LongTerm Liabilities

1
Long-Term Liabilities

• Overview
• Accounting for Leases
• Pensions Statement Analysis

2
Long-Term Liabilities

• Leasing
• To use an asset, a co. can purchase outright or
  enter into a lease agreement with another co.
  that owns an asset it wishes to use.
• The co.,(as lessee), makes periodic payments to
  the other co. (the lessor) in exchange for use of
  the asset over the length of the lease agreement
  (lease term).

3
Leasing

• Benefits of Ownership (i.e. vs. leasing)
• Co. can amortize the asset for tax purposes.
• An investment tax credit (ITC) (provided by the
  CRA to encourage investment in certain types of
  assets - new equip.) might be applicable.
• Profit if value of asset appreciates.

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Long-Term Liabilities

• Leasing Disadvantages of Ownership (vs. leasing)
• Potential loss if asset becomes obsolete.
• Ties up capital that might be used in other
  projects.
• The co.s debt/equity ratio and interest coverage
  ratios will change, possibly dramatically, if the
  co. borrows to buy.

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Long-Term Liabilities

• Leasing Benefits of Leasing
• Lessee
• doesnt have to invest own capital to buy an
  asset.
• doesnt have to borrow - leaves debt/equity and
  interest coverage ratios unchanged.
• transfers risk of obsolescence to lessor.
• If lessee has little taxable income, there may be
  limited tax advantage to amortizing and to
  claiming an ITC. If the lessor can claim CCA,
  then savings may be passed on.
• If lessee does not intend to keep the asset for
  its full useful life, risk of resale value
  resides with the lessor

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Long-Term Liabilities

• Leasing Operating Leases vs. Capital Leases
• If an asset is leased for a short period of time
  (vs. its useful life) and there is no intent to
  buy it Operating Lease --gt recorded as a rent
  expense by lessee.
• If the essence of the agreement is the lessee
  paying for the asset in instalments over its
  useful life and taking title to it at the end of
  the agreement, generally Capital Lease
  --gtconsidered no different than borrowing the
  money and buying the asset for cash.

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Long-Term Liabilities

• Leasing Operating Leases vs. Capital Leases
• A corporation, generally would prefer to treat as
  an operating lease --gt no effect on debt/equity
  and interest coverage ratios.

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Long-Term Liabilities

• Leasing Operating Leases vs. Capital Leases
• Under GAAP, Capital Lease Criteria
• 1. Title to the asset passes to the lessee by the
  end of the lease term.
• 2. Lease term is or gt 75 of the assets useful
  life.
• 3. PV of the minimum lease payments is gt
  90 of the fair value of the asset.
• If any of the above criteria are met,
  its a capital lease.
• If a purchase option is provided to work around
  criteria 1 and the purchase price is a bargain,
  criteria 1 is considered met.

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Long-Term Liabilities

• Leasing Example Operating Lease vs.
  Capital Lease
• Given Term 5 years Payment 2,000
  quarterly Payable in Advance
  Interest Rate 12 Title does not
  pass at end of lease. No purchase
  option.

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Long-Term Liabilities

• Leasing Example Operating Lease vs.
  Capital Lease
• If an operating lease, only rent expense would be
  recorded quarterlyDr/ Rent Expense
  2,000 Cr/ Cash
  2,000

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Long-Term Liabilities

• Leasing Example Operating Lease vs.
  Capital Lease
• If a capital lease, must be recorded as an asset
  and a corresponding debt obligation.
• The value of the asset and the obligation are
  obtained by calculating the PV of the lease
  payments. Since this agreement requires payment
  in advance, this transaction is an annuity in
  advance. (i.e. The first payment is made
  immediately then 19 more payments)- Use PV of
  an Annuity in Arrears Table Table 4 in
  Appendix, Chptr. 10

