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FINANCIAL ACCOUNTING a user perspective
Sixth Canadian Edition
Prepared by: Lynn de Grace C.A.
Chapter 10Long-Term Liabilities
User Relevance
WHAT ARE THE KEY ISSUES?
1.Maturity dates and interest rates of debt:- cash flows must be planned to meet maturity dates and interest payments
- companies commonly replace old debt with new debt;
- high interest rates are detrimental to profitability ratios.
2.Existence of Debt Covenants:- These are special conditions attached to the debt, such as a requirement to maintain a certain ratio of debt to equity or level of retained earnings;
- failure to comply may result in debt becoming due immediately.
John Wiley & Sons Canada, Ltd. ©2011
2
User Relevance
3. Proportion of debt to equity
- Higher debt means greater risk – cash flows must be used at maturity,
- Replacing old debt with new debt may only be possible at higher interest rates;
- Can make lenders reluctant to extend further debt;
- Too much debt results in lower financial leverage and ultimately less shareholder wealth.
4. Is the company using leverage to the advantage of its shareholders ?- This means earning a rate of return on investment that is higher than the cost of debt?
John Wiley & Sons Canada, Ltd. ©2011
3
Long-Term Notes & Mortgages Various markets from which a company
can obtain long term financing Examples:
• Commercial bank loans• often contain conditions or restrictions known
as covenants• Commercial paper – a promissory note sold
to another business• only used by companies with high credit ratings
John Wiley & Sons Canada, Ltd. ©2011
4
Long-Term Notes & Mortgages
Long-term loans with equal blended monthly payments:• Mortgage loans – capital asset is pledged as collateral• Usually structured as instalment loans• Payments are blended – consisting of both interest and
principal• Loan amortization table is usually prepared showing the
allocation of interest and principal payments for the duration of the loan.
John Wiley & Sons Canada, Ltd. ©2011
5
Long-Term Notes & Mortgages
Long-term loans with equal blended monthly payments:
EXAMPLE:
A company that takes out a three-year, $100,000 mortgage on September 30. The interest rate on the loan is 6% per year, and equal blended payments of $3,042.19 are to be made at the end of each month.
Sept 30 Cash 100,000Mortgage payable 100,000
John Wiley & Sons Canada, Ltd. ©2011
6
Long-Term Notes & Mortgages
Long-term loans with equal blended monthly payments:
To record the first three payments:
Oct 31 Interest expense 500.00Mortgage payable 2,542.19
Cash 3042.19
Nov 30 Interest expense 487.29Mortgage payable 2,554.90
Cash 3042.19
Dec 31 Interest expense 474.51Mortgage payable 2,567.68
Cash 3042.19
John Wiley & Sons Canada, Ltd. ©2011
7
Long-Term Notes & Mortgages
Long-term loans with interest only monthly payments:
Oct 31 Cash 100,000.00 Mortgage payable 100,000.00
Oct 31 Interest expense 500.00 Cash 500.00
Nov 30 Interest expense 500.00 Cash 500.00
Dec 31 Interest expense 500.00 Cash 500.00
John Wiley & Sons Canada, Ltd. ©2011
8
Bonds
John Wiley & Sons Canada, Ltd. ©2011
Companies may raise long-term funds through either:
• Equity (stock) market
OR
• Debt market• Borrow money from a commercial bank• Sell bonds to investors
9
Bond Characteristics
John Wiley & Sons Canada, Ltd. ©2011
Formal agreement called an indenture agreement.
