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									                 Chapter 8
            Long - Term Obligations

Chapter 8            Granof-5e        1
      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
                         Cicero. 106-43 B.C.

Chapter 8             Granof-5e                      2
             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
 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).

Chapter 8                     Granof-5e                          3
     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.

Chapter 8              Granof-5e                    4
            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

Chapter 8                Granof-5e          5
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

  Chapter 8                  Granof-5e                         6
Examples of General Long-term Liabilities
  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

     Chapter 8        Granof-5e                7
       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          Granof-5e              8
 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             Granof-5e                  9
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
     Certain claims and judgments are also recorded at present
     Present values more faithfully captures the economic
      substance of debt than face values do.
Chapter 8                    Granof-5e                            10
  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.”
Chapter 8                Granof-5e                    11
Accounting for LT Obligations (cont‘d)
        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.

Chapter 8               Granof-5e                12
             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

    Government-wide (Stmt of Net Assets)*: Would be
       accrued and reported as a long-term liability:
    Vacation pay expense              $300,000
         Accrued vacation payable                         $300,000

    *This is not an actual journal entry. It is the conversion done on the WP at
         the end of the year.

Chapter 8                          Granof-5e                                  13
                    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 long-
            term 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

Chapter 8                            Granof-5e                                   14
        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

Chapter 8                  Granof-5e                      15
      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

     Expenditures                       $6
         Claims payable                           $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

     Claims Expense                $22.8
          Claims payable (current)                          $ 6.0
          Claims payable (long-term)                        16.8

Chapter 8                            Granof-5e                                   16
            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

     Expenditures – acquisition of capital
      assets                                     $3,000,000
          Other financing sources –installment
           note proceeds                                  $3,000,000
     Expenditures – Installment note interest    $ 180,000
          Cash                                            $ 180,000

     Expenditures – Installment note principal   $ 942,330
          Cash                                           $ 942,330

     Government-wide (SNA): Would capitalize the
        asset and depreciate

Chapter 8                            Granof-5e                            17
      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).

     Government-wide: (must accrue)
     Bond Interest expense        $4M
         Accrued bond interest payable                   $4M

Chapter 8                     Granof-5e                          18
            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)      $2

     DSF: Debt service expenditure                 $2
                  Debt service payable                                  $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                             Granof-5e                                    19
        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 government-
  wide statements.

Chapter 8            Granof-5e               20
                  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

Chapter 8                        Granof-5e                               21
                    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?

 Chapter 8               Granof-5e                  22
                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                           $8 mil
             Demand 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 mil
         Demand Bonds payable                        $8 mil
    To record the Equipment acquired with demand bonds.

 Chapter 8                        Granof-5e                              23
     RANs & TANs & BANs . . .
              OH MY!

Chapter 8      Granof-5e        24
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
  Must be accounted for in the funds in which
   the related revenues are reported.

 Chapter 8            Granof-5e                 25
     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.

Chapter 8            Granof-5e                 26
            Capital & Operating

Chapter 8          Granof-5e      27
   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.
Chapter 8                            Granof-5e                      28
    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.

Chapter 8                     Granof-5e                      29
                     Example 1
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

Gov’t-Wide (Governmental Act.):           Dr.             Cr.
   Equipment                              $50,000
      Capital Lease Obligations Payable                   50,000

 Chapter 8                 Granof-5e                        30
                        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.      Cr.
       on Capital Lease (.10 X $57,590)    $5,759
       Expenditures—Principal of Capital
        Lease Obligation                    4,241
          Cash                                      10,000

Chapter 8                   Granof-5e                        31
            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

Chapter 8                       Granof-5e                            32
              Operating Leases
            Illustrative Note from a CAFR

Chapter 8               Granof-5e           33
Chapter 8   Granof-5e   34
            Miscellaneous Topics
                 Revenue Bonds
                   Debt Margin
                 Overlapping Debt
                   Conduit Debt
              Bond Ratings and Ratios
                   Bond Ratings

Chapter 8              Granof-5e        35
                        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
Chapter 8                      Granof-5e                           36
                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                  Granof-5e                      37
            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.

Chapter 8               Granof-5e                 38
            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

Chapter 8                  Granof-5e                      39
                  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
        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                Granof-5e                    40
                Bond-Related Ratios
      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.

    Chapter 8             Granof-5e                 41
                    Bond Ratings
    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.

Chapter 8                   Granof-5e                       42
                 Bond Ratings
City of Houston, CAFR FY ‘06 and compare the ratings
     with FY ‗09. (next slide)

Chapter 8               Granof-5e                      43
               Bond Ratings
City of Houston, CAFR FY ‘09

Chapter 8           Granof-5e   44
 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
 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
Chapter 8                     Granof-5e                           45

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