Chapter 11faculty.uml.edu/ccarter/Chapter11 UML 2… · Web view · 2010-08-18Chapter 11. Long-term Liabilities. In this chapter you will learn how long-term liabilities affect

Ch. 11: Long-term Liabilities 1

Chapter 11Long-term Liabilities

In this chapter you will learn how long-term liabilities affect businesses, how they are controlled, accounted for, and reported in financial statements.

What Are Long-term Liabilities?

As discussed in Chapter 10, when companies obtain resources by borrowing them, the resources are called assets and the sources of the resources are called liabilities. If the dollar amount of the borrowed resources must be paid within one year, the liabilities are considered to be current liabilities. If, on the other hand, the resources do not have to be paid for within a year, the liabilities are considered long-term liabilities. Repeating the Chapter 10 example, if a company borrows $100,000 from a bank on January 15, the result could be an increase in resources (cash) and an increase in liabilities (notes payable). If the cash must be repaid to the bank by July 15, six months after it was borrowed, the notes payable would be considered current liabilities. If the cash must be repaid to the bank by July 15, 18 months after it was borrowed, the notes payable would be considered long-term liabilities.

In terms of the accounting equation, long-term liabilities are obviously liabilities, as shown below. The numbers in parentheses refer to the chapters in which the items are discussed.

AssetsCurrent AssetsCash and Cash Equivalents (6)

Accounts Receivable (7)

Allowance for Uncollible Accounts (7)

MerchandiseInventory (8)

Property, Plant, & EquipmentLand (9)Buildings (9)Accumulated Depreciation, Buildings (9)

Equipment (9)Accumulated Depreciation, Equipment (9)

Autos & Trucks (9)Accumulated Depreciation, Autos & Trucks (9)

= LiabilitiesCurrent LiabilitiesNotes Payable (10)Accounts Payable (10)Taxes Payable (10)Current Portion of Long-term Debt (10)

Long-term Liabilities (11)

+ Stockholders' EquityRevenuesSales (7)Sales Returns & Allowances (7)

Cost of Goods Sold (8)Operating ExpensesUncollectible Accts. Expense (7)

Depreciation Expense (9)

Salary & Wages Expense (10)

Payroll Taxes Expense (10)

Bank Service Expense (6)

Other Revenues & ExpensesInterest Revenue (6)Interest Expense (6)Gain or Loss on Disposal of Property, Plant, & Equipment (9)

Income Taxes Expense (10)

The dollar amount of long-term liabilities differs from company to company. For example, Caterpillar, the largest capital goods company in the United States, reported long-term liabilities of $31 billion on December 31, 2009. This $31

2 Ch. 11: Long-term Liabilities

billion was approximately 52% of Caterpillar’s December 31, 2009 total assets. Mitsubishi Electric, the largest capital goods company outside of the United States, reported long-term liabilities of 979 billion yen on December 31, 2009. The 979 billion yen was approximately 31% of Mitsubishi Electric’s December 31, 2009 total assets. One year earlier, on December 31, 2008, Caterpillar’s long-term liabilities were $35 billion or approximately 52% of Caterpillar’s total assets.

The Nature of Long-term Liabilities

Because there are many different long-term liabilities, all of which have the common characteristic that they will not be paid for within twelve months, and their dollar amounts vary from company to company and year to year, it would be difficult to examine them all, especially in one chapter. The following sections of this chapter examine some of the more important long-term liabilities. As you proceed through this material you should be familiar with some of it from Chapter 10. For example, in the discussion of deferred taxes, you will recognize much of the material from the Chapter 10 deferred taxes coverage.

Bonds Payable and Notes Payable

Bonds payable and notes payable are written promises to pay known dollar amounts, on specific dates, to the owners of the bonds and notes. In fact, bonds and notes can be significantly different or they can be virtually identical. In general, however, notes have shorter lives than bonds. To simplify the discussion and to emphasize the major issues related to long-term debt, the following paragraphs use the term bonds to include both bonds payable and notes payable.

In short, a bond is a contract. In return for resources, usually cash, the company issuing the bond agrees to pay two major items: (1) the amount borrowed (principal) and (2) interest. The principal is paid to the bond owner at the end of the life of the bond, while interest payments are usually made every six months over the life of the bond.

