Chapter 16 LongTerm Liabilities

1
Chapter 16 Long-Term Liabilities
2
Reasons for Long-Term Liabilities

• Long-term liabilities are obligations of a
  business that are due to be paid after one year
  or beyond the operating cycle, whichever is
  longer.
• Decisions related to long-term debt are critical
  because how a company finances its operations is
  the most important factor in the companys
  long-term viability.

3
Reasons and Resources for Long-Term Debt

• The amount and type of debt a company incurs
  depends on many factors, including the nature of
  the business, its competitive environment, the
  state of the financial markets, and the
  predictability of its earnings.
• Growing businesses frequently need long-term
  financing to invest in RD activities and
  long-term assets.

4
Reasons and Resources for Long-Term Debt

• Two key sources of long-term funds
• 1. Issuance of capital stock.
• 2. Issuance of long-term debt such as bonds,
  notes, mortgages, and leases.
• Related management issues
• Whether to have long-term debt.
• How much long-term debt to have.
• What types of long-term debt to have.

5
The Decision to Issue Long-Term Debt

• A key management decision is whether to rely
  solely on stockholders equity or to rely
  partially on long-term debt for long-term funds.
• Advantages of common stock over debt.
• It does not have to be paid back.
• Dividends are paid only if the company earns
  sufficient income.
• Advantages of long-term debt over common stock.
• Stockholder control creditors do not elect
  directors.
• Tax effects - interest is tax deductible.
• Financial leverage after interest is paid, all
  excess earnings accrue to stockholders.

6
Disadvantages of Debt Financing

• Cash is required to make periodic interest
  payments and to pay back the principal amount.
• Company can become overcommitted.

7
Disadvantages of Debt Financing

• Financial leverage can work against a
  company if the earnings from its investments
  do not exceed its interest payments.
• Managers must know the characteristics of the
  various types of long-term liabilities so that
  they can structure a companys long-term
  financing to the best advantage of the company.

8
How Much Debt?

• The use of debt financing varies widely across
  industries.
• Failure to make timely payments could force a
  company into bankruptcy.

9
How Much Debt?

• The interest coverage ratio (ICR) is a measure of
  how much risk a company is undertaking with its
  debt.
• The ICR measures the degree of protection a
  company has from default on interest payments.

10
What Types of Long-Term Debt

• Long-term bonds (debentures) have different
  characteristics.
• Time until repayment.
• Amount of interest.
• Ability to repay early.
• Conversion into other securities.
• Other types of long-term debt.
• Long-term notes.
• Mortgages.
• Long-term leases.
• Long-term financing must be structured to the
  best advantage of the company.

11
Discussion

• Q. What are the advantages and disadvantages of
  issuing long-term debt?
• A. Advantages of long-term debt are (1) common
  stockholders do not relinquish control, (2)
  interest on debt is tax deductible, and (3)
  financial leverage may increase a companys
  earnings. Disadvantages of long-term debt are (1)
  interest and principal must be repaid on
  schedule, and (2) financial leverage can work
  against a company if a project is not successful.

12
The Nature of Bonds

• A bond is a security, usually long term,
  representing money borrowed from the investing
  public by a corporation or some other entity.
• Bonds must be repaid at a specified time and
  require periodic (usually semiannual) payments of
  interest.

13
The Nature of Bonds

• Bondholders are creditors.
• Bonds are promises to repay the amount borrowed
  (principal) and interest at a specified rate on
  specified future dates.

14
The Nature of Bonds

• The bondholder receives a bond certificate as
  evidence of the company's debt.
• A bond issue is the total number of bonds issued
  at one time.

15
The Nature of Bonds

• A bond indenture defines the rights, privileges,
  and limitations of the bondholders.
• The bond indenture describes the maturity date,
  interest payment dates, interest rate, and other
  characteristics of the bonds.

16
The Nature of Bonds (continued)

• The price of bonds is stated in terms of a
  percentage of face (or par) value.
• A quote of 103 1/2 means the price is 1,035 per
  1,000 bond.
• When a bond is sold above 100, it sells at a
  premium.
• When a bond is sold below 100, it sells at a
  discount.

17
Bond Features

• A bond indenture is written to fit the financing
  needs of a business.
• Bonds may have several features.
• Secured or unsecured.
• Term or serial.
• Registered or coupon.

18
Secured or Unsecured Bonds

• Unsecured bonds (debentures) are issued based on
  the companys credit rating.
• Secured bonds give bondholders a pledge of
  certain assets as a guarantee of repayment.

