Chapter 10 LongTerm Liabilities 1 00 Financial Accounting

Chapter 10 Long-Term Liabilities 1, 00 Financial Accounting 4 e by Porter and Norton 0 1

Balance Sheet Classifications Current Liabilities: due within one year of the balance sheet date 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Long-Term Liabilities: due beyond one year 2

Long-Term Liabilities u Bonds Payable u Notes Payable u Leases u Deferred Taxes u Pensions u Other Postretirement Benefits 3

Bonds 0 0 0 , 1 Investor $10, 000 9% Bond Due 2019 Borrower Interest for Investor Borrower Long-term borrowing arrangement u Interest paid at stated rate and times u Principal repaid at maturity date u 4

Bond Features Collateralized backed by specific assets in event of default Debentures backed only by general creditworthiness of issuer 5

Bond Features Term - Entire Serial - Principal principal due on a specific single date 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 repaid in installments over time 6

Bond Features Convertible into common stock Common Stock Callable / Redeemable may be retired before maturity date 0 1, 00 7

Bond Interest Rates Face Rate interest is paid at the rate specified on the bond te Da P ck he c ay r fo ne Ja e Do . . pt De of r re su ea Tr Market Rate the interest rate the bond will yield after selling at a discount or premium 8% Return 8

Interest Rates and Bond Prices BONDS ISSUED: IF STATED RATE: Above face value (at a premium) > MARKET RATE At face value = MARKET RATE Below face value (at a discount) < MARKET RATE 9

Bonds Sold at Face Value Cash Bonds Payable 10, 000 To record issuance of bonds at face value. Face Value of Bonds = Sales Price 10

Relationship of Interest Rates and Bond Prices Market Interest Rates Bond Prices 11

Calculating Bond Prices - two sets of cash flows (1) Interest Payments made each period (annuity) PV = ? $$ $$ $$ etc. $$ (2) Principal due at maturity(single sum) PV = ? $$$$$ 12

Determining Bond Prices Example: On 1/1/04, Discount Firm issues: u $10, 000; 8% bonds. u due December 31, 2007 u Interest payable annually u Market rate of interest = 10% Calculate the issue price of the bonds. 13

Calculating Bond Prices (1) Interest Payments (4 payments @ $800) 2005 2004 PV = ? $800 2006 $800 2007 $800 Interest is always paid at rate stated on bonds ($10, 000 @ 8%) $800 14

Calculating Bond Prices (1) Interest Payments (4 payments @ $800) 2005 2004 PV = ? $800 2006 $800 2007 $800 (2) Principal of $10, 000 due at end of 2007 PV = ? 2007 $10, 000 15

Example of Price Calculation Present value: interest payments $ 800 x 3. 170 = Compute interest payment at stated rate (i. e. 8%). . . $ 2, 536 (PV; n=4; i = 10%) principal payment $ 10, 000 x 0. 683 = …but discount @ market rate 6, 830 (PV; n=4; i = 10%) Bond issue price: $ 9, 366 16

Recording Bond Discounts Cash 9, 366 Discount on Bonds Payable 634 Bonds Payable 10, 000 To record the issuance of bonds at a discount. Assets = Liabilities + Owners’ Equity - + 10, 000 634 + 9, 366 17

Balance Sheet Presentation of Bond Discount At Date of Sale Upon Maturity Long-term Liabilities: Bonds Payable$10, 000 Less: Discount on Bonds Payable (634) -0$ 9, 366 $10, 000 amortize to Interest Expense over the life of the bond 18

Determining Bond Prices Assume Premium Firm sells the same $10, 000; 8% bonds when the market rate on similar bonds is 6%. 19

Example of Price Calculation Present value: interest payments $ 800 x 3. 465 = Compute interest payment at stated rate (i. e. 8%). . . $ 2, 772 (PV; n=4; i = 6%) principal payment $ 10, 000 x 0. 792 = …but discount @ market rate 7, 920 (PV; n=4; i = 6%) Bond issue price: $10, 692 20

