📈Financial Accounting II Unit 2 – Long-Term Liabilities: Bonds and Notes Payable
Long-term liabilities, like bonds and notes payable, are crucial for companies to finance big projects without draining cash. These obligations, expected to be paid after a year, require regular interest payments and can significantly impact financial statements and ratios.
Bonds are debt instruments issued by corporations or governments, while notes payable are written promises to pay. Both provide capital but differ in terms, maturity, and accounting treatment. Understanding their valuation, issuance, and retirement is key to managing a company's long-term financial health.
Long-term liabilities represent obligations a company expects to pay more than one year in the future
Consist of items such as bonds payable, notes payable, and long-term leases
Provide a way for companies to finance large projects or expansions without immediately depleting cash reserves
Require regular interest payments to compensate lenders for the use of their funds over an extended period
Can have a significant impact on a company's financial statements and ratios
Affect the debt-to-equity ratio and the interest coverage ratio
Must be carefully managed to ensure the company can meet its obligations and maintain financial stability
Can be secured by collateral (such as property or equipment) or unsecured based on the company's creditworthiness
Bonds: The Basics
Bonds are long-term debt instruments issued by corporations or governments to raise capital
Represent a contractual agreement between the issuer and the bondholder
Bondholders are creditors of the issuing entity and do not have an ownership stake in the company
Typically have a face value (or par value) of $1,000 which is the amount the bondholder will receive at maturity
Pay a stated interest rate (coupon rate) on the face value at regular intervals (usually semiannually)
Have a specified maturity date when the face value is repaid to the bondholder
Can be traded on secondary markets, allowing bondholders to sell their bonds to other investors before maturity
The market price of a bond can fluctuate based on changes in interest rates and the issuer's creditworthiness
Notes Payable: Not Your Average IOU
Notes payable are written promises to pay a specified amount on a certain date
Can be issued to lenders such as banks or to suppliers for goods or services purchased on credit
Often have a shorter maturity than bonds (usually less than 10 years)
May have a fixed or variable interest rate depending on the terms of the note
Require periodic interest payments and the repayment of principal at maturity
Can be secured by collateral or unsecured based on the borrower's creditworthiness
Accounted for as a liability on the balance sheet
The portion due within one year is classified as a current liability
The portion due beyond one year is classified as a long-term liability
Valuing Bonds: Time Value of Money in Action
The value of a bond is determined by the present value of its future cash flows (interest payments and principal repayment)
Involves discounting the future cash flows at the market interest rate (yield) to determine their present value
The market interest rate reflects the time value of money and the risk associated with the bond
Higher risk bonds require a higher yield to compensate investors
The present value of a bond can be calculated using the following formula:
PV=(1+r)1C+(1+r)2C+...+(1+r)nC+(1+r)nF
Where PV is the present value, C is the periodic coupon payment, r is the periodic yield, n is the number of periods, and F is the face value
If the market interest rate is higher than the coupon rate, the bond will sell at a discount (below face value)
If the market interest rate is lower than the coupon rate, the bond will sell at a premium (above face value)
Issuing Bonds: Above, Below, or At Par
Bonds can be issued at face value (par), at a discount, or at a premium depending on the relationship between the coupon rate and the market interest rate
When a bond is issued at par, the proceeds received equal the face value of the bond
The journal entry is:
Debit Cash
Credit Bonds Payable
When a bond is issued at a discount, the proceeds received are less than the face value
The difference between the face value and the proceeds is recorded as a contra-liability account called Discount on Bonds Payable
The journal entry is:
Debit Cash
Debit Discount on Bonds Payable
Credit Bonds Payable
When a bond is issued at a premium, the proceeds received are greater than the face value
The excess of the proceeds over the face value is recorded as a liability account called Premium on Bonds Payable
The journal entry is:
Debit Cash
Credit Premium on Bonds Payable
Credit Bonds Payable
Interest Expense and Amortization
Interest expense is the cost of borrowing funds and is recognized on the income statement
For bonds issued at par, interest expense equals the periodic coupon payment
For bonds issued at a discount or premium, interest expense consists of the coupon payment adjusted for the amortization of the discount or premium
Amortization is the process of allocating the discount or premium over the life of the bond using the effective interest method
The effective interest method calculates interest expense based on the carrying value of the bond (face value adjusted for unamortized discount or premium)
Ensures that the interest expense recognized each period is based on a constant effective yield
Discount on Bonds Payable is amortized to interest expense, increasing the carrying value of the bond over time
Premium on Bonds Payable is amortized to interest expense, decreasing the carrying value of the bond over time
The journal entries for interest expense and amortization are:
Debit Interest Expense
Debit Discount on Bonds Payable (if issued at a discount)
or
Credit Premium on Bonds Payable (if issued at a premium)
Credit Cash (for the coupon payment)
Early Retirement of Bonds: Gains and Losses
Bonds may be retired before their maturity date through a call provision or an open market purchase
When bonds are retired early, the difference between the carrying value (face value adjusted for unamortized discount or premium) and the reacquisition price is recognized as a gain or loss
If the reacquisition price is less than the carrying value, a gain on bond retirement is recorded
The journal entry is:
Debit Bonds Payable
Debit Premium on Bonds Payable (if applicable)
Credit Discount on Bonds Payable (if applicable)
Credit Cash (for the reacquisition price)
Credit Gain on Bond Retirement
If the reacquisition price is greater than the carrying value, a loss on bond retirement is recorded
The journal entry is:
Debit Bonds Payable
Debit Premium on Bonds Payable (if applicable)
Debit Loss on Bond Retirement
Credit Discount on Bonds Payable (if applicable)
Credit Cash (for the reacquisition price)
Gains and losses on bond retirement are reported on the income statement as other income or expense
Financial Statement Impact and Disclosure
Long-term liabilities, including bonds and notes payable, are reported on the balance sheet
Classified as either current liabilities (portion due within one year) or long-term liabilities (portion due beyond one year)
Interest expense is reported on the income statement as a non-operating expense
Gains and losses on bond retirement are reported on the income statement as other income or expense
The statement of cash flows reflects the issuance of bonds and notes payable as a financing activity (cash inflow)
Interest payments and the retirement of bonds and notes are also reported as financing activities (cash outflows)
Disclosures in the notes to the financial statements provide additional information about long-term liabilities
Includes details such as the face value, interest rates, maturity dates, and any collateral pledged
Also discloses the amount of interest expense recognized during the period and any gains or losses on bond retirement
Ratios such as the debt-to-equity ratio and the interest coverage ratio can be calculated using information from the financial statements
These ratios provide insights into the company's leverage and its ability to meet its debt obligations