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Long-Term Liabilities

• Leasing Example Operating Lease (see pg. 574
  of text) vs. Capital Lease
• Capital Lease Entry (at signing date)Dr/ Asset
  under Lease 30,647.60 Cr/ Lease
  Obligation 30,647.60
• Capital Lease Expense Entry (at end of qtr.)Dr/
  Amortization Expense 1,532.38 Cr/
  Accumulated Amortization 1,532.38Since
  title doesnt pass at the end, useful life
  lease term and residual value 0. Therefore,
  assuming straight-line amortn., qrtrly amortn.
  (30,647,60 / 20 quarters)

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Long-Term Liabilities

• Leasing Example Operating Lease vs.
  Capital Lease
• Capital Lease Payment Entry (1st day of qtr.)Dr/
  Lease Obligation 2,000.00 Cr/
  Cash
  2,000.00
• Capital Lease Expense Entry (_at_ end of 1st
  qtr.)Dr/ Interest Expense
  859.43 Cr/ Lease Obligation
  859.43 (30,647.60 - 2,000) x 12 x
  3/12 28,647.60 x 3

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Long-Term Liabilities

• Leasing Example Operating Lease vs.
  Capital Lease
• Capital Lease Expense Entry (_at_ end of 2nd
  qtr.)Dr/ Interest Expense
  825.21 Cr/ Lease Obligation
  825.21 ( 28,647.60 859.43 - 2,000) x
  12 x 3/12 27,507.03 x 3
• By the end of the lease term, the lease
  obligation will be 0.
• For a lease, interest is added directly to the
  lease obligation account and cash payments
  directly reduce the balance.

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Long-Term Liabilities

• Leasing Example Operating Lease vs.
  Capital Lease
• Effects of capital lease on financial stmts.
• assets and liabilities will be higher by
  30,647.60
• on the income stmt., both amortization expense
  and interest expense are reported vs. only rent
  expense.
• total expense over the life of the lease is equal
  under both leases (i.e. 40,000) but the capital
  lease creates greater expense early in the lease.
  (see exhib. 10-10, pg.
  576)

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Long-Term Liabilities

• Leasing GAAP Disclosure
• co.s with capital leases and with significant
  operating leases are required to disclose future
  lease payments in total and for each of the next
  5 years.
• disclosure is in the form of a note to the
  financial statements under long-term debts,
  commitments, or contingencies.

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Long-Term Liabilities

• Leasing Lessor Accounting
• for capital leases
• The asset is provided to the lessee. Therefore,
  the capital asset is replaced (credited) and a
  receivable asset is set up on the lessors
  balance sheet.
• for operating leases
• The lessor retains the asset as owner.
• Lease revenue is recorded.

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Long-Term Liabilities

• Pensions
• Agreements between employers and employees that
  provide employees with specified benefits
  (income) upon retirement.
• Represent a future obligation.
• 2 types - Defined Contribution Plans
  - Defined Benefit Plans
• Vested - if there is a provision that benefits
  belong to employees whether they remain employed
  by the co. or not.

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Long-Term Liabilities

• Pensions Defined Contribution Plans
• Employer agrees to contribute a set (defined)
  amount (usually a of salary) to the employees
  retirement fund. The employees may also make
  contributions in some plans.
• The employers obligation is satisfied upon
  payment into the fund.
• Usually managed by a trustee. Assets are kept
  separate from the assets of the co. Therefore,
  not reported on the balance sheet.

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Long-Term Liabilities

• Pensions Defined Contribution Plans
• Co.s record pension expense and normally pay the
  obligation promptly. Only payments are
  recognized as expense for tax purposes.
• Accrual Entry
• Dr/ Pension Expense xxxx Cr/
  Pension Obligation xxxx
• Funding Entry
• Dr/ Pension Obligation xxxx Cr/
  Cash xxxx

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Long-Term Liabilities

• Pensions Defined Benefit Plans
• Guarantees to pay a certain amount of money
  during each retirement year to an employee.
• Payment s usually take into consideration - an
  employees length of employment as well as
  highest salaries (or ave. of highest
  salaries).(e.g. ave. highest salaries x factor
  x of years) 60,000 x 3 x 20 years
  36,000/year

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Long-Term Liabilities

• Pensions Defined Benefit Plans
• To estimate present value, factors, (normally
  based on the average employee), to be considered
  are
• Projections of length of employee service.
• Age at retirement.
• Average salary at retirement.
• Length of life after retirement.
• Whether will remain employed with co.
• Appropriate interest rate for NPV calculation.
• An Actuary (trained in statistical procedures) is
  usually retained by a co. to make pension
  calculations.

