1. Long-Term Liabilities Skyline College Lecture Notes
Chapter 10
Long-Term Liabilities
Skyline College
Lecture Notes

2. How do companies raise long-term funds?
Funding Growth
Growth usually requires investment in long-term assets and research and development
How do companies raise long-term funds?
Issuance of capital stock
Issuance of long-term debt
Take on long-term debt?
How much debt to carry?
What types of debt to incur?
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3. Deciding to Issue Long-Term Debt
Advantages to
consider
Disadvantages to consider
The interest on debt is tax-deductible
If earnings on funds borrowed exceed interest on debt, financial leverage is gained
No loss of stockholder control as when issuing stock
If earnings on funds borrowed do not exceed interest on debt, negative financial leverage is experienced
A high level of debt exposes a company to financial risk
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4. Average Debt to Equity for Selected Industries
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5. Evaluating Long-Term Debt
Many companies use the debt to equity ratio when assessing how much debt to carry
McDonald’s also has long-term leases
that do not appear on the balance sheet,
called off-balance sheet financing.
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6. Interest Coverage Ratio
Measures how much risk a company is undertaking with its long-term debt
Measures the degree of protection a company has from default on interest payments
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7. Interest Coverage Ratio Illustrated
McDonald’s 2004 annual report shows that the
company had income before income taxes of $3,202.4
million and interest expense of $358.4 million.
McDonald’s interest expense was covered 9.9 times in However, management will add the company’s off-the-balance sheet rent expense of $1,003.2 to its interest expense. This procedure decreases the coverage ratio to 3.4 times, still adequate to cover interest payments.
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8. Types of Long-Term Debt
Bonds payable
Notes payable
Mortgages payable
Long-term leases
Pensions
Other postretirement benefits
Deferred income taxes
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9. Long-Term Debt Bonds Payable Notes Payable
Most common type of long-term debt
May be convertible to common stock
Involves a debt to many creditors
Represents a loan from a bank or other creditor
Deutsche Telekom International Finance recently raised $14.6 billion by issuing a series of long-term notes denominated in dollars, Euros, pounds, and yen.
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10. Mortgages Payable
Long-term debt secured by real property. Usually repaid in equal monthly installments that include interest on the debt and a reduction in the initial debt.
Illustration: Monthly Payment Schedule on a $50,000, 12% mortgage
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11. Leases Companies may obtain an operating asset in three ways:
Borrow the money and buy the asset
Rent the asset on a short-term lease (operating lease; payments are treated as rent expense)
Obtain the asset on a long-term lease (may be structured as a capital lease or an operating lease)
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12. Capital Leases
Accounting standards require that a lease be treated as a capital lease if the lease:
Accounting for a
Capital Lease
The lessee should:
Record the asset
Record depreciation on the asset
Record a liability equal to the present value of the total lease payments during the lease term
Cannot be cancelled
Has about the same duration as the useful life of the asset
Stipulates that the lessee has the option to buy the asset at a nominal price at the end of the lease
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13. Capital Lease Illustrated
Glenellen Manufacturing Company enters into a long-term lease for a machine. The lease terms call for an annual payment of $4,000 for six years, which approximates the useful life of the machine. At the end of the lease period, the title to the machine passes to Glenellen.
Use present value techniques to place a value on the asset and on the corresponding liability. Assume that the interest cost on the unpaid part of the obligation is 16 percent.
$4,000 x = $14,740
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14. Capital Lease Illustrated (cont’d)
Each year, Glenellen must record depreciation on the leased asset. Assume the company uses the straight-line method and no salvage value.
Glenellen must also record interest expense for the lease. The interest expense for each year is computed by multiplying the interest rate by the amount of remaining lease obligation.
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15. Off-Balance Sheet Financing
A legal way of structuring a lease commitment so that it does not have to be included on the balance sheet as a liability
Financial statement users should review the notes to the financial statements for information about any leases that may have the effect of long-term liabilities
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16. Discussion: Ethics on the Job
Cardle Industries plans to apply for a large loan from United Bank in 20x8. In 20x6, the controller recommends that the company renegotiate the duration of its leases so that the company may categorize them as operating leases. This will improve the company’s debt to equity ratio.