To illustrate the use of bonds to obtain resources, consider the Lowell Merchandising Corporation on February 1, issuing bonds with a principal of $2,000,000, a life of 20 years, an annual interest rate of 9%, with interest to be paid every six months. When the Lowell Merchandising Corporation issues the bonds, it agrees to pay bonds owners $2,000,000 principal at the end of 20 years and $90,000 interest every six months during the 20-year life of the bonds. Remember, interest is calculated as follows: interest = principal x rate x time. For the Lowell Merchandising Corporation bonds, the six-month interest is $90,000 ($2,000,000 x .09 x 6/12). The 6/12 represents the number of months the cash is borrowed before interest is paid. As you remember, the use of this 6/12 is necessary because, in business, it is common to state interest rates, such as the 9%, on an annual or 365-day basis.

Because bonds are contracts, issuing companies can determine many effects borrowing will have on their resources as soon as the bonds are issued. If the Lowell Merchandising Corporation issued the bonds and received $2,000,000 on February 1, knowing it must pay $90,000 interest every six months and $2,000,000 principal at the end of 20 years, the company can determine it will cost $3,600,000 to borrow the money for 20 years, as follows.


Item Amount AmountCash received on February 1 $2,000,000Cash PaymentsInterest: $90,000 paid on August 1 and February 1 each year for 20 years: ($90,000 x 2 x 20) $3,600,000

Principal payment on January 31, (after 20 years) $2,000,000

Total interest and principal payments $5,600,000Cost of borrowing: (cash payments - cash received) $3,600,000

At the time the bonds are issued on February 1, the Lowell Merchandising Corporation knows its resources will immediately increase by $2,000,000, the cash received. Over 20 years the company's resources will decrease by $5,600,000 as the $90,000 interest payments are made every six months and the $2,000,000 principal payment is made at the end of 20 years. Thus, the Lowell Merchandising Corporation knows over 20 years its resources will decrease by $3,600,000 by issuing bonds ($5,600,000 - $2,000,000). Hopefully, the company can use the $2,000,000 obtained from issuing the bonds to generate more than enough resources to offset the $3,600,000 cost of borrowing.

Issuing bonds Continuing the Lowell Merchandising Corporation example, if the company issued the bonds and received $2,000,000, the effects on the accounting equation would be as follows.

Total Resources

=Sources of Borrowed Resources

+Sources of

Owner Invested Resources

+Sources of

Management Generated Resources

Assets = Liabilities + Stockholders' Equity+ $2,000,000 = + $2,000,000

Lowell Merchandising Corporation's resources increase by $2,000,000 because it now has $2,000,000 more cash. Sources of resources (liabilities) increase because the company owes $2,000,000 to the owners of the bonds. In terms of a journal entry, remembering assets increase with debits and debits must equal credits, the following entry would result.

Date DescriptionPosting Ref. Debits Credits

Feb. 1 Cash 111 2,000,000Bonds Payable 221 2,000,000

Bonds payable issued.

Since the bonds payable $2,000,000 principal does not have to be paid until after 20 years, it is reported on the balance sheet as a long-term liability for many years. At the end of the nineteenth year, the $2,000,000 bonds payable will be reported as a current liability on the balance sheet, as the current portion of long-term debt, as discussed in Chapter 10.

Bonds interest As time passes and Lowell Merchandising Corporation uses cash obtained from issuing the bonds, the dollar amount Lowell Merchandising Corporation owes to the bonds owners increases. As you recall, this increase is for interest. On a monthly basis, the bonds interest is $15,000 ($2,000,000 x .09 x 1/12). Since the terms of the bonds require interest payments every six


months, not every month, the monthly cost of borrowing by using bonds affects Lowell Merchandising Corporation's accounting equation as follows.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity+ $15,000 + - $15,000

The monthly cost of borrowing does not immediately change the Lowell Merchandising Corporation's resources. The company has not acquired additional resources from the bonds owners, other than the $2,000,000 cash, nor has it paid out any resources to them. Liabilities (interest payable) increase by $15,000 because every month the company owes an additional $15,000 to the bonds owners. Lowell Merchandising Corporation's stockholders' equity decreases by the $15,000 monthly cost of borrowing (interest expense). In terms of a journal entry, remembering liabilities increase with credits and debits must equal credits, the following entry would result every month for 20 years.


Monthly Interest Expense 522 15,000Interest Payable 217 15,000

Interest on bonds payable

The interest expense resulting from bonds payable is reported as part of other revenues and expenses on the income statement. Since the interest payable is to be paid within six months, it is reported on the balance sheet as a current liability.

Every six months, when the Lowell Merchandising Corporation pays the $90,000 interest to the bonds owners, the effects on the company's accounting equation are as follows.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity- $90,000 = - $90,000

Lowell Merchandising Corporation's resources decrease because the company pays $90,000 to the bonds owners. Lowell Merchandising Corporation's liabilities (interest payable) decrease by $90,000 because once the interest is paid to bonds owners, the company no longer owes them the $90,000. In terms of a journal entry, remembering assets decrease with credits and debits must equal credits, the following entry would result every six months for 20 years.


