Chapter 8
Long - Term Obligations
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Thought to Ponder: Chapter 8
"The budget should be balanced; the treasury
should be refilled; public debt should be reduced;
and the arrogance of public officials should be
controlled."
Cicero. 106-43 B.C.
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FACTS: Did you know?
 As of March 1, 2010, the total U.S.
federal(public) debt, called the national debt
passed the $12.4 trillion mark, for the first time,
with about $40,427.08 per capita (that is, per
U.S. resident). Of this amount, debt held by the
public (federal debt held by states, corp.,
individuals and foreign govts) was roughly $7.7
trillion.
 Adding unfunded Medicaid, Social Security,
Medicare, and similar obligations, this figure
rises to a total of $107 trillion (this is as of June 11, 2009).
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FACTS: Long Term Obligations
For FY 2009, the City of Houston had
 total bonded debt outstanding of $14.1 billion.
The two largest portions of this total
 $3 billion comprising debt backed by the “full
faith and credit” of the government and
 $8.2 billion comprising various enterprise fund
revenue bonds
For FY 2008, City of NY had
 Outstanding General Obligation fixed and
variable rate debt of $28.69 billion and $7.41
billion, respectively.
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Learning Objectives
 Importance of information on Long Term Debt
 Significance of bankruptcy
 Accounting for LTD in both Fund and
Government-wide Statements
 Demand Bonds
 RANs, TANs, BANs
 Capital & Operating Leases
 Miscellaneous Topics
o Revenue bonds
o Overlapping debt
o Conduit debt
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Long-Term Obligations-Overview
What is General Long-term Obligations Debt?
 Issued by almost every government.
 Takes form of liabilities, usually bonds, that are
secured by the “full faith and credit” of the
governmental unit.
 Arises from the governmental funds’ activities not
proprietary or fiduciary funds*.
o *If debt reported in a proprietary or fiduciary fund
also has general obligation (“full faith and credit”)
backing of the government, then the
government’s contingent liability needs to be
disclosed in the notes to the financial
statements
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Examples of General Long-term Liabilities
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Tax-supported bonds
Long-term warrants
Long-term notes
Capital lease obligations
Unfunded compensated absences
(vacation and sick leave)
 Unfunded pension obligations
 Long-term portion of judgments and claims
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Importance of Long-Term Debt
 Failure to make timely payments can
have profound repercussions.
 Creditor incurs losses
 Governments and non-profits will face
loss of credit
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Bankruptcy
 Bankruptcy: ultimate fiscal failure
 Failure to satisfy claims results in bankruptcy.
 Many cities avoided bankruptcy by
being under ‘financial control boards.’
 Governments can either raise tax or cut back
services when in bankruptcy
 A government in bankruptcy transfers control
to independent trustee.
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Accounting for Long-Term Obligations
Government-wide Statements:
 All general long-term debt is reported in the
governmental activities column of the
government-wide Statement of Net Assets.
 General LT obligations are recorded either at
face value or at the amortized issue price.
 GASB Std. # 34 requires governments to
report bonds and LT obligations at present
value.
 Certain claims and judgments are also recorded at present
value.
 Present values more faithfully captures the economic
substance of debt than face values do.
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Accounting for LT Obligations (cont’d)
Fund Statements:
 NOT reported as long term liabilities of
governmental funds. Recorded in schedule of
Long Term Debt.
 Recall that a debt service fund (a governmental
fund), is generally established to account for the
principal and interest payments on general
long-term debt.
 LT obligations are not reported as a liability
Instead, it is offset by “other financing
sources—bond proceeds.”
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Accounting for LT Obligations (cont’d)
RECALL:
 ONLY debts resulting from past
transactions for which government has
already received a benefit are recognized.
 Excludes commitments for payments of
interest for which no benefit was enjoyed.
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Example – Vacation Leave
City employees earned $300,000 in vacation leave they
did not take in 2010. The leave vests and can be
taken at any time up to retirement.
The liability should be reported only in a schedule of long-term
liabilities and the government-wide statements and should be
based on wage and salary rates in effect on the balance sheet date
(and hence adjusted each year). It should not be recognized as an
expenditure.
