Long Term Liabilities In DetailWhile current liabilities are obligations which are generally due within a year and are settled by using current assets such as cash or merchandise inventory, long-term liabilities are borrowings or other obligations which are not due or payable for at least one year and perhaps will not be settled in full until many years in the future.

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I now will discuss long-term liabilities referred to as Non-Current Liabilities in this post in much more detail overview, illustrated with calculation and presentation examples. Enjoy!

 

Here is presentation example of Long-term Liabilities on a Balance Sheet

Balance Sheet Reporting:

Long-Term Liabilities
Notes Payable                             =$ 10,000
Mortgage Notes Payable             =$ 97,000
Capital Lease Obligations           =$137,000
Pension Obligations                    =$ 60,000
Bonds Payable                             =$ 92,000
Deferred Income Tax Liabilities  =$    4,000
Total Long-Term Liabilities        =$400,000

Next, we are going to overview each of the above element one-by-one in details. Follow on…

 

Notes Payable

A company may negotiate a loan from a financial institution or another lender to cover its short-term or long-term cash needs and sign a promissory note which specifies the interest rate, maturity date, and repayment terms. It may be an unsecured loan; if the borrower defaults and does not repay the note when due, no specific assets are pledged as collateral for the loan. The lender may require monthly payments which include principal and interest (see Mortgage Note Payable example below), require that only period interest payments be made, or allow the borrower to wait until the loan matures to repay both the principal and the interest that has accumulated.

As an example, assume a company signed a $10,000, 12 percent, five-year promissory note on January 1, 2009. It was required to make semiannual interest payments only on July 1 and January 1 of each year, but wait to repay the principal amount due when the loan matures. The semiannual interest payment would be calculated as follows:

Principal x Interest rate x Time     = Interest
$10,000  x 12%  x  6/12 months  = $600

 
Assume the company made the first interest payment on July 1, 2009, but will not make the second interest payment until January 1, 2010, the interest payment due date. When the December 31, 2009, balance sheet is prepared, interest payable of $600 will be classified as a current liability, and the $10,000 note payable will be classified as a long-term liability, as shown below:

Notes and Interest Payable
December 31, 2009

Current Liabilities
Interest Payable = $600

Long-Term Liabilities
Note Payable = $10,000

 

In the final year before the loan matures, in most cases the note payable will be classified as a current liability as it is due within a year and will be repaid (settled by using current assets). But what if the company renegotiates the loan, and rather than repaying when it matures, it signs a new five-year note? In this case, the note may continue to be reported as a long-term liability as it will not be settled in cash but instead replaced with another long-term note.

 

Mortgage Notes Payable

A mortgage note payable is another form of long-term borrowing that typically is used to finance the purchase of land and/or buildings. A mortgage is a secured loan; the property financed by the loan is pledged as collateral and can be sold to cover the amount owed to the lender if the borrower defaults. Mortgage loans typically require monthly installment payments of principal and interest.

Assume the principal balance of a 15-year mortgage loan is $100,000, and $3,000 of this balance is due within the coming year. The mortgage loan will appear in both the current liability and long-term liability classifications, as shown below:

Mortgage Loan Repaid in Installments
December 31, 2009

Current Liabilities
Current Portion of Long-Term Debt         = $  3,000

Long-Term Liabilities
Mortgage Note Payable        = $100,000
Less: Current Portion           =      (3,000)
Total Long-Term Liabilities                      = $ 97,000
Total Liabilities                                         = $100,000

 

Discounted Notes Payable

Before we discuss what we mean by a discounted note payable, let’s start with a more straightforward example:

Assume that Company A purchases an acre of land in a business park for $10,000 and signs a promissory note payable to the bank. The principal amount of the note is $10,000, it has a 10 percent stated interest rate, and it matures in two years. However, the 10 percent interest will be compounded and added to the amount owed and will be paid when the note matures in two years rather than being paid each year. Below figure shows how the interest is calculated and shows that a total of $12,100 will be repaid in two years: the $10,000 principal balance of the loan and the $2,100 compound interest.

