Chapter 8. Long - Term Obligations. Chapter 8 Granof-5e 1

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1 Chapter 8 Long - Term Obligations Chapter 8 Granof-5e 1

2 Thought to Ponder: Chapter 8 "The budget should be balanced; the treasury should be refilled; public debt should be reduced; and the arrogance of public officials should be controlled." Cicero B.C. Chapter 8 Granof-5e 2

3 FACTS: Did you know? As of March 1, 2010, the total U.S. federal(public) debt, called the national debt passed the $12.4 trillion mark, for the first time, with about $40, per capita (that is, per U.S. resident). Of this amount, debt held by the public (federal debt held by states, corp., individuals and foreign govts) was roughly $7.7 trillion. Adding unfunded Medicaid, Social Security, Medicare, and similar obligations, this figure rises to a total of $107 trillion (this is as of June 11, 2009). Chapter 8 Granof-5e 3

4 FACTS: Long Term Obligations For FY 2009, the City of Houston had total bonded debt outstanding of $14.1 billion. The two largest portions of this total $3 billion comprising debt backed by the full faith and credit of the government and $8.2 billion comprising various enterprise fund revenue bonds For FY 2008, City of NY had Outstanding General Obligation fixed and variable rate debt of $28.69 billion and $7.41 billion, respectively. Chapter 8 Granof-5e 4

5 Learning Objectives Importance of information on Long Term Debt Significance of bankruptcy Accounting for LTD in both Fund and Government-wide Statements Demand Bonds RANs, TANs, BANs Capital & Operating Leases Miscellaneous Topics o Revenue bonds o Overlapping debt o Conduit debt Chapter 8 Granof-5e 5

6 Long-Term Obligations-Overview What is General Long-term Obligations Debt? Issued by almost every government. Takes form of liabilities, usually bonds, that are secured by the full faith and credit of the governmental unit. Arises from the governmental funds activities not proprietary or fiduciary funds*. o *If debt reported in a proprietary or fiduciary fund also has general obligation ( full faith and credit ) backing of the government, then the government s contingent liability needs to be disclosed in the notes to the financial statements Chapter 8 Granof-5e 6

7 Examples of General Long-term Liabilities Tax-supported bonds Long-term warrants Long-term notes Capital lease obligations Unfunded compensated absences (vacation and sick leave) Unfunded pension obligations Long-term portion of judgments and claims Chapter 8 Granof-5e 7

8 Importance of Long-Term Debt Failure to make timely payments can have profound repercussions. Creditor incurs losses Governments and non-profits will face loss of credit Chapter 8 Granof-5e 8

9 Bankruptcy Bankruptcy: ultimate fiscal failure Failure to satisfy claims results in bankruptcy. Many cities avoided bankruptcy by being under financial control boards. Governments can either raise tax or cut back services when in bankruptcy A government in bankruptcy transfers control to independent trustee. Chapter 8 Granof-5e 9

10 Accounting for Long-Term Obligations Government-wide Statements: All general long-term debt is reported in the governmental activities column of the governmentwide Statement of Net Assets. General LT obligations are recorded either at face value or at the amortized issue price. GASB Std. # 34 requires governments to report bonds and LT obligations at present value. Certain claims and judgments are also recorded at present value. Present values more faithfully captures the economic substance of debt than face values do. Chapter 8 Granof-5e 10

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13 Accounting for LT Obligations (cont d) Fund Statements: NOT reported as long term liabilities of governmental funds. Recorded in schedule of Long Term Debt. Recall that a debt service fund (a governmental fund), is generally established to account for the principal and interest payments on general long-term debt. LT obligations are not reported as a liability Instead, it is offset by other financing sources bond proceeds. Chapter 8 Granof-5e 13

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19 Examples Slides Chapter 8 Granof-5e 19

20 Accounting for LT Obligations (cont d) RECALL: ONLY debts resulting from past transactions for which government has already received a benefit are recognized. Excludes commitments for payments of interest for which no benefit was enjoyed. Chapter 8 Granof-5e 20

21 Example Vacation Leave City employees earned $300,000 in vacation leave they did not take in The leave vests and can be taken at any time up to retirement. The liability should be reported only in a schedule of long-term liabilities and the government-wide statements and should be based on wage and salary rates in effect on the balance sheet date (and hence adjusted each year). It should not be recognized as an expenditure. Government-wide (Stmt of Net Assets)*: Would be accrued and reported as a long-term liability: Vacation pay expense $300,000 Accrued vacation payable $300,000 *This is not an actual journal entry. It is the conversion done on the WP at the end of the year. Chapter 8 Granof-5e 21

