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Long - Term Liabilities Page 1 of 10 Long - Term Liabilities Pratt, Fi nancial Accounting 7 e, Chapter 11 Liabilities and Interest Rates In many cases a liability the effective interest rate associated with a liability will be stated in the borrowing rate will be stated or the stated rate will be abnormally low. In these cases the effective rate must be imputed and used to record interest expense. Example 1: On January 1, 2007, Medina Corporation borrowed $100,000 for two years. The borrowing agreem ent requires Medina to repay $100,000 plus interest at the 8% rate at the end of the two year period. Date Accounts Debit Credit 1/1/07 Cash 100,000 Notes Payable 100,000 12/31/07 Interest Expense 8,000 Interest Payable 8,000 12/31/08 Interest Expense 8,000 Interest Payable 8,000 1/1/09 Notes Payable 100,000 Interest Payable 16,000 Cash 116,000 Long - Term Liabilities Page 2 of 10 Example 2: On January 1, 2007, Guadalupe Corporation borrowed money to finance a new operation. The borrowing agreement contained the following terms: No interest rate was mentioned, but Guadalupe received $420,840 on 1/1/07 and will be required to pay back $500,000 when the loan matures in 2 years. The implicit i nterest rate for this loan is the rate that makes the present value ($420,840) equal to the future value ($500,000). That rate is 9%. Date Accounts Debit Credit 1/1/07 Cash 420,840 Discount on Notes Payable 79,160 Notes Payable 500,000 12/31/07 Interest Expense 37,876 Discount on Notes Payable 37,876 420,840 X .09 12/31/08 Interest Expense 41,284 Discount on Notes Payable 41,284 458,716 X .09 1/1/09 Notes Payable 500,000 Cash 500,000 Long - Term Liabilities Page 3 of 10 Bonds Payable Bonds are structured so that interest is paid regularly (typically on a semiannual basis) to the bond holder with princip al paid back at the end the coupon rate) When bonds are issued the called the effective rate which reflects the market’s assessment of the unique risk of the company and other market wide factors that affect interest rates Bonds that issue for less than their maturity value are said to issue at a discount Bonds that issue for more than their maturity value are said to issue at a premium Relationship of Stated Rate and Effective Rate Bond Issue Price SR ER Discount SR = ER Maturity Value (Par) SR ER Premium Long - Term Liabilities Page 4 of 10 Example 1: Blanco Corp. issued at par $1,000,000 of 8 year, 8% bonds on January 1, 2007. Interest was payable semiannually on June 30 and December 31. Date Accounts Debit Credit 1/1/07 Cash 1,000,000 Bonds Payable 1,000,000 Each Year During the Life of the Bonds 6/30 Bond Interest Expense 40,000 Cash 40,000 1,000,000 X .08 x 6/12 12/31 Bond Interest Expense 40,000 Cash 40,000 At Maturity 12/31/14 Bonds Payable 1,000,000 Cash 1,000,000 Long - Term Liabilities Page 5 of 10 Example 2: Negro Corp. issued at par $1,000,000 of 8 year, 8% bonds on January 1, 2007. Interest was payable semiannually on June 30 and December 31. The company received $ 891,618 resulting in an effective interest rate of 10%. Date Accounts Debit Credit 1/1/07 Cash 891,618 Discount on Bonds Payable 108,382 Bonds Payable 1,000,000 6/30 /07 Bond Interest Expense 4 4 , 581 Cash 40,000 Discount on Bonds Payable 4,581 (1) 1,000,000 X .08 X 6/12 (2) 891,618 X .10 X 6/12 12/31 Bond Interest Expense 4 4 , 810 Cash 40,000 Discount on Bonds Payable 4,810 (1) 1,000,000 X .08 X 6/12 (2) 896,199 X .10 X 6/12 At Maturity 12/31/14 Bonds Payable 1,000,000 Cash 1,000,000 Long - Term Liabilities Page 6 of 10 An amortization table is a useful tool to compute interest expense for each period. Date Cash Paid Interest Expense Discount Amortized Carrying Amount of Bonds 1/1/07 891,618.00 6/30/07 40,000.00 44,580.90 4,580.90 896,198.90 12/31/07 40,000.00 44,809.95 4,809.95 901,008.85 6/30/08 40,000.00 45,050.44 5,050.44 906,059.29 12/31/08 40,000.00 45,302.96 5,302.96 911,362.25 6/30/09 40,000.00 45,568.11 5,568.11 916,930.36 12/31/09 40,000.00 45,846.52 5,846.52 922,776.88 6/30/10 40,000.00 46,138.84 6,138.84 928,915.73 12/31/10 40,000.00 46,445.79 6,445.79 935,361.51 6/30/11 40,000.00 46,768.08 6,768.08 942,129.59 12/31/11 40,000.00 