CHAPTER 10 LONG-TERM LIABILITIES
MODULE 5 APPENDIX DEFERRED TAX
Module 5
LO 10
Deferred Tax
Deferred tax is the account used to reconcile the difference between the amount recorded as income tax
expense and the amount that is payable as income tax.
◼ Results from different rules for computing book income and taxable income.
◼ Differences between financial and tax reporting are classified into two types.
• Permanent differences are items that affect the tax records but not the accounting records, or
vice versa.
For example, certain interest income (municipal bond interest) is exempt from taxes, but
is included as revenue for financial reporting.
• Temporary differences are items that affect both book and taxes, but not in the same time
period.
• See Example 10-9 for the calculation and reporting of deferred tax.
• Deferred tax account is a balance sheet account.
Balance in the account is a liability since it represents a future liability to the IRS.
NOTE:
The amount listed as Tax Expense on the income statement does not represent the
amount of cash paid to the government for taxes.
INSTRUCTOR’S MANUAL
10–14
The amount in the Deferred Tax account on the balance sheet reflects all of the
temporary differences between the accounting method chosen for tax and book
purposes.
CHAPTER 10 LONG-TERM LIABILITIES
10–15
Lecture Suggestions
Module 1
LO 2
To make it easier for students to understand bond characteristics, talk about each characteristic and
determine if it increases or decreases the risk to the bondholder. For example, a debenture bond is
riskier than a secured bond. The more risks a bondholder has to take, the less he is willing to pay
for the bond. The price of a bond is determined by risk and interest rates.
Module 2
LO 5
By now the students have been shown so many calculations and so much terminology that they are
dazed. Use an amortization table (Exhibits 10-4 or 10-5) to summarize the bond information.
Students can see how the numbers relate to one another. Assign at least two bond problems, one
with a discount, one with a premium, using bonds with fairly short lives, where students have to
prepare a complete amortization table for a bond. You might even want to expand the table with
some additional columns as follows:
(1) Bond payable has a credit balance and so does the premium, therefore they need to be
added.
(2) Bond payable has a credit balance and the discount has a debit balance, so they must be
subtracted.
And finally:
The only time the contract rate is used is to determine the amount of the interest payment.
INSTRUCTOR’S MANUAL
10–16
Module 2
LO 6
The retirement of bonds causes confusion because it looks very similar in journal form to the
disposal of an asset, which the students have just learned. They treat it similarly, trying to debit
cash instead of crediting it. They fail to see the gain and loss correctly. Remind them that the
Module 3
LO 7
Students may think that the rules for capitalizing a lease under GAAP are iron-clad. But are they?
One criterion is that the lease term is 75% or more of the asset’s economic life. But who
determines economic life? The answer of course is management. And we have already discussed
that economic life is an estimate. So if management does not want a capital lease, they could set
the economic life a little higher. Another criterion is the lease contains a bargain purchase option
to purchase the asset at an amount lower than its fair market value. Is a bargain easily
quantifiable? Is fair market value another arbitrary value?
CHAPTER 10 LONG-TERM LIABILITIES
10–17
Projects and Activities
Module 1
LO 2
Characteristics of Bonds
In-class discussion: The deductibility of bond interest
You have learned that interest on bonds is tax deductible, whereas dividends on stock are not. What are the
differences between stocks and bonds? What are the differences between dividends and interest, including
any tax differences?
Solution
Stock is ownership in the company. Bonds are a sophisticated way for the company to borrow money. This
In-class discussion: Callable bonds
Callable bonds give the issuing company the right to pay back their obligation to the bondholders
before the stated maturity date.
1. Would a company issue callable bonds if they expect the interest rates to increase?
2. In most cases, does the issuing company pay the face amount of the bond when they call they
bond?
3. Is a callable bond worth more or less to an investor than a noncallable bond?
4. Where would the bondholder find the information related to the call feature of the bond?
Solution
1. A company would issue callable bonds if they expect the interest rates to decrease. If the
interest rates drop, the company will call the bonds and issue new bonds at a lower interest
INSTRUCTOR’S MANUAL
10–18
Module 1
LO 3
Factors Affecting Bond Price
Outside assignment: Interaction between interest rates and issue price of a bond
Look at that bond’s issue under three different circumstances.
1. First, suppose the market rate for similar securities on the date of issue is 10%. What amount
will the bond likely be sold? How much interest will be paid to the purchaser after six
months? What is the company’s interest expense for that period? How much will the company
pay the purchaser after one year? How much is interest expense? If bonds are accounted for
using compound interest rates, why is there no apparent compounding here?
2. Second, suppose the bond is issued when the market rate is 12%. Would you expect the bond
to sell for $1,000, or more, or less? Why would the issue price change? Why not just change
the interest rate? Whose expectations, the issuer’s or the buyer’s, govern the issue price?
3. Third, what if the market rate was 8%? How would you expect that to affect the issue price of
the bond? In this case, whose expectations would have the biggest influence on the issue
price?
4. Why is the issue price of a bond calculated at “the present value of the future cash flows”?
What are these cash flows? What does this present value mean?
Solution
1. If the market rate and the coupon rate are the same, the bond would likely be issued at its par
2. In the second case, the market rate exceeds the coupon rate on the bond. Since investors can
earn a 12% return on similar investments, the only way they will buy this bond is if it also
gives them a 12% return. The structure of bonds is such that the maturity value and the
CHAPTER 10 LONG-TERM LIABILITIES
3. The expectations of the bond investors, who want to earn no less than the market rate, control
the issue price.
