Long-Term Liabilities

Introduction

Long-term liabilities are financial obligations that are due beyond one year. In financial accounting, bonds payable are a common form of long-term liability, and understanding their accounting treatment is essential for accurate financial reporting.

Learning Objectives

• Account for bonds payable and interest expense with straight-line amortization

• Account for other features of bonds payable

• Describe other long-term liabilities

• Analyze the impact of leverage on the financial statements

• Report long-term liabilities on the financial statements

• Describe how scenario analysis tools can help companies comply with debt covenants

Accounting for Bonds Payable

Account for Bonds

Bonds are debt agreements in which a Bond Holder (Investor/Lender) loans funds to a Bond Issuer (Borrower) for a specified period. At maturity, the issuer repays the principal, and periodic interest payments are made based on the bond's stated rate.

• Term Bonds: All mature at the same time.

• Serial Bonds: Mature in installments over time.

• Secured Bonds: Give bondholders rights to issuer's assets if the company defaults.

The Basics of Bonds

• Principal: The amount of the loan (face value, maturity value, par value), typically in $1,000 increments.

• Maturity Date: The date the loan must be repaid.

• Annual Interest Rate: The fixed rate stated on the bond (stated/coupon rate).

• Interest Payment Dates: Usually semi-annual (twice a year).

Bond Prices

Bond prices are determined by the relationship between the bond's stated interest rate and the current market rate. Unlike a standard bank loan, bonds are sold to multiple investors, and market fluctuations affect their pricing.

• If market rate > stated rate, bonds sell at a discount.

• If market rate < stated rate, bonds sell at a premium.

• If market rate = stated rate, bonds sell at par.

Example: If ABC Corp. issues a $1,000 bond at a 9% stated rate, but the market rate is 11%, the bond must be sold at a discount so the investor's effective yield matches the market rate.

Bond Price Quotation

• Par: $1,000 bond quoted at 100 sells for $1,000.

• Premium: $1,000 bond quoted at 101.5 sells for $1,015.

• Discount: $1,000 bond quoted at 88.375 sells for $883.75.

HTML Table: Issue Price of Bonds

Accounting for Bond Issuance

Issuance at Par

When bonds are issued at par, the stated rate equals the market rate. The issuer receives cash equal to the face value and records the following entry:

• Journal Entry (Issuer): Db. Cash $700,000 Cr. Bonds Payable $700,000

• Journal Entry (Holder): Db. HTM Investments in Bonds $700,000 Cr. Cash $700,000

Periodic Interest Payment Calculation:

• Formula:

• Journal Entry: Db. Interest Expense $42,000 Cr. Cash $42,000

Issuance at Discount;

If the market rate is higher than the stated rate, bonds are issued at a discount. The issuer receives less cash than the face value and records the difference in a contra-liability account.

• Journal Entry (Issuer): Db. Cash $666,633 Db. Discount $33,367 Cr. Bonds Payable $700,000

• Discount: Represents deferred interest expense, amortized over the bond's life.

Determining Selling Price: The price of the bond is the present value of future cash flows (principal and interest) discounted at the market rate.

• Formula:

Cost of Financing by Selling Bonds

There are two cash outflows in bond financing:

• Repayment of principal at maturity

• Periodic interest payments

The total cost includes the net outflow from paying back more than the proceeds received and the interest paid during the bond term.

Methods to Amortize Discounts

The discount is allocated to interest expense over the bond's term using the straight-line method.

• Formula:

• Journal Entry: Db. Interest Expense (Total interest + amortized discount) Cr. Discount (amortized portion) Cr. Cash (interest paid)

Example: If the total discount is $33,367 over 6 periods, amortization per period is $5,561.

Effects on Accounts and Carrying Value

The carrying value of bonds increases as the discount is amortized. At maturity, the carrying value equals the face value.

• Carrying Value Formula:

Summary Table: Key Bond Terms

Additional info:

• Appendix F (Time Value of Money) is referenced for present value calculations.

• Accounting for bonds at premium, partial-period interest, and other long-term liabilities are covered in subsequent slides/sections.