Specifies• How the money is to be paid back• Conditions that must be met during the
period of the loan• Stated in the indenture agreement• May specify restrictions (debt covenants)
10
Bond Characteristics
John Wiley & Sons Canada, Ltd. ©2011
Bonds traded in public markets are standardized, stating:• Face value: $1,000 per bond
• Specifies the cash payment to be made at the maturity date of the bond
• Usually semi-annual interest payments• Bond interest rate
• Stated as an annual percentage
11
Bond Characteristics
John Wiley & Sons Canada, Ltd. ©2011
Mortgage bond• Has real property as collateral
Collateral trust bond• Provides shares and bonds of other
companies as collateral Debenture bond
• Carries no specific collateral• Senior debenture bonds• Subordinated debenture bonds
12
Bond Characteristics
John Wiley & Sons Canada, Ltd. ©2011
Some bonds have special provisions• Convertible bonds
• Can be converted to a specified number of common shares;
• Usually based on the occurrence of a specific event or a specified period of time.
13
Bond Pricing
John Wiley & Sons Canada, Ltd. ©2011
Market price of bonds is determined by discounting two sources of future cash flows:
Repayment of principal – present value of a single sum
PLUS
Periodic interest payments – present value of a series of payments
14
Bond Pricing
John Wiley & Sons Canada, Ltd. ©2011
Example: On December 31, 2011 a company issues bonds
with a total face value of $100,000, a bond interest rate of 8%, maturing on December 31, 2014.
The company expects the investor to demand a return of 10% (the risk-adjusted market rate) compounded semi-annually from this type of investment.
AT WHAT PRICE WILL THE BONDS BE ISSUED ?
15
Bond Pricing
Preliminary calculation: The cash flows must be discounted using the yield
rate* of 10%*Often called the discount rate or market rate
• Number of periods = Time to maturity x 2 = 3 years x 2 = 6 periods
• Yield rate per period = Yield rate ÷ 2 = 10% ÷ 2 = 5% per period
• Interest payments = Face amount x coupon rate x 6/12 = $100,000 x 8% x 6/12 = $4,000
John Wiley & Sons Canada, Ltd. ©2011
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Bond Pricing
Summary of key data:• Face value 100,000• Bond interest rate* 8%• Time to maturity 3 years• Yield rate 10%• Semi-annual yield rate 5%• Semi-annual interest payments $4,000• Number of semi-annual periods 6 *often referred to as the coupon rate
John Wiley & Sons Canada, Ltd. ©2011
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Bond Pricing
Calculation:Present value of the interest payments (an
annuity):$4,000 x 5.07569* = 20,302.76*present value interest factor of an annuity in
arrears for 6 periods at 5%PLUSPresent value of the principal sum:($100,000 x 0.74622) = 74,622.00= $20,302.76 + $74,622.00 = $94,924.76 = $94,924.76 Bond is issued at a discount
John Wiley & Sons Canada, Ltd. ©2011
18
Bond Pricing
WHAT IF THE COMPETITIVE INTEREST RATE IN THE MARKET IS 6% ?
If the buyers demand a 6% return on their investment:
PV of bond = PV of interest payments + PV of maturity payment
= PV of annuity of $4,000 for 6 periods at 3% + PV of $100,000 for 6 periods at 3%
= ($4,000 x 5.41719) + ($100,000 x 0.83748) = $105,416.76 Bond is issued at a premium.
John Wiley & Sons Canada, Ltd. ©2011
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Bond Price Relationship
John Wiley & Sons Canada, Ltd. ©2011
Coupon Rate Bonds Issued at:
• Higher than expected yield Premium
• Lower than expected rateDiscount
• Equal to expected yield Par
20
Bond Price Relationship
Yield Rates
Coupon Rates
6% 8% 10% 12%
6% $1,000.00 $963.70 $929.08 $896.05
8% $1,037.17 $1,000.00 $964.54 $930.70
10% $1,074.34 $1,036.30 $1,000.00 $965.35
12% $1,111.51 $1,072.60 $1,035.46 $1,000.00
John Wiley & Sons Canada, Ltd. ©2011
Bonds Issued at Par
John Wiley & Sons Canada, Ltd. ©2011
Bonds issued at par are said to be issued at 100.