Government-wide (Stmt of Net Assets)*: Would be
accrued and reported as a long-term liability:
Vacation pay expense
Accrued vacation payable
$300,000
$300,000
*This is not an actual journal entry. It is the conversion done on the WP at
the end of the year.
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Example – Sick Leave
1.
City employees earned $500,000 in sick leave that
they did not take in 2010. City employees are
permitted to accumulate up to 120 days sick leave.
Any unused sick leave cannot be taken as a
termination benefit.
Sick leave should only be reported as a liability in a schedule of longterm liabilities and the government-wide statements only to the extent
that it will be paid as a termination benefit. Hence, the sick leave
earned need not be reported as a liability or an expenditure.
Government-wide: Same
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Example – Sabbatical Leave
1.
City teachers are entitled to sabbatical leaves of six
months every 7 years for research and renewal.
The 2010 share of leave costs to be taken in the
future was $300,000.
Sabbatical leaves need not be recognized as a liability
unless the leave is a reward for past service and is
automatic (i.e. is for unrestricted time off). It need
not be accrued if it constitutes merely a change in
assigned duties (e.g. research instead of teaching).
Government-wide: Same
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Example – Claims & Judgments
1.
The City settled a judgment brought against it by an injured employee. The
City agreed to pay $6 million in 2010 and $4 million in each of the next five
years.
Expenditures
Claims payable
$6
$6
In addition the $20 million balance in the settlement should be reported in a
schedule of long-term obligations as well as in the government-wide
statements. However the $20 million should be discounted to reflect the time
value of money, since the settlement is “structured” (payments are on
specified dates in the future – see Statement No. 10, para. 59).
Government-wide: Would accrue; assume a discount rate of 6
percent and five payments at the end of the following five
years.
Claims Expense
$22.8
Claims payable (current)
Claims payable (long-term)
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$ 6.0
16.8
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Example – Installment Note
1.
It acquired the same computer, issuing a three-year, 6 percent,
installment note for the purchase price. During the year it paid the
first installment of $1,122,330 (interest of $180,000 and principal of
$942,330).
GF:
Expenditures – acquisition of capital
assets
Other financing sources –installment
note proceeds
DSF:
Expenditures – Installment note interest
Cash
Expenditures – Installment note principal
Cash
$3,000,000
$3,000,000
$ 180,000
$ 180,000
$ 942,330
$ 942,330
Government-wide (SNA): Would capitalize the
asset and depreciate
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Example – General Obligation Debt
1.
On July 1, 2010, the City issued $100 million in 8
percent general obligation debt to finance capital
improvements. The first interest payment of $4
million is due in early January 2011.
No entry in the funds – no need to accrue (unless budgeted in
the current fiscal period and as stated in early Jan).
12/31/2010
Government-wide: (must accrue)
Bond Interest expense
$4M
Accrued bond interest payable
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$4M
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Example – Debt Servicing
1.
In December the City transferred $2 million to the debt service
fund for repayment of principal on serial bonds issued several
years earlier. The payment is due in January.
GF: Nonreciprocal transfer-out (debt service)$2
Cash
$2
Can recognize an expenditure and a liability in the debt service fund as long as
payment is due within one month (Per §13 of Interpretation No. 6):
DSF: Cash
$2
Nonreciprocal transfer-in (from general fund)
DSF: Debt service expenditure
Debt service payable
$2
$2
$2
Government-wide: No entry would be necessary.
Payment of principal is recorded as a reduction
of a liability (Bonds Payable) when paid.
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Short Term Vs. Long Term Debt
 Short term: Debts expected to be liquidated
with currently available assets. These debts
are reported in governmental funds.
 Long term: reported only in governmentwide statements.
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DEMAND BONDS
 Demand bonds: obligations that permit the holder
(the lender) to demand redemption within a specified
(usually short) period of time. Hence, usually
classified as short-term obligations.
 Short Term obligations if . . .
 The nature of demand bonds-taken by themselves are short-term.
 Long Term (as opposed to fund) obligations if . . .
1) The government (issuer) enters into a contract called a take-out
agreement where the financial institution (lender) promises to lend
the issuer sufficient funds to repay the bonds and the contract
satisfies the following criteria.
2) does not expire within one year
3) is not cancelable by the lender during that year
4) is capable of being financially satisfied by the lender
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Example 1
A city financed the acquisition of an equipment with
bonds that could be redeemed at any time at the
option of the holder.