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Long-Term Liabilities

• Pensions Defined Benefit Plans -Accounting
  Entries
• Accrual and funding entries are the same as for
  defined contribution plans.
• Many pension plan agreements require the co. to
  fund the pension obligation. However, there is
  no requirement that the s expensed the s
  funded.
• If s expensed gt s funded, then a net pension
  obligation.
• If s expensed lt s funded, then a net pension
  asset.

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Long-Term Liabilities

• Pensions Defined Benefit Plans - Funding
• Pension funds are
• Fully funded - if assets in the fund the PV of
  future pension obligations.
• Overfunded - if assets in the fund gt the PV of
  future pension obligations.
• Underfunded - if the PV of future pension
  obligations gt assets in the fund.
• A trustee normally handles the fund and is
  responsible for investing the contributions to
  provide sufficient funds to pay benefits from the
  fund assets.
• Contributions to a fund cannot be returned to an
  employer except under extraordinary
  circumstances.

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Long-Term Liabilities

• Pensions GAAP Annual Statement Disclosures
• Defined contribution plans- simply contribution
  amounts for the period.
• Defined benefit plans- disclosure is extensive
  (including PV of future obligations and
  fair value of pension fund assets).

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Long-Term Liabilities

• Other Employment Benefits
• To date, health-care and life insurance costs,
  due to publicly funded health care in Canada,
  create limited exposure to co.s.
• Therefore, in the past these were expensed as
  cash was paid out.
• As of 2000, since limited exposure may not hold
  true into the future, companies are required to
  account for these items much the same way as
  pensions.

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Liabilities

• Statement Analysis Considerations
• Major concern is the possibility of unrecorded
  liabilities or off-balance-sheet liabilities
  (e.g. operating leases).
• Debt/equity ratio can be understated and times
  interest earned ratio can be overstated.
• Therefore, understand the co. and the types of
  contracts it enters into.

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Liabilities

• Statement Analysis Considerations
• Fluctuations in market interest rates cause
  differences between the book values of
  liabilities (as per GAAP, calculated at interest
  rates in effect when the debt was issued) and
  their current market values.
• Fluctuations in foreign currency rates can cause
  increases or decreases in those liabilities
  expressed in Cdn. s.

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Liabilities

• Statement Analysis Considerations
• Fluctuations in interest rates on debt agreements
  with floating (or variable) interest rates can
  cause significantly higher future interest
  payments.
• Both the risk of currency and interest rate
  fluctuations can be minimized through through
  hedging techniques.
• There is a guideline requiring co.s to disclose
  interest and currency transactions and their
  associated risks.

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Liabilities

• Statement Analysis
• Both the Debt/Equity Ratio and the Times Interest
  Earned Ratio are used to evaluate a co.s ability
  to repay its obligations. (i.e. Long-term
  liquidity.) Debt/Equity Ratio (D/E)
  Total Liabilities
• Total LiabilitiesShareholders Equity
• Norm for non-financial corporations is between
  45 and 50. (see Exhib. 10-14 and
  Pgs. 584-586)

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Liabilities

• Statement Analysis
• Times Interest Earned Ratio (TIE)
  
• Income before interest
  and taxes
• Interest
• Net income Taxes
  Interest
• Interest
• Compares the amount of earnings available to pay
  interest to the level of interest expense.
  (i.e. measures the co.s ability to pay
  interest out of earnings). Low single digits
  might signal a warning.
• Both ratios are used in trend analysis and/or
  comparison to other co.s in an industry.