19
Term or Serial Bonds

• Term bonds all mature at the same time.
• Serial bonds mature on several different dates.

20
Registered or Coupon Bonds

• Registered bondholders are recorded with the
  issuing company. Interest is paid by check.
• Coupon bonds are not registered with the
  corporation instead, they bear interest coupons
  stating the amount of interest due and the
  payment date.
• The bondholder removes the coupons from the bonds
  on the interest payment dates and presents them
  at a bank for collection.

21
Discussion

• Q. What are a bond certificate, a bond issue,
  and a bond indenture?
• A. A bond certificate is the document that gives
  evidence of a companys debt to a bondholder. A
  bond issue is the total amount of bonds made
  available at one time. A bond indenture is the
  supplementary agreement that specifies the
  characteristics of the bond issue.

22
Accounting for Bonds Payable

• When the board of directors decides to issue
  bonds, it presents the proposal to the
  stockholders for approval.
• Certificates and a bond agreement are prepared.
• When bonds are authorized, no journal entry is
  required.
• Normally, a memo entry is made giving the
  particulars of the bond issue.

23
Balance Sheet Disclosure of Bonds

• Bonds are disclosed on the balance sheet in one
  of two ways
• Usually as long-term liabilities.
• Possibly as current liabilities if maturity date
  is within one year.

24
Important Provisions of the Bond Indenture

• Important provisions of the bond indenture are
  reported in the notes to the financial
  statements.
• List of bond issues.
• Kinds of bonds.
• Interest rates.
• Any securities connected with the bonds.
• Interest payment dates.
• Maturity dates.
• Effective interest rates.

25
Bonds Issued at Face Value

• Jan. 1 Cash 100,000
• Bonds Payable 100,000
• Sold 100,000 of 9, 5-year bonds
  at face value
• July 1 Bond Interest Expense 4,500
• Cash 4,500
• Semiannual interest
  100,000 x .09 x 6/12 year

26
Face and Market Interest Rate

• Face Interest Rate the rate of interest, on
  an annual basis, paid to bondholders, expressed
  as a percentage of the face value of the bond.
  
• Market Interest Rate the rate of interest paid
  in the market on bonds of similar risk, also
  called effective interest rate.
• Discounts or Premiums result from a difference
  between the Market Interest Rate on date of issue
  and the Face Interest Rate, established by the
  bond issuer prior to the date of issue.

27
Bonds Issued at a Discount

• Jan. 1 Cash 96,149
• Unamortized Bond Discount 3,851
• Bonds Payable 100,000
• Sold 100,000 of 9, 5-year bonds at
  96.149
• Face amount of bonds 100,000
• Less purchase price 96,149
• Unamortized bond discount
  3,851

28
Bonds Issued at a Premium

• Jan. 1 Cash 104,100
• Unamortized Bond Premium
  4,100
• Bonds Payable 100,000
• Sold 100,000 of 9, 5-year bonds at
  104.1 Purchase price 104,100
• Less face amount 100,000
• Unamortized premium 4,100

29
Bond Issue Costs

• Fees to underwriters.
• Amortized over the life of the bonds in a
  separate account.
• Bond issue costs decrease the amount of cash
  received.
• Increase bond discount.
• Decrease bond premium.
• Bond issue costs can be spread over the life of
  the bonds through the amortization of a discount
  or premium.

30
Discussion

• Q. Under what circumstance does a bond sell at
  face value?
• A. When the face interest rate of the bond is
  identical to the market interest for similar
  bonds on the date of issue.

31
Using Present Value toValue a Bond

• Present value is relevant to the study of bonds
  because the value of a bond is based on the
  present value of two components of cash flow.

1. A series of fixed interest payments. 2. A
single payment at maturity.

• The amount of interest a bond pays is fixed over
  its life.

32
Influence of theMarket Interest Rate

• The market interest rate varies from day to day
  and therefore what investors are willing to pay
  changes as well.
• If the current market interest rate is now
  greater than the bonds interest rate
• Investors are willing to pay less.
• If the current market interest rate is now less
  than the bonds interest rate
• Investors are willing to pay more.

33
Discussion

• Q. A corporation sold 500,000 of 5, 1,000
  bonds on the interest payment date. What would
  the proceeds from the sale be if the bonds were
  issued at 95, at 100, and at 102?
• A. The proceeds from the sale of 500,000 in
  bonds at 95 would be 475,000 at 100,
  500,000 and at 102, 510,000.

