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Accounting for Long-Term Liabilities

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  • 0:01 What Are Long-Term…
  • 0:52 Bonds
  • 2:50 Pensions
  • 3:55 Long-Term Leases
  • 5:18 Mortgages
  • 5:48 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define long-term liabilities and discuss four examples: bonds, pensions, long-term leases and mortgages. You'll also learn how to account for these types of long-term liabilities.

What Are Long-Term Liabilities?

Jan just graduated from the University of Pacific and has landed her dream job. She meets with her boss on the first day, and he asks her if she could give a presentation on long-term liabilities to the summer interns.

Of course, Jan agrees, but she feels a little uneasy about what to present. She remembers long-term liabilities are obligations owed by a company for more than a year. However, beyond that she's a little rusty.

She decides to visit her former college professor for some help. He tells her she should include in her presentation some of the more purposeful long-term liabilities, such as bonds, pensions, long-term leases and mortgages. This jogs Jan's memory, and she starts preparing for the seminar.

For the rest of this lesson, we'll explore how to account for bonds, pensions, long-term leases, and mortgages.

Bonds

When a company wants to create a new product line, expand their operations, or invest in another geographical area, they have three main financing options: take a loan from a financial institution, sell stock, or sell bonds.

A bond is similar to an IOU or loan. The company issues bonds, and investors purchase those bonds with a promise of repayment years in the future. What makes a bond attractive to the investor is that they receive periodic payments until the full amount is paid back.

The amount the company borrowed is called the principal, and the periodic annual payments made to the investor are called interest payments. When an investor purchases the bond at a value less than the principal, the bond is considered sold at a discount.

For example, if the bond's purchase price is $100,000 but the principal amount to be repaid is $125,000, then the investor purchased the bond at a discount.

However, if the bond purchase price is $150,000 but the principal amount to be repaid is $135,000, the investor purchased the bond at a premium. In sum, premium means purchasing the bond at a greater value than the principal. Why would an investor purchase a bond for less than it's worth? Remember, investors receive annual interest payments. Sometimes these payments can total more than the loss of principal once the bond matures and can result in a substantial net profit for the investor.

Regardless of whether the investor purchases the bond at a premium or discount, the company issuing the bond must carry the principal, the amount to be repaid as a long-term liability on the balance sheet. Now, let's define pension and see how they are accounted for.

Pensions

A pension is an arrangement whereby an employer provides lifetime payments to an employee after they retire. While the employee is working, the employer deducts a percentage of the employee's paycheck and has the amounts invested in a pension fund.

Although the explanation of a pension sounds simple, it's a complicated process, and there are many important factors to consider when accounting for pensions. One factor is called vesting. In order for an employee to be eligible for pension benefits, they must be vested. Vesting requires a certain number of service years before the employee is entitled to pension benefits. The vested benefits are listed as a long-term liability on the balance sheet.

Pensions also have associated expenses, such as the cost of maintaining the pension plans, so be careful not to include those as a long-term liability on the balance sheet. Remember, expenses are the cost of doing business and should be reported on the income statement. Now, let's move on to long-term leases.

Long-Term Leases

When companies want to purchase expensive equipment, they often calculate the benefits of purchasing the equipment vs. leasing. While there are advantages and disadvantages of both, we'll explore two types of leases and discuss how to account for them.

Leasing provides a contractual arrangement between the company and the lessor that gives the company the right to use the equipment in exchange for periodic payments for a specific period of time.

There are two types of leases: capital and operating. It's important for you to know the difference as they are reported differently from an accounting perspective.

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