thought to ponder: chapter 8 - cdn.ymaws.com · 3/7/2016 6 granof, et al. –7th edition chapter 8...

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Granof, et al. – 7th edition Chapter 8 |

Chapter 8Long – Term Obligations

© 2016 John Wiley & Sons, Inc. All rights reserved. 1


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. 106-43 B.C.

The Outstanding Public Debt as of 01 February 2016 is: $18.99 trillion. The National Debt has continued to increase an average of $2.41 billion per day since September 30, 2012!

http://en.wikipedia.org/wiki/National_Debt_Clock#cite_note-NYT_2009-0


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FACTS: Did you know? • At the end of FY 2014, the total U.S. federal(public) debt, called the national

debt passed the $17 trillion mark, with about $55,623 per capita (that is, per

U.S. citizen). As of October 2015, the US govt debt is $18.2 trillion. At the

end of FY 2016, it is estimated to be $19.33 trillion

• Of this amount, debt held by the public (federal debt held by states, corp.,

individuals and foreign govts) was roughly $12 trillion.

• Adding unfunded Medicaid, Social Security, Medicare, and similar obligations,

this figure rises to a total of $127 + trillion (this is as of Oct 9, 2014)

http://en.wikipedia.org/wiki/United_States_public_debt

http://www.usdebtclock.org/


Granof, et al. – 7th edition © 2016 John Wiley & Sons, Inc. All rights reserved. 4Chapter 8 |

http://en.wikipedia.org/wiki/Medicaid

http://en.wikipedia.org/wiki/Medicare_(United_States)

http://en.wikipedia.org/wiki/United_States_public_debt

http://www.usdebtclock.org/

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FACTS: Long Term ObligationsFor FY 2015, the City of Houston had

total bonded debt outstanding of $14.7 billion.

The two largest portions of this total

$2.9 billion comprising debt backed by the “full faith and credit” of the government and

$8.8 billion comprising various enterprise fund revenue bonds

For FY 2011, City of NY had

Total debt outstanding at year-end was > $56.1billion, comprised of $45.9 billion in

governmental activities and $10.2 billion in business-type activities.



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

Revenue bonds

Overlapping debt

Conduit debt


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Long-Term Obligations-OverviewWhat 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, thenthe government’s contingent liability needs to be disclosed in the notes to the financial statements



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


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Importance of Long-Term DebtFailure to make timely payments can have profound repercussions.

Creditor incurs losses

Governments and non-profits will face loss of credit



BankruptcyBankruptcy: 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.


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Accounting for Long-Term ObligationsGovernment-wide Statements:

• All general long-term debt is reported in the governmental activities column of the government-wide 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.

o Certain claims and judgments are also recorded at present value.

o Present values more faithfully captures the economic substance of debt than face values do.



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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.”


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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.


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Example – Vacation LeaveCity employees earned $300,000 in vacation leave they did not take in 2016. 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.



Example – Sick LeaveCity employees earned $500,000 in sick leave that they did not take in 2016. 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 long-term 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


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Example – Sabbatical LeaveCity teachers are entitled to sabbatical leaves of six months every 7 years for research and renewal. The 2016 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



Example – Claims & JudgmentsThe City settled a judgment brought against it by an injured employee. The City agreed to pay $6 million in

2016 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


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Example – Installment NoteIt 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 (Stmt of Net Position):

Would capitalize the asset and depreciate



Example – General Obligation DebtOn July 1, 2016, the City issued $100 million in 8 percent general obligation debtto finance capital improvements. The first interest payment of $4 million is due inearly January 2012.

No entry in the funds – no need to accrue (unless budgeted in the current fiscal period and as stated in early Jan).

12/31/2016 (Conversion posting after the end of the fiscal period)

Government-wide: (must accrue)

Bond Interest expense $4M

Accrued bond interest payable $4M


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Example – Debt ServicingIn 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.



Short Term Vs. Long Term DebtShort term: Debts expected to be liquidated with currently available assets. These debts are reported in governmental funds.

Long term: reported only in government-wide statements.


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DEMAND BONDSDemand bonds: obligations that permit the holder (the lender) to demand redemption within a specified

(usually short) period of time. Hence, usually classified as short-term 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



Example 1A 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?


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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 milDemand 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 $8 milDemand Bonds payable $8 mil

To record the Equipment acquired with demand bonds.


Granof, et al. – 7th edition © 2016 John Wiley & Sons, Inc. All rights reserved. 32

OH MY!

RANs & TANs & BANs . . .

Chapter 8 |

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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.



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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.



Capital Vs. Operating LeaseCapital Leases: financing arrangements. ◦ Lessee purchases an asset in exchange for LT note.

Operating Lease: conventional rental agreements◦ Lessee uses property for a portion of its useful life.

◦ 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

Non-appropriation clause or fiscal funding clause permits governments to cancel lease at the end of each year.


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Accounting for Capital LeasesGASB: 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.



Example 1Capital 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


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Example 2Assume 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



Example 3 – Leased AssetThe City leased a computer, which has a fair market value of $3 million and an estimateduseful life of three years. The lease cannot be canceled. The lease payment for 2011was $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 $3,000,000Debt Service Fund:Expenditures – lease interest $ 180,000

Cash $ 180,000Expenditures – lease principal $ 942,330

Cash $ 942.300

Government-wide: Would capitalize and depreciate


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Miscellaneous TopicsCertificates of Participation

Revenue Bonds

Debt Margin

Overlapping Debt

Conduit Debt

Bond Ratings and Ratios

Bond Ratings


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Debt JargonDirect 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 331, 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


Granof, et al. – 7th edition © 2016 John Wiley & Sons, Inc. All rights reserved. 44

A certificate-of-Participation

Arrangement

Tenant—lessee

government

Nonprofit public benefit

corporation

(landlord—lessor)

Trustee for all investors

Investors

COP (lease) service

(principal and interest payments)

Lease of property from

corporation

Assignment of lease

agreementAllocated COP

service payment

Total COP proceeds (loan to corporation)

Chapter 8 |

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Revenue BondsRevenue bonds are backed only by specific revenue stream; 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.



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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.



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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.



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Conduit debtObligations issued in the name of a government on behalf of a non-governmental 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.



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Bond-Related RatiosRatio 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.



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Bond RatingsBond 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.


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Bond RatingsCity of Houston, CAFR FY ’11 and compare the ratings with FY ‘13



Bond RatingsCity of Houston, CAFR FY ’13


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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.


thought to ponder: chapter 8 - cdn.ymaws.com · 3/7/2016 6 granof, et al. –7th edition chapter 8...

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