Note that no interest was paid in 2009 and so the 2010 interest is calculated on the total amount owed; in other words, the interest was compounded.

 

Calculation of Compound Interest and Maturity Value of a Note Payable

Year     Beginning Balance + 10% Interest = Ending Balance

2009    $10,000                + $1,000         = $11,000
2010    $11,000                + $1,100         = $12,100

 

Assume Lie Dharma Putra Company purchases an adjacent acre of land in the same business park and signs a note payable, promising to pay $12,100 in two years with zero interest.

Does it seem realistic that Lie Dharma Putra Company could borrow for two years and pay no interest?

 

Probably not. There is an implied component of interest in this transaction even though none was stated specifically. If the market value of the land is $10,000, the additional $2,100 paid when the note matures is the implied interest or imputed interest that has accumulated during the two years.

The substance of Lie Dharma Putra Company’s loan is identical to that of Company A, although the forms of the two notes differ. In Lie Dharma Putra Company’s case, we would say that we are discounting the note to reflect the implied interest and that the present value of the note is $10,000. Both companies would record the land at its cost of $10,000, and both would pay $12,100 when the notes mature, which includes $2,100 of com-pound interest. However, on the date the note was signed, Lie Dharma Putra Company would report the note on its balance sheet as shown below:

Discounted Note Payable—Lie Dharma Putra Company
January 1, 2009

Long-Term Liabilities
Note Payable                                 =$12,100
Less: Discount on Note Payable    = (2,100)
Total Long-Term Liabilities          =$10,000

 

Lie Dharma Putra Company’s 2009 income statement would include $1,000 of interest expense ($10,000 x 10 percent), and the December 31, 2009, balance sheet would present the new ending balance of the loan as shown below:

Discounted Note Payable—Lie Dharma Putra Company
December 31, 2009

Note Payable                                 = $12,100
Less: Discount on Note Payable    =   (1,100)
Total Long-Term Liabilities          = $11,000
Lie Dharma Putra Company’s 2010 income statement would include $1,100 of interest expense ($11,000 x 10 percent), and the December 31, 2010, balance sheet would present the new ending balance of the loan, the total amount that will be repaid, as shown below:

Discounted Note Payable—Lie Dharma Putra Company
December 31, 2010

Note Payable                                 = $12,100
Less: Discount on Note Payable    =            0
Total Long-Term Liabilities          = $12,100

 

Financial statements include many other applications of the concepts similar to those described in the examples above. Although a detailed discussion of these concepts is beyond the scope of this post, similar concepts are applied to capital lease obligations and bonds payable, which are discussed below.

 

Capital Lease Obligations

A company may enter into rental or lease agreements for equipment, buildings, or other assets as an alternative to financing an actual purchase of those assets on its own. A rental or lease arrangement may be for a short duration, such as renting specialized equipment for a few days, but for buildings and other assets the lease term may span many years. There are many considerations involved in a lease versus buy decision, along with many complex financial reporting issues that are beyond the scope of this post, but we will discuss a couple of examples briefly below.

Let’s first examine an example of what might be called an operating lease. A company decides to rent office space and signs a one-year lease agreement in December 2009, pays the first two months in advance, and makes monthly rent payments for the remainder of the lease term. When financial statements are prepared on December 31, 2009, one month of rent expense will be reported in the income statement, and the other month paid in advance will be reported as a current asset, prepaid rent, and not an expense until the following year in accordance with the matching principle.

Now let’s consider a company that needs its own office building and can either finance the purchase of the building with a 25-year mortgage note payable and make monthly loan payments or enter into a 25-year agreement to lease another office building and make monthly lease payments. If it decides to borrow money and purchase a building, the building will be included in plant assets, and the mortgage note payable will be included in liabilities on the balance sheet.

But what if the company instead decides to lease the other building and is legally obligated to make 25 years of lease payments, along with other terms and conditions?