Every 6 Interest Payable 217 90,000Months Cash 111 90,000

Interest on Bonds Payable

Bonds principal payment At the end of 20 years on January 31, when Lowell Merchandising Corporation pays the principal to the bonds owners, the effect is


to reduce Lowell Merchandising Corporation's resources and sources of resources, as follows.


Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity- $2,000,000 = - $2,000,000

Lowell Merchandising Corporation's resources decrease because its cash has been reduced. Liabilities decrease because the company no longer owes the $2,000,000 to the bonds owners. In terms of a journal entry, remembering assets decrease with credits and debits must equal credits, the following entry would result.


Jan. 31 Bonds Payable 221 2,000,000Cash 111 2,000,000

Bonds payable payment

Growth through bonds A review of the preceding example shows Lowell Merchandising Corporation acquired $2,000,000 cash from bonds owners by paying them $5,600,000 over 20 years. In total, resources decreased by $3,600,000 (cash first increased by $2,000,000 then decreased by $5,600,000) and stockholders' equity decreased as a result of the $3,600,000 interest expense. As with previous discussions of liabilities, the important question to consider is: Why would Lowell Merchandising Corporation pay $5,600,000 for $2,000,000 cash. The answer, of course, is Lowell Merchandising Corporation expects to use the $2,000,000 cash during the 20 years and have more resources after it has paid the principal and all the interest to the bonds owners. By borrowing cash by issuing bonds and using it in its operations, Lowell Merchandising Corporation expects to increase its resources. For example, if Lowell Merchandising Corporation uses the $2,000,000 cash to expand its operations and generate an additional $5,000,000 cash over 20 years, its resources would increase by $1,400,000 ($2,000,000 borrowed + $5,000,000 generated - $2,000,000 principal paid - $3,600,000 interest paid). The fact that companies can increase resources through the above process is why companies are willing to borrow even though it costs them interest.

** You now have the background to do exercises 11.1, 11.2, 11.3, and 11.4.

The process of issuing bonds Bonds are major sources of resources for U.S. corporations. It is common for companies issuing bonds to use services of accountants, financial consultants, and lawyers to assist in the reporting required to meet Securities and Exchange Commission (SEC) regulations. Additionally, companies issuing bonds often use underwriters who buy the bonds from the issuing companies and then sell them at higher prices to other interested parties. By using underwriters, companies issuing bonds receive cash faster and do not have to find individual buyers for the bonds.

When a company decides to issue bonds, it must make several choices, including the bonds principal, interest rate, interest payment dates, and life. For most bonds, the principal is set at $1,000 per bond and the interest rate is set as close as possible to what the company believes lenders are willing to pay. Interest payment dates and the lives of bonds, however, can vary significantly from company to company and even from one bond issue to another within a company. For example, on December 31, 2009, Caterpillar had bonds payable with many different lives, some ending as early as 2010 while over $5 billion end later


than 2014. In addition to having to make several choices, a company issuing bonds must complete numerous activities, including complying with the rules of regulatory agencies, like the SEC, designed to provide some protection to individuals and companies who buy the bonds. For example, the company must submit a prospectus to the SEC. The prospectus is a detailed explanation of the terms of the bonds, including descriptions of how the company intends to use the cash received, as well as information concerning the financial condition of the company issuing the bonds.

One result of having to complete the many activities related to issuing bonds is that several weeks or even months can pass between the time when the company establishes the bonds principal, interest rate, interest payment dates, and life and when the company actually issues the bonds and receives cash. The effect of time passing can be very important if there are changes in the investment opportunities of companies and individuals who might buy the bonds. For example, if a company sets its bonds interest rate at what it believes to be a competitive rate, 10% for instance, and then, due to changes in economic conditions, interest rates available to potential investors rise to 10 1/4%, the company could find it difficult to sell its 10% bonds because investors could go elsewhere and earn higher returns. In fact, this is precisely what happens because the investment opportunities available to potential investors in bonds change constantly. As a result, it is very common for companies to receive more or less cash than the bonds principal dollar amount when they issue bonds.

When bonds are issued, the market price is quoted in the financial press as a percentage of bond principal. For example, if a bond with a $1,000 principal is sold for $1,040, its price would be quoted as 104, meaning the bond sold at 104% of its principal ($1,000 x 1.04 = $1,040). The use of this system makes it easy to list bonds prices, since the total amount of bonds issued can vary significantly among companies.

