7 e 10 Long-Term Liabilities Statements and the Annual

Balance Sheet Classifications Current liabilities: Due within one year of the balance sheet date Long-term liabilities: Due beyond one year LO 1

Long-Term Liabilities v Bonds payable v Notes payable v Leases v Deferred taxes

Bonds Investor Borrower v Long-term borrowing arrangement v Interest paid at stated rate and times v Principal repaid at maturity date LO 2

Bond Interest Rates Face rate of interest the rate specified on the bond certificate also called: stated rate coupon rate nominal rate contract rate Market rate of interest the rate that investors could obtain by investing in other bonds similar to the issuing firm’s bonds also called: effective rate yield LO 3

Calculating Bond Prices Two sets of cash flows (1) Interest payments made each period PV = ? $$ $$ $$ etc. $$ (2) Principal due at maturity PV = ? $$$$$

Determining Bond Prices Example: On 1/1/10, Discount Firm issues: v $10, 000, 8% bonds v Due December 31, 2011 v Interest payable annually v Market rate of interest = 10% Calculate the issue price of the bonds.

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

Recording Bond Discount LO 4

Balance Sheet Presentation of Bond Discount Long-term liabilities: Bonds payable $10, 000 Less: Discount on bonds payable 634 $ 9, 366

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

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

Recording Bond Premiums

Balance Sheet Presentation of Bond Premium Long-term liabilities: Bonds payable $10, 000 Plus: Premium on bonds payable 692 $10, 692

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

Amortization of Bond Premiums and Discounts Transferring an amount from the discount or premium account to interest expense over the life of the bond using the effective interest method Premium reduces interest expense Discount increases interest expense LO 5

Amortization Schedule – Discount Cash Interest Discount Carrying Date Interest Expense Amortized Value 1/ 1/10 — — — $ 9, 366 12/31/10 $800 $937 $137 9, 503 12/31/11 800 950 150 9, 653 12/31/12 800 965 165 9, 818 12/31/13 800 982 10, 000 (rounded)

Amortization Schedule – Premium Cash Interest Discount Carrying Date Interest Expense Amortized Value 1/1/10 — — — $10, 692 12/31/10 $800 $642 $158 10, 534 12/31/11 800 632 168 10, 366 12/31/12 800 622 178 10, 188 12/31/13 800 612 188 10, 000 (rounded)

Redemption of Bonds v Reasons for early redemption: • Excess cash • Changing interest rates Gain = Carrying Value – Redemption Price Loss = Redemption Price – Carrying Value LO 6

Leases v Contractual arrangement v Grants right to use asset in exchange for payments v Form of financing Lessee Lessor LO 7

Operating Leases v Record as rent (lease) expense each period v Disclose future lease obligations in financial statement notes OFFICE SPACE FOR LEASE

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

Criteria for Lease Capitalization Lease meets one or more: v Transfers ownership of property v Contains a bargain-purchase option v Term is > 75% of property’s life v Present value of payments is > 90% of property’s fair market value

IFRS and Leases v In U. S. , if any of the previous criteria are present, the lease is considered a capital lease v IFRS considers these criteria as “guidelines” rather than rigid rules v Because of these differences , there is much more flexibility with international standards.

Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed as compared to owners? LO 8

Times Interest Earned Ratio Income Before Interest and Tax Interest Expense Will they be able to pay the interest on their debt?

Debt Service Coverage Ratio Cash Flow from Operations Before Interest and Tax Interest and Principal Payments Will they be able to repay the principal on their loan?

Long-Term Liabilities on the Statement of Cash Flows Operating Activities Net income Increase in current liability Decrease in current liability Investing Activities Financing Activities Increase in long-term liability Decrease in long-term liability xxx + – LO 9

Appendix Accounting Tools: Other Liabilities

Deferred Tax v Used to reconcile the differences between the accounting for book purposes and for tax purposes v Should reflect temporary differences but not permanent differences Permanent difference – affects the tax records but not the accounting records, or vice versa Temporary difference – affects both book and tax records but not in the same period LO 10

Deferred Income Taxes Sales Depreciation Expense Taxable Income × Tax Rate Tax Payable to IRS Difference recorded as deferred tax Book $6, 000 2, 500 3, 500 40% $1, 400 Tax $6, 000 4, 000 2, 000 40% $ 800 $ 600

Deferred Income Taxes Income tax Book $1, 400 $ 600 Tax $ 800

Deferred Income Taxes

End of Chapter 10