Accounting for Long-Term Liabilities: Bonds, Notes, Leases, and Pensions

Bond Financing: Overview, Advantages, and Disadvantages

Bond financing involves a corporation issuing bonds to investors to raise capital. During the life of the bond, the corporation makes periodic interest payments to the investors, and at the maturity date, the par value (principal) is returned.

Advantages of Bond Financing

Owner Control: Issuing bonds does not affect the control of the current owners, as bondholders do not have voting rights.
Tax Deductibility: Interest paid on bonds is a tax-deductible expense, whereas dividends paid to stockholders are not.
Increased Return on Equity (ROE): If the corporation earns a higher return on the borrowed funds than the interest rate paid on the bonds, it increases the return for stockholders. This is known as financial leverage.

Disadvantages of Bond Financing

Required Payments: Corporations are legally required to pay periodic interest and the par value at maturity. Failure to do so can lead to bankruptcy.
Potential Decrease in ROE: If the corporation's projects do not earn a return higher than the interest rate, bond financing can decrease the return on equity.

Return on Equity (ROE) Comparison Table

Exhibit 14.1 illustrates the impact of different financing plans on Return on Equity (in millions):

Item	Plan A: Do Not Expand	Plan B: Equity Financing	Plan C: Bond Financing
Income before interest expense	$\$100$	$\$225$	$\$225$
Interest expense	$-$	$-$	$(\$50)$
Net income	$\$100$	$\$225$	$\$175$
Equity	$\$1,000$	$\$1,500$	$\$1,000$
Return on equity	$10.0\%$	$15.0\%$	$17.5\%$

Bond Trading and Market Value

Bonds are securities that can be actively traded in financial markets. Their market value is typically expressed as a percentage of their par (face) value.

Example: IBM Bond Data

An IBM bond example shows the following characteristics:

Coupon Rate: $4.0\%$
Issuance Date: June 20, 2012
Maturity Date: June 20, 2042
Yield to Maturity (YTM): $5.764\%$
Closing Price: $80.284\%$
Payments: Semiannual, Fixed
Credit Rating (S&P): A-

A closing price of $80.284$ indicates the bond is selling at $80.284\%$ of its face value (at a discount).

Accounting for Par Bonds

Bonds are issued at par when the contract interest rate equals the market interest rate.

Issuance at Par

On December 31, 2027, a company issues bonds with a par value of $\$100,000$ , a stated rate of $8\%$ , and a 2-year maturity (December 31, 2029).

Journal Entry (Dec. 31, 2027):

Debit Cash: $\$100,000$
Credit Bonds Payable: $\$100,000$

Interest Payments

Interest is paid semiannually (June 30 and December 31). The calculation for the payment is: $\text{Interest Payment} = \text{Par Value} \times \text{Contract Rate} \times \text{Time}$ $\$100,000 \times 8\% \times \frac{1}{2}\,\text{year} = \$\text{4,000}$

Journal Entry (June 30, 2028):

Debit Bond Interest Expense: $\$4,000$
Credit Cash: $\$4,000$

Maturity

At the end of the bond's life, the issuer pays back the principal.

Journal Entry (Dec. 31, 2029):

Debit Bonds Payable: $\$100,000$
Credit Cash: $\$100,000$

Bond Pricing: Discount and Premium

The price of a bond is determined by the relationship between the Contract Rate (set by the bond) and the Market Rate (set by the market).

Bond sells at Par: Contract Rate $=$ Market Rate.
Bond sells at Premium: Contract Rate $>$ Market Rate.
Bond sells at Discount: Contract Rate $<$ Market Rate.

Accounting for Discount Bonds

Issuance of Discount Bonds

Fila issues bonds with a par value of $\$100,000$ at an issue price of $96.400\%$ of par. The stated rate is $8\%$ and the market rate is $10\%$ .

Cash Proceeds: $\$100,000 \times 96.400\% = \$96,400$
Discount: $\$100,000 - \$96,400 = \$3,600$

Journal Entry (Dec. 31, 2027):

Debit Cash: $\$96,400$
Debit Discount on Bonds Payable: $\$3,600$ (Contra-liability account)
Credit Bonds Payable: $\$100,000$

Balance Sheet Presentation

Under Long-term liabilities:

Bonds payable: $\$100,000$
Less discount on bonds payable: $(\$3,600)$
Carrying Value: $\$96,400$

Amortization (Straight-Line)

Total discount of $\$3,600$ divided by 4 semiannual periods equals $\$900$ per period.