 

That’s a pretty big commitment. If this arrangement is considered to be an operating lease, the monthly lease payments would be reported as rent expense in the income statement, but you would not find the obligation for the future lease payments included among the liabilities; in other words, this would be an off–balance sheet arrangement (now almost a household term thanks to Enron and its clever arrangements to conceal its activities).

In contrast to an operating lease, a capital lease is the term used to describe lease arrangements that more closely resemble financing the purchase of an asset with long-term debt. Regardless of the form of the written agreement, the economic substance should be considered carefully because it may indicate that the arrangement is like a purchase in disguise in an effort to keep debt off a company’s balance sheet.

If the 25-year lease arrangement above was determined to be a capital lease, it would be treated much like the actual purchase of the office building with a mortgage note payable. The capital lease obligation would represent the present value of the future lease payments (using concepts similar to the discounted note payable discussed earlier) and would be treated very much like a mortgage note pay able, with a portion of each lease payment applied to pay down the capital lease obligation (much like principal payments on a loan) and the remainder of each payment is much like the interest portion of a mortgage loan payment. The building would be capitalized as though it had been purchased, included in plant assets, and depreciated.

 

Bonds Payable

Bonds are a common form of financing that are used not only by large corporations but also by federal and state governments and agencies, school districts, and many other parties which need to borrow substantial amounts of money for a long period of time. When you purchase a U.S. savings bond, you are lending your money to the government. If you purchase a school district bond, you are making a loan to help pay for the construction of new schools or other improvements. If you purchase a corporate bond, you are lending money the corporation will use to finance expansion and growth either internally or to acquire other companies to achieve external growth.

This post is focused on the financial statements of business entities, and so we will emphasize concepts pertaining to corporate bonds, although many of the concepts are similar for bonds issued by other parties.

 

Debentures are a form of unsecured bonds (no specific collateral), while other types of bonds may pledge assets or specific revenue sources as collateral. Some bond agreements require the company to make periodic payments into a sinking fund which will be used to repay the bonds on the maturity date.

One advantage of this form of long-term borrowing is the company’s ability to raise substantial amounts of money that it may not have to repay for years or even decades without relying upon a single lender, such as a bank, to do so. The denomination of a typical corporate bond is $1,000; in theory, if the corporation needs to borrow $10,000,000, it could borrow $1,000 each from 10,000 different parties.

Another advantage is that a bondholder (the investor) can sell the bond investment to other parties and not have to wait to be repaid when the bonds mature, which might be many years in the future. Just like stock investments, bonds are purchased and sold daily in the financial markets.

 

Although the principal (or maturity value) of the bond may not be repaid for many years in the future, a stated amount of interest is owed and generally is paid semiannually. For example: if the corporation issues $10,000,000 of bonds with a stated annual interest rate of 4 percent and pays the interest semiannually, every six months the cash interest payment would be calculated as shown below:

Principal         x Interest Rate    x Time                 = Interest
$10,000,000  x 4%                    x 6/12 months    = $200,000

 

Amounts received by the corporation at the time it issues bonds may differ from the amount it is required to repay when the bonds mature to adjust for differences in the interest rate specified for the bonds and market rates of interest at the time of borrowing. Thus, bonds payable are shown in the balance sheet at their present value, based on implied or imputed interest, similar to the example of the discounted note payable that was discussed earlier in this post.