34
Present Value of a Bond

• For a bond with a face value of 10,000, paying
  450 every 6 months (9 annual rate), due in 5
  years, cash flows to bondholder are 9 payments of
  450 every six months, followed by one payment of
  10,450.
• If the Market Rate is 14 on date of issue, use
  tables, calculator, or computer for number of
  periods 10, i 7, to give present value of
  cash flows 8,240.80.
• If the Market Rate is 8 on date of issue, number
  of periods 10, i 4, to give present value of
  cash flows 10,409.95.

35
Bond Discount Issues

• When a bond is sold at a discount, the discount
  affects interest expense in each year of the bond
  issue.
• Discount should be amortized over the life of the
  issue.
• Unamortized bond discount decreases gradually
  over time.

36
Bond Discount Issues

• Carrying value increases gradually.
• By maturity date
• The carrying value of the issue equals the face
  value amount of the bonds.
• The unamortized bond discount is zero.

37
Calculation of Total Interest Cost

• When bonds are sold at a discount, the effective
  interest rate paid by the company is greater than
  the face interest rate on the bonds.
• Total Interest Cost Total Stated Interest
  Bond Discount.
• Actual Interest Expense
• (Issue Price - Face Value) Total Interest
  Payments.

38
Calculation of Total Interest Cost(continued)

• Cash to be paid to bondholders
• Face value at maturity 100,000
• Interest payments 45,000
• Total cash to be paid 145,000
• Less cash received 96,149
• Total interest cost 48,851
• Or
• Interest Payments 45,000
• Bond discount 3,851
• Total interest cost 48,851

39
Accounting for Total Interest Cost

• Effective Interest Rate Stated Rate Discount.
• The discount must be allocated over the remaining
  life of the bonds as an increase in the interest
  expense each period this is amortization of the
  bond discount.
• The interest expense for each period will exceed
  the actual payment of interest by the amount of
  the bond discount amortized over the period.
• Zero coupon bonds are issued by some companies
  and governmental units.
• They do not require periodic interest payments.
• They represent a promise to pay a fixed amount at
  the maturity date.

40
Zero Coupon Bonds

• Zero coupon bonds are issued by some companies
  and governmental units.
• They do not require periodic interest payments.
• They represent a promise to pay a fixed amount at
  the maturity date.

41
Methods of Amortizinga Bond Discount

• Straight-line method only used when not
  significantly different from effective interest
  method.
• Effective interest method preferred by APB.

42
Methods of Amortizing a Bond Discount

• Straight-Line Method
• Equal amortization of bond discount over each
  accounting period.
• Bond Discount 3,851
• Number of interest periods 10
• Amortization of Bond Discount per Interest
  Period 385
• First, semiannual interest payment
• July 1 Bond Interest Expense 4,885
• Unamortized Bond Discount 385
• Cash 4,500
• Paid semiannual interest to bondholders and
  amortized the discount on 9, 5-year bonds.

43
Methods of Amortizing a Bond Discount

• Effective Interest Method
• Apply a constant rate of interest to the
  carrying value at the beginning of
  each accounting period.
• Face value of bond 10,000
• Bond discount 3,851
• Carrying value at beginning of
• first period 96,149
• Semiannual interest expense _at_ 5 4,807
• Cash paid to bondholder 4,500
• Amortization of bond discount for first
• interest period 307
• Bond discount (at end of first period) 3,544
  (3,851 - 307)
• Carrying value at end of first period 96,456
  (10,000 - 3,544)

44
Amortizing a Bond Premium

• A bond premium represents an amount that
  bondholders will not receive at maturity.
• The premium is a reduction, in advance, of the
  total interest paid on the bonds over the life of
  the bond issue.

45
Calculation of Total Interest Cost

• Cash to be paid to bondholders
• Face value at maturity 100,000
• Interest payments (100,000 x .09 x 5yrs)
  45,000
• Total cash to be paid 145,000
• Less cash received
  
  104,100
• Total interest cost
  40,900
• Total interest payments of 45,000 exceed the
  total interest costs of 40,900 by 4,100, the
  amount of the bond premium.

