LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES

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1 FINANCIAL ACCOUNTING Week 10 LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES I. Learning Objectives - Long-term Liabilities A. Understand what are long-term liabilities, e.g., longterm notes payable, bonds payable, and leasehold obligations, the economic consequences of using them to borrow, and how they are used as important sources of financing. B. Understand the different forms of contractual obligations. What are the income statement, balance sheet, and cash flow effects of each? C. Understand the terms effective interest rate and stated interest rate. How do they affect the market price or how much you receive or pay for a debt obligation? D. Understand how the effective interest rate method underlies the balance sheet presentation of long-term liabilities and the accounting for long-term liabilities. E. Differentiate between operating leases and capitalized leases and describe the accounting treatment of each. II. Long-term (LT) liabilities are probable future sacrifices of economic benefits from the present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. The obligation will require the disbursement of assets outside the time frame of current assets. All of them are expressed in terms of the present value of the obligation, see page 82. III. Economic consequences of LT liabilities A. Credit ratings B. Debt covenants 1. Can limit a company's operating, investing, and financing activities. 2. If the covenant is violated, the lender can require one of the following: a. Immediate repayment of the debt b. Renegotiate the debt at terms that are more costly to the borrower 1

2 IV. Overview of LT Liabilities A. Notes, bonds, and leases are supported by contracts 1. The timing and dollar amount of future cash flows are specified in the contracts. 2. Types of contractual forms a. Non-interest-bearing obligations do not require periodic interest payments. They require only the payment of the face value at the end of the contract period. b. Interest bearing obligations require (1) Periodic cash payments calculated at a stated percentage of the obligation's face value (principal or maturity value). (2) Payment of the face value at the end of the contract period. c. Installment obligations require periodic payments throughout the obligation's life, and the periodic payments include both principal and interest. 3. The contracts may specify the following: a. Collateral b. Restrictions B. Types of LT liabilities 1. LT notes payable 2. Bonds payable a. Used to raise large amount of cash to finance LT projects b. Secured versus debentures c. Interest is usually paid semi-annually on bonds 3. Leases C. Example - Your company needs $1,000,000 now. You have received three different offers to loan the firm the funds for five years. What are the cash flow effects and impacts on the income statement and balance sheet of the three options? Interest rate for all three offers is assumed to be 10%. 2

3 1. Option 1 - Receive $1,000,000 now and pay it back in one lump sum in five years. (Non-interest bearing) 2. Option 2 - Receive $1,000,000 now and pay interest only for five years, with the principal due in full in five years. (Interest bearing) 3. Option 3 - Receive $1,000,000 now and make level payments of principal and interest. (Installment) Stmt Now Year 1 Year 2 Year 3 Year 4 Year 5 Option 1 C/F I/S BS(L) Option 2 C/F I/S BS(L) Option 3 C/F I/S BS(L) 3

4 V. Issuing notes and bonds A. Long-Term (LT) debt is accounted for using the present value (PV) of future cash flows. PV is acceptable under GAAP for LT debt because the future cash flows are contractually specified, which means the future cash flows can be objectively measured. B. Effective interest rate 1. The effective interest rate is the interest rate the company actually incurs on the obligation. 2. The effective interest rate is the rate that equates the undiscounted future cash flows of an obligation with the present value (PV) of the obligation. In other words, the effective interest rate is the interest rate used to discount the future cash flows of an obligation so that the PV of the future cash flows equals the fair market value (FMV) of that which is received in the exchange. 3. Relation of stated (SR) and effective (ER) interest rate for notes and bonds. See p a. SR = ER: The PV of future cash flows equals the face value of the debt. That is, the note or bond is issued at face value. b. ER > SR (1) The PV of future cash flows is less than the face value, thereby resulting in a discount. That is, the note or bond is issued for less than its face value. (2) Discounts represent future interest expense. c. SR > ER or ER < SR: The PV of future cash flows is greater than the face value, thereby resulting in a premium. That is, the bond is issued for more than its face value. 4. Homework a. E11-3 b. E11-7. c. Ell-4 (only the first, third and last problems. Also, compute interest expense for the first year of the loan.) d. ID11-2. VI. Bond Redemptions - see page 504. A. At maturity 4

5 At maturity, the company should be paying the face value of the bond to the bondholder. B. Before maturity. 1. Call provisions grant the issuing company the right to repurchase bonds prior to the maturity date. 2. Calling bonds normally gives rise to gains or losses. If the gain or loss is material, it should be reported on the income statement as an extraordinary item. VII. Leases A. Definition: A contract granting use or occupation of property during a specified period of time in exchange for rent payments. Leases allow companies to use or occupy property without many of the associated costs and risks of ownership. B. Types of leases 1. Operating a. The lessor or owner temporarily transfers the right to use the property to the lessee for a specified period of time in exchange for periodic payments. The lessor is normally responsible for the normal maintenance of the property over the life of the lease. The right to use the property reverts to the lessor at the end of the lease. b. The property is reported as an asset on the lessor's books. The periodic rental payments are reported on the lessor's books as rent revenue. The cash received for the rental payments is reported in the operating section of the Statement of Cash Flows. c. The periodic rental payments are reported on the lessee's books as rent expense. The payments are reported in the operating section of the Statement of Cash Flows. 2. Capital a. Definition: Leases that, in substance transfer the rights and risks of ownership to the lessee. b. Criteria for a lease to be classified as a capital lease. If a lease meets one of the 5

6 following criteria, the property is considered a purchase rather than being rental expense. See page 509. (1) Ownership is transferred to the lessee by the end of the lease term. (2) The lessee has the right to purchase the property from the lessor for less than what the property is actually worth - a bargain purchase. (3) The term of the lease is 75% or more of the leased property's useful life. (4) The present value of the lease payments equals or exceeds 90 percent of property's FMV. c. Accounting for capital leases on the lessee's books. See page 508. C. Statement Presentation 1. Toys-R-Us 2. Lawson D. P (1) After signing the lease agreement, the lessee records a liability equal to the PV of the future lease payments and a noncurrent asset of an equal amount. (2) The asset should be depreciated, if appropriate, over the useful life. (3) The periodic Αrental payments serve to reduce the lease liability and to recognize interest expense. Interest expense is computed using the effective interest method. The payments which reduce the lease liability are shown in the Financing section and payments which are treated as interest expense are shown in the Operating section of the Statement of Cash Flows. E. Metro Problem 10A (See course website) F. BE11-3. VIII. Review Learning Objectives 6

NON-CURRENT (LONG-TERM) LIABILITIES

NON-CURRENT (LONG-TERM) LIABILITIES 1 MRI = Market Rate of Interest CR = Coupon Rate IE = Interest Expense FV = Fair Value PV = Present Value A&L = Assets & Liabilities CV = Carrying Value BS = Balance