For example: if 4 percent bonds were issued when market rates of interest were higher than 4 percent, the bondholders might pay only $9,200,000 to purchase the bonds but if the bondholders hold their investment to maturity they still will be paid the full $10,000,000 when the bonds mature which compensates them for the additional interest they expected to earn. We would say the bonds are issued at a discount, based on concepts similar to the discounted note payable example that was discussed earlier. (The amount paid for the bonds, $9,200,000 in this case, is not a random number. It is based on a mathematical calculation using the timing and amounts of cash payments and an applicable interest rate, a topic beyond the scope of this post). The bonds would be presented on the balance sheet as shown below:

Bonds Payable Issued at a Discount

Long-Term Liabilities
Bonds Payable (4% interest rate, maturing in 20 years) = $10,000,000
Less: Discount on Bonds Payable                                  =     (800,000)
Total Long-Term Liabilities                                          =   $9,200,000

 

By contrast, if the market rate of interest at the time the bonds are issued is less than 4 percent, the corporation will issue the bonds at a higher price; for example: the bonds might sell for $10,800,000. (Again, this is not a random number; it is computed using calculations that provide the bondholders with a lower interest rate that the market is willing to accept at the time.) This lower effective interest rate of return is achieved because the company will repay only $10,000,000 at maturity, reducing its overall effective interest cost.

I would say the bonds are issued at a premium, and the bonds would be presented in the balance sheet as shown below:

Bonds Payable Issued at a Premium

Long-Term Liabilities
Bonds Payable (4% interest rate, maturing in 20 years) = $10,000,000
Add: Premium on Bonds Payable                                   = $     800,000
Total Long-Term Liabilities                                          = $10,800,000

 

Covenants, Collateral, and Sinking Funds

The terms and conditions for long-term borrowing arrangements can be very detailed and complex, and the agreement may specify conditions that must be met throughout the term of the loan or may impose restrictions. These conditions and restrictions, which are referred to as loan covenants, may limit the amount of cash dividend payments to the stockholders, require the company to meet certain financial benchmarks (including certain ratios), or require it to pledge specific assets as collateral for the loan in the event of default.

Some agreements require that money be set aside and invested in a fund that will be used to repay the loan at maturity, such as the sinking fund that was discussed in the section on long-term investments. The financial statement footnotes for long-term debt will provide considerable additional information, including key covenants, pledged assets, stated and effective interest rates, maturity dates, and scheduled payments or sinking fund requirements for each of the next five years.

 

Deferred Income Taxes

Corporations are considered legal entities separate from their owners and a corporate entity must file tax returns and pay federal and state income taxes on its profits. A corporation makes quarterly estimates of its taxable income for the current year and makes quarterly estimated tax payments; any unpaid taxes owed for the current year are reported under current liabilities as income taxes payable.

By contrast, amounts reported as deferred income tax liabilities represent income taxes which may become payable in later years and are related to differences in accounting and taxable income. According to the matching principle, the amount reported as income tax expense in the current year’s income statement represents the tax due on the basis of the revenues and expenses including in accounting income for that year.

However, according to tax law, not all revenues are taxable income in the same year they are considered to have been earned under financial accounting concepts. Likewise, not all expenses are tax-deductible in the same year they were incurred and reported in the income statement. Accounting for income tax liabilities is a very complex issue that is beyond the scope of this post, but a brief example may help explain the concept. Deferred income taxes commonly arise when the depreciation methods used in the financial statements (discussed earlier in this post) differ from the depreciation methods and tax deductions specified in the tax law, although there are many other examples.

 

Assume a corporation recently purchased equipment and capitalized a cost of $100,000. It expects to use this equipment for 10 years, after which the trade-in value is presumed to be zero, and even if it could be sold for its scrap value, that would be a negligible amount. It will depreciate $10,000 per year for a total of $100,000, using the straight-line method of depreciation explained earlier in this post.

According to the matching principle, income tax expense in the income statement is based on the accounting income earned in that period that will be subject to income taxation but not necessarily reported on the tax return for that particular year. Assume income before depreciation is $500,000 and the income tax rate is 40 percent. As shown below, the company will report income tax expense of $196,000 in its 2009 income statement, based on accounting depreciation of $10,000.

