Chapter 8
Long - Term Obligations
Granof & Khumawala - 6e
Chapter 8
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Thought to Ponder: Chapter 8
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Cicero. 106-43 B.C.
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."
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o Revenue bonds
o Overlapping debt
o Conduit debt
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• Importance of information on Long Term Debt
• Significance of bankruptcy
• Accounting for LTD in both Fund and Governmentwide Statements
• Demand Bonds
• RANs, TANs, BANs
• Capital & Operating Leases
• Miscellaneous Topics
Chapter 8
Learning Objectives
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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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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*.
Chapter 8
Long-Term Obligations-Overview
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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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Chapter 8
Examples of General
Long-term Liabilities
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Importance of Long-Term Debt
• Governments and non-profits will face loss of credit
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• Creditor incurs losses
Chapter 8
• Failure to make timely payments can have profound
repercussions.
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• 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.
Chapter 8
Bankruptcy
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o Certain claims and judgments are also recorded at
present value.
o Present values more faithfully captures the economic
substance of debt than face values do.
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Government-wide Statements:
• All general long-term debt is reported in the
governmental activities column of the governmentwide 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.
Chapter 8
Accounting for Long-Term Obligations
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Accounting for LT Obligations (cont’d)
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• 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 longterm debt.
• LT obligations are not reported as a liability
Instead, it is offset by “other financing
sources—bond proceeds.”
Chapter 8
Fund Statements:
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Chapter 8
Examples
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• Excludes commitments for payments of interest for
which no benefit was enjoyed.
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RECALL:
• ONLY debts resulting from past transactions for
which government has already received a benefit
are recognized.
Chapter 8
Accounting for LT Obligations (cont’d)
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Example – Vacation Leave
Vacation pay expense
$300,000
Accrued vacation payable
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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 Position)*: Would be
accrued and reported as a long-term liability:
Chapter 8
City employees earned $300,000 in vacation leave they did
not take in 2013. The leave vests and can be taken at any
time up to retirement.
$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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City employees earned $500,000 in sick leave that
they did not take in 2013. 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 long-term liabilities and the governmentwide 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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Chapter 8
Example – Sick Leave
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City teachers are entitled to sabbatical leaves of six
months every 7 years for research and renewal. The
2013 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).
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Chapter 8
Example – Sabbatical Leave
Government-wide: Same
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Example – Claims & Judgments
$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)
$ 6.0
16.8
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Expenditures
$6
Claims payable
Chapter 8
1. The City settled a judgment brought against it by an injured
employee. The City agreed to pay $6 million in 2013 and $4 million
in each of the next five years.
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Example – Installment Note
GF:
Expenditures – acquisition of capital
assets
$3,000,000
Other financing sources –installment
note proceeds
$3,000,000
DSF:
Expenditures – Installment note interest $ 180,000
Cash
$ 180,000
Expenditures – Installment note principal $ 942,330
Cash
$ 942,330
Government-wide (Stmt of Net Position Assets):
Would capitalize the asset and depreciate
Chapter 8
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).
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Example – General Obligation Debt
No entry in the funds – no need to accrue (unless budgeted
in the current fiscal period and as stated in early Jan).
12/31/2013 (Conversion posting after the end of the fiscal
period)
Government-wide: (must accrue)
Bond Interest expense
$4M
Accrued bond interest payable
$4M
Chapter 8
On July 1, 2013, 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 2014.
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Example – Debt Servicing
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)
$2
DSF: Debt service expenditure
Debt service payable
$2
$2
Government-wide: No entry would be necessary. Payment of
principal is recorded as a reduction of a liability (Bonds
Payable) when paid.
Chapter 8
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.
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• Long term: reported only in government-wide
statements.
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• Short term: Debts expected to be liquidated with
currently available assets. These debts are reported
in governmental funds.
Chapter 8
Short Term Vs. Long Term Debt
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DEMAND BONDS
• Demand bonds: obligations that permit the holder (the
• 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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• Short Term obligations if . . .
o The nature of demand bonds-taken by themselves are
short-term.
Chapter 8
lender) to demand redemption within a specified (usually
short) period of time. Hence, usually classified as short-term
obligations.
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Granof & Khumawala - 6e
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?
Chapter 8
Example 1
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Example 1 (Cont’d)
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.
