Long-Term Liabilities: Long-Term Liabilities: Notes, Bonds, and LeasesNotes, Bonds, and Leases

Presentations for Chapter 11 by Glenn Owen

Key PointsKey Points Long-term notes payable, bonds payable, and leasehold

obligations, and how companies use these instruments as important sources of financing.

Economic consequences created by borrowing. Different forms of contractual obligations. The effective interest rate and how it is determined for

contractual obligations. The effective interest method. How changes in market interest rates can lead to misstated

balance sheet values for long-term liabilities. Operating leases, capital leases, and off-balance-sheet

financing.

Long-Term Liabilities as a Percentage Long-Term Liabilities as a Percentage of Total Assetsof Total Assets

Company (Industry)

LTL Liabilities /Total Assets

General Electric (Manufacturing) .52

Chevron Oil (Oil drilling and refining) .33

Super Value (Grocery) .30

Tommy Hilfiger (Clothing) .33

Yahoo (Internet search engine) .01

Cisco (Internet systems) .03

SBC Communications (Telcom services) .37

Wendy’s (Restaurant services) .17

Bank of America (Banking services) .11

Merrill Lynch (Investment services) .17

Long-Term Liabilities as a Percentage Long-Term Liabilities as a Percentage of Total Liabilitiesof Total Liabilities

Company (Industry)

LTL Liabilities /Total Liabilities

General Electric (Manufacturing) .59

Chevron Oil (Oil drilling and refining) .64

Super Value (Grocery) .44

Tommy Hilfiger (Clothing) .71

Yahoo (Internet search engine) .10

Cisco (Internet systems) .18

SBC Communications (Telcom services) .55

Wendy’s (Restaurant services) .53

Bank of America (Banking services) .14

Merrill Lynch (Investment services) .18

Long-Term Liabilities as a Percentage Long-Term Liabilities as a Percentage of Stockholders’ Equityof Stockholders’ Equity

Company (Industry)

LTL Liabilities /Stockholders’

Equity General Electric (Manufacturing) 4.33

Chevron Oil (Oil drilling and refining) .69

Super Value (Grocery) 1.11

Tommy Hilfiger (Clothing) .61

Yahoo (Internet search engine) .01

Cisco (Internet systems) .04

SBC Communications (Telcom services) 1.19

Wendy’s (Restaurant services) .30

Bank of America (Banking services) 1.57

Merrill Lynch (Investment services) 3.40

Basic Definitions and Different Basic Definitions and Different Contractual FormsContractual Forms

Installment notes– Cash (bank loan)– Noncash (lease or real estate purchase)

Non-interest-bearing notes– Cash (zero coupon bond)– Noncash (equipment purchase)

Interest-bearing notes– Cash (bond)– Noncash (equipment purchase)

Effective Interest RateEffective Interest Rate

Actual interest rate paid by issuer May or may not be same as the stated rate Determined by discount rate that sets the present

value of the future cash outflows equal to the fair market value of that which is received in the exchange.

Effective Interest RateEffective Interest Rate

Installment payment formula– Present Value = – Annuity Cash Payment – x (PV Table Factor Ordinary Annuity: n = period, i = ?)

Non-interest bearing formula– Present Value =– Single Sum Cash Payment– x (PV Table Factor Single Sum: n = period, i = ?)

Effective Interest RateEffective Interest Rate

Interest-bearing formula– Present Value = – Annuity Cash Payment (Interest Payment)– x (PV Table Factor Ordinary Annuity: n = period, i = ?)– + Single Sum Cash Payment– x (PV Table Factor Single Sum: n = period, i = ?)

Accounting for Accounting for Long-Term ObligationsLong-Term Obligations

Record the asset acquired in the exchange at its fair market value.

Record the obligation at its face value. Record a discount if the obligation exceeds the fair

market value of the asset acquired. Record interest expense for each period: Effective

interest rate x Balance sheet value of the obligation at the beginning of the period.

Bonds PayableBonds Payable Terminology and terms of bond contracts

– Life– Maturity date– Face value, principal, par value, or maturity value– Interest payment– Proceeds at issuance– Effective interest rate

Other provisions– Restrictions– Security– Call provision

LeasesLeases Operating leases

– Lessee assumes no risk of ownership– At end of lease term, right to use the property reverts to

the owner

Capital leases– Effectively an installment purchase– Lessee assumes rights and risks of ownership– Treated as purchases

Off-balance-sheet financing

Review ProblemReview Problem Facts

– 500 bonds issued, each with a $1,000 face value– Issued January 1, 2003 at 91.89– Stated annual rate of 6%– Interest paid semiannually on Dec. 31 and June 30– Called July 1, 2004 at 96

Cash Flow– Proceeds $459,450 (500 x $1,000 x 918.90)– Semi-annual interest payments $15,000

(500 x $1,000 x 6% x 1/2)– Redemption payment (7/1/04) $480,000

(500 x $1,000 x .96)

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

1/1/03 6/30/03 12/31/03 6/30/04

DiscountBalance

Net BookValue

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

Cash 459,450Discount 40,550 Bonds Payable 500,000

Cash 459,450Discount 40,550 Bonds Payable 500,000

+$459,450(proceeds)