Calculation of Income Tax Expense

Income before Depreciation Expense         = $500,000
Depreciation Expense                                 = (10,000)
Income before Taxes                                  = $490,000
Income Tax Expense ($490,000 × 40%)      = (196,000)
Net Income                                                 = $294,000

 

However, for income tax purposes, assume that this asset qualifies for a shorter five-year life and that depreciation is based on the MACRS method discussed earlier in this post. A total of $100,000 of depreciation will be taken, with a depreciation deduction in the income tax return of $20,000 in the first year of use. Taxable income and income taxes currently payable would be determined as shown below:

Calculation of Income Tax Currently Payable  

Taxable Income before Depreciation Deduction = $500,000
Depreciation Deduction                                      =   (20,000)
Taxable Income                                                  =    480,000
Income Tax Rate                                                           ×40%
Income Taxes Currently Payable                         = $192,000

 

 

 

 

The amount reported as income taxes payable of $192,000 represents the income tax the corporation is obligated to pay for the 2009 income tax year. Most corporations pay estimated income taxes owed on a quarterly basis and so the amount reported as a current liability may be only the unpaid fourth quarter installment (or $48,000 in this example).

The deferred income tax liability of $4,000 at December 31, 2009, represents the additional income taxes the corporation expects to pay in a future year (or years) when taxable income is greater than accounting income. In the early years of the asset’s useful life, the tax deduction for depreciation is greater than depreciation expense in the income statement, and the deferred income tax liability will increase as the corporation postpones paying income taxes it eventually will owe. However, in later years, when the income tax deduction is lower (or zero), the income taxes that were postponed or deferred become payable.

The total amount of depreciation for both income tax and accounting purposes is $100,000 in this example. If all other factors are held constant, the total amount of income tax paid would equal the total amount of income tax expense that was reported in the income statement for the ten years the asset is used and depreciated. However, in individual years the timing and the amounts differ, which is aptly referred to as a timing difference.

You can think of the deferred income tax liability arising in 2009 as the timing difference between tax depreciation ($20,000) and income statement depreciation ($10,000) times the 40 percent income tax rate, which is $4,000; in other words, the income taxes that were deferred or postponed for the time being but must be paid in the future.

Assuming the company has not paid its 2009 income taxes yet, its year-end balance sheet would include the information shown below:

Income Tax Liabilities

Current Liabilities
Income Taxes Payable = $192,000

Long-Term Liabilities
Deferred Income Tax Liability = $4,000

 

The amount reported as income taxes payable of $192,000 represents the income tax the corporation is obligated to pay for the 2009 income tax year. Most corporations pay estimated income taxes owed on a quarterly basis and so the amount reported as a current liability may be only the unpaid fourth quarter installment (or $48,000 in this example).

The deferred income tax liability of $4,000 at December 31, 2009, represents the additional income taxes the corporation expects to pay in a future year (or years) when taxable income is greater than accounting income. In the early years of the asset’s useful life, the tax deduction for depreciation is greater than depreciation expense in the income statement, and the deferred income tax liability will increase as the corporation postpones paying income taxes it eventually will owe. However, in later years, when the income tax deduction is lower (or zero), the income taxes that were postponed or deferred become payable.

The total amount of depreciation for both income tax and accounting purposes is $100,000 in this example. If all other factors are held constant, the total amount of income tax paid would equal the total amount of income tax expense that was reported in the income statement for the ten years the asset is used and depreciated. However, in individual years the timing and the amounts differ, which is aptly referred to as a timing difference.

You can think of the deferred income tax liability arising in 2009 as the timing difference between tax depreciation ($20,000) and income statement depreciation ($10,000) times the 40 percent income tax rate, which is $4,000; in other words, the income taxes that were deferred or postponed for the time being but must be paid in the future.

You also may find deferred income tax assets on the balance sheet. In this case, certain revenues may be taxable income before the revenue is earned according to the revenue recognition principle and reported in the income statement, and certain expenses reported in the income statement may not be tax-deductible until a later year. In this case, it is almost as though the corporation had prepaid its income tax, but this prepayment is referred to as a deferred income tax asset on the balance sheet because it is quite different from other prepaid expenses such as rent or insurance. The financial accounting treatment of deferred income taxes is a very complex area.