Granof & Khumawala - 6e
Governmental Fund
Capital Assets Expenditure
$8 mil
Demand Bonds payable
$8 mil
Chapter 8
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.
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Granof & Khumawala - 6e
• 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.
Chapter 8
Revenue Anticipation Notes (RANs)
and Tax Anticipation Notes (TANs)
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Granof & Khumawala - 6e
• 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.
Chapter 8
Bond Anticipation Notes (BANs)
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Granof & Khumawala - 6e
Chapter 8
Leases
Capital & Operating
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Need asset only for a small part of its useful life
Avoid risks of ownership
Unavailability of cash or credit to purchase
• Non-appropriation clause or fiscal funding clause permits
governments to cancel lease at the end of each year.
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• Capital Leases: financing arrangements.
o 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:
Chapter 8
Capital Vs. Operating Lease
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Accounting for Capital Leases
• Fund Statements:
Dr. “expenditure” and Cr. “other financing sources –
capital leases”
• Government-wide:
o Accounted for as a purchase/borrow transactions.
o The asset is depreciated over the term of the lease.
o General long-term liability recorded.
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1) accounted for like an installment purchase.
2) recorded at present value
Chapter 8
• GASB: capital leases are treated as a purchase of
an asset and issuance of long-term debt.
• Leased asset and related liability are
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Example 1
Gov’t-Wide (Governmental Act.):
Dr.
Equipment
$50,000
Capital Lease Obligations Payable
Cr.
50,000
Cr.
50,000
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Special Revenue Fund:
Dr.
Expenditures
$50,000
Other Fin. Source-Cap. Lease Agreements
Chapter 8
Capital lease with present value of minimum lease
payments of $50,000
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Debt Service Fund:
Expenditures—Interest
on Capital Lease (.10 X $57,590)
Expenditures—Principal of Capital
Lease Obligation
Cash
Dr.
Cr.
$5,759
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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:
Chapter 8
Example 2
4,241
10,000
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Example 3 – Leased Asset
General Fund:
Expenditures – acquisition of capital assets
$3,000,000
Other financing sources – capital leases
$3,000,000
Debt Service Fund:
Expenditures – lease interest
Cash
Expenditures – lease principal
Cash
$ 180,000
$ 180,000
$ 942,330
$ 942,330
Government-wide: Would capitalize and depreciate
Chapter 8
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 2013 was
$1,122,330 (interest of $180,000 and principal of $942,330).
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Illustrative Note from a CAFR
Chapter 8
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Operating Leases
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Certificates of Participation
Revenue Bonds
Debt Margin
Overlapping Debt
Conduit Debt
Bond Ratings and Ratios
Bond Ratings
Chapter 8
Granof & Khumawala - 6e
Miscellaneous Topics
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Debt Jargon
• 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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• 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 331, which also explains legal debt margin and the example on
ppt. slide
Chapter 8
 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.
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A certificate-of-Participation
Arrangement
Lease of property
from corporation
Nonprofit public benefit
corporation
(landlord—lessor)
Trustee for all
investors
Assignment of lease
agreement
Allocated COP
service
payment
Investors
Total COP proceeds (loan to corporation)
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Tenant—lessee
government
Chapter 8
COP (lease) service
(principal and interest
payments)
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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).
o In many jurisdictions they are a means of avoiding voter
approvals and other debt limitations.
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• Revenue bonds are backed only by specific revenue
stream; generally reported in enterprise funds.
• The main reasons for issuing revenue as opposed
to GO bonds are:
o They provide a better match of debt service costs and the
benefits received;
o Although interest rates are likely to be higher for any specific
Chapter 8
Revenue Bonds
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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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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?
Chapter 8
Debt Margin - Example
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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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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?
Chapter 8
Overlapping Debt - Example
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Granof & Khumawala - 6e
• Obligations issued in the name of a government on
behalf of a non-governmental 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.
Chapter 8
Conduit debt
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•
•
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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.
Granof & Khumawala - 6e
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Chapter 8
Bond-Related Ratios
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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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Chapter 8
Bond Ratings
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Bond Ratings
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Chapter 8
City of Houston, CAFR FY ’08 and compare the ratings
with FY ‘11. (next slide)
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Bond Ratings
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Chapter 8
City of Houston, CAFR FY ’11
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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.
Granof & Khumawala - 6e
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Chapter 8
Summary
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