Cash (A) 1,000Bonds Payable (L) 1,000
Because interest accrues as time passes, no interest is recognized on the date of issuance
22
Accounting for Bonds
John Wiley & Sons Canada, Ltd. ©2011
Interest expense versus Interest Payment• Actual interest payment is based on the bond
coupon rate• Company nets any discount or premium against
the bonds payable account.• Interest expense for accounting purposes
will include both the actual interest payment and a portion of the discount or premium, if any.
• This is accomplished by calculating interest expense based on the Yield Rate x Bond Carrying Value.
23
Accounting for Bonds
John Wiley & Sons Canada, Ltd. ©2011
Case 1 Bonds Issued at a Discount:Issue date:
Cash (A)94,924.76Bond liability (L) 94,924.76
First interest payment:Interest expense (SE) 4,746.24
Bond liability (L) 746.24Interest payable (L) 4,000.00
Second interest payment:Interest expense (SE) 4,783.55
Bond liability (L) 783.55Interest payable (L) 4,000.00
25
Accounting for Bonds
John Wiley & Sons Canada, Ltd. ©2011
Case 2 Bonds Issued at a Premium:Issue date:
Cash (A)105,416.76Bond liability (L) 105,416.76
First interest payment:Interest expense (SE) 3,162.50Bond liability (L) 837.50
Interest payable (L) 4,000.00Second interest payment*:
Interest expense (SE) 3,137.38Bond liability (L) 783.55Interest payable (L) 4,000.00
(*Difference due to rounding)
27
Accounting for Bonds Issued at Par
John Wiley & Sons Canada, Ltd. ©2011
Interest expense and Interest payable amount will be the same in all six interest periods over the life of the bond.
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Early Retirement of Debt
Sometimes makes sense to pay off debt early Callable bonds – a feature that allows the
company to buy them back at a predetermined price before maturity
Usually a gain or loss will arise because the price paid to retire the bonds differs from their carrying value.
John Wiley & Sons Canada, Ltd. ©2011
29
WestJetLong Term Debt Note
Long Term Debt with No Explicit Interest Often, long term assets are purchased under arrangements
whereby interest expense is not explicitly stated in the loan agreement.
Loan agreement specifies the amounts and timing of the payments
If payment is not due until a later period, more appropriate to record the initial debt at present value.
Present value represents the true value of the asset at the time of purchase if the company does not have to pay for it until later.
The appropriate discount rate should be the rate at which the company would have to borrow to buy the asset.
Interest expense is calculated each period using the discount rate times the carrying value of the debt.
John Wiley & Sons Canada, Ltd. ©2011
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Long Term Debt with No Explicit Interest
EXAMPLE: A company negotiates the purchase of some equipment for $100,000, which is to be paid at the end of three years with no interest added. The company would normally have been charged an interest rate of 6% annually for a three-year loan.PVIF 6%, 3 = 0.83962
Purchase Date:Equipment 83,962
Long term note payable 83,962
First year’s interest expense:Interest expense 5,038
Long term note payable 5,038[$83,962 x 6% = 5,038]
John Wiley & Sons Canada, Ltd. ©2011
31
Leases
John Wiley & Sons Canada, Ltd. ©2011
What is a lease agreement?
One party (the lessor) buys the asset and the second party (the lessee) makes periodic payments in exchange for the use of the asset over the lease term.
32
Owning Versus Leasing
John Wiley & Sons Canada, Ltd. ©2011
Ownership pros: Company can use the CCA to reduce income
taxes. Investment tax credits may also be available
Benefits from the increase in value of the asset
Ownership cons: Ties up capital that could have been used for
something else Financing the assets will negatively impact
debt ratios and interest coverage ratios.
33
Owning Versus Leasing
John Wiley & Sons Canada, Ltd. ©2011
Leasing: Favourable terms can mean a low cost form of financing Frees up capital for other purposes Not necessary to incur debt – less impact on debt ratios Lowers lessee’s risk that the asset will become obsolete Lessee may opt to use the asset for less than its useful
life.
