Financial Accounting Study Notes: Long-Term Liabilities
TYPES OF LONG-TERM DEBT
PART A
LO9–1 Explain financing alternatives.
Financing Alternatives:
Capital structure: Mixture of liabilities and stockholders’ equity that a business uses.
Debt financing: Borrowing money.
Equity financing: Obtaining investment from stockholders.
Cost of Financing:
Debt: Interest expense is tax-deductible.
Equity: Dividends are not tax-deductible.
Examples of Debt:
Types include: Notes, leases, and bonds.
Key Points:
Companies obtain external funds through:
Debt financing (liabilities)
Equity financing (stockholders’ equity)
Advantage of Debt Financing: Interest on borrowed funds is tax-deductible.
LO9–2 Account for installment notes payable.
Installment Notes: Commonly used in car loans and home loans (mortgages) requiring monthly installment payments rather than one lump sum at maturity.
Each installment includes:
Interest on borrowed amount.
Reduction of outstanding loan balance.
Companies often borrow cash using installment notes.
Key Data Points:
Important components of an Installment Note:
Date: Date payments are due.
Term: Length of Note (typically stated in months or years).
Face Value/Note Value/Principal: Amount of the initial loan.
Interest Rate: Rate of interest charged per annum.
Example:
California Closets:
Principal: $25,000
Terms: 4 years (48 months)
Monthly Payment: $587.13
Interest Rate: 6%
Payment schedule: $587.13 at the end of each month for 48 months, including both interest and principal.
Amortization Schedule:
Overview: Lists cash paid, interest expense, carrying value, and how each installment affects principal and interest over time.
For a $25,000, 6%, four-year loan, the first month's breakdown:
Cash Paid: $587.13
Interest Expense: $125.00
Decrease in Carrying Value: $462.13
Remaining Carrying Value: $24,537.87
Installment Loan Transactions:
Recording the establishment of the Note Payable: On November 1, 2024, the company records the establishment by debiting Cash for $25,000 and crediting Notes Payable for $25,000.
After First Payment:
On November 30, 2024:
Debit Interest Expense: $125.00
Debit Notes Payable (difference): $462.13
Credit Cash: $587.13
Key Points: Most notes payable require periodic installment payments, consisting of interest expense and a reduction of the carrying value.
LO9–3 Understand how leases are recorded.
Leases: A contractual arrangement where the lessor (owner) provides the lessee (user) the right to use an asset for a specified period of time.
Recording Leases:
Recorded by the lessee as:
Debit to Lease Asset: Corresponding to the right to use the asset over the lease period.
Credit to Lease Payable: Present value of obligation to make payments at the lease term's beginning.
Decision Maker’s Perspective:
Reasons for Leasing Instead of Buying:
Reduces upfront cash needed to use an asset.
Lease payments usually lower than installment payments.
Offers flexibility and lower costs when disposing of an asset.
Provides protection against the risk of declining asset values.
Recording Lease Payable:
Example: On November 1, 2024:
Debit Lease Asset: $15,000
Credit Lease Payable: $15,000 (The amount is the present value of the lease payments)
Calculating the Present Value:
To find the present value of lease payments (annuity), use:
Present value is calculated based on interest rates specified in the lease agreement and the number of payment periods.
Key Points:**
Leasing gives the lessee rights without transferring ownership.
Must establish an asset and liability for the lease.
LO9–4 Account for the issuance of bonds at face amount.
Bonds: A formal debt instrument issued to borrow money.
Issuer promises to pay investors:
Stated principal/face amount at maturity.
Periodic interest payments over the bond’s life.
Interest Payments: Traditionally paid semiannually.
Timeline of a Bond Issue:
Example from California Coasters:
Face Amount: $100,000 at maturity.
Interest Payments: $3,500 every six months where $3,500 = $100,000 × 7% × ½.
Issue Date: January 1, 2024 and matures in 10 years.
Recording a Bond Issuance:
At issuance:
Debit Cash: $100,000
Credit Bonds Payable: $100,000 (for the issuance of bonds at face amount).
Recording Interest Payments:
First semiannual payment on June 30, 2024:
Debit Interest Expense: $3,500
Credit Cash: $3,500.
Retiring a Bond:
At maturity, record:
Debit Bonds Payable: $100,000
Credit Cash: $100,000 (for retiring bonds).
Summary of Bond Characteristics:
Distinguishing Characteristics of Bonds:
Secured vs. Unsecured: Backed by collateral or not.
Term vs. Serial: mature on a single date or installments.
Callable vs. Convertible: Ability to pay off bonds early or convert to common stock.
Key Point:
Characteristics of bonds influence their security and maturity dates, assessed through various financial metrics.
BONDS ISSUED AT DISCOUNT OR PREMIUM
PART B
LO9–5 Account for the issuance of bonds at a discount or premium.
Market Rate vs. Stated Rate:
Stated Interest Rate: Specified in the bond contract.
Market Interest Rate: Not fixed; higher risk leads to higher returns demanded.
Bonds Issued at Discount:
If a company issues bonds at a discount (for example, $93,205 of bonds at a face amount of $100,000 with investors demanding 8%), the accounting entries would include:
Debit Cash: $93,205
Debit Discount on Bonds Payable: $6,795
Credit Bonds Payable: $100,000.
Interest Paid vs. Interest Expense:
Example Calculation:
Cash Paid for Interest:
$3,500 = $100,000 × 7% × ½
d- Interest Expense:$3,728 = $93,205 × 8% × ½.
Difference Results in Reduction of Discount:
$228.
Common Mistakes:
Students often mistake interest expense with the stated amount instead of recognizing the market value.
Interest Expense and Interest Payment for Bonds Issued at a Discount:
Detailed schedule showing the amortization of the discount across various periods with cash paid, interest expense, and increase in carrying value recorded.
Bonds Issued at Premium:
Similar to bonds issued at a discount, but reflect higher cash input leading to accounting nuances around premiums.
Key Points:
Bonds sold at a discount decrease in carrying value and increase in interest expense over time.
Bonds issued at a premium increase in carrying value and decrease in interest expense over time.
LO9–6 Record gain or loss on retirement of bonds.
Bond Retirements at Maturity:
Example: On December 31, 2033, record retirement of bonds at maturity:
Debit Bonds Payable: $100,000
Credit Cash: $100,000.
Retirement of Bonds Before Maturity:
Bonds may include a call feature allowing early retirement.
Company records a gain/loss during early extinguishment:
Example calculation for loss.
Key Point:
No gain/loss when bonds retire at maturity.
Recognition of the difference in cash versus carrying value on early retirement of bonds is essential.