46
Straight-Line Method of Amortizing a Bond Premium

• Bond premium is spread evenly over the life of
  the bond issue.
• Bond Interest Stated Interest - Premium.
• Bond Interest Expense per period Total Interest
  Cost Number of periods
• July 1 Bond Interest Expense 4,090
• Unamortized Bond Premium 410
• Cash 4,500
• Paid semiannual interest and
• amortized premium on
• 9, 5-year bonds

47
Effective Interest Method of Amortizing a Bond
Premium

• The interest expense decreases slightly each
  period because the amount of the bond premium
  amortized increases slightly each period.
• Apply a constant interest rate to the carrying
  value at the beginning of each period.
• July 1 Bond Interest Expense 4,164
• Unamortized Bond Premium 336
• Cash 4,500
• Paid semiannual
• interest to bondholders and
• amortized premium on 9,
• 5-year bonds

48
Discussion

• Q. Why is a bond discount considered a component
  of total interest cost?
• A. A bond discount represents the amount in
  excess of the issue price that must be paid by
  the corporation at the time of maturity.

49
Sale of Bonds Between Interest Dates

• Generally accepted method is to collect from
  investors the interest that would have accrued
  for the partial period preceding the issue date.
• When the first interest period is completed, the
  corporation pays investors the interest for the
  entire period.

50
Sale of Bonds Between Interest Dates

• This procedure is followed for two reasons
• 1. Decreases bookkeeping for sales at
  various dates.
• 2. When the accrued amount is netted against
  the full interest paid on the interest payment
  date, the result is the interest expense for
  the time the money was borrowed.

51
Accounting for Sale of Bonds Between Interest
Dates

• May 1 Cash 103,000
• Bond Interest Expense 3,000
• Bonds Payable 100,000
• Sold 9, 5-year bonds at face plus 4
  months accrued interest 100,000 x
  .09 x 4/12 3,000
• July 1 Bond Interest Expense 4,500
• Cash 4,500
• Paid semiannual interest 100,000 x
  .09 x 6/12 4,500

52
Effect on Bond Interest Expense When Bonds Are
Issued Between Interest Dates
53
Year-End Accrual for Bond Interest Expense

• Assume fiscal year ends Sept. 30
• Sept. 30 Bond Interest Expense 2,075.50
• Unamortized Bond
• Premium 174.50
• Interest Payable
  2,250.00 To record accrual of interest on
• 9 bonds payable for 3 months
• and amortization of one half of the
• premium for the second interest
• payment period

54

• When the next interest payment date occurs
• Jan. 1 Bond Interest Expense 2,075.50
• Interest Payable 2,250.00
• Unamortized Bond
• Premium 174.50
• Cash 4,500.00
• Paid semiannual interest
• including interest previously
• accrued, and amortized the
• premium for the period since
• the end of the fiscal year

55
Retirement of Bonds

• Most bond issues give the corporation a chance to
  buy back and retire the bonds at a call price,
  usually above face value, before maturity.
• Such bonds are known as callable bonds.
• The retirement of a bond issue before its
  maturity date is called early extinguishment of
  debt.

56
Accounting forRetirement of Bonds

• Retirement of Bonds (on an interest payment date)
  at 105, as stated in the bond indenture.
• July 1 Bonds Payable 100,000
• Unamortized Bond Premium 1,447
• Loss on Retirement of Bonds 3,553
• Cash 105,000
• Retired 9 bonds at 105

57
Conversion of Bonds into Common Stock

• Convertible bonds can be exchanged for other
  securities of the corporation.
• Convertibility enables an investor to make more
  money because if the market price of the common
  stock rises, the value of the bonds rises.
• If the stock price does not rise, the investor
  still holds the bonds and receives both interest
  payments and principal at the maturity date.

58
Reasons a Company Issues Convertible Bonds

• Desirability of convertible bonds to investors
  enable companies to issue at lower
  interest rates lower cost.
• Management does not give up any control
  bondholders have no voting rights.
• Bond interest expense is tax deductible tax
  savings.
• If the company earns a return higher than the
  interest expense, income will increase.
• Financial flexibility If stock price increases
  and convertible bond price exceeds face value,
  management can avoid repaying bonds because
  bondholders will want to convert into common
  stock.

59
Possible Disadvantages of Convertible Bonds

• Bond interest payments must be made on stated
  dates (usually semiannually.) Failure to do so
  can lead to bankruptcy.
• When bonds are converted, bondholders become
  stockholders with additional rights, e.g. voting
  rights.
• Conversion to common stock dilutes existing
  stockholders ownership.

