Chapter 9: Long-term liabilities

To finance buildings, machines and acquisitions, companies borrow for many years: through long-term notes payable, mortgages and bonds. This chapter explains how such loans are recorded, how bonds can be issued at face value, at a discount or at a premium, how the discount or premium becomes part of interest expense, how bonds are retired, and how the debt to equity ratio measures financial leverage.

Long-term notes payable and mortgages

Long-term liabilities need not be paid within one year (or the operating cycle if longer). When a note is repaid in instalments, an amortization schedule shows for each payment how much is interest and how much repays principal, plus the beginning and ending balance. Interest each period = beginning balance × interest rate × time.

Example: on 31 December Smart Touch Learning signs a $20,000 note, repaid in four annual instalments of $5,000 principal plus 6% interest on the outstanding balance. The first payment, a year later, is interest 20,000 × 6% = $1,200 plus principal $5,000:

The second payment carries interest of 15,000 × 6% = $900, and so on: interest falls as the balance falls. At each balance sheet date the $5,000 due in the next year is the current portion.

A mortgage payable is a long-term debt secured by specific property: if the borrower does not pay, the lender can take the property. Mortgages are usually paid in equal monthly amounts that include both interest and principal. Example: a building of $150,000 is bought with $49,925 cash and a 30-year, 6% mortgage of $100,075, paid at $600 a month. The first month's interest is 100,075 × 0.06 / 12 = $500, so $100 reduces the principal (Dr Mortgages payable 100, Dr Interest expense 500, Cr Cash 600). In the exercise from the solutions a $500,000 mortgage at 6% with monthly payments of $3,582.16 gives interest of $2,500 in the first month and a principal reduction of $1,082.16.

Bonds payable

Bonds payable are long-term debts issued to many lenders, the bondholders, usually in units of $1,000. With bonds a company can borrow millions from thousands of investors instead of one bank. Key terms:

• Face value (par, principal): the amount repaid at the maturity date.
• Maturity date: when the principal must be repaid.
• Stated interest rate (coupon rate): printed on the bond; it determines the cash interest paid each year.
• Market interest rate (effective rate): the rate investors demand for lending their money at the time of issue.

Types: term bonds all mature at the same time; serial bonds mature in instalments; secured bonds give bondholders a claim on specific assets if the issuer defaults; debentures are unsecured, backed only by the issuer's creditworthiness.

A five-year, 9%, $100,000 bond paying interest twice a year pays 100,000 × 9% × 6/12 = $4,500 every six months (ten payments) and $100,000 at maturity.

Issue price: par, discount or premium

Bond prices are quoted as a percentage of face value: a price of 96 means $96 per $100 of face value. The price depends on the stated rate compared with the market rate:

Issuing at a discount. Smart Touch Learning issues $100,000 of 9%, five-year bonds when the market rate is 10% and receives $96,149:

The discount on bonds payable is a contra liability account. Bonds payable minus the discount is the carrying amount (carrying value): $96,149 at issue. The company borrowed $96,149 but must repay $100,000; the $3,851 difference is extra interest, which raises the true interest cost to the market rate of 10%.

Issuing at a premium. When the market rate is 8%, the bonds sell at 104.10, so the company receives $104,100 and records a premium on bonds payable of $4,100. The premium is an adjunct account: it is added to bonds payable, so the carrying amount is $104,100. The premium lowers the true interest cost.

Amortizing the discount or premium

The discount or premium is spread over the life of the bond through amortization (gradual reduction). The slides use the straight-line method: an equal amount every interest period.

• Discount: 3,851 / 10 = $385 per period. Interest expense = cash interest + amortization = 4,500 + 385 = $4,885 (Dr Interest expense 4,885, Cr Discount on bonds payable 385, Cr Cash 4,500). After the first year (two payments) the discount is 3,851 − 770 = $3,081 and the carrying amount $96,919: the carrying amount rises towards face value.
• Premium: 4,100 / 10 = $410 per period. Interest expense = 4,500 − 410 = $4,090 (Dr Interest expense 4,090, Dr Premium on bonds payable 410, Cr Cash 4,500). After one year the premium is $3,280: the carrying amount falls towards face value.

At maturity the discount or premium is fully amortized, so the carrying amount equals face value.

Effective-interest method. In the exercise sessions the more precise effective-interest method is also used. Interest expense = carrying amount × market rate × time; amortization = interest expense − cash interest. Example: a $100,000, 6% bond with annual interest is issued for $94,000 when the market rate is 8%. Year 1: interest expense = 94,000 × 8% = $7,520; cash paid = 100,000 × 6% = $6,000; discount amortized = $1,520. Because the carrying amount grows, interest expense grows each period.

Retiring bonds

At maturity: Dr Bonds payable, Cr Cash, for the face value (the discount or premium is zero by then). Companies sometimes retire bonds early, to get rid of the interest burden, by buying them back on the market or by calling callable bonds at a set price. Steps: update interest and amortization; remove the face value and the remaining discount or premium; record the cash paid; the difference is a gain or loss.

Example: just after the 31 December payment, $100,000 of bonds with a remaining discount of $3,081 (carrying amount $96,919) are bought back at 95, so for $95,000. The company pays less than the carrying amount: gain on retirement of $1,919.

Reporting liabilities and the debt to equity ratio

On the balance sheet, current liabilities (including the current portion of long-term debt) come first, then long-term liabilities, with bonds shown net of their discount or including their premium.

The ratio measures financial leverage. Above 1 means the company finances more of its assets with debt than with equity. Kohl's: 6,942 / 5,527 = 1.26 in 2018, down from 7,970 / 5,419 = 1.47 a year earlier: less risky.