34
Classification of Leases
John Wiley & Sons Canada, Ltd. ©2011
OPERATING LEASE:• If the lease term is a relatively short period of time
compared to the life of the assets, then:• Lessee is not buying, but renting the asset• Payments are recorded as rent expense CAPITAL/FINANCE LEASE:• Lease is for a major part of the asset’s useful life• Lease is effectively a financing arrangement with
installments• Asset is recorded at its cost – measured at the
present value of the future lease payments;• Obligation to the lessor is recorded as a non-current
liability and interest is recognized over the term of the lease.
35
Classification of Leases
John Wiley & Sons Canada, Ltd. ©2011
A lease qualifies as a capital/finance lease if any one of the following criteria is met:
1.The lease transfers ownership of the asset to the lessee by the end of the lease term;2.The lessee has a “bargain purchase” and it is reasonably certain that this “bargain purchase option” will be exercised;3.The lease term is for the major part of the asset’s economic life;4.The present value of the minimum lease payments is equal to substantially all of the fair value of the asset;5.The leased asset is of such a specialized nature that, without major modifications, only the lessee can use it.
36
Accounting For Leases
John Wiley & Sons Canada, Ltd. ©2011
Example:
• Asset is leased for 3 years• Monthly lease payments of $1,000, payable
at the end of each month• Interest rate is 12%
Under an operating lease, the monthly journal entry is:
Equipment rental/lease expense (SE) 1,000Cash (A) 1,000
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Accounting For Leases
John Wiley & Sons Canada, Ltd. ©2011
Under a capital/finance lease:• Asset and liability are recorded at present
value Key data:
• 36 periods, 1% per periodPVIFA1%, 36 = 30.10751
Journal entry to record lease transaction:Leased equipment (A) 30,107.51
Lease obligation (L)30,107.51
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Accounting For Leases
John Wiley & Sons Canada, Ltd. ©2011
Capital/finance lease (cont’d): At the end of the first month:
Interest expense (SE) 301.08Lease obligation (L) 698.92
Cash (A) 1,000.00[Interest = 1% x 30,107.51]
At the end of the second month:Interest expense (SE) 294.09Lease obligation (L) 705.91
Cash (A) 1,000.00[Interest = 1% x (30,107.51-698.92)]
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Accounting For Leases
John Wiley & Sons Canada, Ltd. ©2011
Capital/finance lease (cont’d): Assuming straight-line amortization
over 36 months At the end of each month:Depreciation expense (SE) 836.32
Accumulated depreciation (XA) 836.32 - leased equipment
40
Pensions
John Wiley & Sons Canada, Ltd. ©2011
Agreements between employers and employees that provide employees with specified benefits (income) upon retirement
Represents an estimated future obligation for the services that the employee is rendering to the company presently,
Makes sense to include the costs of this obligation in the same period as the benefits received
41
Pensions
John Wiley & Sons Canada, Ltd. ©2011
Defined contribution pension plans:• Employer agrees to make a pre-defined
contribution to a retirement fund for the employee.
• Risk of increases or decreases to the plan’s market value is borne by the employee.
• Pension expense is generally equal to the contribution.
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Pensions
John Wiley & Sons Canada, Ltd. ©2011
Defined benefit pension plans:• Employee is guaranteed a certain amount of money
during each year of retirement.• Risk of increases or decreases to the plan’s market
value is borne by the employer.• Employer must continually assess plan assets to
determine if the current contributions to the plan will be sufficient to meet the future obligation.
• Pension obligation is determined as the present value of the future obligation.
• Pension expense consists of both the current pension expense (determined by an actuary) plus/minus any adjustments or contributions required to fund plan assets in order to meet the present value of the future obligation.
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Pension Plan Disclosure
For a defined contribution plan, the contributed amounts must be disclosed.
