Long Term Liabilities

A long term liability is one that will be paid after one year. Typical long term liabilities include Bonds Payable and Mortgages Payable. This chapter discusses the accounting issues involved for these noncurrent liabilities. A central issue to consider is that these types of liabilities involve cash flows that are due after one year. For example, a bond might have a 30 year maturity, in which case, the borrower would be paying interest each year for 30 years, and the principal at the end of year 30. Because these payments are so far out in time, we discount them, according to the time value of money. Payments made after one year are not valued the same as payments made within one year.

Learning Objectives

This chapter focuses mostly on bonds payable and installment loans. Corporations use bonds and mortgages to finance long term asset purchases, such as the purchase of vehicles, buildings, and machinery. You will note that bonds payable and mortgages have somewhat different cash flow patterns, however.

Bonds Payable -- Introduction

Quite often, large companies need money for financing various projects, and will consider two primary methods of acquiring funds. These are issuance of stock or issuance of bonds. You already know some of the implications of issuing stock. Why would a company issue bonds? Here are some reasons:

  1. Stockholder control is unaffected, because bond holders do not have voting rights.   This is because bond holders are creditors, not owners.

  2. Bond Interest is a deductible expense on the income statement, unlike payment of cash dividends.

  3. Borrowing money can result in favorable financial leverage. Imagine a situation in which a company borrows $1,000,000 at 6% and is able to put the money into an investment earning 8%. In such a case, the company's earnings will be greatly enhanced, compared to its earnings without such use of debt. This use of fixed-charge debt is called financial leverage. Financial leverage can also be unfavorable, such as in a case where a company borrows at 6%, but only earns 4% on its investment.

Reflecting on item 3 above, borrowing using bonds can be advantageous, because money comes into the firm with no additional shares of Common Stock issued. Then, if the money is invested wisely, earnings per share can be increased. Note: this strategy can also backfire. If the economy declines, a company could find itself trying to pay back a 6% loan at a time when it is making only 4%.

The first section of the textbook chapter focuses on the effects of borrowing on earnings per share.

Bonds Payable -- Vocabulary

There are many types of bonds, and each bond may have certain characteristics. Here are a few possibilities:

A bond may be a term bond, if all the bonds in the issue mature at the same time. A set of bonds could be considered serial bonds if they mature sequentially, year by year. There are some bonds that, at the bond buyer's option, are convertible into shares of common stock. The buyer of such a bond would hope that the dividends or capital gains on the stock might make conversion profitable in the future. Some corporations issue callable bonds, thinking that at some point, it wants to avoid paying interest. The corporation issues the bonds, then some years later, pays the bond holder to get the bonds back.

Accounting for Bonds

Like stocks, bonds are sold to investors who are eager to earn a return on their investment. When a company sells bonds, investors pay a certain amount to own the bond. Usually, bonds are sold in $1000 denominations, and carry an interest rate (called the contract rate) that the company hopes is high enough to entice investors, but low enough to minimize the cost of financing. This interest rate is fixed, and is printed on the face of the bond. For example, a bond issued by Clark Manufacturing might carry an interest rate of 9%, with a face value of $5,000, and may mature on 1/1/2020.

A bond is a contract. If you purchased this Clark Manufacturing bond, you would receive a total of $450 per year as interest on this bond (.09 times $5,000). Note: interest is usually semiannual, so the bond would pay you $225 twice per year. Reading the really small print, it appears that the semiannual interest dates are January 1 and July 1. If you held this bond to maturity, you would receive the face amount of $5,000 on January 1, 2020.

The tricky part is that, although the face value of the bond is $5,000, investors will probably pay more or less than $5,000 to acquire the bond. The amount paid will depend upon the interest rate offered by that bond compared to bonds of similar quality in the market. For example, if you were considering the Clark Manufacturing bond and comparing it to a bond that offered 10%, you might only invest in the 9% Clark bond if you could purchase it for less than $5,000. To go a step further, you would like to purchase the Clark bond at an amount that will allow you to make a 10% yield on that bond, meaning that you'd want to make up the difference between a rate of 9% and 10% by purchasing the 9% bond at a sufficient discount.

Because bonds are issued with maturity dates that might be 20-30 years away, and there is only one interest rate printed on its face, it is likely that the bond will sell for more than face value at times, and less than face value at other times. The purchase price of the bond, then, will fluctuate with market conditions, as well as the strength of the issuing company. Here are a couple of examples. Focus on the relationship between the interest rate offered by the bond versus the market rate of interest.

Example 1: XYZ Company sells its 6% $1000 20-year bond in a market where bonds of similar quality are offering 8%. XYZ's bonds will have to be sold at a discount (an amount less than $1000) so that investors can earn the same yield that they would get with an 8% bond.

Example 2: XYZ Company sells its 6% $1000 20 year-bond in a market where bonds of similar quality are offering only 4%. Since XYZ's bond offers a higher interest rate, it will sell at a premium. You might predict that the premium paid equates the 6% bond with a 4% yield.