Bonds issued at a premium When a company issues bonds and receives more than the bonds principal, the bonds are said to be issued at a premium. The premium is calculated as the difference between the cash received and the bonds principal. For example, consider again the Lowell Merchandising Corporation's February 1, issue of $2,000,000, 9%, 20-year bonds. Remember, because of the many activities required in issuing bonds, the Lowell Merchandising Corporation would have determined the bonds interest rate sometime in January, December, or even earlier. What would potential buyers of the Lowell Merchandising Corporation bonds do if after the company set the bonds interest rate at 9%, they learn the interest rate on similar investments available to them has fallen from 9% to 8 3/4%? The answer, of course, is that if the Lowell Merchandising Corporation bonds will pay interest at a rate of 9%, while other similar investments will pay only 8 3/4%, potential investors will be very interested in buying Lowell Merchandising Corporation bonds. As you would expect, if many investors are interested in the same bonds, they will compete for the bonds and, as a result, they will bid up the price of the bonds. Through a process such as this, when companies sell bonds that pay interest at rates higher than the existing rate available (called the market rate of interest), they receive more cash than the bonds principal. In other words, such bonds sell at a premium.

To illustrate the effects of selling bonds at a premium, consider the Lowell Merchandising Corporation, on February 1, issuing bonds with a principal of $2,000,000, a life of 20 years, an annual interest rate of 9%, with interest paid every six months. If the market rate of interest is below 9% at the time the company issues the bonds, the company's bonds will be attractive to potential investors who compete for them and bid up the price of the bonds. If, for example, the Lowell Merchandising Corporation's bonds sell at 103, the company will receive $2,060,000 ($2,000,000 x 1.03) when it issues the bonds. Thus, the


Lowell Merchandising Corporation will receive a $60,000 premium ($2,060,000 - $2,000,000).

As stated before, because bonds are contracts, issuing companies can determine many effects borrowing will have on their resources as soon as the bonds are issued. If the Lowell Merchandising Corporation issued bonds and received $2,060,000 on February 1, knowing it must pay $90,000 interest every six months for 20 years and $2,000,000 principal at the end of 20 years, the company can determine it will cost $3,540,000 to borrow the money for 20 years, as follows.

Item Amount AmountCash received on February 1 $2,060,000Cash PaymentsInterest: $90,000 paid on August 1 and February 1 each year for 20 years: ($90,000 x 2 x 20) $3,600,000

Principal payment on January 31, (after 20 years) $2,000,000

Total interest and principal payments $5,600,000Cost of borrowing: (cash payments - cash received) $3,540,000

At the time the bonds are issued, the Lowell Merchandising Corporation knows its resources immediately increase by $2,060,000, the cash received. Over 20 years the company's resources will decrease by $5,600,000 as $90,000 interest payments are made every six months and $2,000,000 principal payment is made at the end of 20 years. As a result of the $2,060,000 increase in resources followed by the $5,600,000 decrease in resources, the company's resources will decrease by $3,540,000 over 20 years ($5,600,000 - $2,060,000). Thus, it will cost the Lowell Merchandising Corporation $3,540,000 to borrow over 20 years. This cost could be calculated as $177,000 per year ($3,540,000 / 20) or $14,750 every month ($177,000 / 12).

In order to further illustrate the overall effects of issuing bonds at a premium, the following table compares the cost of borrowing when $2,000,000, 9%, 20-years bonds are sold at their principal amount with the cost of borrowing when such bonds are sold at a $60,000 premium.

Item

Bonds Issued atPrincipal

Bonds Issued atPremium

Cash received on February 1 $2,000,000 $2,060,000Cash PaymentsInterest: $90,000 paid on August 1 and February 1 each year for 20 years: ($90,000 x 2 x 20) $3,600,000 $3,600,000

Principal payment on January 31, (after 20 years) $2,000,000 $2,000,000

Total interest and principal payments $5,600,000 $5,600,000Cost of borrowing: (cash payments - cash received) $3,600,000 $3,540,000

As shown above, when bonds are sold at a premium, the cost of borrowing is reduced for the company issuing the bonds. This is logical because the bond contract (called an indenture) determines the cash payments the issuing company must make. These payments are required no matter how much cash is received when bonds are issued. Remember, a bond is a legal contract. Thus, since cash


payments are determined by contract, the company's cost is reduced by receiving more cash when bonds are issued. The more cash the company receives, the lower will be its final cost of borrowing. In the case of the Lowell Merchandising Corporation, it will lower its final cost of borrowing by $60,000 if it can issue bonds at a $60,000 premium.