4. In the third instance, the market rate has dropped. Now the influence shifts to the borrower, or
In-class discussion: How do market interest rates affect bond prices?
Theory says, “If you buy a $1,000 bond paying 10% and rates rise to 15%, your bond will lose resale
value.”
1. Why is this true? Explain how a bond you already own can suddenly become less valuable
when nothing has happened to the company who issued it. They are still sending you your
interest checks regularly.
2. Would the opposite also be true? That is, if rates drop to 5%, will your bond suddenly surge
up in value?
3. What if you have a bond paying 10 % and rates move up from 9½% to 9¾%? Since your
bond is paying slightly above the market rate either way, would you still expect this ¼%
increase in rates to negatively affect the market value of your bond? Explain why or why not.
Solution
1. Your bond will lose value because potential buyers of the bond (this time from you, not the
INSTRUCTOR’S MANUAL
10–20
Module 4
LO 9
How Long-Term Liabilities Affect the Statement of Cash Flows
Outside assignment: Meaning of amortization table and bond terms
Study the following table:
Date
Beginning
Net
Effective
Interest
Nominal
Interest
Discount
(Premium)
Face
Value
Unamort.
Discount
Ending
Net
12/31/15
Liability
–
@ 4%
–
@ 5%
–
Amortized
–
10,000
(Premium)
363
Liability
10,363
Use the table above to answer the following questions:
1. What was the issue price of the bonds?
2. Were the bonds issued at a discount or premium?
3. If the opposite were true, what would be the relationship between the face value and the net
liability?
4. How much interest (in dollars, not %) will investors in the bonds receive periodically, and how
often will they receive it?
5. What is the issuing company’s effective annual borrowing rate?
6. Show how the bonds would appear on the issuer’s balance sheet on the date of issue.
7. What is the journal entry to issue the bonds?
8. Give the journal entry the company would make on December 31, 2016.
9. If the company chose to retire the bonds for $10,150, on June 30, 2017, after all interest payments
were made and amortization recorded, would their income statement show a gain or a loss?
10. Show the journal entry for this retirement.
11. Where on the statement of cash flows would the retirement appear? What is the cash effect of the
gain or loss?
12. Calculate the total amount of cash the company would save by retiring the bonds on this date.
How much would they save in accrual terms?
13. Regardless of how you prepared the journal entry “a” above, do you think the company believes
they “gained” or “lost” on the early retirement?
14. If the bonds were left until maturity, what final journal entry would be made concerning the bonds
on December 31, 2017?
15. Why is the company paying back less at maturity than they borrowed?
Solution
1. The issue price was $10,363.
CHAPTER 10 LONG-TERM LIABILITIES
9. The company would record a loss, since they will pay the investors more than the outstanding
liability of $10,096.
10. Bonds payable 10,000
Premium on bonds payable 96
Loss on redemption of bonds 54
Cash 10,150
Module 5
LO 10
Deferred Tax
In-class discussion: Why is this account growing?
Your text discusses the view of many financial analysts that deferred tax is not a “real” liability. One of
their reasons for this view is that the account appears for most companies to keep growing.
4. If it is a real liability, why does this account keep increasing?
5. Are other liabilities also increasing?
INSTRUCTOR’S MANUAL
10–22
Solution
6. If the tax break is only a deferral, we have to ask why the total liability on most companies’
books is growing. Companies in good financial health replace assets on a regular schedule.
Ethical decision: Operating versus capital leases
Decision
Model You are a consultant to a small commuter airline that operates a dozen planes between a cluster of suburban
areas and a large city. The owner has engaged your services to prepare a loan application to a large city
bank for funds to expand the business. He wants to present his case in the best way possible because he has
received indications that the bank is not certain he should take on additional debt. The owner feels that his
business is increasing rapidly and will easily accommodate the interest and principal on the new debt.
When you ask your client about the accounting treatment of the four airplanes, he tells you not to worry
about them. They have been listed that way for a few years now with no problem, and having them on the
balance sheet is the last thing he needs right now.
Use the Ethics Decision Making Model to determine your course of action.
Solution
1. Recognize an ethical dilemma. How should the airplane leases be treated on the loan
application?
CHAPTER 10 LONG-TERM LIABILITIES
10–23
3. Determine what alternative methods are available to report the transaction, situation or
event. The consultant must decide whether the leases in question meet the criteria for
4. Resolution. The consultant must follow the criteria of FASB to determine how the leases must be
handled.
Decision Ratio Analysis and Business Decision Model
Model
COMPANY A
COMPANY B
Total current liabilities
$ 400,000
$ 450,000
Total long-term liabilities
$ 300,000
$ 325,000
Total stockholders’ equity
$1,200,000
$1,300,000
Using the Ratio Analysis Model and the Business Decision Model, determine which company you
will invest in.
Solution:
• Ratio Analysis Model:
1. Formulate the Question. What is the debt-to-equity ratio of Company A and Company B?
Which company has the better ratio?
INSTRUCTOR’S MANUAL
10–24
• Business Decision Model:
6. Formulate the Question. After considering all relevant information, which company will I
invest in?
7. Gather Information from the Financial Statements and Other Sources. Other
information which should have already been considered would include:
a. The balance sheet which provides information on liquidity.
8. Analyze the Information Gathered. All information has been gathered and analyzed,
except for the debt-to-equity ratio. Up to this point, there are no significant differences in the
ratios or other financial analysis. The debt–to-equity ratio of Company A is 58% and
Company B is 60%. There does not appear to be a significant difference between the two