11.2 Long-term liabilities

Types of Long-Term Liabilities

Long-term liabilities are financial obligations not due within the next 12 months. They show up in the non-current section of the balance sheet and tell you a lot about how a company funds its operations and what it owes down the road.

The main categories include bonds payable, notes payable, leases, deferred income taxes, and pension obligations. Each has its own accounting treatment and disclosure requirements, but they all share a common thread: proper recognition, measurement, and presentation are critical for accurate financial statement analysis.

Bonds Payable

Bonds payable are long-term debt instruments companies issue to raise capital from investors. Every bond has three key features:

• Face value (par value): the amount repaid at maturity
• Stated interest rate (coupon rate): the rate used to calculate periodic cash interest payments
• Maturity date: when the principal must be repaid

The company must account for the bond's issuance and then recognize interest expense over the bond's life.

Accounting for Bonds Issued at Par

When the market interest rate equals the stated rate, the bond sells at par. The proceeds equal the face value.

The journal entry is straightforward:

• Debit Cash for the face value
• Credit Bonds Payable for the face value

Each period, interest expense equals the stated rate multiplied by the face value. No discount or premium exists, so there's nothing to amortize.

Bonds Issued at a Discount or Premium

When market rates and stated rates don't match, the bond sells at a price different from face value:

• Discount: Market rate > stated rate. Investors pay less than face value because the coupon payments are below what the market demands. For example, a $1{,}000$ bond with a 5% coupon when the market rate is 6% will sell below $1{,}000$.
• Premium: Market rate < stated rate. Investors pay more than face value because the coupon payments exceed market expectations.

The discount or premium is amortized over the bond's life, which adjusts the interest expense recognized each period toward the true economic cost of borrowing.

Effective Interest Method vs. Straight-Line Amortization

Two methods exist for amortizing bond discounts and premiums:

1. Effective interest method: Interest expense each period = carrying value of the bond × market rate at issuance. This produces a constant yield (percentage) but a changing dollar amount of interest expense as the carrying value changes. This is the preferred method under U.S. GAAP.
2. Straight-line method: The total discount or premium is divided evenly across all periods. Simpler to calculate, but it produces a constant dollar amount rather than a constant yield. Permitted only when results are not materially different from the effective interest method.

Notes Payable

Notes payable are written promises to pay a specific amount on a specific date, typically issued to banks or suppliers. They can be short-term or long-term; here we focus on notes due beyond one year.

Accounting for Notes Payable

The issuance entry mirrors bonds at a basic level:

• Debit Cash (or the asset received)
• Credit Notes Payable

Interest expense is recognized each period. If the note carries a stated rate equal to the market rate, accounting is straightforward. If the note is issued at a discount (e.g., a zero-interest-bearing note), the discount is amortized over the note's life using the effective interest method.

Interest Expense Calculation

The basic formula:

$\text{Interest Expense} = \text{Principal} \times \text{Interest Rate} \times \text{Time}$

For a $100{,}000$ note at 6% annual interest for one year, interest expense is $100{,}000 \times 0.06 \times 1 = 6{,}000$. Each period, the corresponding journal entry debits Interest Expense and credits Interest Payable (or Cash, if paid).

Leases

A lease is a contract where the lessee obtains the right to use an asset owned by the lessor for a specified period in exchange for periodic payments. Lease classification drives the accounting treatment.

Operating vs. Finance Leases

• Operating leases do not transfer substantially all the risks and rewards of ownership to the lessee. Think of renting office space on a short-term basis relative to the building's life.
• Finance leases (also called capital leases) do transfer substantially all risks and rewards. Under ASC 842, a lease is classified as a finance lease if it meets any one of five criteria (e.g., transfer of ownership, bargain purchase option, lease term is a major part of the asset's economic life, present value of payments is substantially all of the asset's fair value, or the asset is specialized with no alternative use to the lessor).

Lessee Accounting for Finance Leases

1. At lease commencement, record a right-of-use asset and a lease liability, both at the present value of future lease payments.
2. Depreciate the right-of-use asset over the shorter of the lease term or the asset's useful life (unless ownership transfers, in which case use the full useful life).
3. Each lease payment is split between interest expense (on the lease liability) and a reduction of the lease liability principal.

Lessor Accounting for Finance Leases

1. Derecognize the underlying asset from the balance sheet.
2. Record a lease receivable at the present value of lease payments plus any unguaranteed residual value.
3. As payments are received, allocate them between interest income and a reduction of the receivable.