Another way to understand the premium is to consider what the Lowell Merchandising Corporation must do with the $2,060,000 it receives when it issues bonds at a premium. The $2,000,000 is the bonds principal and it must be paid to the bonds owners at the end of the bonds' life. The $60,000 premium, however, does not have to be paid to the bonds owners as long as the company fulfills its obligations, that is, as long as the company pays the required interest and principal. Thus, in effect, the company earns the right to keep the $60,000 premium by providing service to the bonds owners. From an investment standpoint, the service the company provides is the higher rate of interest the company is paying than bonds owners could earn by investing elsewhere. Remember, the Lowell Merchandising Corporation's bonds interest rate is 9% while the market rate of interest is below 9%.

Retiring bonds before they mature As a company's opportunities change over time, it may decide to eliminate its bonds payable liability. For example, if interest rates decrease significantly, a company may try to eliminate its bonds payable paying interest at a rate higher than the current market rate. To provide for the possible elimination of the bonds payable liability, most bonds contracts include a call provision. This call provision, which is stated as a percentage of the bonds principal, allows companies to buy back bonds from the bonds owners, at a stated price. For example, a $1,000 bond with a 1.05 call provision could be purchased from bonds owners for $1,050 ($1,000 x 1.05). A second way in which bonds payable can be eliminated is for companies to purchase them on the open market. Regardless of how the bonds are obtained, either through exercise of the call provision or through purchase on the open market, a gain or loss may need to be recognized.

Consider the Lowell Merchandising Corporation February 1, issue of $2,000,000, 9% bonds, for which the company received $2,000,000 (assume the bonds were issued at their principal amount). Assume also the bonds had a call provision of 1.07. When the bonds were issued on February 1, the company's liability was $2,000,000, which was recorded in the bonds payable account. If after five years, on February 1, the company decides to eliminate, or retire, the bonds by exercising the call option, it would have to pay the bonds owners $2,140,000 ($2,000,000 x 1.07). Since the company must pay $2,140,000 to eliminate a $2,000,000 liability, it cost the company an extra $140,000 to retire the bonds. These calculations may be summarized as follows.

Cash paid on bonds retirement $2,140,000Bond liability on retirement date $2,000,000Gain or (loss) on bonds retirement ($140,000)

Continuing the Lowell Merchandising Corporation example, if the company retired the bonds on February 1, after five years by paying $2,140,000, the effects on the company's accounting equation would be as follows.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity- $2,140,000 = - $2,000,000 + - $140,000


Lowell Merchandising Corporation's resources decrease by $2,140,000 because they now have $2,140,000 less cash. Liabilities decrease by $2,000,000 because the company no longer owes the bonds owners. The company's stockholders' equity decreases because it cost the company an extra $140,000 to retire the bonds. In terms of a journal entry, remembering assets decrease with credits and debits must equal credits, the following entry would result.


Feb. 1 Bonds Payable 221 2,000,000Loss on Early Retirement of Bonds 555 140,000

Cash 111 2,140,000Bonds payable retirement

Although the above entry may appear a bit complicated, the important points to remember are as follows. Although bonds payable are long-term liabilities, they can be eliminated through such action as exercising the bonds call provision or through open market purchases. When the bonds are eliminated, all related liability accounts must also be eliminated because the company no longer owes anything to the bonds owners. If the dollar amount of resources paid out to retire the bonds exceeds the amount of the total liability eliminated, a loss on retirement of bonds results. If, on the other hand, the dollar amount of resources paid out to retire the bonds is less than the amount of the total liability eliminated, a gain on retirement of bonds results.

From 1975 until 2002, gains or losses on early retirement of bonds were reported on income statements in a special section called extraordinary items. This section appeared after income from continuing operations but before net income. The accounting profession required such reporting of gains and losses on early retirement of bonds to prevent companies from retiring their long-term liabilities in an attempt to manipulate their ordinary income, which is reported as income from continuing operations. Such gains or losses were reported net of any income tax effects. This means the gains were reported after being reduced for any increase in income taxes resulting from the gains. Similarly, losses were reported after being reduced for any decrease in income taxes resulting from the losses. In 2002, the reporting of gains or losses on early retirement of bonds was changed. Currently, if gains or losses on retirement of bonds occur as part of the normal process of long-term financing, they are reported on the income statement as other revenues and expenses, similar to the way interest revenues and expenses are reported. On the other hand, under certain special conditions, gains or losses on early retirement of bonds may be reported as extraordinary items. The reporting of extraordinary items will be discussed further in Chapter 13.

** You now have the background to do exercise 11.5.

Deferred Taxes Payable

As discussed in Chapter 10, it is legal and very common for corporations to follow one set of rules for tax purposes and another set of rules in the accounting systems they use to produce financial statements. When a company uses accounting methods for tax purposes that differ from methods it uses for its financial statements, the result usually is the income taxes expense reported in the company's income statement differs from income taxes reported in the company's tax return. Since the company pays income taxes based on its tax return, the result is the company's income taxes expense differs from its income taxes payable liability. When a company's income taxes expense differs from its


income taxes payable liability, the difference is reported as the liability deferred taxes.

