Chapter 10

Long-Term Liabilities

Slide 10.1
 Chapter 10 Learning
Objectives
Define the key information needs of decision makers
regarding long-term liabilities.
Account for bonds payable and related interest expense.
Distinguish between operating leases and capital leases
and describe the accounting treatment for each.
Discuss accounting issues for long-term liabilities
stemming from pension and OPB plans.
Identify key control activities for long-term liabilities.
Compute and interpret the long-term debt to equity and
times interest earned ratios.
(Appendix) Amortize bond discount and premium using
the effective-interest method.

Slide 10.2
 Long-Term Liabilities . . . An
Introduction

Long-term liabilities: the debts and obligations

of a business other than those classified as
current liabilities.
Two types of long-term liabilities: 1)
long-term loans (such as bonds payable) 2)
long-term accrued liabilities
Many businesses consolidate long-
term borrowings into one
balance sheet line item “Long-
Term Debt”

Slide 10.3
 Long-Term Liabilities on the
Corporate Balance Sheet

Sprint Corporation
Long-Term Debt:
First Mortgage Bonds
Debentures
Notes Payable and Commercial Paper
Deferred Income Taxes
Postretirement and Other Benefit Obligations

Slide 10.4
 Long-Term Liabilities: Key
Information Needs of Decision
Makers
Completeness: “off-balance sheet
financing” results in
many long-term
obligations
going unreported
Valuation methods: very important
disclosure for long-term accrued
liabilities--which are typically
“soft” numbers
Unusual circumstances: such as,
potential violations of restrictive
debt covenants

Slide 10.5
Accounting for Bonds
Payable
Bonds payable . . . a long-term
liability that represents the collective
amount owed the parties who have
purchased a company’s bonds.

Major focus of this chapter is bonds payable

because . . .

Bonds payable is among the most

common long-term liabilities of
large firms.
Many of the accounting issues posed
by bonds payable are relevant to
other long-term liabilities.

Slide 10.6
Key Terms Related to Bonds
Payable
Bond
Bond issue
Bond indenture
Face value
Stated interest rate
Effective interest rate
Current yield

Slide 10.7
 Types of Bonds

Secured bonds
Unsecured bonds
(debentures)
Callable bonds
Convertible bonds

Slide 10.8
 Factors Affecting the
Selling Price of Bonds

Interest rates
Time to maturity
Financial condition of issuing
company
Investors’ preferences and
expectations

Note: The key accounting decisions

involving bonds are resolved on the
date they are sold.

Slide 10.9
 Determining the Selling Price
of Corporate Bonds

The relationship between the stated

interest rate for a bond issue and the
market interest rate (effective
interest rate) determines whether
the bonds will sell for . . .

1) a discount (stated interest rate < market interest rate)

2) face value (stated interest rate = market interest rate)
3) a premium (stated interest rate > market interest rate)

Slide 10.10
 Selling Bonds at a Discount . . .

FACTS:
Face value: $100,000
Stated interest rate: 10%
Term: 5 Years
Date sold: April 1, Year 1
Interest payment
dates: April 1 & October 1
Market (effective)
interest rate: 11%

Slide 10.11
 Selling Bonds at a Discount,
continued . . .

Computation of selling price:

PV of principal payment: $100,000 x .58543 = $58,543
PV of interest payments: $5,000 x 7.53763 = 37,688
$96,231
.58543 = PVF for 10 periods and 5.5% in Table 3
7.53763 = PVAF for 10 periods and 5.5% in Table 4

Key Point: The market interest rate

on the date bonds are sold
determines the present value of the
future cash outflows related to the
bonds.

Slide 10.12
Accounting for Bonds Payable
Issued at a Discount

The text also discusses accounting for

bonds issued at face value and at a
premium.
A bond discount must be amortized”
(written off) over the bond term.
The write-off of a bond discount results
in . . . interest
expense > interest payment
Two methods for amortizing bond
discount: straight-line & effective-
interest. (We will use the straight-
line method.)

Slide 10.13
 Accounting for Bonds Payable
Issued at a Discount, continued . . .

April 1, Year 1: Sale of bonds

Cash 96,231
Discount on Bonds Payable 3,769
Bonds Payable 100,000

October 1, Year 1: Interest payment

Interest Expense 5,377
Cash 5,000
Discount on Bonds Payable 377*
*$3,769 / 10 interest payment periods

Slide 10.14
 Accounting for Bonds Payable
Issued at a Discount, continued . . .

December 31, Year 1: Accrual of Interest Expense

Interest Expense 2,689
Interest Payable 2,500
Discount on Bonds Payable 189*
*$377 / 2

April 1, Year 2: Interest payment

Interest Expense 2,688
Interest Payable 2,500
Cash 5,000
Discount on Bonds Payable 188

Slide 10.15
 Accounting Issues for Other
Long-Term Liabilities

Long-Term Notes Payable

Long-Term Lease Obligations
Pension Liabilities
Other Postretirement Benefit
Liabilities

Slide 10.16
 Long-Term Lease Obligations

Operating lease: a lease that is usually

cancelable by the lessee, has a relatively
short term, and does not transfer ownership
rights to the lessee
Capital lease: a lease that is generally
noncancelable, long-term, and transfers at
least some ownership rights or risks to the
lessee

Key accounting treatments:

Operating leases: Lease payments are debited
to Rent Expense
Capital leases: Present value of lease
payments is debited to an asset account and
credited to a long-term liability account, such as
Capital Lease Obligations

Slide 10.17
 Key Control Activities for
Long-Term Liabilities

Proper authorization of long-term

borrowing decisions
Adequate documentation, such as
a bond indenture
Payment controls, such as
preparation of an amortization
schedule (see p. 471)
Monitoring compliance with
restrictive debt covenants

Slide 10.18
Analyzing Long-Term Liabilities . . .

Long-Term Debt to Equity Ratio

This ratio measures “financial
leverage.”
The higher this ratio . . . the higher
risk a company faces of “going
under.”
Equation:
Total Long-Term Debt /Total Stockholders’ Equity

Slide 10.19
Analyzing Long-Term Liabilities . . .

Times Interest Earned Ratio

This ratio measures a firm’s ability
to make interest payments on
long-term debt.
The higher this ratio . . . the lower
default risk a company faces.
Equation:

Net Income + Interest Expense + Income Taxes Expense

Interest Expense

Slide 10.20
 Effective-Interest Method of
Amortizing Bond Discount and
Premium

Conceptually speaking, the effective-interest

method is superior to the straight-line
method.
Under the effective-interest method, bond
interest expense is a constant percentage of
the bonds’ carrying value . . .
. . . this constant percentage is the market
interest rate on the date the bonds were sold
(also referred to as the effective interest
rate).
The effective interest rate is the true rate of
interest incurred over the term of a bond
issue.

Slide 10.21