The challenge of a bond is that everything is fixed except for the selling price. Another way to say this is that the cash flows for interest and face value at maturity are stated on the bond. If the price for a bond were not allowed to fluctuate, some bonds would never be purchased. If you had two choices of a bond investment--one offering 6% interest and one offering 8%, and each one costs $1,000, you would rationally purchase the 8% bond. But because in reality, bond prices are allowed to fluctuate, it is possible that you could find a 6% bond that yields a 8%. How is this possible? The bond would have to be available for sale at less than $1,000. Using present value techniques, you can figure out what price for the 6% bond would equate to an 8% yield.

If a bond is issued for less than face value, a discount results. The issuing company is not receiving the face value--but must carry out the bond contract by paying the stated interest rate and the face value at maturity. The following example illustrates the accounting for a discount.

Accounting for Bond Discounts

When a company issues bonds at below face value, a discount results. The following accounts are used:

wpe13.gif (3412 bytes)

Example: Johnson Company issues $1,000,000 of 5-year, 13% bonds at 98 (meaning 98% of face value), with interest payable semiannually. The entry would be:

wpeF.gif (2348 bytes)

Why would Johnson Company's bond sell at a discount of $20,000. Probably there are other bonds in the market that offer a slightly higher interest rate--maybe 14%. A bond buyer would buy the Johnson bond only if the prevailing interest rate (14%) could be earned. The bond buyer might reason that a $20,000 discount is enough to cover the 1% difference between the Johnson bond and other bonds in the market.

Notice that Johnson Company must pay off $1,000,000 in five years, despite the fact that the company only received $980,000. The difference of $20,000 is placed in Discount on Bonds Payable, a contra liability account.

You could consider the $20,000 to be an increase in the interest expense on this bond. However, the $20,000 must be spread out (amortized) over the five year life of the bond. We divide the discount amount of $20,000 by the number of payments for the bond to determine the periodic amortization amount. So, $20,000 divided by 10 payments = $2,000 of discount amortization per payment. At each semiannual payment date, the company pays out $65,000 of interest in cash, and adds $2000 of interest expense as a result of the amortization. Here is the entry:

wpe11.gif (2391 bytes)

Consider the effects of this transaction:

  1. Cash to be paid out is 13% of $1,000,000 for one-half year ($65,000);

  2. The Discount on Bonds Payable account is reduced by $2000, and will reach zero after ten half-year periods have elapsed;

  3. There are two elements to Bond Interest Expense: the cash paid out plus amortization of the discount.  A discount will mean that the interest expense incurred is higher than the cash paid out.  This is because the bond sold for less than face value, and we consider the discount to be "extra" interest expense.

At the end of the five year period, the Bonds Payable account will be debited for $1,000,000 and Cash will be credited, to pay off the Bonds.  The Discount on Bonds Payable account will be at zero. Conclusion: if a company issues a bond at a discount, the discount represents extra interest expense incurred because the interest rate printed on the bond was lower than that of competing bonds.

Accounting for a Premium on Bonds Payable

A bond premium is handled in a similar way. The accounts used are:

wpe12.gif (3404 bytes)

Suppose Jason industries issues $100,000 of 9% bonds maturing in 5 years, that are issued at 104.  This means that the market rate of interest is less than 9%, causing the price of Jason's bonds to rise. Notice that the effect of issuance of bonds at a premium is to reduce the interest expense recorded semiannually, over the life of the bonds.  This is because the bonds sold for more than face value, and the extra amount received is considered a reduction in interest expense.

The amortization of Discounts and Premiums shown up to this point is called straight-line amortization, because the total Discount or Premium is divided by the number of interest periods, and an equal portion amortized at each interest date. Straight line amortization is a good way to learn the process of amortization, but is not the preferred method because it does not consider the time value of money. Effective interest amortization (the theoretically correct method) is covered in Appendix 2to this chapter.

Bond Redemption and Conversion

The final entry for any bond at maturity is to debit bonds payable for the face value and credit cash. There will be no discount or premium left, because all of it will have been amortized over the life of the bond.

Some companies choose to redeem the bonds before maturity which may lead to a gain or loss. Or, the bonds may have a convertible feature which allows the creditor to convert the bonds to ownership, in the form of common stock. Some companies may place the convertible feature on the bond in order to be able to offer a slightly lower rate of interest. At conversion from bonds to stock, no gain or loss is recorded.

Installment Notes Payable

The purchase of a building or vehicle often involves financing using an installment loan. An installment loan on a house or other real estate is called a mortgage. Such loans generally require monthly payments by the borrower which may continue for 30 years or more. The basic arrangement is that the payments are exactly equal each month, and interest is levied based on the unpaid balance of the loan. Each payment consists two components: principal and interest.