47,106.48 7,106.48 949,236.07 6/30/12 40,000.00 47,461.80 7,461.80 956,697.87 12/31/12 40,000.00 47,834.89 7,834.89 964,532.76 6/30/13 40,000.00 48,226.64 8,226.64 972,759.40 12/31/13 40,000.00 48,637.97 8,637.97 981,397.37 6/30/14 40,000.00 49,069.87 9,069.87 990,467.24 12/31/14 40,000.00 49,532.76 9,532.76 1,000,000.00 640,000.00 748,382.00 108,382.00 Economic Gains and Losses from Borrowing – the current accounting for borrowing determines the effective interest rate when bonds are issued. Subsequent changes in interest rates are ignored which means in most cases the economic gains and losses from borrowing will not be recognized in the financial statements. Long - Term Liabilities Page 7 of 10 Leases Operating vs. Capital Leases Operating – you are renting the asset Capital – you are the lease A lease must be treated as a capital lease if any of the following are true: The lease transfers ownership of the property at the end of the lease term The lease contains an option to purchase the property at a bargain price The lease term is 75% or more of the estimated economic The present value of the minimum lease payments is 90% or inception of the lease If none of the above is true the lease is treated as an operating lease . Event Operating Lease Capital Lease A t lease inception No entry required Lease Obligation Each period during the life of the lease Rent Expense Cash Interest Expense Lease Obligation Cash Depreciation Expense Accumulated Deprec. Long - Term Liabilities Page 8 of 10 Example 1. United Cellular Systems leased a satellite transmission device from Pinnacle Leasing Services on January 1, 2007 under the following terms: 2. The lease is noncancelable and the term is for three years. 3. Annual lease payments of $120,000 were due at the end of each year. 4. The fair value of the device at the inception of the lease was $288.219.60 and it has a 3 year economic life. 5. Pinnacle established the lease payment based on a 12% inte rest rate and this fact is known to United Cellular. 6. 7. Similar equipment owned by United Cellular is depreciated on a straight - line basis. Lease is noncancelable Capital? Title does not transfer No No bargain purchase option No Lease term 3 years 75% of useful life (3 years) Yes PV of Lease payment* 90% of FV ($288,219.60) Yes * PV = $120,000 x (PVOA i=6%,n=5 ) = $120,000 X 2.40183 = $288,219.60 Date Cash Paid Interest Expense Principle Reduction Lease Liability 1/1/2007 288,219.60 12/31/2007 120,000.00 34,586.35 85,413.65 202,805.95 12/31/2008 120,000.00 24,336.71 95,663.29 107,142.66 12/31/2009 120,000.00 12,857.34 107,142.66 - 360,000.00 71,780.40 288,219.60 Long - Term Liabilities Page 9 of 10 2007 1/1/07 Leased Satellite 288,219.60 Lease Liability 288,219,60 7/1/07 Lease Liability 89,413.65 Interest Expense 34,586.35 Cash 120,000.00 12/31/07 Depreciation Expense (288,219.60/3) 96,073.20 Accumulated Depreciation 96,073.20 2008 12/1/08 Lease Liability 95,663.29 Interest Expense 24,336.71 Cash 120,000.00 12/31/08 Depreciation Expense 96,073.20 Accumulated Depreciation 96,073.20 2009 1/1/09 Lease Liability 107,142.66 Interest Expense 12,857.34 Cash 120,000.00 12/31/09 Depreciation Expense 96,073.20 Accumulated Depreciation 96,073.20 If the lease had been treated as an operating lease instead of a capital lease the following entries would have been made. 2007 1/1/07 No entry required 12/31/07 Rent Expense 120,000.00 Cash 120,000.00 2008 12/31/07 Rent Expense 120,000.00 Cash 120,000.00 2009 12/31/07 Rent Expense 120,000.00 Cash 120,000.00 Long - Term Liabilities Page 10 of 10 Summary of the Income Statement Impact of Capital vs. Operating Leases Operating Lease Capital Lease Year Rent Expense Interest Expense Depreciation Expense Total Expense 2007 120,000.00 34,586.35 96,073.20 130,659.55 2008 120,000.00 24,336.71 96,073.20 120,409.91 2009 120,000.00 12,857.34 96,073.20 108,930.54 360,000.00 71,780.40 288,219.60 360,000.00 Summary of the Balance Sheet Impact of a Capital Leases Year Cash Leased Lease Liability Equity 1/1/2007 0.00 288,219.60 288,219.60 0.00 12/31/2007 (120,000.00) 192,146,40 202,805.95 (130,659.55) 12/31/2008 (120,000.00) 96,073.20 107,142,66 (120,409.91) 12/31/2009 (120,000.00) 0.00 0.00 (108,930.54)