22 Example Sick Leave 1. City employees earned $500,000 in sick leave that they did not take in City employees are permitted to accumulate up to 120 days sick leave. Any unused sick leave cannot be taken as a termination benefit. Sick leave should only be reported as a liability in a schedule of longterm liabilities and the government-wide statements only to the extent that it will be paid as a termination benefit. Hence, the sick leave earned need not be reported as a liability or an expenditure. Government-wide: Same Chapter 8 Granof-5e 22

23 Example Sabbatical Leave 1. City teachers are entitled to sabbatical leaves of six months every 7 years for research and renewal. The 2010 share of leave costs to be taken in the future was $300,000. Sabbatical leaves need not be recognized as a liability unless the leave is a reward for past service and is automatic (i.e. is for unrestricted time off). It need not be accrued if it constitutes merely a change in assigned duties (e.g. research instead of teaching). Government-wide: Same Chapter 8 Granof-5e 23

24 Example Claims & Judgments 1. The City settled a judgment brought against it by an injured employee. The City agreed to pay $6 million in 2010 and $4 million in each of the next five years. Expenditures $6 Claims payable $6 In addition the $20 million balance in the settlement should be reported in a schedule of long-term obligations as well as in the government-wide statements. However the $20 million should be discounted to reflect the time value of money, since the settlement is structured (payments are on specified dates in the future see Statement No. 10, para. 59). Government-wide: Would accrue; assume a discount rate of 6 percent and five payments at the end of the following five years. Claims Expense $22.8 Claims payable (current) $ 6.0 Claims payable (long-term) 16.8 Chapter 8 Granof-5e 24

25 Example Installment Note 1. It acquired the same computer, issuing a three-year, 6 percent, installment note for the purchase price. During the year it paid the first installment of $1,122,330 (interest of $180,000 and principal of $942,330). GF: Expenditures acquisition of capital assets $3,000,000 Other financing sources installment note proceeds $3,000,000 DSF: Expenditures Installment note interest $ 180,000 Cash $ 180,000 Expenditures Installment note principal $ 942,330 Cash $ 942,330 Government-wide (SNA): Would capitalize the asset and depreciate Chapter 8 Granof-5e 25

26 Example General Obligation Debt 1. On July 1, 2010, the City issued $100 million in 8 percent general obligation debt to finance capital improvements. The first interest payment of $4 million is due in early January No entry in the funds no need to accrue (unless budgeted in the current fiscal period and as stated in early Jan). 12/31/2010 Government-wide: (must accrue) Bond Interest expense $4M Accrued bond interest payable $4M Chapter 8 Granof-5e 26

27 Example Debt Servicing 1. In December the City transferred $2 million to the debt service fund for repayment of principal on serial bonds issued several years earlier. The payment is due in January. GF: Nonreciprocal transfer-out (debt service)$2 Cash $2 Can recognize an expenditure and a liability in the debt service fund as long as payment is due within one month (Per 13 of Interpretation No. 6): DSF: Cash $2 Nonreciprocal transfer-in (from general fund) $2 DSF: Debt service expenditure $2 Debt service payable $2 Government-wide: No entry would be necessary. Payment of principal is recorded as a reduction of a liability (Bonds Payable) when paid. Chapter 8 Granof-5e 27

28 Short Term Vs. Long Term Debt Short term: Debts expected to be liquidated with currently available assets. These debts are reported in governmental funds. Long term: reported only in governmentwide statements. Chapter 8 Granof-5e 28

29 DEMAND BONDS Demand bonds: obligations that permit the holder (the lender) to demand redemption within a specified (usually short) period of time. Hence, usually classified as shortterm obligations. Short Term obligations if... The nature of demand bonds-taken by themselves are short-term. Long Term (as opposed to fund) obligations if... 1) The government (issuer) enters into a contract called a take-out agreement where the financial institution (lender) promises to lend the issuer sufficient funds to repay the bonds and the contract satisfies the following criteria. 2) does not expire within one year 3) is not cancelable by the lender during that year 4) is capable of being financially satisfied by the lender Chapter 8 Granof-5e 29

