonds Payable  A security or financial instrument that allows firms to borrow large sums of money and repay the loan over a long period of time  The borrower (issuing company) agrees to pay interest on specific dates, usually semiannually or annually  The borrower also agrees to repay the principal at the maturity, or due date, of the bond  Face value or par value: The denomination of the bond is usually referred to as the face value or par value, usually in denominations of $1,000 LO 2

Bonds Payable—Characteristics  Debenture bonds: not backed by specific collateral  Secured bond: the certificate indicates specific assets that serve as collateral in case of default  Term bonds: entire principal amount is due on a single date  Serial bonds: a portion of the bonds comes due each time period

Bonds Payable—Characteristics (continued)  Convertible bonds: can be converted into common stock at a future time  Callable bonds: redeemed or retired before their specified due date

Exhibit 10.2—Bond Certificate

Factors Affecting Bond Price  Face rate of interest: also called stated rate, nominal rate, contract rate, coupon rate  The rate of interest on the bond certificate  Market rate of interest: also called effective rate, bond yield  The rate that investors could obtain by investing in other bonds  Bond issue price: the present value of the annuity of interest payments plus the present value of the principal LO 3

Premium or Discount on Bonds LO 4 If Market Rate = Face Rate If Market Rate > Face Rate If Market Rate < Face Rate issued at face value issued at a discount issued at a premium Discount = Face Value − Issue Price Premium = Issue Price − Face Value The relationship between interest rates and bond prices is always inverse

Recording Bond Issuance at Discount  Discount Firm could identify and analyze the effect of the issuance of the bonds as follows:

Recording Bond Issuance at Discount (continued)  The Discount on Bonds Payable account is shown as a contra liability on the balance sheet as a deduction from Bonds Payable. 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:

Example 10.2—Calculating Bond Issuance at a Premium  On January 1, 2014, Premium Firm wants to issue the same bonds as in Example 10-1: $10,000 face value bonds with an 8% face rate of interest and with interest paid annually each year for four years. Assume, however, that the market rate of interest is 6% for similar bonds. The issue price is calculated as the present value of the annuity of interest payments plus the present value of the principal at the market rate of interest. The calculations are as follows:  We have calculated that the bonds would be issued for $10,693. The amount of the premium is calculated as follows:

Bond Issuance at a Premium  Premium Firm could identify and analyze the effect of the issuance of the bonds as follows:

Bond Issuance at a Premium  The account Premium on Bonds Payable is an addition to the Bonds Payable account. 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:

Bond Amortization  Process of transferring an amount from the discount or premium account to interest expense each time period  Effective interest rate: produces a constant effective interest rate from period to period  Carrying value: Carrying Value = Face Value − Unamortized Discount OR Carrying Value =Face Value + Unamortized Premium LO 5 Effective Rate = Annual Interest Expense/Carrying Value

Exhibit 10.4—Discount Amortization: Effective Interest Method of Amortization

Example 10.3—Recording Amortization of Discount  Exhibit 10-4 is the basis for determining the effect of amortization on the firm’s financial statements

Amortization of Discount  On the balance sheet presented as of December 31, 2014, the unamortized portion of the discount appears as the balance of the Discount on Bonds Payable account as follows:

Exhibit 10.5—Premium Amortization: Effective Interest Method of Amortization

Example 10.4—Recording Amortization of a Premium  Exhibit 10-5 is the basis for determining the effect of amortization of a premium on the firm’s financial statements. Premium Firm could identify and analyze the effect of the payment of interest and amortization of premium as follows:

Amortization of a Premium  In Example 10-4, the December 31, 2014, balance represents the amount unamortized, or the amount that will be amortized in future time periods. On December 31, 2014, the unamortized portion of the premium appears as the balance of the Premium on Bonds Payable account as follows:

Redemption of Bonds  Retirement of bonds by repayment of the principal  If redeemed at maturity, no gain or loss occurs  If retired before maturity, a gain or loss occurs  The gain or loss on bond redemption is shown on the income statement LO 6 Gain = Carrying Value − Redemption Price Loss = Redemption Price − Carrying Value

Liability for Leases  Contractual arrangement between two parties  Allows the lessee the right to use an asset in exchange for making payments to its owner, the lessor  A common example of a lease arrangement is the rental of an apartment The tenant is the lessee, and the landlord is the lessor LO 7

Liability for Leases  Operating lease: off-balance-sheet financing  The lessee acquires the right to use an asset for a limited period of time  The lessee is not required to record the right to use the property as an asset or record the obligation for payments as a liability  Capital lease:  Recorded as an asset by the lessee  The lessee has the right of ownership and control