Repeating the Chapter 10 discussion, assume the Lowell Merchandising Corporation reported taxable income of $30,000,000 in its income statement. Consider what happens if, in using accelerated depreciation for federal tax purposes and straight-line depreciation for its financial statements, the company reports $2,000,000 higher depreciation expense in its tax return than in its financial statements. With $2,000,000 higher depreciation expense, the company's taxable income will be $2,000,000 lower in its tax return than it will be in its income statement. Using the 35% federal tax rate, the company would calculate its federal income taxes as follows.

IncomeStatement

FederalTax Return

Taxable income $30,000,000 $28,000,000Income taxes expense (35%) $10,500,000 $9,800,000

The above calculations show the Lowell Merchandising Corporation owes only $9,800,000 to the federal government for income taxes, not the $10,500,000 taxes reported in its income statement. However, the company knows as its assets get older, accelerated depreciation expense will become less than straight-line depreciation expense. (Remember, you can review this depreciation material in Chapter 9.) When this occurs, the income taxes expense reported in the company's income statement will be less than the income taxes reported in its tax return. However, it could take several years for this to happen.

Because it is common for income taxes expense in companies' income statements to differ from income taxes reported in their tax returns, companies use the following system:

Income taxes expense = income taxes expense reported in incomestatement

Income taxes payable = income taxes reported in tax return

Deferred taxes = difference between income taxes expense andincome taxes payable

Deferred taxes are liabilities because they will eventually have to be paid. They are considered current liabilities if they will be paid in the next twelve months. Usually, however, they are considered long-term liabilities because it may be many years before they will be paid to the government.

Continuing the Lowell Merchandising Corporation example, the effect of income taxes on the Lowell Merchandising Corporation's accounting equation would be as follows.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity+ $9,800,000 + - $10,500,000+ $700,000

Lowell Merchandising Corporation's resources do not change because the company did not pay the taxes until they were due. Sources of resources (liabilities) increase because the company owes the federal government $10,500,000. However, because only $9,800,000 of the taxes must be paid in the


near future, $9,800,000 would be a current liability and $700,000 would be considered a long-term liability, deferred taxes. The company's sources of resources (stockholders' equity) decrease to recognize the expense related to using the government's services (income taxes expense). In terms of a journal entry, remembering liabilities increase with credits and debits must equal credits, the following entry would result.



Dec. 31 Income Taxes Expense 551 10,500,000Income Taxes Payable 219 9,800,000Deferred Income Taxes Payable 229 700,000

Income taxes

** You now have the background to do exercise 11.6.

Financial Statement Reporting of Long-term Liabilities

Long-term liabilities are reported as liabilities on the balance sheet as shown below.

AssetsCurrent AssetsCash $18,330Accounts Receivable $75,000Less: Allowance for Uncollectible Accounts $1,500 $73,500Merchandise Inventory $210,000Total Current Assets $301,880

Property, Plant, and EquipmentLand $30,000Buildings $120,000Less: Accumulated Depreciation $40,000 $80,000Machinery & Equipment $150,000Less: Accumulated Depreciation $50,000 $100,000Autos & Trucks $95,000Less: Accumulated Depreciation $55,000 $40,000Total Property, Plant, & Equipment $250,000

Total Assets $551,880

Liabilities and Stockholders' EquityLiabilities

Current LiabilitiesNotes Payable $34,500Accounts Payable $84,490Taxes Payable $11,900Current Portion of Long-term Debt $28,000Total Current Liabilities $158,890

Long-term LiabilitiesLong-term Debt $146,400Deferred Taxes $10,500Obligations Under Capital Leases $27,200Total Long-term Liabilities $184,000

Total Liabilities $342,890

Reported in the long-term debt category are notes payable and bonds payable. The various activities that gave rise to long-term liabilities would appear elsewhere on the financial statements. Cash borrowed through the use of bonds payable could still be in the balance sheet cash account reported as an asset. Similarly, assets leased through capital leases appear on the balance sheet as part of property, plant, and equipment. Depreciation expense resulting from the use of such leased resources is included as part of operating expenses


on the income statement. Interest expense, which is the cost of borrowing, is reported as other revenues and expenses on the income statement. Income taxes, which resulted in the deferred taxes reported as part of the taxes payable liability, would be reported as income taxes expense on the income statement. Any gains or losses resulting from the early retirement of long-term debt would be reported on the income statement as other revenues and expenses or in a special section titled extraordinary items.