30 Example 1 A city financed the acquisition of an equipment with bonds that could be redeemed at any time at the option of the holder. -The bonds pay interest at the rate of 6%. -At year-end, prevailing interest rates had decreased to 5%. -The city does not have a take-out agreement providing for refinancing if the bonds are presented for payment. -How should the city record the debt? Chapter 8 Granof-5e 30

31 Example 1 (Cont d) Since the city does not have take-out agreement, it cannot record the bonds as LT obligations irrespective of the interest rates. It must record the debt as a ST obligation of the general fund. Governmental Fund Capital Assets Expenditure $8 mil Demand Bonds payable $8 mil To record the acquisition of the capital asset as financed with Demand Bonds that do not satisfy the criteria of LT debt. Government-wide (Statement of Net Assets): Equipment Demand Bonds payable $8 mil To record the Equipment acquired with demand bonds. $8 mil Chapter 8 Granof-5e 31

32 RANs & TANs & BANs... OH MY! Chapter 8 Granof-5e 32

33 Revenue Anticipation Notes (RANs) and Tax Anticipation Notes (TANs) Short Term notes payable that are of specified streams of revenues. Issued to meet cash needs earlier in the year. They are NOT converted into Long Term instruments. Must be accounted for in the funds in which the related revenues are reported. Chapter 8 Granof-5e 33

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35 Bond Anticipation Notes (BANs) BANs: Short Term notes issued with the expectation that it will be replaced with Long Term bonds. GAAP says that BANs may be recognized as Long Term obligations if: 1) BANs are refinanced 2) The entity enters into an agreement that doesn t expire in 1 year, has not been violated, and is capable of being honored by the lender. Chapter 8 Granof-5e 35

36 Leases Capital & Operating Chapter 8 Granof-5e 36

37 Capital Vs. Operating Lease Capital Leases: financing arrangements. Lessee purchases an asset in exchange for LT note. Operating Lease: conventional rental agreements o Lessee uses property for a portion of its useful life. o Governments enter into operating leases because: Need asset only for a small part of its useful life Avoid risks of ownership Unavailability of cash or credit to purchase Nonappropriation clause or fiscal funding clause: permits governments to cancel lease at the end of each year. Chapter 8 Granof-5e 37

38 Accounting for Capital Leases GASB: capital leases are treated as a purchase of an asset and issuance of long-term debt. Leased asset and related liability are 1) accounted for like an installment purchase. 2) recorded at present value Fund Statements: --Dr. expenditure and Cr. other financing sources capital leases Government-wide: Accounted for as a purchase/borrow transactions. The asset is depreciated over the term of the lease. General long-term liability recorded. Chapter 8 Granof-5e 38

39 Example 1 Capital lease with present value of minimum lease payments of $50,000 Special Revenue Fund: Dr. Cr. Expenditures $50,000 Other Fin. Source-Cap. Lease Agreements 50,000 Gov t-wide (Governmental Act.): Dr. Cr. Equipment $50,000 Capital Lease Obligations Payable 50,000 Chapter 8 Granof-5e 39

40 Example 2 Assume for a particular capital lease the unpaid lease obligation at the beginning of the year was $57,590 and a $10,000 lease payment is made at the end of each year. If the lease has an implicit interest rate of 10% per annum, the end of year payment would be recorded as follows: Debt Service Fund: Dr. Cr. Expenditures Interest on Capital Lease (.10 X $57,590) $5,759 Expenditures Principal of Capital Lease Obligation 4,241 Cash 10,000 Chapter 8 Granof-5e 40

41 Example 3 Leased Asset 1. The City leased a computer, which has a fair market value of $3 million and an estimated useful life of three years. The lease cannot be canceled. The lease payment for 2007 was $1,122,330 (interest of $180,000 and principal of $942,330). General Fund: Expenditures acquisition of capital assets $3,000,000 Other financing sources capital leases $3,000,000 Debt Service Fund: Expenditures lease interest $ 180,000 Cash $ 180,000 Expenditures lease principal $ 942,330 Cash $ Government-wide: Would capitalize and depreciate Chapter 8 Granof-5e 41

42 Operating Leases Illustrative Note from a CAFR Chapter 8 Granof-5e 42

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44 Miscellaneous Topics Revenue Bonds Debt Margin Overlapping Debt Conduit Debt Bond Ratings and Ratios Bond Ratings Chapter 8 Granof-5e 44