Q. Do you think this recommendation is ethical?
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17. Pension benefits paid to
Pension Liabilities
Pension plans
Require a company to pay benefits to employees after they retire
Some companies pay full cost of pension plan
Employees often share the cost of pension plans
Pension Fund
Employer
contributions
Employee
Pension benefits paid to
retired employees
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18. Pension Plans Defined Contribution Plan Defined Benefit Plan
Employer makes fixed, agreed-upon, annual contribution
Retirement payments depend on how much the fund earns
Employees usually control their own accounts and can transfer funds if they leave the firm
Employer makes variable payments required to fund the estimated future liability
Retirement benefits are fixed
More complex accounting required
Examples: 401(K) plans, profit-sharing plans, and ESOPs
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19. Other Postretirement Benefits
Retired employees may also be provided health care benefits and other postretirement benefits
Recent accounting standards hold postretirement benefits should be estimated and expensed during the time that employees are working in accordance with the matching rule.
Estimates should account for retirement age, mortality, future trends in health care
Future benefits should be discounted to the current period
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20. Deferred Income Taxes
Results from using different accounting methods to calculate income taxes on the income statement and income tax liability on the income tax return
A company might use straight-line depreciation for financial reporting and an accelerated method for income tax purposes.
The difference in taxes resulting from the two methods is listed as a long-term liability.
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21. Bonds
A security, usually long term, representing money that a corporation borrows from the investing public
Governments and foreign countries
also issue bonds to raise money
Must be repaid at a specified time and require periodic payments of interest at a specified rate at specified times
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22. What Is a Bond Issue? Prices of Bonds
Stated in terms of a percentage of face value
Bonds selling at 100
Sell at face or par value
Bonds selling above 100
Sell at a premium
Bonds selling below 100
Sell at a discount
A bond issue is the total value of bonds issued at one time
For example, a $1,000,000 bond issue could consist of one thousand, $1,000 bonds
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23. Selling Price of Bond Illustrated
A bond issue is quoted at 103 ½
What is the selling price of a $1,000 bond?
A bond issue quoted at 103 ½ means that the bond sells at percent of its face value
This bond sells at a premium and would cost the buyer $1,035
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24. Interest Rates Face Interest Rate Market Interest Rate
Fixed rate of interest paid to bondholders based on the face value of the bonds
Rate of interest paid in the market on bonds of similar risk, also called the effective interest rate
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25. Discounts and Premiums
Equals the excess of the face value over the issue price.
The issue price will be less than the face value when:
Market > Face
Premium
Equals the excess of the issue price over the face value.
The issue price will be more than the face value when
Market < Face
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26. Bond Characteristics Unsecured
Callable
Serial
Convertible
Registered
Term
Coupon
Unsecured
Issued on the basis of a firm’s general credit
Carry a pledge of certain corporate assets as a guarantee of repayment
Secured
All bonds of an issue mature at the same time
Bonds of an issue mature on different dates
Gives issuer the right to buy back and retire the bonds before maturity at a specified call price
Allows bondholder to exchange a bond for a specified number of shares of common stock
Issued to a specific bondholder
Not registered with the organization
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27. Issuing Bonds Payable
The board of directors must submit the appropriate legal documents to the Securities and Exchange Commission (SEC) for approval to issue bonds
No journal entry is required for the authorization of the bond issue (most companies disclose in the notes to the financial statements)
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28. Bonds Issued at Face Value
Katakis Corporation issues $100,000 of 9 percent, 5-year bonds on January 1, 20x4 and sells them on the same date for their face value. The bond indenture states that interest is to be paid on January 1 and July 1 of each year.
Record a semiannual interest payment:
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29. Bonds Issued at a Discount
Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at on January 1, 20x4, when the market rate is 10 percent.
Record the issuance of the bonds at a discount:
Unamortized Bond Discount is a contra-liability account
Carrying Value of Bonds = Face Value – Unamortized Bond Discount
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30. Bonds Issued at a Premium
Katakis Corporation issues $100,000 of 9 percent, 5-year bonds for $104,100 on January 1, 20x4, when the market rate is 8 percent.