For a defined benefit plan disclosure is usually extensive and can be complex.• Generally, in order to determine whether
the pension plan is underfunded, overfunded, or fully funded, it is necessary to read the notes to the financial statements
John Wiley & Sons Canada, Ltd. ©2011
44
Deferred Income Taxes
Basic Concepts:• Income tax expense is an accrual
accounting concept since it is based on accounting income from the income statement
• Income taxes payable must be calculated according to the rules established by Canada Revenue Agency (CRA)
• Difference is deferred income tax – it can be either an asset or a liability, depending on the cause of the difference.
Canadian practice uses the liability method to account for these differences.
45
John Wiley & Sons Canada, Ltd. ©2011
Deferred Income Tax - Liability Method
A calculation of the income tax that will be payable in the future or deductible in the future, based on the temporary differences (the differences between the accounting records and the tax records) that exist in the current period.
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John Wiley & Sons Canada, Ltd. ©2011
Deferred Income Tax - Liability Method
EXAMPLE - Warranties For accounting purposes, the company estimates
the probable costs associated with the warranty and records the total amount as warranty expense in the year of the sale, as well as a liability (warranty obligation). For tax purposes, the CRA does not permit a company to deduct the estimated warranty expense in calculating its taxable income; the company can only claim a tax deduction for the actual costs that it incurs each year to settle claims under the warranty.
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John Wiley & Sons Canada, Ltd. ©2011
Deferred Income Tax - Liability Method
Example: Assumptions
• Income before tax and warranties: $10,000• Estimated warranty expense (for accounting
purposes)• Year 1: $ 500
• Actual warranty costs incurred:• Year 1: $ 125• Year 2: $ 175• Year 3: $ 200
• Tax rate (same in year 1, year 2, and year 3): 40%
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John Wiley & Sons Canada, Ltd. ©2011
Deferred Income Tax - Liability Method
Year 1 Year 2 Year 3
Income before warranty expense & income taxes
10,000 10,000 10,000
Actual warranty costs incurred
(125) (175) (200)
Taxable income 9,875 9,825 9,800
40% 40% 40%
Taxes payable $3,950 $3,930 $3,920
Income tax currently payable:
John Wiley & Sons Canada, Ltd. ©2011
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Deferred Income Tax - Liability Method
Year 1 Year 2 Year 3
Beginning warranty obligation
$ 500 $ 375 $ 200
Actual warranty costs incurred
125 175 200
Ending warranty obligation (Temporary difference)
$ 375 $ 200 $ -0-
Tax rate 40% 40% 40%
Deferred tax asset $ 150 $ 80 $ -0-
Increase (decrease) in deferred tax asset
$ 150 ( $70) ( $80)
Calculation of deferred income taxes:
John Wiley & Sons Canada, Ltd. ©2011
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Deferred Income Tax - Liability Method
Year 1 Year 2 Year 3
Income taxes payable (3,950) (3,930) (3,920)
Future income taxes 150 (70) (80)
Income tax expense $3,800 $4,000 $4,000
Calculation of income tax expense:
51
John Wiley & Sons Canada, Ltd. ©2011
Income Tax Disclosures
Reconciliation of the difference between the tax expense reported on the income statement and the amount that would have been reported if all revenues, expenses, gains, and losses were subject to tax at the stated tax rates
Summary of the temporary differences creating the deferred income tax amounts
Breakdown of the taxes into the amounts that are currently payable and the amounts that are deferred to the future
52
John Wiley & Sons Canada, Ltd. ©2011
West Timber Lumber Co.Income Tax Note
Statement Analysis
John Wiley & Sons Canada, Ltd. ©2011
Debt/Equity Ratio =
Total Liabilities
Total liabilities + Shareholder’s Equity
53
WestJetBalance Sheet
Times-Interest-Earned Ratio
John Wiley & Sons Canada, Ltd. ©2011
Times- interest- earned
Income before interest and taxes
Interest=
=Net income + Taxes + Interest Interest
55
WestJetIncome Statement
Times-Interest-Earned Ratio
John Wiley & Sons Canada, Ltd. ©2011
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WestJet Times Interest Earned Ratio:
Copyright © 2011 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
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