Financial Accounting II

📈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.

What's the Deal with Long-Term Liabilities?

  • 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=C(1+r)1+C(1+r)2+...+C(1+r)n+F(1+r)nPV = \frac{C}{(1+r)^1} + \frac{C}{(1+r)^2} + ... + \frac{C}{(1+r)^n} + \frac{F}{(1+r)^n}
    • 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


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© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.