-The bonds pay interest at the rate of 6%.
-At year-end, prevailing interest rates had decreased
to 5%.
-The city does not have a take-out agreement
providing for refinancing if the bonds are presented
for payment.
How should the city record the debt?
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Example 1 (Cont’d)
Since the city does not have take-out agreement, it cannot
record the bonds as LT obligations irrespective of the
interest rates. It must record the debt as a ST obligation
of the general fund.
Governmental Fund
Capital Assets Expenditure
Demand Bonds payable
$8 mil
$8 mil
To record the acquisition of the capital asset as financed with Demand
Bonds that do not satisfy the criteria of LT debt.
Government-wide (Statement of Net Assets):
Equipment
$8 mil
Demand Bonds payable
$8 mil
To record the Equipment acquired with demand bonds.
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RANs & TANs & BANs . . .
OH MY!
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Revenue Anticipation Notes (RANs) and
Tax Anticipation Notes (TANs)
 Short Term notes payable that are of
specified streams of revenues.
 Issued to meet cash needs earlier in the year.
 They are NOT converted into Long Term
instruments.
 Must be accounted for in the funds in which
the related revenues are reported.
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Bond Anticipation Notes (BANs)
 BANs: Short Term notes issued with the
expectation that it will be replaced with Long
Term bonds.
 GAAP says that BANs may be recognized as
Long Term obligations if:
1) BANs are refinanced
2) The entity enters into an agreement that
doesn’t expire in 1 year, has not been
violated, and is capable of being honored
by the lender.
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Leases
Capital & Operating
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Capital Vs. Operating Lease
 Capital Leases: financing arrangements.
 Lessee purchases an asset in exchange for LT note.
 Operating Lease: conventional rental agreements
o Lessee uses property for a portion of its useful life.
o Governments enter into operating leases because:
 Need asset only for a small part of its useful life
 Avoid risks of ownership
 Unavailability of cash or credit to purchase
 Nonappropriation clause or fiscal funding
clause: permits governments to cancel lease
at the end of each year.
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Accounting for Capital Leases
 GASB: capital leases are treated as a purchase of
an asset and issuance of long-term debt.
 Leased asset and related liability are
 1) accounted for like an installment purchase.
 2) recorded at present value
 Fund Statements:
--Dr. “expenditure” and Cr. “other financing sources
–capital leases”
 Government-wide:
 Accounted for as a purchase/borrow transactions.
 The asset is depreciated over the term of the lease.
 General long-term liability recorded.
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Example 1
Capital lease with present value of minimum lease payments
of $50,000
Special Revenue Fund:
Dr.
Expenditures
$50,000
Other Fin. Source-Cap. Lease Agreements
Gov’t-Wide (Governmental Act.):
Equipment
Capital Lease Obligations Payable
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Cr.
50,000
Dr.
$50,000
Cr.
50,000
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Example 2
Assume for a particular capital lease the unpaid lease
obligation at the beginning of the year was $57,590
and a $10,000 lease payment is made at the end of
each year. If the lease has an implicit interest rate of
10% per annum, the end of year payment would be
recorded as follows:
Debt Service Fund:
Dr.
Expenditures—Interest
on Capital Lease (.10 X $57,590)
Expenditures—Principal of Capital
Lease Obligation
Cash
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Cr.
$5,759
4,241
10,000
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Example 3 – Leased Asset
1.
The City leased a computer, which has a fair market value of
$3 million and an estimated useful life of three years. The
lease cannot be canceled. The lease payment for 2007 was
$1,122,330 (interest of $180,000 and principal of $942,330).
General Fund:
Expenditures – acquisition of capital assets
$3,000,000
Other financing sources – capital leases
$3,000,000
Debt Service Fund:
Expenditures – lease interest
$ 180,000
Cash
$ 180,000
Expenditures – lease principal
$ 942,330
Cash
$ 942.300
Government-wide: Would capitalize and depreciate
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Operating Leases
Illustrative Note from a CAFR
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Miscellaneous Topics
Revenue Bonds
Debt Margin
Overlapping Debt
Conduit Debt
Bond Ratings and Ratios
Bond Ratings
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Debt Jargon
 Direct debt - debt that a government unit has incurred in its own
name or assumed through the annexation of territory or
consolidation with another governmental unit. Obligations that
will be repaid by the government whose debt is being evaluated.