60
Accounting for Conversion of Bonds into Common
Stock

• July 1 Bonds Payable 100,000
• Unamortized Bond Premium 1,447
• Common Stock 32,000
• Paid-in Capital in Excess
• of Par Value, Common 69,447
• Converted 9 bonds payable
• into 8 par value common stock
• at a rate of 40 shares for each
• 1,000 bond

61
Discussion

• Q. Why would a company want to exercise the
  callable provision of a bond when it can wait to
  pay off the debt?
• A. A company may have earned enough money to pay
  off the debt the reason for the debt may no
  longer exist market conditions may have
  changed, making it cost-effective to call
  thedebt or the company may want to restructure
  its debt to equity ratio.

62
Mortgages Payable

• A mortgage is a long-term debt secured by real
  property, usually paid in equal monthly
  installments.

63
Installment Notes Payable

• Installment notes payable occur when the terms of
  a note call for a series of periodic payments.
• Each payment includes the interest plus a
  repayment of part of the amount that was borrowed.

64
Installment Notes Payable

• On 12/31/x1, 100,000 is borrowed on a 15,
  5-year installment note.
• 12/31/x1 Cash 100,000
• Notes Payable 100,000
• Borrowed 100,000 at 15 on a 5-year
  installment note

65
Payments of Accrued Interest Plus Equal Amounts
of Principal

• 12/31/x2 Notes Payable 20,000
• Interest Expense 15,000
• Cash 35,000
• Made first installment
  payment on note 100,000 x .15
  15,000
• 12/31/x3 Notes Payable 20,000
• Interest Expense 12,000
• Cash 32,000
• Made second installment
  payment on note
  80,000 x .15 12,000

66
Payments of Accrued Interest Plus Increasing
Amounts of Principal

• 12/31/x2 Notes Payable 14,833
• Interest Expense 15,000
• Cash 29,833
• Made first installment
  payment on note
• 12/31/x3 Notes Payable 17,058
• Interest Expense 12,775
• Cash 29,833
• Made second installment
  payment on note

67
Long-Term Leases

• There are several ways for a company to obtain
  new operating assets.
• 1. Borrow money and buy the asset.
• Asset and liability are recorded at the amount
  paid.
• Asset is subject to periodic depreciation.

68
Long-Term Leases

• 2. Rent the asset on a short-term lease.
• Operating lease.
• Risks of ownership remain with the lessor.
• 3. Obtain the asset on a long-term lease.
• Requires no immediate cash payment.
• Rental payment is deducted in full for tax
  purposes.
• Cost is less than a short-term lease.

69
Related Accounting Challenges for Long-Term Leases

• Often the lease cannot be canceled.
• Duration of the lease may be about the same as
  the useful life of the asset.
• There may be a provision for the lessee to buy
  the asset at the end of the lease term.
• Similar to an installment purchase.

70
Capital Leases

• A capital lease is more like a purchase or
  installment sale.
• The lessee must record an asset and a long-term
  liability equal to the present value of the lease
  payments over the lease term.
• Each lease payment consists of interest and
  repayment of debt.
• Depreciation is computed on the asset.

71
Classifications withLong-Term Leases

• Equipment Under Capital Lease is classified as a
  long-term asset.
• Obligations Under Capital Lease are classified as
  a long-term liability.

72
Pensions

• A pension plan is a contract between a company
  and its employees in which the company agrees to
  pay benefits to the employees after they retire.
• Contributions from the employee and the company
  are paid into a pension fund.

73
Pensions

• Defined contribution plans require that the
  employer contribute an annual amount specified by
  an agreement between the company and its
  employees or a resolution of the board of
  directors.

74
Pensions

• Defined benefit plans require that the employers
  annual contribution is the amount needed to fund
  pension liabilities arising from employment in
  the current year, but the exact amount will not
  be determined until the retirement and death of
  the current employees.

75
Other Postretirement Benefits

• Postretirement benefits are in addition to
  pension benefits and include health care and
  other benefits.
• In the past, they were accounted for on a cash
  basis.
• The FASB has concluded that they should be
  estimated and accrued while the employee is
  working, in order to follow the matching
  principle.

76
Discussion

• Q. What is a pension plan? What assumptions must
  be made to account for the expenses of such
  a plan?
• A. A pension plan is a contract between a company
  and its employees in which the company agrees to
  pay benefits to the employees after they retire.
  Among the assumptions that must be made to
  determine the costs of a pension plan are the
  average remaining service life of active
  employees, the expected return on pension plan
  assets, and expected future salary increases.