Disclosure Requirements for Leases

Companies must disclose in the notes:

• A description of leasing arrangements and key terms
• The discount rate used to calculate present values
• Future minimum lease payments, broken out by year
• For finance leases: carrying amounts of right-of-use assets and accumulated depreciation

Deferred Income Taxes

Deferred income taxes arise because the rules for computing taxable income (tax code) differ from the rules for computing book income (GAAP). These differences create situations where tax expense on the income statement doesn't match the tax actually owed to the government in a given year.

Companies account for deferred taxes using the asset-liability method.

Temporary vs. Permanent Differences

• Temporary differences reverse over time. They create deferred tax assets or liabilities. A classic example: a company uses accelerated depreciation for tax purposes but straight-line for books. In early years, tax depreciation exceeds book depreciation (creating a deferred tax liability), but this reverses in later years.
• Permanent differences never reverse and are excluded from deferred tax calculations entirely. Examples include tax-exempt municipal bond interest income and non-deductible fines or penalties.

Deferred Tax Assets and Liabilities

• Deferred tax assets (DTAs) arise from deductible temporary differences and tax loss carryforwards. They represent future tax savings.
• Deferred tax liabilities (DTLs) arise from taxable temporary differences. They represent future tax obligations.

Both are measured using the enacted tax rates expected to apply when the temporary differences reverse.

Valuation Allowance for Deferred Tax Assets

If it's more likely than not (greater than 50% probability) that some or all of a DTA won't be realized, the company must record a valuation allowance to reduce the DTA's carrying amount.

This assessment happens every reporting period. Factors include:

• Projections of future taxable income
• Available tax planning strategies
• The scheduled reversal of existing taxable temporary differences

A valuation allowance is a contra-asset, so increasing it reduces net deferred tax assets and increases tax expense.

Pension Plans

Pension plans provide retirement benefits to employees. The accounting complexity depends heavily on the type of plan.

Defined Benefit vs. Defined Contribution Plans

• Defined benefit plans promise a specific retirement benefit, usually based on years of service and salary history. The employer bears the investment risk and longevity risk.
• Defined contribution plans (like a 401(k)) specify only what the employer contributes. The employee bears the investment risk. Accounting is simple: the employer records an expense equal to the contribution each period.

The rest of this section focuses on defined benefit plans, which are far more complex.

Accounting for Defined Benefit Plans

The balance sheet reports the net pension liability (or asset), calculated as:

$\text{Net Pension Liability} = \text{Projected Benefit Obligation (PBO)} - \text{Fair Value of Plan Assets}$

• The PBO is the present value of all benefits earned by employees to date, factoring in expected future salary increases.
• Plan assets are the investments set aside to fund the obligation, measured at fair value.

If plan assets exceed the PBO, the company reports a net pension asset.

Pension Expense Components

Pension expense on the income statement has five components:

1. Service cost: present value of benefits earned by employees during the current period
2. Interest cost: increase in the PBO due to the passage of time (PBO × discount rate)
3. Expected return on plan assets: reduces pension expense (based on expected long-term rate of return × fair value of plan assets)
4. Amortization of prior service cost: spreading the cost of retroactive benefit changes over employees' remaining service periods
5. Amortization of net actuarial gains or losses: smoothing the effects of changes in actuarial assumptions

Pension Plan Disclosures

Required disclosures include:

• Description of the plan and its terms
• Components of pension expense
• Funded status (PBO vs. plan assets)
• Key assumptions: discount rate, expected return on plan assets, rate of compensation increase
• Expected future benefit payments
• Composition of plan assets by category (equities, bonds, etc.)

Other Long-Term Liabilities

Several other obligations fall into the long-term liability category.

Asset Retirement Obligations

An asset retirement obligation (ARO) is a legal obligation to dismantle, remove, or restore a long-lived asset at the end of its useful life (e.g., decommissioning an oil rig).

1. Recognize the ARO at fair value when the obligation is incurred.
2. Increase the carrying amount of the related asset by the same amount (this gets depreciated over the asset's life).
3. Each period, the ARO liability grows through accretion expense, which is essentially unwinding the discount as the settlement date approaches. Accretion expense is recognized in the income statement.

Deferred Revenue

Deferred revenue arises when a company receives cash before delivering goods or services. The payment is recorded as a liability because the company still owes the customer something.