Period End	Unamortized Discount	Carrying Value
12/31/2027	$\$3,600$	$\$96,400$
06/30/2028	$\$2,700$	$\$97,300$
12/31/2028	$\$1,800$	$\$98,200$
06/30/2029	$\$900$	$\$99,100$
12/31/2029	$\$0$	$\$100,000$

Accounting for Premium Bonds

Issuance of Premium Bonds

Adidas issues bonds with a par value of $\$100,000$ at $103.600\%$ of par. The stated rate is $12\%$ and the market rate is $10\%$ .

Cash Proceeds: $\$100,000 \times 103.600\% = \$103,600$
Premium: $\$103,600 - \$100,000 = \$3,600$

Journal Entry (Dec. 31, 2027):

Debit Cash: $\$103,600$
Credit Premium on Bonds Payable: $\$3,600$ (Adjunct-liability account)
Credit Bonds Payable: $\$100,000$

Balance Sheet Presentation

Under Long-term liabilities:

Bonds payable: $\$100,000$
Plus premium on bonds payable: $\$3,600$
Carrying Value: $\$103,600$

Amortization (Straight-Line)

Semiannual cash payment: $\$100,000 \times 12\% \times \frac{1}{2} = \$6,000$ . Amortization amount: $\$3,600 / 4\,\text{periods} = \$900$ . Interest Expense: $\$6,000 - \$900 = \$5,100$ .

Period End	Unamortized Premium	Carrying Value
12/31/2027	$\$3,600$	$\$103,600$
06/30/2028	$\$2,700$	$\$102,700$
12/31/2028	$\$1,800$	$\$101,800$
06/30/2029	$\$900$	$\$100,900$
12/31/2029	$\$0$	$\$100,000$

Bond Retirement

Retirement at Maturity

At maturity, the discount or premium is fully amortized, so the carrying value equals the par value ( $\$100,000$ ).

Journal Entry (Dec. 31, 2029):

Debit Bonds Payable: $\$100,000$
Credit Cash: $\$100,000$

Retirement before Maturity

If bonds are retired early, a gain or loss may occur:

Carrying Value $>$ Retirement Price $=$ Gain
Carrying Value $<$ Retirement Price $=$ Loss

Example: Callable bonds are retired on July 1.

Carrying Value: $\$104,500$ ( $\$100,000\,\text{par} + \$4,500\,\text{premium}$ ).
Call Premium: $\$3,000$ (making the retirement price $\$100,000 + \$3,000 = \$103,000$ ).

Journal Entry:

Debit Bonds Payable: $\$100,000$
Debit Premium on Bonds Payable: $\$4,500$
Credit Gain on Bond Retirement: $\$1,500$
Credit Cash: $\$103,000$

Long-Term Notes Payable

Long-term notes payable represent obligations that are repaid over a period exceeding one year. This includes installment notes where principal and interest are repaid periodically.

Installment Notes with Equal Payments

Foghog borrows $\$60,000$ on January 1, 2026, with an $8\%$ installment note requiring 3 annual payments.

Computing Periodic Payment

The payment is calculated by dividing the principal by the Present Value (PV) factor for an annuity of $\$1$ at the given rate and period (Table B.3).

Principal: $\$60,000$
PV Factor (8%, 3 periods): $2.5771$
Periodic Payment: $\$60,000 / 2.5771 = \$23,282$

Amortization Table for Note

Period	Beg. Balance	Interest (8%)	Principal Reduction	Cash Payment	End Balance
1 (2027)	$\$60,000$	$\$4,800$	$\$18,482$	$\$23,282$	$\$41,518$
2 (2028)	$\$41,518$	$\$3,321$	$\$19,961$	$\$23,282$	$\$21,557$
3 (2029)	$\$21,557$	$\$1,725$	$\$21,557$	$\$23,282$	$\$0$

Mortgages

A mortgage is a legal agreement protecting the lender by giving them the right to be paid from the sale of specifically identified assets if the borrower defaults.

Example Entry: Purchasing equipment for $\$75,000$ with $\$15,000$ cash and a $\$60,000$ mortgage note:

Debit Equipment: $\$75,000$
Credit Cash: $\$15,000$
Credit Notes Payable: $\$60,000$

Features of Bonds and Notes

Secured vs. Unsecured: Secured debt has specific assets pledged as collateral; Unsecured (Debentures) relies on the borrower's credit.
Term vs. Serial: Term bonds mature on a single date; Serial bonds mature at different points in time.
Convertible vs. Callable: Convertible bonds can be exchanged for stock; Callable bonds can be retired early by the issuer.
Registered vs. Bearer: Registered bonds are in the owner's name; Bearer bonds (coupon bonds) are payable to whoever holds them.

