Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
Long-Term Liabilities & Annuities
Dan is a senior at the University of Financial Management. He's enrolled in Accounting III and his first day of class starts in two weeks. The professor has given the class a summer project due the first day of fall classes.
Dan's a little apprehensive about the project because he's unfamiliar with the topic: measuring long-term liabilities and annuities. Dan knows long-term liabilities are obligations owed for more than a year. He also remembers an annuity represents a series of payments. However, he's unclear about the correlation between the two and how to measure them. Dan decides to schedule a tutoring session to learn more about the subject. For the rest of this lesson, we'll explore examples of a long-term liability and an annuity, and discuss how they are measured.
Liabilities are categorized on the balance sheet as current or long term. Current means the obligation will be paid within a year. Long term, on the other hand, means obligations take more than a year to pay. Examples of long-term liabilities are a mortgage on a building, which usually has a term of 15 to 30 years, and a company car loan, which usually has a term of three to five years.
These types of liabilities are easy to calculate and are spelled out in a loan contract. To measure long term liabilities we simply find the balance, which is the difference between the dollar amount of payments we've made and remaining principal and interest. Principal is the amount borrowed, and interest is the cost associated with borrowing the money.
The balance is listed on our statement from the financial institution, and if we're constructing a balance sheet, we use that dollar figure as our remaining long term liability. Now that we've discussed examples of long-term liabilities and how they are measured, let's discuss annuities.
An example of an annuity is a bond. A bond is similar to an IOU. Let's say your neighbor wants to borrow $1,000 and will pay you ten percent interest until he pays you back in five years. You think that's a pretty good deal, so you agree to the terms. Each of the five years, your neighbor pays you $100 ($1,000 * .10) interest. Then at the end of year five, your neighbor pays you the $1,000 back. In financial terms, the $1,000 is considered the principal and $100 is interest.
Now, from a corporate perspective, when a company wants to expand and grow, invest in research and develop or create a new product, they may issue bonds to investors. Investors purchase the bonds with a promise to receive periodic, regular interest payments and the principal at maturity. The reason why it's considered a liability for the corporation is because it's a long term obligation they owe to the investor. In order to determine how much investors will pay for a bond, the corporation estimates how much the bond is worth by calculating the present value.
In simple terms, the present value is the value of a bond now, in present time, discounted by an interest rate. Let's look at an example. Let's say BQB Corporation wants to issue $100,000 of bonds and pay coupon interest of $9,000 annually with an 11% interest rate due in five years. What will buyers pay for this bond issue? To find out how much the bonds are worth, we must calculate the present value of an annuity.
There are several ways to calculate the present value of an annuity: manually, by a financial calculator, spreadsheet or online calculator. To calculate manually we need financial tables. These are found in the back of an accounting or finance textbook or online. The financial tables show a 3-digit decimal that allows us to discount a number to the present value based on the bond's interest rate and maturity or number of years.
Below is the present value of $1-table. Based on the bond above, find 11% in the column and five periods in the row. Where they intersect, we have a factor of .593. We multiply .593 * $100,000 to derive at $59,345. Thus, $100,000 discounted five years to the present is $59,300.
Step two of this calculation is finding the present value of the coupon interest payments. We need to access the present value of an annuity table. An annuity is a series of payments, and since we'll receive the coupon interest payments annually for five years, we need to use the present value of an annuity table to discount these payments to the present value.
You will use 11% at five periods to find a factor of 3.69 and multiply the factor times $9,000. Therefore, the present value of $9,000 of payments for five years is $33,210. Add the present value of the principal to the present value of the coupon interest payments to derive at the current price of $92,510 ($59,300 + $33,210). This is how much the investors would be willing to pay for this bond, and as a result, when constructing a balance sheet, we would list this figure under bonds payable.
Long-term liabilities are obligations owed for more than a year. Examples of long-term liabilities are a mortgage or car loan. These are pretty easy to calculate since we must pay back the principal, the amount borrowed, and the cost associated with borrowing the money, which is considered interest.
Bonds are also long-term liabilities. Bonds are considered an IOU and are issued when corporations want to expand and grow. Bonds are also considered an annuity because the corporation must pay a series of regular payments to the investor. Before they announce the dollar amount of the bond issue, the corporation calculates the present value of the bond to determine how much investors would be willing to pay today.
To find the present value, we use financial tables and discount the principal using the present value of $1-table and discount the annuity by using the present value of an annuity table.
long-term liabilities: obligations owed for more than a year
principal: the amount borrowed
interest: the cost associated with borrowing money
bonds: an IOU that is issued when a corporation wants to expand and grow
annuity: a series of regular payments
present value: the value of the bond, determined by how much investors would be willing to pay today
Completing this lesson should help you meet the following goals:
- Define long-term liabilities and other related terms
- Describe how long-term liabilities are calculated and managed
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