Record the issuance of the bonds at a premium:
Carrying Value of Bonds = Face Value + Unamortized Bond Premium
= $100,000 + $4,100 = $104,100
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31. Can amount to as much as 5 percent
Bond Issue Costs
Can amount to as much as 5 percent
of a bond issue
Establish a long-term prepaid account for these costs and amortize over life of bonds
or issue costs can be subtracted from the proceeds making the discount bigger or the premium smaller
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32. Influence of the Market Interest Rate on Bonds
The market interest rate varies from day to day and therefore what investors are willing to pay changes as well
If current market interest rate > face interest investors are willing to pay less
If current market interest rate < face interest investors are willing to pay more
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33. Case 1: Present Value Market interest rate > Face interest rate
A bond has a face value of $10,000 and pays fixed interest of $450 every six months (a 9 percent annual rate). The bond is due in 5 years and the market interest rate is 12 percent.
What is the present value of the bond?
Determine the interest rate and number of periods to use in the present value tables
Divide the annual interest rate by the number of periods in the year
12% ÷ 2 = 6%
Multiply the number of periods in one year by the number of years
2 x 5 = 10 periods
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34. Case 2: Present Value Market interest rate < Face interest rate
A bond has a face value of $10,000 and pays fixed interest of $450 every six months (a 9 percent annual rate). The bond is due in 5 years and the market interest rate is 8 percent.
What is the present value of the bond?
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35. Bond Discounts or Premiums
Amount by which the total interest
cost is higher or lower than the
total interest payments
Amortized over the life of the bonds
Use straight-line
or effective interest method
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36. Total Interest Cost Illustrated
Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at when the market rate is 10 percent. The bonds sold for $96,149 resulting in an unamortized bond discount of $3,851.
The bonds were issued at a discount:
Although the company does not receive the full face value of the bonds on issue, it still must pay back the full face value at maturity
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37. Calculating Total Interest Cost
Katakis Corporation issues $100,000 of 9 %, 5-year bonds at when the market rate is 10 percent. The bonds sold for $96,149, resulting in an unamortized bond discount of $3,851.
Or, alternately
The bond discount increases the interest paid on the bonds from the stated interest rate to the effective interest rate.
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38. Accounting for Total Interest Cost
Effective Interest Rate = Stated Rate + Discount
Amortization of the bond discount
Must be allocated over the remaining life of the bonds as an increase in the interest expense each period
Interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period
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39. Zero Coupon Bonds Do not require periodic interest payments
Represent a promise to pay a fixed amount at the maturity date
Zero coupon bonds are issued by
some companies
and governmental units
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40. Equal amortization of the bond discount for each interest period
Straight-Line Method
Equal amortization of the bond discount for each interest period
Face value = $100,000
Face interest rate = 9%
Life of bond = 5 years
Interest payments = Semiannual
Bond discount = $3,851
Step 1: Determine the total number of interest payments
Step 2: Determine the amount of bond discount to amortize each interest period
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41. Straight-Line Method (cont’d)
Step 3: Determine the cash interest payment amount
Step 4: Determine the total interest expense per interest period
Record first semiannual interest payment and amortization of
bond discount
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42. Weaknesses of the Straight-Line Method
When used to amortize a discount, the carrying value goes up each period, but the bond interest expense stays the same; thus, the rate of interest falls over time.
When used to amortize a premium, the rate of interest rises over time.
used only when it does not lead to a material difference from the effective interest method
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43. Effective Interest Method
Applies a constant interest rate to the carrying value of bonds at the beginning of the interest period
Rate equals the market, or effective, rate at the time the bonds were issued.
Amount amortized is the difference between interest computed and actual interest paid to bondholders
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44. Interest and Amortization of a Bond Discount: Effective Interest Method
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45. Bond Amortization – Effective Interest Method
Face value = $100,000
Face Interest rate = 9%
Life of bond = 5 years
Interest payments = Semiannual
Bond discount = $3,851
Column A
Carrying value = Face value – Unamortized bond discount
Column B – Use market interest rate
($96,149 x .10 x 6/12 = $4,807)
Column C – Use face interest rate on bond
($100,00 x .09 x 6/12 = $4,500)
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46. Bond Amortization – Effective Interest Method (cont’d)
Column D
Discount amortized =
Effective interest expense –
Actual interest payment to
bondholders
($4,807 – $4,500 = $307)
Column F
Carrying value at beg. of
period + Amort. during the period
($96,149 + $307 = $96,456)
Column E
Bond discount at beg. of period –
Current pd amort. ($3,851 – $307 = $3,544)
Notice that the sum of the carrying value and the unamortized discount always equals the face value of the bonds
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47. Bond Amortization – Effective Interest Method (cont’d)
Record first semiannual interest payment and amortization of bond discount:
It is not necessary to prepare an interest
and amortization table to determine
amortization of a discount for the period
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48. Bond Premiums Bondholders pay more than face value for bonds
Premium is an amount that bondholders have prepaid their own interest over life of the issue
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49. Total Interest Cost
Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at on January 1, 20x4, when the market rate is 8 percent. The bonds sold for $104,100 resulting in an unamortized bond premium of $4,100.