Sales $400,000Cost of Goods Sold $160,000Gross Profit $240,000Operating Expenses

Salaries and Wages Expense $103,000Depreciation Expense $10,000Supplies Expense $3,000Utilities Expense $9,000Rent and Insurance Expense $14,000Uncollectible Accounts Expense $1,000

Total Operating Expenses $140,000Income from Operations $100,000Other Revenues and (Expenses) ($1,260)Income Before Taxes $98,740Income Taxes Expense $34,650Net Income $64,090

** You now have the background to do problems 11.1 and 11.2.

Chapter 11 Critical Points

• One important source of resources is borrowing.• If borrowed resources do not have to be paid for within twelve

months, the source of the resources is considered to be a long-term liability.

• Bonds payable are contracts requiring payment of principal and interest at specific dates in the future.

• Over the life of a bond, interest expense, which is the cost of borrowing, is the difference between the cash received when the bond is issued and the cash paid to the bond owner over the bond's life.

• Gains or losses on early retirement of bonds payable are reported in the income statement as other revenues and expenses or occasionally as extraordinary items in a separate section.

• Deferred taxes will result when a company's taxable income on its income statement differs from its taxable income on its tax return.

• Long-term liabilities are reported in a separate section of the balance sheet.

• The following major topics have been examined so far.


AssetsCurrent AssetsCash and Cash Equivalents (6)

Accounts Receivable (7)

Allowance for Uncollible Accounts (7)

Merchandise Inventory (8)

Property, Plant, & EquipmentLand (9)Buildings (9)Accumulated Depreciation, Buildings (9)

Equipment (9)Accumulated Depreciation, Equipment (9)

Autos & Trucks (9)Accumulated Depreciation, Autos & Trucks (9)

= LiabilitiesCurrent LiabilitiesNotes Payable (10)Accounts Payable (10)Taxes Payable (10)Current Portion of Long-term Debt (10)

Long-term LiabilitiesBonds Payable (11)Deferred Taxes (11)Obligations Under Capital Leases (11)

+ Stockholders' EquityRevenuesSales (7)Sales Returns & Allowances (7)

Cost of Goods Sold (8)Operating ExpensesUncollectible Accounts Expense (7)

Depreciation Expense (9) & (11)

Salary & Wages Expense (10)

Payroll Taxes Expense (10)

Bank Service Expense (6)

Other Revenues & ExpensesInterest Revenue (6)Interest Expense (6) & (11)

Gain or Loss on Disposal of Property, Plant, & Equipment (9)

Gain or Loss on EarlyRetirement of

Bonds (11)Income Taxes Expense (10)

Chapter Eleven Questions

1. Define the term long-term liabilities.

2. Give three examples of long-term liabilities.

3. What are bonds payable and notes payable?

4. Identify one difference between bonds payable and notes payable.

5. During the life of a bond, what two dollar amounts must be paid to the bond's owner and when are the payments usually made?

6. State the formula for calculating interest on a bond payable.


7. In which financial statement and in which section of the statement is interest expense reported?


8. Why do companies use underwriters when they issue bonds?

9. Identify four choices companies must make when they decide to issue bonds.

10. Why can it take several weeks or months between when a company establishes a bond's interest rate and the date the company actually issues the bonds and receives cash?

11. What are deferred taxes and why do they exist?

12. On which financial statement are long-term liabilities reported?

Chapter Eleven Exercises

Exercise 11.1: Bonds Payable Cash Payments

The Kokernak Corporation is considering issuing bonds. For each of the three bonds below, calculate the total cash amount the Kokernak Corporation would pay out during the life of the bonds.

1. $5,000,000, 8%, 15-year bond.

2. $6,000,000, 9%, 20-year bond.

3. $8,000,000, 10%, 25-year bond.

Exercise 11.2: Bonds Payable: Cost of Borrowing

Over the last several years, the Keo Corporation issued bonds three different times. For each of the three bond issues, calculate the Keo Corporation's cost of borrowing.

Issue one: $10,000,000 principal, 7% annual interest, 20-year life. Cash received by the Keo Corporation was $10,000,000.


Issue two: $10,000,000 principal, 7.2% annual interest, 20-year life. Cash received by the Keo Corporation was $10,800,000.

Issue three: $10,000,000 principal, 6.9% annual interest, 20-year life. Cash received by the Keo Corporation was $9,700,000.

Exercise 11.3: Bond Transactions: Issued at Principal Amount

On July 1, the Andriolo Corporation issued $45,000,000, 8%, 20-year bonds and received $45,000,000. Interest on the bonds is to be paid every six months beginning on Jan. 1.