Debt-to-Equity Ratio

This ratio assesses financial risk by comparing total liabilities to total equity. $\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Total Equity}}$

Case Study Analysis

Company	Metric	Current Year	1 Year Ago	2 Years Ago
Nike	Debt-to-Equity	$1.68$	$1.64$	$1.96$
Under Armour	Debt-to-Equity	$1.21$	$1.46$	$1.58$

Appendix 14A: Bond Pricing and Valuation

Bond price is the present value of all future cash flows: the periodic interest (annuity) and the par value (lump sum at maturity).

Example: Pricing Fila Discount Bonds

Par Value: $\$100,000$
Semiannual Market Rate: $10.031\% / 2 = 5.0155\%$
Semiannual Interest (8% coupon): $\$4,000$
Periods: 4

PV of Par Value: $\$100,000 \times 0.8222\,(\text{Table B.1 factor}) = \$82,220$
PV of Interest: $\$4,000 \times 3.5449\,(\text{Table B.3 factor}) = \$14,180$
Total Bond Price: $\$82,220 + \$14,180 = \$96,400$

Example: Pricing Adidas Premium Bonds

Par Value: $\$100,000$
Semiannual Market Rate: $9.97\% / 2 = 4.9851\%$
Semiannual Interest (12% coupon): $\$6,000$
Periods: 4

PV of Par Value: $\$100,000 \times 0.8232 = \$82,320$
PV of Interest: $\$6,000 \times 3.5467 = \$21,280$
Total Bond Price: $\$82,320 + \$21,280 = \$103,600$

Appendix 14B: Effective Interest Amortization

This method calculates bond interest expense using the carrying value and the market interest rate.

Effective Interest Table: Discount Bonds

Semiannual Contract Rate: $4\%$
Semiannual Market Rate: $5.0155\%$

Period	Cash Paid (4% Par)	Interest Expense (5.0155% CV)	Discount Amort.	Carrying Value
0	-	-	-	$\$96,400$
1	$\$4,000$	$\$4,835$	$\$835$	$\$97,235$
2	$\$4,000$	$\$4,877$	$\$877$	$\$98,112$
3	$\$4,000$	$\$4,921$	$\$921$	$\$99,033$
4	$\$4,000$	$\$4,967$	$\$967$	$\$100,000$

Journal Entry (Effective Interest Discount):

Debit Bond Interest Expense: $\$4,835$
Credit Discount on Bonds Payable: $\$835$
Credit Cash: $\$4,000$

Effective Interest Table: Premium Bonds

Semiannual Contract Rate: $6\%$
Semiannual Market Rate: $4.9851\%$

Period	Cash Paid (6% Par)	Interest Expense (4.9851% CV)	Premium Amort.	Carrying Value
0	-	-	-	$\$103,600$
1	$\$6,000$	$\$5,165$	$\$835$	$\$102,765$
2	$\$6,000$	$\$5,123$	$\$877$	$\$101,888$
3	$\$6,000$	$\$5,079$	$\$921$	$\$100,967$
4	$\$6,000$	$\$5,033$	$\$967$	$\$100,000$

Appendix 14C: Leases and Pensions

Leases

A lease is an agreement between a lessor (owner) and lessee (renter).

Finance Leases

Long-term leases where the lessee receives substantially all benefits. A lease is a finance lease if it meets one of these 5 criteria:

Ownership transfers to lessee at end of term.
Lessee is reasonably certain to exercise a purchase option.
Lease term covers a major part of the asset's economic life.
Present value of lease payments equals or exceeds substantially all of the asset's fair value.
The asset is specialized with no alternative use to the lessor.

Operating Leases

Any long-term lease not meeting the finance lease criteria. Lease amortization for operating leases is calculated as: $\text{Amortization} = \text{Lease Payment} - \text{Interest on Lease Liability}$

Pensions

A pension is an agreement for an employer to provide benefits to employees after retirement.

Defined Benefit Plans: Employer contributions vary based on future asset/liability assumptions.
Underfunded Plan: Accumulated benefit obligation $>$ plan assets (reported as pension liability).
Overfunded Plan: Accumulated benefit obligation $<$ plan assets (reported as pension asset).