Recording Bond Premiums Cash 10, 692 Bonds Payable 10, 000 Premium on Bonds Payable 692 To record the issuance of bonds at a premium. Assets = Liabilities + Owners’ Equity + + 10, 000 692 +10, 692 21

Balance Sheet Presentation of Bond Premium At Date of Sale Upon Maturity Long-term Liabilities: Bonds Payable$10, 000 Plus: Premium on Bonds Payable 692 -0$10, 692 $10, 000 amortize to Interest Expense over the life of the bond 22

Amortization of Bond Premiums and Discounts Transfer to interest expense over the life of the bond using effective interest method Premium reduces interest expense Discount increases interest expense 23

Amortization Schedule - Discount Cash Interest Date Interest Expense 1/1/04 – – 12/31/04 $ 800 $ 937 12/31/05 800 950 12/31/06 800 965 12/31/07 800 982 Discount Carrying Amortized Value – $ 9, 366 $ 137 9, 503 150 9, 653 165 9, 818 182 10, 000 (rounded) 24

Amortization Schedule - Premium Cash Date Interest 1/1/04 – 12/31/04 $ 800 12/31/05 800 12/31/06 800 12/31/05 800 Interest Premium Carrying Expense Amortized Value – – $ 10, 692 $ 642 $ 158 10, 534 632 168 10, 366 622 178 10, 188 612 188 10, 000 (rounded) 25

Redemption of Bonds u Reasons for early redemption: l Excess cash l Changing Interest Rates Gain = Carrying Value - Redemption Price (Loss) = Redemption Price - Carrying Value 26

Leases Contractual arrangement u Grants right to use asset in exchange for payment u Form of financing u Lessor Lessee Rights 27

Capital Lease u Record as asset and corresponding liability (as if purchased through borrowings) u Depreciate asset over lease term u Separate payments into principal and interest components using the effective interest method 28

Criteria for Lease Capitalization Lease meets one or more: u Transfers u Contains u Term Title ownership of property bargain purchase option is > 75% of property’s life u PV of payments > 90% of property FMV ck he yc Pa 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 te Da r fo ne Ja e Do . pt of ea Tr r re su De 29

Operating Leases u Record as rent (lease) expense each period u Disclose future lease obligations in footnotes OFFICE SPACE FOR LEASE 30

Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed as compared to owners? 31

Long-Term Liabilities on the Statement of Cash Flows Operating Activities Net income xxx Increase in current liability + Decrease in current liability Investing Activities Financing Activities Increase in long-term liability + Decrease in long-term liability 32

Appendix Accounting Tools: Other Liabilities 33

Deferred Taxes u Reflects temporary differences between book and tax accounting methods u Book tax expense Income Statement Expense = Cash paid to IRS Tax Return Liability y to Pa of: r e ord IRS e h t . Co C B A 34

Deferred Income Taxes Sales Depreciation expense Income before tax Tax rate Income tax Difference recorded as deferred tax Book. Tax $6, 000 2, 500 4, 000 3, 500 2, 000 40% $1, 400 $ 800 $ 600 35

Deferred Income Taxes Income tax Book Tax $1, 400 $ 800 $ 600 Journal Entry: Tax Expense Tax Payable Deferred Tax Dr. 1, 400 Cr. 800 600 36

Pensions Employer contributes to Pays benefits to retired employees Pension Fund te Da Pen sio und n. F . pt De te Da . orp ZC Y X of r re su ea Tr k ec ch r fo y Pa ne Ja k ec ch r fo y Pa ck he yc Pa . pt e Do De ne Ja r fo te Daurer ea Tr s e t Da. of pt De e Do ne Ja of er r su ea Tr r re e Do . pt of su ea Tr De 37

Pensions u Expense accrued in period employee earns benefits (regardless of when paid) u Expense may = amount funded 38

Pensions on the Balance Sheet ASSETS LIABILITIES Prepaid Pension Cost $$ Accrued Pension Cost $$ Funding > Expense > Funding 39

Postretirement Benefits u Benefits paid to employees after retirement l e. g. , health costs u Record expense when employee earns benefits, not when paid (matching principle) 40

End of Chapter 10 0 1, 00 41