Notes

Long-term liabilities are financial obligations with a due date that is at least one year in the future. Learn about the processes used in accounting to document and manage long-term liabilities. Review the definition and explore types of long-term liabilities, including bonds, pensions, long-term leases, and mortgages.
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 more 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.

Capital leases are where the company retains the equipment after the lease ends. In essence, it's similar to a rent to own concept. The equipment is an asset, an item owned by the company, and the lease payments are a liability, an obligation owed. Both are listed on the balance sheet. The new GAAP standard on leases prefers that most leases are now qualified as Capital or Finance Leases. GAAP prefers that the leased asset and Present Value of the lease payments be recorded on the balance sheet as an asset and liability.

The next type of lease is an operating lease. An operating lease is where the lessor keeps the equipment after the lease ends, meaning the company uses the equipment for a specific period of time, and after the lease ends, they have no ownership rights. Operating lease payments are listed as an expense on the income statement. Under the new GAAP standard, it is difficult to qualify for an Operating Lease. The answer to 5 questions about the lease must all be false in order to qualify. Rather than list them here, I will just say it's difficult. Now, let's move on to another type of long-term liability.

Mortgages
When a company wants to purchase a building, they typically do not pay cash. They seek a mortgage loan from a financial institution. Since the mortgage loan is an obligation owed, it's listed on the balance sheet as a liability.

Liabilities are categorized as current and long term. Current represents the mortgage payments that will be paid within a year, while long-term are payments that will be paid after that year, essentially the balance of the loan.

Lesson Summary
Long-term liabilities are obligations owed by a company for more than a year. Examples of long-term liabilities are bonds, pensions, long-term leases, and mortgages.

A bond is similar to an IOU. The company issues bonds, and investors purchase those bonds with a promise of repayment years in the future. 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.

Bonds can also be purchased at a premium, purchasing the bond at a greater value than the principal. Remember, the interest payments can more than make up for the loss in principal. Nevertheless, bonds must be listed on the balance sheet as a long-term liability.

A pension is an arrangement whereby an employer provides lifetime payments to an employee after they retire. Vesting is an important component as it relates to listing the benefit as a liability. Vesting requires a certain number of service years before the employee is entitled to pension benefits. Those vested benefits are listed on the balance sheet as a long-term liability.

Leasing provides a company the right to use equipment. There are types of leases which have different accounting treatments. Capital leases are where the company retains the equipment after the lease ends; the equipment is listed as an asset, and the payments are listed as a liability. On the other hand, an operating lease is where the lessor keeps the equipment after the lease ends, and those payments are listed as an expense on the income statement.

Lastly, there are mortgage loans where the company has borrowed money for a building. Mortgage loans are long-term in nature; however, the payments due within a year should be listed in the current liabilities section of the balance sheet.

Accounting for Long-Term Liabilities: Vocabulary Table
longtermliabilities
Terms Explanations
Long-term liabilities obligations owed by a company for more than a year
Bond similar to an IOU; company issues bonds, and investors purchase those bonds with a promise of repayment years in the future
Principal amount the company borrowed
Discount an investor purchases the bond at a value less than the principal
Premium purchasing the bond at a greater value than the principal
Pension an arrangement whereby an employer provides lifetime payments to an employee after they retire
Vesting requires a certain number of service years before the employee is entitled to pension benefits
Leasing provides a company the right to use equipment
Capital leases where the company retains the equipment after the lease ends (payments are listed as a liability)
Operating lease the lessor keeps the equipment after the lease ends (payments are listed as an expense)
Mortgage loans where the company has borrowed money for a building
Current represents the mortgage payments that will be paid within a year
Long-term payments that will be paid after that year
Learning Outcomes
You've finished this lesson and now you are able to:

Recognize what long-term liabilities are
Identify, describe and discuss the types of long-term liabilities
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Additional Activities
Accounting for Long-Term Liabilities: A Practical Exercise:
The following exercise the designed to allow students to apply their knowledge on Long-Term Liabilities.

Context:
You are a consultant that specializes in Financial Reporting. You receive a call from a long-time friend and new entrepreneur, Molly Milk.

"I decided to start a new business this year by opening an ice cream shop downtown. I come form a family that has always worked in the dairy industry and thus I thought I would continue the family tradition and make some homemade ice cream near the College campus. My friend in business said that I should be careful about accumulating long-term liabilities because they can hurt my ability to obtain more financing if ever I want to open a second location. I have a list of transactions that I just sent to you. I would want to know which of them create long-term liabilities so that I can keep my books in order."

Transaction list:

Molly obtained a loan from the bank specifically to help finance the purchase of her retail store. It is due in 5 years.
Molly has to pay interest on the bank loan mentioned above. The interest is due in 3 months.
Molly opted to pay her supplier for dairy on credit. She has 90 days to pay the supplier.
Molly has to repay the government loan received to start her business. It is due in 18 months.
The ice cream shop leases its machinery from a large dealer. The lease is deemed to be an operating lease.
Molly has sales taxes to pay for the government. They are due at the beginning of next year, which is 30 days from today.
Required:
Review the list of transactions. For each transaction, determine:

Whether the transaction creates a long-term liability, and
If yes, what specific type of long-term liability is it?
Solution:
See below.

Transaction Creation of long-term liability? Nature of long-term liability
1 Yes Mortgage payable
2 No N/A
3 No N/A
4 Yes Loan Payable
5 No N/A
6 No N/A