Chapter 8 1

Chapter 8

Long - Term Obligations

Chapter 8 2

Learning Objectives

Importance of information on Long Term Debt Significance of bankruptcy Accounting for LTD in both Fund and

Government-wide Statements Nature of Demand Bonds, BAN, TAN, RAN and

accounting for them. Leasing of assets Revenue bonds Overlapping debt Conduit debt

Chapter 8 3

What is General Long-term Obligations Debt? Almost every government issues general obligation

debt. This debt is in the form of liabilities, usually bonds, that are secured by the “full faith and credit” of the governmental unit. This debt arises from the activities of governmental funds. These liabilities are not accounted for as fund liabilities of a proprietary or fiduciary fund.

If debt reported in a proprietary or fiduciary fund also has general obligation (“full faith and credit”) backing of the government, then the contingent liability needs to be disclosed in the notes to the financial statements

Long-Term Obligations

Chapter 8 4

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

Examples of General Long-term Liabilities

Chapter 8 5

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

Chapter 8 6

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.

Chapter 8 7

Accounting for Long-Term Obligations

All general long-term debt is reported in the governmental activities column of the government-wide Statement of Net Assets.

NOT reported as liabilities of governmental funds.

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.

Chapter 8 8

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.

In governmental funds: LT obligations are not reported as a liability

Instead, it is offset by “other financing sources—bond proceeds.”

Chapter 8 9

Accounting for LT Obligations (cont’d)

In government-wide: 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 faithfully capture the economic substance than face values do.

Chapter 8 10

Long-Term Debt Example

Example from City of Houston CAFR FY 2004

(Note 8, pages 58–73, CAFR).

At the end of fiscal year (June 30, 2004), the City of Houston had total bonded debt outstanding of $9.3 billion. Of this amount, $2.1 billion comprises debt backed by the full faith and credit of the government and $25 million is debt related to the United States Department of Housing and Urban Development housing loans for which the government is liable in the event of default by the borrowers. The remainder of the City of Houston’s debt represents bonds secured solely by specified revenue sources (i.e., revenue bonds and long-term contracts).

Chapter 8 11

General Long-Term Liabilities, City of Houston Total bonds and notes payable $2,490,636 as of June 30, 2005

Terms of Long-Term Debt1. General Obligation Bonds

These bonds are payable from the general revenue of the City. No new General Obligation Bonds were issued this fiscal year.

2. Public Improvement Bonds The City has issued Public Improvement Bonds on numerous occasions.

The proceeds are used for street and bridge improvements, traffic signals, municipal buildings, parks, and other capital

improvements. Interest is payable semi-annually; principal is payable in various amounts annually through March 1, 2025.

3. General Obligation Swap Agreements On February 20, 2004 the City entered into a basis swap referred to as a

“synthetic reduced variance coupon swap”. Objective. The objective of the swap is for the City to reduce its fixed rate

debt service costs through a swap structure that takes on basis risk.

Chapter 8 12

Short 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 government-wide statements.

Demand bonds: obligations that permit the holder (the lender) to demand redemption within a specified (usually short) period of time. Hence, classified as short-term obligations.

Chapter 8 13

DEMAND BONDS

The nature of demand bonds-taken by themselves are short-term.

The circumstances under which they may be recognized as long-term (as opposed to fund) obligations are when: -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.

-does not expire within one year-is not cancelable by the lender during that year-is capable of being financially satisfied by the lender

Chapter 8 14

Demand Bonds-Example

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 15

Example (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 $8 milDemand Bonds payable $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 milDemand Bonds payable $8 mil

To record the Equipment acquired with demand bonds.

Chapter 8 16

Bond Anticipation Notes (BANs)

BANs: short term notes issued with the expectation to replace it with long-term bonds.

GAAP says that BANs may be recognized as LT obligations if:

-BANs are refinanced

-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 17

Tax Anticipation (TANs) and Revenue Anticipation Notes (RANs)

TANs and BANs: short-term notes payable are of specified streams of revenues.

Issued to meet cash needs earlier in the year.

They are NOT converted into LT instruments.

Must be accounted for in the funds in which the related revenues are reported.

Chapter 8 18

CITY OF HOUSTON, TEXASNOTES TO THE BASIC FINANCIAL STATEMENTS

June 30, 2004

• Note 7: Short-Term Debt – Tax and Revenue Anticipation Notes• The City issues tax and revenue anticipation notes (“TRANS”) in advance of property

tax collections, depositing the proceeds in its general fund. These notes are necessary because the City’s operating expenses are spread over

the entire fiscal year, and the collection of major revenue sources such as property and sales taxes does not coincide with these expenses.

• Short-term debt activity for the year ended June 30, 2004, was as follows (amounts in thousands):

Balance Balance• July 1, 2003 Issued Redeemed June 30, 2004• Tax and revenueAnticipation notes - $ 190,000 $ 190,000 $ - $

• On July 1, 2003, the City closed on the sale of $175,000,000 Tax and Revenue Anticipation Notes (“TRANS”), Series 2003. The proceeds of the TRANS were used to pay working capital expenditures until tax revenues were received. The stated interest rate range was 1.5% to 2.0%, and the average yield was 0.86%. The notes matured on June 30, 2004.

Chapter 8 19

Capital Vs. Operating Lease

Capital Leases: financing arrangements. Lessee purchases an asset in exchange for

LT note. Operating Lease: conventional rental

agreements Lessee uses property for a portion of its

useful life.

Chapter 8 20

Capital Vs. Operating Lease (cont’d)

Nonappropriation clause or fiscal funding clause: permits governments to cancel lease at the end of each year.

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

Chapter 8 21

Accounting for Capital Leases

GASB: capital leases are treated as a purchase of an asset and issuance of long-term debt.

The acquired asset and incurred debt is recorded at present value

Leased asset and related asset liability accounted for like an installment purchase.

Governmental fund: Dr. “expenditure” and Cr. “other financing sources –capital leases”

Government-wide: capital lease accounted as a purchase/borrow transactions.

The asset is depreciated over the term of the lease.

Chapter 8 22

Accounting for Capital Leases(cont’d)

Example: Capital lease with present value of minimum lease payments of $50,000

Special Revenue Fund: Dr. Cr.

Expenditures $50,000

Other Fin. Source-Cap. Lease Agreements 50,000

Governmental Activities: Dr. Cr.

Equipment $50,000

Capital Lease Obligations Payable 50,000

Chapter 8 23

Liabilities Arising Capital Lease Agreements

The acquisition of a long-lived asset through a capital lease: The general long-term liability arising from that capital lease is recorded in the government-wide statements:

Governmental Activities: Dr. Cr.Equipment $50,000

Capital Lease Obligation Payable 50,000

Chapter 8 24

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. Cr.

Expenditures—Interest

on Capital Lease (.10 X $57,590) $5,759

Expenditures—Principal of Capital

Lease Obligation 4,241

Cash 10,000

Capital Lease Agreements (cont’d)

Chapter 8 25

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.

Chapter 8 26

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 314, which also explains legal debt margin and the example on slide 27

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 slide 28

Chapter 8 27

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 $ 3million—10% of its $30 million limit.

Chapter 8 28

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.

Chapter 8 29

Conduit debt

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 30

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.

Bond-Related Ratios

Chapter 8 31

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.

Bond Ratings

Chapter 8 32

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.

Summary

Chapter 8 33

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