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All about long-term liabilities

All about long-term liabilities

Long-term liabilities are obligations due in a period exceeding one year or operating cycle, whichever is longer.

Long-term liabilities can be classified as follows:
  • Operational obligations
  • Financing obligations
  • Other

In this article we will review operational and financing obligations.

Operational obligations are liabilities that arise from business operations.

Financing obligations are liabilities that arise from financing agreements (i.e., from borrowing money). Such obligations usually require payments of interest and principal.

Operational long-term liabilities

Examples of long-term liabilities relating to operational obligations include (non-exhaustive list): deferred taxes, pension obligations, post retirement benefit, warranties, capital leases, etc.

Deferred Taxes

Many companies report long-term liability called deferred taxes.

Deferred taxes are assets and liabilities that arise from the temporary differences between the amounts reported for tax purposes and those reported for financial accounting purposes.

In other words, deferred taxes arise due to the differences between revenues or expenses reported in financial statements (i.e., income statement) in accordance with GAAP and those reported in tax returns in accordance with the Internal Revenue Code (for the USA). Such differences result in taxable (i.e., payable) or deductible (i.e., refundable) amounts in the future. Taxable amounts in the future represent deferred tax liabilities while deducible amounts represent deferred tax assets.

Deferred tax liabilities are deferred tax expenses. That is, deferred tax liabilities will results in the increase in taxes payable in the future. When a deferred tax liability reverses in the future, a company will pay more taxes to the IRS than the amount of income taxes reported on the income statement. Deferred tax liabilities can be related to accounts receivable, depreciation, etc.

Pension and Post retirement Obligations

Pension and post retirement liabilities represent deferred compensation obligations to employees for the services provided in accordance with a pension and post retirement plan.

For example, post retirement liabilities arise when a post retirement plan is underfunded: that is, when the fair value of plan assets is below the accumulated post retirement benefit obligation.

Warranties

Warranty is assurance by the seller of goods or services that the goods or services will not have deficiencies in their performance or quality for a stated period of time. Warranties usually provide for repair or replacement.

Under accrual basis accounting in the year of sale, an entity should record estimated warranty expense and warranty payable (i.e., liability).

Warranty liabilities are obligations that arise out of product warranties.

Capital Lease

Capital lease liabilities are obligations that arise out of capital leases.

Capital lease is a long-term lease of an asset. To be considered a capital lease, a lease must meet any of the following four (4) criteria:

  • Lease term is 75% or more of the asset’s expected useful life
  • Asset ownership is transferred to the lessee at the end of the lease term
  • The lessee can purchase the asset at a price lower than its fair market value
  • When the lease is signed, the present value of the lease payments is 90% or more of the fair market

Financing long-term liabilities

Examples of long-term liabilities relating to financing agreements include (non-exhaustive list): notes payable, bonds, credit agreements, etc.

Note Payable

Note payable is an obligation in the form of a written promissory note signed by the borrower.

Notes payable represent private placements: that is, the long-term debt is raised from one creditor (e.g., bank, insurance company, pension plan). Notes include information about the rate of interest, term of maturity, and collateral pledged to secure the loan.

Bonds Payable

Bonds payable are somewhat similar to notes payable. Bonds payable represent a long-term publicly traded debt raised from multiple creditors.  

Bond is a formal contract according to which the debtor promises to repay the creditor the bond’s maturity value and interest at fixed intervals (usually semi-annually).

The key bond types include:

  • Debenture (i.e., unsecured bond)
  • Secured bond
  • Convertible bond
  • Callable bond

Legal provisions of a bond are specified in a bond contract called bond indenture. Indentures usually have such provisions as the maturity date, interest rate, interest payment dates, conversion privileges, and covenants (e.g., limitation of new debt, limitation on payment of dividends). To learn more about debt covenants, refer to the article on What are debt covenants?

Credit Agreement

Credit agreement is a contract with a creditor (e.g., bank) to provide a loan, extend credit, or delay loan payments for a specified amount of time.

All about long-term liabilities

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