1. Calculate the Andriolo Corporation's total 20-year cost of borrowing by issuing the bonds.

2. Calculate the Andriolo Corporation's monthly cost of borrowing by issuing the bonds.

3. Prepare journal entries to record the corporation's following transactions. Before you prepare each journal entry, determine the transaction's effects on the company's resources and sources of resources.

July 1: Bonds issued.

Total Resources


+Sources of


+Sources of


Assets = Liabilities + Stockholders' Equity


July 1


July 31: Monthly interest.

Total Resources


+Sources of


+Sources of




July 31

Jan. 1: Interest payment.

Total Resources


+Sources of


+Sources of




Jan. 1

June 30, at the end of 20 years: Bond retirement.

Total Resources


+Sources of


+Sources of




June 30

4. Compare your answer in part 2 to the July 31 journal entry.


Exercise 11.4: Advantage of Borrowing: Bonds Issued at Principal Amount

The Campaigne Corporation is considering a plan to increase the size of its operations. As a result of increased operations, without considering the cost of borrowing, the company expects income before taxes to increase by $5,000,000 per year in years 1-3, $7,000,000 per year in years 4-8, $9,000,000 per year in years 9-15, and $6,000,000 per year in years 16-20. To increase operations the company would issue $50,000,000, 12%, 20-year bonds. The company expects to be able to issue the bonds at their principal.

1. Calculate the Campaigne Corporation's total expected 20-year increase in income before taxes without considering the cost of borrowing.

2. Calculate the Campaigne Corporation's total expected 20-year cost of borrowing.

3. Calculate the Campaigne Corporation's total expected 20-year increase in income before taxes after considering the cost of borrowing.

4. Assuming a 35% effective income tax rate, calculate the Campaigne Corporation's total expected 20-year increase in resources if it issues the bonds and increases its operations.

Exercise 11.5: Early Retirement of Bonds Issued at Principal Amount

Due to recent declines in interest rates, the Hughes Corporation is considering retiring one of its bonds issues on March 1. The bonds are $20,000,000, 8%, 15-year bonds, issued at par on September 1, almost 13 years ago.

1. Calculate the gain or loss the company would recognize if it retired the bonds for $21,500,000. Assume appropriate interest payments will be made on the bonds before they are retired.


2. Prepare the journal entry to record the bond retirement. Before you prepare the journal entry, determine the transaction's effects on the company's resources and sources of resources.

Total Resources


+Sources of


+Sources of




Mar. 1

Exercise 11.6: Deferred Income Taxes

There are several differences between the accounting methods the Baetz Corporation uses in preparation of its financial statements and in preparation of its federal income taxes return. For the year ended December 31, the company's taxable income on its income statement was $200,000,000, while it was $180,000,000 for income taxes purposes. For simplification, assume the income taxes rate is 35%.

1. Calculate the income taxes expense the company would report on its income statement.

2. Calculate the income taxes expense the company would report on its income taxes return.

3. Prepare the journal entry to record the corporation's income taxes. Before you prepare the entry, determine the transaction's effects on the company's resources and sources of resources.

Total Resources


+Sources of


+Sources of




Dec. 31



Chapter Eleven Problem

Problem 11.1: Cost of Bond Sold at Principal

1. The Craig Lonegan Merchandising Company is considering raising cash on January 1, by issuing a 16%, 4-year bond, $100,000 principal, with interest paid each December 31. The Craig Lonegan Merchandising Company expects to receive $100,000 when the bond is issued. Determine the following.

A. Interest payment amount required each December 31 $_______________.

B. Total interest payments amount required over the life of the bond $_______________.

C. Bond principal payment amount required at the end of bond's life $_______________.

D. Total four-year cost of borrowing by issuing the bond $_______________.

E. Interest expense amount to be recognized each year $_______________.

2. During the second year of the bond's life, the Craig Lonegan Merchandising Company reported the following additional information: cost of goods sold, $560,000; operating expenses, $372,000; sales, $1,180,000. The company's income tax rate is 35%. Prepare a classified income statement for the Craig Lonegan Merchandising Company for this second year.

Craig Lonegan Merchandising CompanyIncome Statement

For the Year Ended December 31

Sales $___________Cost of Goods Sold $___________Gross Profit $___________Operating Expenses $___________Income from Operations $___________Other Revenues and (Expenses) $___________Income Before Taxes $___________Income Taxes Expense $ 81,200Net Income $___________

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Chapter 11faculty.uml.edu/ccarter/Chapter11 UML 2… · Web view · 2010-08-18Chapter 11. Long-term Liabilities. In this chapter you will learn how long-term liabilities affect