Revenue is recognized when the performance obligation is satisfied. The long-term portion of deferred revenue represents obligations that won't be fulfilled for more than a year (e.g., multi-year software licenses or long-term service contracts).

Contingent Liabilities

Contingent liabilities are potential obligations whose outcome depends on uncertain future events. The accounting treatment follows a probability framework:

• Probable and estimable: Record the liability on the balance sheet (accrue it).
• Reasonably possible: Don't accrue, but disclose in the notes.
• Remote: Generally no disclosure required.

Presentation and Disclosure

Balance Sheet Classification

• Long-term liabilities appear in the non-current section of the balance sheet.
• Any portion of a long-term liability due within one year gets reclassified as a current liability. For example, if a 10-year bond has a $50{,}000$ principal payment due next year, that $50{,}000$ moves to current liabilities.
• This current/non-current split gives users insight into both liquidity (short-term) and solvency (long-term).

Notes to Financial Statements

The notes supplement the balance sheet with details that don't appear on its face:

• Terms of debt agreements (interest rates, maturity dates, collateral)
• Restrictive covenants and compliance status
• Specific disclosures for leases, pensions, and other complex liabilities

Debt Covenants and Violations

Debt covenants are restrictions lenders impose on borrowers to protect their interests. They're a standard feature of most long-term debt agreements.

Types of Debt Covenants

• Affirmative covenants require the borrower to do something: maintain insurance, submit financial statements to the lender, keep assets in good condition.
• Negative covenants restrict the borrower from doing something: taking on additional debt, paying dividends above a certain threshold, selling major assets without lender approval.
• Financial covenants set specific ratio thresholds the borrower must maintain, such as a minimum interest coverage ratio of 3.0x or a maximum debt-to-equity ratio of 2.0x.

Accounting for Debt Covenant Violations

A covenant violation can trigger serious consequences. If the lender has the right to demand immediate repayment (acceleration), the borrower must reclassify the entire debt as a current liability on the balance sheet, even if the original maturity is years away.

However, if the lender waives the violation or grants a grace period that extends beyond the balance sheet date, the debt may remain classified as non-current. The company must disclose the violation and the waiver in the notes.

Modifications and Extinguishments

Sometimes the terms of a debt agreement change, or the debt gets settled early. The accounting depends on whether the change is considered a modification or an extinguishment.

Debt Modifications

A modification changes the terms of an existing debt (e.g., extending the maturity, changing the interest rate) while the original instrument stays in place.

The key test: compare the present value of cash flows under the new terms to the present value of remaining cash flows under the original terms.

• If the difference is 10% or more, treat it as an extinguishment of the old debt and issuance of new debt.
• If the difference is less than 10%, it remains a modification. Adjust the carrying amount and recognize any difference as a gain or loss, then compute a new effective interest rate going forward.

Debt Extinguishments

An extinguishment occurs when debt is settled before maturity through repayment, redemption, or exchange for equity or other securities.

The gain or loss is calculated as:

$\text{Gain or Loss} = \text{Reacquisition Price} - \text{Net Carrying Amount of Debt}$

The net carrying amount includes the face value adjusted for any unamortized premium, discount, or issuance costs.

Gain or Loss on Extinguishment

• Gain: Reacquisition price < net carrying amount (you settled the debt for less than its book value).
• Loss: Reacquisition price > net carrying amount (you paid more than book value to retire the debt).

This gain or loss is reported in the income statement, typically as a separate line item within non-operating income or expense.

Long-Term Liability Ratios

These ratios help you evaluate a company's ability to meet its long-term obligations and assess its financial risk relative to peers.

Debt-to-Equity Ratio

$\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Shareholders' Equity}}$

A higher ratio means greater financial leverage. A company with a debt-to-equity ratio of 2.0 has twice as much debt as equity financing. This isn't inherently bad, but it does mean more risk if earnings decline.

Times Interest Earned Ratio

$\text{Times Interest Earned} = \frac{\text{EBIT}}{\text{Interest Expense}}$

This measures how comfortably a company can cover its interest payments from operating earnings. A ratio of 5.0x means the company earns five times its interest obligation. Below 1.5x generally signals potential trouble.

Fixed Charge Coverage Ratio

$\text{Fixed Charge Coverage} = \frac{\text{EBITDAR}}{\text{Interest Expense + Lease Payments}}$

This broadens the analysis beyond just interest to include lease payments and other fixed charges. It's particularly useful for companies with significant operating leases (like airlines or retailers). A higher ratio indicates stronger ability to meet all fixed obligations.