In-Depth Notes on Long-Term Liabilities

Learning Objectives

The chapter on Long-Term Liabilities outlines several learning objectives aimed at grasping both the theoretical and practical aspects of long-term liabilities. These include:
• LO1: Understanding the significance of long-term liabilities to users of financial statements, which emphasizes their long-term impact on a company's financial health.
• LO2: Identifying the long-term liabilities that arise from transactions with lenders and understanding their accounting treatment.
• LO3: Recognizing long-term liabilities resulting from transactions with other creditors, alongside their accounting implications.
• LO4: Exploring long-term liabilities associated with employee transactions and their respective accounting methods.
• LO5: Understanding long-term liabilities that emerge from discrepancies between accounting practices and tax regulations.
• LO6: Gaining insight into commitments and guarantees, including their accounting treatments.
• LO7: Learning about contingencies and their accounting principles.
• LO8: Calculating leverage and coverage ratios to evaluate a company’s financial standing.

Relevance to Users

Long-term liabilities are pivotal for various reasons:
• They reflect commitments that can influence the financial landscape of a company for years to come.
• Certain liabilities may not be recorded but could emerge from contractual obligations or potential litigation outcomes, underscoring their latent financial impact.
• They may substantially affect future operational results, thereby being vital for stakeholders aiming to assess a company's risk and long-term financial health.

Common Long-Term Liabilities

Key categories of long-term liabilities include:

1. Long-term loans: Liabilities arising from borrowings over extended periods.

2. Bonds payable: Debt securities issued to investors, representing borrowed funds.

3. Lease liabilities: Obligations arising from finance leases where a lessee pays for the right to use an asset.

4. Pension and other post-employment benefit liabilities: Future commitments to employees.

5. Deferred income taxes: Tax obligations that arise due to timing differences between accounting and tax treatment.

Understanding Long-Term Loans and Mortgages

Long-term loans typically involve a financing agreement between the borrower (company) and the lender.

• Mortgage loans: Often involve a capital asset pledged as collateral.

• Structured as installment loans: Payments combine interest and principal, which can be analyzed through an amortization table showing payment allocation over time.

Example: Long-Term Loan with Blended Repayments

For instance, consider a three-year $100,000 mortgage at a 6% interest rate, with equal monthly payments of $3,042.19. Upon borrowing, the journal entry would be:

Sept 30   Cash                         100,000  
           Long-Term Loan Payable          100,000  

The first month's journal entries would involve recording the interest expense and the reduction of the loan:

Oct 31 Interest Expense            500.00  
           Long Term Loan Payable      2,542.19  
           Cash                       3,042.19  

Bonds as a Means of Raising Funds

Companies can finance their operations through either
equity or debt markets, issuing bonds to raise long-term capital.

• Bond Indenture Agreement: A formal contract outlining repayment terms and related covenants.

• Characteristics of Bonds:

  • Bonds usually have a face value (typically $1,000), generating semi-annual interest payments.

  • The bond’s contract rate is crucial for periodic interest payments, and its market price may vary based on the effective interest rates at the time.

Bond Pricing and Market Dynamics

Bonds are priced by discounting future cash flows, which include principal repayments and periodic interest payments. Their pricing is influenced by the relative rates of yield versus contract rate, with scenarios leading to discounts or premiums based on market conditions.

Accounting for Bonds

When accounting for bonds, recognize them at the issuance price, which might differ from face values due to market conditions. For example, bonds issued at a discount of 98.4 need careful treatment in accounting records.

• Interest Expense vs. Interest Payment: Actual amounts paid are based on the contract rate, but interest expense reflects the yield, incorporating amortization of any bond discount or premium.

Step-by-Step Accounting for Semi-Annual Interest Payments

1. Calculate Cash Interest Payment: (Semi Annual Interest PMT){Face Value} X {Contract Rate} X 6/12)

2. Determine Interest Expense: {Carrying Value} x {Yield} x (6/12)

3. Amortization: {Interest Expense} - {Interest Payment}

4. Calculate Amortization of Premium or Discount: This amount will adjust the carrying value on the balance sheet accordingly. Finally, update the carrying value after each period to reflect the changes resulting from amortization and ensure accurate reporting.

Example: Accounting for Bonds

If a five-year bond with a $100,000 face value is issued at 97.977, with a 7% contract rate and a yield of 7.5%, journal entries would reflect the cash received and the liability recorded. Subsequently, each interest payment must accurately reflect the interest expense, adjusting for the bond discount.

Leases

A lease represents a financial agreement where one party (lessor) allows another (lessee) to use an asset in exchange for regular payments over the lease term.

• Leases require liabilities to be recognized similarly to loans, reflecting both right-of-use assets and corresponding lease liabilities. The lessee must depreciate the asset while also accounting for the interest over the lease term.