45 Debt Jargon Direct debt - debt that a government unit has incurred in its own name or assumed through the annexation of territory or consolidation with another governmental unit. Obligations that will be repaid by the government whose debt is being evaluated. Debt Limit - Usually a ceiling on the amount of debt. Maximum amount of gross or net debt that is legally permitted. Debt margin - The difference between the debt limit and the net amount of debt outstanding subject to the limit. See the example on page 328, which also explains legal debt margin and the example on ppt. slide Moral Obligation Debt -Bonds/Notes issued by one entity but backed by the promise of another entity. It is motivated to avoid voter approvals or to circumvent debt limitations. Overlapping (indirect) debt - obligations of other governments that also have the power to tax property located in the jurisdiction of the government whose debt is being evaluated ex. City, County and School District. (See Figure 8-1) and also the example on the ppt slide Chapter 8 Granof-5e 45

46 Revenue Bonds Revenue bonds are backed only by specific revenues; generally reported in enterprise funds. The main reasons for issuing revenue as opposed to GO bonds are: -They provide a better match of debt service costs and the benefits received; -Although interest rates are likely to be higher for any specific issue of bonds, they are unlikely to increase the overall risk of the entity s debt as a whole and therefore its total interest costs (i.e. they redistribute risk among the various classes of bondholders). In many jurisdictions they are a means of avoiding voter approvals and other debt limitations. Chapter 8 Granof-5e 46

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50 Debt Margin - Example Q: The city is permitted to issue a maximum of $30 million of general obligation bonds. It already has $19 million of qualifying debt outstanding. What would be the city s debt margin after issuing $8 million of new debt subject to the limits? A: After issuing the $8 million of new debt, the city would have total debt outstanding of $27 million. Its debt margin would be only $ 3 million 10% of its $30 million limit. Chapter 8 Granof-5e 50

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52 Overlapping Debt - Example Q: A city served by an independent school district that includes the city as well as nearby towns. The assessed value of taxable property within the city is $600 million; that of the school district is $800 million. The school district has $48 million of debt outstanding. What is the city s overlapping debt with respect to school district? A: Of the taxable property in the school district, 75% is located within the city. Therefore, the city is responsible for 75% of the school district s debt--$36 million. Chapter 8 Granof-5e 52

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54 Conduit debt Obligations issued in the name of a government on behalf of a nongovernmental entity. Also referred to as non-commitment debt: in case of default, bondholders have claim only on the property and the lease payments. Is a form of government assistance to beneficiary organizations to obtain financing at lower rates. GASB says that note disclosure of conduit debt is sufficient. Chapter 8 Granof-5e 54

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56 Bond-Related Ratios Ratio of debt per capita to percentage of taxable property Ratio of debt service expenditures to total general expenditures Multiple year trends in above ratios Note: Investors look for these ratios to assess the ability to pay and the risk of default. Chapter 8 Granof-5e 56

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59 Bond Ratings Bond Rating agencies such as S&P, Moody s and Fitch Ratings assign a quality rating to the debt instruments of any issuer The agencies base their ratings on a comprehensive review of all factors affecting the issuer s ability to pay and continue to monitor the issuer. Debt ratings are of critical concern to both issuers and investors because they affect the debt s marketability and hence it s interest rate. A bond rating service downgrade can be a traumatic fiscal event. Chapter 8 Granof-5e 59

60 Bond Ratings City of Houston, CAFR FY 06 and compare the ratings with FY 09. (next slide) Chapter 8 Granof-5e 60

61 Bond Ratings City of Houston, CAFR FY 09 Chapter 8 Granof-5e 61

62 Summary Long-term obligations represent claims upon the entity s resources. Governmental funds which follow modified accrual basis do not give recognition to either long-term obligations or the assets they finance. Government-wide statements which follow full accrual basis report both long-term obligations and capital assets. Demand bonds may be reported as long-term debt only if the issuer has entered into a take-out agreement. Similarly for BANs if the issuer has a refinancing agreement. TANs and RANs are not converted into long-term debts. Leases that meet the criteria of capital leases are also reported as long-term debt. Revenue bonds and overlapping debt, though not strictly full faith and credit liabilities of the reporting government impose financial obligations on the citizens. Bond ratings are of critical concern to issuers and investors because they affect the debt instrument s marketability and interest rate. Chapter 8 Granof-5e 62