DiscountBalance

Net BookValue

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

Cash 459,450Discount 40,550 Bonds Payable 500,000

Cash 459,450Discount 40,550 Bonds Payable 500,000

+$459,450(proceeds)

Discount $40,550Balance

Net BookValue $459,450

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

Discount $40,550Balance

Net BookValue $459,450

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

Interest Expense 18,378 Cash 15,000 Discount 3,378

Interest Expense 18,378 Cash 15,000 Discount 3,378

+$459,450(proceeds)

-$15,000(interest)

Discount $40,550Balance

Net BookValue $459,450

Net Book Value x Effective Interest Rate$459,450 x 8% x 1/2 = $18,378

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

Interest Expense 18,378 Cash 15,000 Discount 3,378

Interest Expense 18,378 Cash 15,000 Discount 3,378

+$459,450(proceeds)

-$15,000(interest)

Discount $40,550 $37,172 ($40,550 - $3,378)Balance

Net BookValue $459,450 $462,828 ($500,000 - $37,172)

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

Discount $40,550 $37,172Balance

Net BookValue $459,450 $462,828

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

Discount $40,550 $37,172Balance

Net BookValue $459,450 $462,828

Interest Expense 18,513 Cash 15,000 Discount 3,513

Interest Expense 18,513 Cash 15,000 Discount 3,513

$462,828 x 8% x 1/2 = $18,513

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

Discount $40,550 $37,172 $33,669Balance

Net BookValue $459,450 $462,828 $466,341

Interest Expense 18,513 Cash 15,000 Discount 3,513

Interest Expense 18,513 Cash 15,000 Discount 3,513

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

-$15,000(interest)

Discount $40,550 $37,172 $33,669Balance

Net BookValue $459,450 $462,828 $466,341

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

-$15,000(interest)

Discount $40,550 $37,172 $33,669Balance

Net BookValue $459,450 $462,828 $466,341

Interest Expense 18,653 Cash 15,000 Discount 3,653

Interest Expense 18,653 Cash 15,000 Discount 3,653

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

-$15,000(interest)

Discount $40,550 $37,172 $33,669 $30,006Balance

Net BookValue $459,450 $462,828 $466,341 $469,994

Interest Expense 18,653 Cash 15,000 Discount 3,653

Interest Expense 18,653 Cash 15,000 Discount 3,653

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

-$15,000(interest)-$480,000

(redemption)

Discount $40,550 $37,172 $33,669 $30,006Balance

Net BookValue $459,450 $462,828 $466,341 $469,994

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

Bonds Payable 500,000Loss on Retirement 10,006 Discount 30,006 Cash 480,000

Bonds Payable 500,000Loss on Retirement 10,006 Discount 30,006 Cash 480,000

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

-$15,000(interest)-$480,000

(redemption)

Discount $40,550 $37,172 $33,669 $30,006Balance

Net BookValue $459,450 $462,828 $466,341 $469,994

1/1/03 6/30/03 12/31/03 6/30/04

Review ProblemReview ProblemTime Line and SolutionTime Line and Solution

Bonds Payable 500,000Loss on Retirement 10,006 Discount 30,006 Cash 480,000

Bonds Payable 500,000Loss on Retirement 10,006 Discount 30,006 Cash 480,000

+$459,450(proceeds)

-$15,000(interest)

-$15,000(interest)

-$15,000(interest)-$480,000

(redemption)

Discount $40,550 $37,172 $33,669 $0Balance

Net BookValue $459,450 $462,828 $466,341 $0

1/1/03 6/30/03 12/31/03 6/30/04

C O P Y R I G H T

C o p y r i g h t © 2 0 0 3 , J o h n W i l e y & S o n s , I n c . A l l r i g h t s r e s e r v e d .R e p r o d u c t i o n o r t r a n s l a t i o n o f t h i s w o r k b e y o n d t h a t p e r m i t t e d i n S e c t i o n 1 1 7 o f t h e 1 9 7 6 U n i t e d S t a t e s C o p y r i g h t A c t w i t h o u t t h ee x p r e s s w r i t t e n p e r m i s s i o n o f t h e c o p y r i g h t o w n e r i s u n l a w f u l . R e q u e s t f o r f u r t h e r i n f o r m a t i o n s h o u l d b e a d d r e s s e d t o t h e P e r m i s s i o n s D e p a r t m e n t , J o h n W i l e y & S o n s , I n c . T h e p u r c h a s e r m a y m a k e b a c k - u p c o p i e s f o r h i s / h e r o w n u s e o n l y a n d n o t f o r d i s t r i b u t i o n o r r e s a l e . T h e P u b l i s h e r a s s u m e s n o r e s p o n s i b i l i t yf o r e r r o r s , o m i s s i o n s , o r d a m a g e s , c a u s e d b y t h e u s e o f t h e s e p r o g r a m s o r f r o m t h e u s e o f t h e i n f o r m a t i o n c o n t a i n e d h e r e i n .