Or, alternately
The bond premium decreases the interest paid on the bonds from the stated interest rate to the effective interest rate.
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50. Interest and Amortization of a Bond Premium: Effective Interest Method
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51. Bond Amortization – Effective Interest Method (cont’d)
Record first semiannual interest payment and amortization of bond premium:
It is not necessary to prepare an interest
and amortization table to determine
amortization of a premium for the period
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52. Why call bonds before their maturity date?
Calling Bonds
Why call bonds before their maturity date?
If bond interest rates drop, the company can call the bonds and reissue debt at a lower cost.
Company has earned enough to pay off the debt.
The reason for having the debt no longer exists.
The company wants to restructure its debt to equity ratio.
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53. Callable Bonds Illustrated
The issuer has the right to buy back and retire bonds at a specified call price
Katakis Corporation can call or retire at 105 the $100,000 of bonds it issued at a premium (104.1). It decides to do so on July 1, 20x7. The entry for the required interest payment and amortization of the premium has already been made.
Record the retirement of the bonds:
The loss occurs because the call price of the bonds is greater than the carrying value
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54. Callable Bonds (Purchase)
Katakis Corporation can call or retire at 105 the $100,000 of bonds it issued at a premium (104.1). Because of a rise in interest rates, Katakis is able to purchase the $100,000 bond issue on the open market for 85. The entry for the required interest payment and amortization of the premium has already been made.
Record the purchase of the bonds:
The gain occurs because the call price of the bonds is less than than the carrying value
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55. Convertible Bonds Illustrated
Katakis Corporation issued $100,000 of convertible bonds on January 1, 20x4, that can be converted to 40 shares of common stock for each $1,000 bond. The bondholders decide to convert all the bonds to $8 par value common stock on July 1, 20x7.
Record the bond conversion:
No loss or gain is recorded because the bond liability and the associated unamortized discount or premium are written off the books.
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56. Sale of Bonds Between Interest Dates
When a company sells a bond between interest dates…
it collects the interest that would have accrued for the partial period preceding the issue date, and…
at the end of the first period, it pays the interest for the entire period.
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57. Sale of Bonds Between Interest Dates Illustrated
Katakis Corporation sold $100,000 of 9 percent, 5-year bonds on May 1, 20x4 (after the January 1, 20x4 issue date).
Record the sale of the bonds:
Bond Interest Expense
Bondholder pays interest that would have accrued for the partial period from the issue date to the sale date
Bal
May ,000
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58. Sale of Bonds Between Interest Dates Illustrated (cont’d)
Katakis Corporation sold $100,000 of 9 percent, 5-year bonds on May 1, 20x4 (after the January 1, 20x4 issue date).
Record first semiannual interest payment:
The bondholder is reimbursed for the partial interest payment made at time of sale ($3,000) plus paid interest for the partial period the bond was held ($1,500)
Bond Interest Expense
Corporation pays the bondholder interest for the entire period
Bal
May ,000
July ,500
Bal ,500
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59. Year-End Accrual of Bond Interest Expense
Bond interest payment dates rarely correspond with a company’s fiscal year. A year-end adjustment is required.
Katakis Corporation issues $100,000 of 9 percent, 5-year bonds at on January 1, 20x4. The company’s fiscal year ends September 31, 20x4
Interest and amortization were recorded on July 1, 20x4. Three months of interest has accrued since then.
Record the year-end accrual of bond interest expense:
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60. Year-End Accrual of Bond Interest Expense (cont’d)
Record second semiannual interest payment and amortization of bond premium:
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