Criteria for Lease Capitalization  One or more of the following criteria must be met:  Transfer of ownership of property to the lessee at the end of the lease term  Contains a bargain-purchase option to purchase the asset for lower than its fair market value  The lease term is 75% or more of property’s economic life  The present value of payments is 90% or more of property’s fair market value at the inception of the lease

Exhibit 10.6—Gap, Inc.’s 2011 Note Disclosure of Leases  Although operating leases are not recorded on the balance sheet, FASB requires note disclosure

Example 10.8—Calculating the Amount to Capitalize for a Lease  Suppose a lease agreement is signed with Lessor Dealer on January 1, 2014, to lease a car for the year for $4,000, payable on December 31, The terms of the agreement specify that Lessee will make annual lease payments of $4,000 per year for five years, payable each December 31. Also, assume that the lease specifies that at the end of the lease agreement, the title to the car is transferred to Lessee Firm  The lease should be treated as a capital lease by Lessee because it meets at least one of the four criteria(It meets the first criteria concerning transfer of title)  A capital lease must be recorded at its present value by Lessee as an asset and as an obligation  As of January 1,2014, we must calculate the present value of the annual payments  If we assume an interest rate of 8%, the present value of the payments is $15,972 ($4,000 * an annuity factor of )

Capital Lease  For Example 10-8, the first entry is made on the basis of the present value

Capital Lease (continued)  Because the leased asset represents depreciable property, depreciation (or amortization) must be reported for each of the five years of asset use as follows. On December 31, 2014, Lessee records depreciation of $3,194 ($15,972/5 years), assuming that the straight-line method is adopted.

Exhibit 10.7—Lease Amortization: Effective Interest Method of Amortization

Lease Amortization: Effective Interest Method of Amortization  On December 31, 2014, Lessee Firm records the following entry for the annual payment

Recording Lease Assets: Leased assets$15,972 Less: Accumulated depreciation3,194 $12,778 Current liabilities: Lease obligation$ 2,940 Long-term liabilities: Lease obligation$10,310  On the balance sheet as of December 31, 2014, Lessee Firm reports the following balances related to the lease obligation :

IFRS and Leasing  U.S. accounting standards: rule based  If lease meets any of the criteria—capital lease  Does not meet any criteria—operating lease  IFRS: criteria are used as ‘‘guidelines’’ rather than rigid rules  More flexibility in applying the lease standards

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  Another ratio used to measure the degree of debt obligation is the times interest earned ratio LO 8

Debt-to-Equity ratio  Measures the proportion of a company’s debt to its equity

Times Interest Earned Ratio  Measures a company’s ability to meet interest obligations as they come due

The Ratio Analysis Model 1. What is the amount of debt in relation to the total equity of a company? Will the company be able to meet its obligations? 2. Gather the information about total debt and total equity, income before interest and tax, and interest expense 3. Calculate debt-to-equity ratio and times interest earned ratio 4. Compare the ratio with prior years and with competitors 5. Interpret the results

The Business Decision Model 1. If you were a lender, would you be willing to lend money to a company? 2. Gather information from the financial statements and other sources 3. Compare the company's ratios with industry averages and look at trends 4. Lend money or find an alternative use for the money 5. Monitor your investment periodically

Exhibit 10.8—Long-Term Liabilities on the Statement of Cash Flows LO 9

Exhibit 10.9—The Coca-Cola Company and Subsidiaries’ 2011 Consolidated Statements of Cash Flows (Partial)

Other Liabilities—Deferred Tax  Reconciles the differences between the accounting done for financial reporting purposes and tax purposes  Reconcile the difference between the income tax expense and income tax payable  Permanent difference: affects the tax records and not the accounting records, or vice versa  Temporary difference: affects both book and tax records but not in the same time period LO 10

Example 10.9—Calculation and Reporting Deferred Tax  Assume that Startup Firm begins business on January 1, During 2014, the firm has sales of $6,000 and has no expenses other than depreciation and income tax at the rate of 40%. Startup has depreciation on only one asset. That asset was purchased on January 1, 2014, for $10,000 and has a four-year life. Startup has decided to use the straight-line depreciation method for financial reporting purposes. Startup’s accountants have chosen to use MACRS for tax purposes, however, resulting in $4,000 depreciation in 2014 and a decline of $1,000 per year thereafter

Example 10.9—Calculation and Reporting Deferred Tax (continued)  Startup’s tax calculation for 2014 is based on the accelerated depreciation of $4,000  Startup’s income statement for 2014

Deferred Tax  In Example 10-9, Startup must make an accounting entry to record the amount of tax expense and tax payable for 2014

End of Chapter 10