 Debt Limit - Usually a ceiling on the amount of debt.
Maximum amount of gross or net debt that is legally permitted.
 Debt margin - The difference between the debt limit and the net
amount of debt outstanding subject to the limit. See the example
on page 328, which also explains legal debt margin and the
example on ppt. slide
 Moral Obligation Debt -Bonds/Notes issued by one entity but
backed by the promise of another entity. It is motivated to avoid
voter approvals or to circumvent debt limitations.
 Overlapping (indirect) debt - obligations of other governments
that also have the power to tax property located in the jurisdiction
of the government whose debt is being evaluated –ex. City,
County and School District.
(See Figure 8-1) and also the example on the ppt slide
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Revenue Bonds
 Revenue bonds are backed only by specific revenues;
generally reported in enterprise funds.
 The main reasons for issuing revenue as opposed to
GO bonds are:
-They provide a better match of debt service costs and
the benefits received;
-Although interest rates are likely to be higher for any
specific issue of bonds, they are unlikely to increase
the overall risk of the entity’s debt as a whole and
therefore its total interest costs (i.e. they redistribute
risk among the various classes of bondholders).
 In many jurisdictions they are a means of avoiding
voter approvals and other debt limitations.
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Debt Margin - Example
Q: The city is permitted to issue a maximum of
$30 million of general obligation bonds. It
already has $19 million of qualifying debt
outstanding. What would be the city’s debt
margin after issuing $8 million of new debt
subject to the limits?
A: After issuing the $8 million of new debt,
the city would have total debt
outstanding of $27 million. Its debt
margin would be only $ 3 million—10%
of its $30 million limit.
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Overlapping Debt - Example
Q: A city served by an independent school district that
includes the city as well as nearby towns. The
assessed value of taxable property within the city is
$600 million; that of the school district is $800 million.
The school district has $48 million of debt
outstanding. What is the city’s overlapping debt with
respect to school district?
A: Of the taxable property in the school district, 75% is
located within the city. Therefore, the city is
responsible for 75% of the school district’s debt--$36
million.
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Conduit debt
 Obligations issued in the name of a
government on behalf of a nongovernmental entity.
 Also referred to as non-commitment debt:
in case of default, bondholders have claim
only on the property and the lease
payments.
 Is a form of government assistance to
beneficiary organizations to obtain
financing at lower rates.
 GASB says that note disclosure of conduit
debt is sufficient.
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Bond-Related Ratios
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Ratio of debt per capita to percentage of
taxable property
Ratio of debt service expenditures
to total general expenditures
Multiple year trends in above ratios
Note: Investors look for these ratios to assess
the ability to pay and the risk of default.
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Bond Ratings
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Bond Rating agencies such as S&P, Moody’s and
Fitch Ratings assign a quality rating to the debt
instruments of any issuer
The agencies base their ratings on a comprehensive
review of all factors affecting the issuer’s ability to pay
and continue to monitor the issuer.
Debt ratings are of critical concern to both issuers and
investors because they affect the debt’s marketability
and hence it’s interest rate.
A bond rating service downgrade can be a traumatic
fiscal event.
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Bond Ratings
City of Houston, CAFR FY ’06 and compare the ratings
with FY ‘09. (next slide)
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Bond Ratings
City of Houston, CAFR FY ’09
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Summary
 Long-term obligations represent claims upon the entity’s resources.
 Governmental funds which follow modified accrual basis do not give
recognition to either long-term obligations or the assets they
finance.
 Government-wide statements which follow full accrual basis report
both long-term obligations and capital assets.
 Demand bonds may be reported as long-term debt only if the issuer
has entered into a “take-out” agreement. Similarly for BANs if the
issuer has a refinancing agreement.
 TANs and RANs are not converted into long-term debts.
 Leases that meet the criteria of capital leases are also reported as
long-term debt.
 Revenue bonds and overlapping debt, though not strictly full faith
and credit liabilities of the reporting government impose financial
obligations on the citizens.
 Bond ratings are of critical concern to issuers and investors
because they affect the debt instrument’s marketability and interest
rate.
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