LongTerm Liabilities

1
Chapter 14

• Long-Term Liabilities

2
Nature of Long-Term Liabilities

• Present obligations not payable within the
  operating cycle, or a year whichever is longer
• Long-term creditors have no vote in management
  affairs and only receive a stated rate of
  interest regardless of the level of earnings

3
Nature of Long-Term Liabilities

• Covenants or restrictions, for the protection of
  both lenders and borrowers, are stated in the
  bond indenture or note agreement

4
Bonds Payable

• Arise from a contract known as a bond indenture
• Represent a promise to pay the principle at
  maturity and periodic interest based on the
  stated interest rate and the face value of the
  bond
• Types-term, serial, secured, unsecured,
  convertible, commodity-backed, deep discount,
  registered, coupon

5
Bonds Payable

• Bond selling price determined by the bonds
  stated interest rate and its market rate
• Selling price equals sum of the present value of
  principle and the present value of the periodic
  interest

6
Bond Selling Price

• If stated rate market rate, bonds will sell at
  par (equal to face value)
• If stated rate lt market rate, bonds will sell at
  a discount (less than face value)
• If stated rate gt market rate, bonds will sell at
  a premium (more than face value)

7
Issuance of Bonds

• Discount on Bonds Payable is a contra-account to
  (subtracted from) Bonds Payable
• Premium on Bonds Payable is an adjunct account to
  (added to) Bonds Payable

8
Bonds Sold Between Interest Payment Dates

• Interest accrued since last interest payment
  collected from purchaser
• Accrued interest is credited to Bond Interest
  Expense
• A full period of Interest Expense and Interest
  Payment is made at the next interest payment date

9
Amortization of Bond Discounts Premiums

• Amortization or allocation period is the period
  of time that the bonds are expected to be
  outstanding
• Bond interest expense is increased by
  amortization of a discount and decreased by
  amortization of a premium
• Effective interest method of amortization is
  preferred over the straight line method

10
Effective Interest Method of Amortization

• Carrying Value of Bonds Face Value plus Premium
  (or less Discount)
• Interest Payable Stated Interest Rate X Face
  Value of Bonds
• Interest Expense Effective Interest Rate X
  Carrying Value of Bonds
• Amortization is difference between Interest
  Payable and Interest Expense

11
Bond Issuance Expenses

• Are debited to a deferred charge account such as
  Bond Issue Costs and amortized over the life of
  the bond issue, using the straight line method

12
Treasury Bonds

• Issued bonds that have been reacquired
• Shown on balance sheet, at par, as a deduction
  from bonds payable

13
Extinguishment of Debt

• Difference between the net carrying amount and
  the re-acquisition price is a gain or loss
• Reacquisition price price call premium
  reacquisition expenses
• Carrying amount face value /- unamortized
  premium/discount unamortized issuance costs
• Gain or Loss is NOT an extraordinary item

14
Long-Term Notes Payable

• Applying APB 21 insures proper accounting for
  transactions where form does not reflect economic
  substance of the arrangement because of a failure
  to provide for a realistic interest rate on
  amounts payable or receivable

15
Notes Not Issued at Face Value

• Zero Interest-Bearing Notes Issued for Cash
• Implicit interest rate is rate that equates the
  cash received (PV) with the amounts received in
  the future
• Difference between face amount and present value
  is the discount or premium and it is amortized
  over the life of the note

16
Notes Not Issued at Face Value

• Interest-Bearing Notes with an Effective Rate
  Different than the Stated Rate
• If the stated rate is unreasonable, an imputed
  interest rate must be used to determine the PV of
  the note
• Any discount or premium must be recognized and
  amortized over the life of the note

17
Special Note Payable Situations

• Notes exchanged for cash and some right or
  privilege
• Difference between present value of payable and
  amount of cash loaned should be regarded as a
  discount on the note
• Unearned income should be credited for same
  amount
• Unearned income recognized as revenue each period
  as the right or privilege is exercised

18
Special Note Payable Situations

• Non-cash transactions
• Present value of the debt is measured by the fair
  value of the property, goods, or services
  changing hands or by an amount that reasonable
  approximates the market value of the note

19
Special Note Payable Situations

• Imputing an interest rate
• The rate that would have resulted if an
  independent borrower and lender had negotiated a
  similar transaction
• When interest is imputed, the effective interest
  method must be used
• Journal entries are similar to entries for bonds
  payable issued at a discount

20
Mortgage Notes Payable

• Promissory note secured by property
• Usually receive cash equal to face value of the
  note
• If lender assesses points, borrower received less
  than face value of the note
• A point equals 1 of the notes face value
• Record as a note with a discount

21
Off-Balance Sheet Financing

• Project financing arrangements
• Two or more entities form new entity to construct
  operating plant that will be used by both parties
• New entity borrows funds to construct project and
  repays debt from proceeds received from project
• Payment of debt is guaranteed by companies that
  formed the new entity

22
Off-Balance Sheet Financing

• Take-or-pay-contracts
• Purchaser of goods signs agreement with seller to
  pay specified amounts periodically in return for
  an option to receive products
• Payment is made even if purchaser does not take
  delivery of goods
• Through-put agreements
• Same as take-or-pay except that a service instead
  of a product is provided

23
Off-Balance Sheet Financing

• These arrangements are only disclosed in the
  notes to the statements. They are not recorded
  in the accounts.
• Rationale
• Attempt to enhance the quality of the balance
  sheet
• Conform to loan covenants
• Balance understatement of assets

24
Reporting Long-Term Debt

• If mature within one year, report as current
  liability, unless retirement to be paid with
  other than current assets
• Disclosures indicate nature, maturity dates,
  interest rates, call provisions, conversion
  privileges, restrictions imposed by lender, and
  assets pledged as security

25
Reporting Long-Term Debt

• Future payments for sinking fund requirements and
  maturity amounts of long term debt during each of
  the next five years
• Right of setoff generally not allowed because
  netting of assets against liabilities results in
  loss of important information about rights and
  obligations

26
Reporting Long-Term Debt

• Unconditional purchase obligations disclose
• Nature and term of obligations
• Total amount of fixed and determinable portion of
  obligations at balance sheet date and for each of
  next five years (as well as imputed interest rate
  used to compute PV)
• Nature of any variable portions
• Amounts purchased each period

27
Analysis of Long-Term Debt

• Solvency
• Debt to total assets ratio
• Total debt / total assets
• Higher ratio, greater risk of insolvency
• Times interest earned
• EBIT / Interest expense
• Higher ratios, greater ability to pay

28
Appendix Troubled Debt

• Accounting Issues
• Recognition-losses should be recorded immediately
  if it is probable that a loss will occur
• Measurement
• Aggregate cash flows
• Present value-original rate
• Present value-market rate

29
Troubled Debt

• Impairments
• Impaired loan exists when it is probable that the
  creditor will be unable to collect all amounts or
  principal and interest due according to terms of
  loan
• Impairment loss is difference between carrying
  value of loan and present value of future cash
  flows discounted at its original rate

30
Troubled Debt Restructurings

• Settlement of debt
• Debtor (creditor) records gain (loss) equal to
  the excess of carrying amount of the payable
  (receivable) over the fair value of the assets
  transferred
• Debtor also recognizes gain or loss equal to the
  difference between the fair value of the assets
  transferred and their book value

31
Troubled Debt Restructurings

• Modification of terms
• Debtor does not record gain when total future
  cash flows exceed the pre-restructuring carrying
  amount of the debt
• Debtor does record a gain when the
  pre-structuring carrying amount of the debt
  exceeds the future cash flows