An automobile loan or mortgage loan is usually set up with monthly payments. For example, an auto loan might be for $25,000 over five years at 6%, with a fixed monthly payment. There will be 60 payments altogether, with each payment consisting of interest expense and repayment of principal. Something to remember is that the interest is on the unpaid balance. Since the unpaid balance at the beginning of the loan is at its maximum, the interest portion of the payment is high at the beginning, and gradually declines with each payment. Conversely, the repayment of principle starts out very low, and gets larger with each payment.

If you are familiar with present value concepts, we could say that the borrower receives $25,000 in time period zero, and then pays off the loan as an annuity--a series of equal monthly payments for 60 months. From the borrower's standpoint, he/she loans out $25,000 to the borrower, and receives a payment each month for 60 months, earning 6% on the borrower's unpaid balance.

A home loan is quite similar, but usually the loan is for 30 years, or 360 payments. Again, the payment is fixed, with each payment consisting of interest and principal repayment.

Example 1--A 3-year loan of $3,000 at 6%

Let's say we borrow $3,000 for 3 years, with annual payments. Using a present value table, look up the Interest Factor of 6% for 3-years. (You can use this table.) The interest factor turns out to be 2.6730.

Divide the loan amount by this interest factor to calculate the annual payment. So, $3000/2.6730 is equal to $1,122.33. I'm borrowing $3,000 today and will pay it back with one payment per year of $1122.33 for 3 years.

Create a loan amortization table:

Period Payment Interest Exp Principal Reduction Loan Balance
0       3,000
1 1122.33 180 942.33 2057.67
2 1122.33 123.46 998.87 1058.80
3 1122.33 63.53 1058.80 0.00

For the table above, put the loan balance of $3,000 in the right column under Loan Balance.
The payments are entered for periods 1, 2 and 3 with the constant loan payment amount, $1122.33.

The Interest Expense is calculated as .06 times the loan unpaid balance. In period 1, this is .06*3000=180; in period 2, the Interest Expense is .06*2057.67, and in period three, Interest Expense is .06*1058.80.

Principal Reduction = Loan Payment minus the Interest Expense. So in period 1, the Principal Reduction is 1122.33-180=942.33.

The Loan Balance is the previous Loan Balance minus the Principal Reduction. In period 1, the Loan Balance = 3,000 minus 942.33=2057.67.

If your calculations are correct, your Loan Balance should hit zero (or close to it) after the final payment. Note that since we are using a present value table with only four decimal places, we might be left with a final loan balance of a dollar or two. Use a table with more decimal places to get closer to zero.

A Second Example--with Semiannual Payments

Here is another example. Suppose that a company borrows $500,000 at 12% for 5 years, with semiannual payments (semiannual implies two payments per year). Each semiannual payment will be equal and will consist of interest expense and principal reduction, as before.

Similar to the first example, the payment each period is constant. In financial terms, this is an annuity. An annuity is a cash stream of equal payments. Each payment will consist of principal payment plus an interest payment, where the interest is computed on the unpaid balance of the loan.

As before you will need to figure out the semiannual payment amount. Here are the steps to follow: Begin by writing down the facts of the problem: a $500,000 loan to be paid off in five years semiannually interest at 12%.

  1. Turn to the Present Value Table in your text, or use this link.

  2. Our problem involves borrowing $500,000 at 12% for 5 years, with semiannual payments. The table assumes one payment per period, but in our case there will be 2 payments per year because it's semiannual.

    a. Divide the interest rate by 2; so the interest rate becomes 12% / 2 = 6%;
    b. Multiply the number of years by 2; so the number of periods will be 5 years * 2 = 10 periods.

    Thus, with semiannual payments, our table figure will be found at the intersection of 6% and 10 periods. The table figure (called the interest factor) is 7.360.

  3. Divide the principal of the loan by the interest factor. $500,000 / 7.36009 = $67,934, which is the payment amount.

Once the payment amount is known, you can build your mortgage payment schedule:

wpeE.gif (8023 bytes)

Notice the following characteristics of the table:

  1. The cash paid each semiannual period will stay constant ($67,934);

  2. The portion of the cash paid which is applied to interest (column B) is 6% of the unpaid balance (column D), and the interest amount declines as the balance declines;

  3. The portion of cash paid which is applicable to the repayment of principal (Column C) increases over the term of the loan;

  4. The unpaid balance reaches zero after the tenth semiannual payment.

This type of amortization table is very common in accounting. You should study it until you can do one by heart, because you will see it again.

Effective Interest Amortization of Bond Discount

Your textbook describes the effective interest method of of bond amortization. You will not be held responsible for the Effective Interest Method--the exercises for this chapter use the straight line method illustrated in the body of the chapter.

Times Interest Earned

The chapter concludes with a calculation of an often-used ratio called "Times Interest Earned." Times Interest Earned can be calculated as follows:

Times Interest Earned = Earnings Before Income Tax / Interest Expense

If you are a bondholder, this measurement would be important to you, as you expect to get your interest payments as they become due. This measurement provides an idea of how much money the company is earning compared to the size of the interest expense. The higher the ratio, the more comfortable a bondholder would feel.