Chapter 5: Long Term Liabilities

Nature of Long Term Liabilities

In order to finance and expand their operations companies need funds. Although some of the necessary funding can be provided by their own operations, companies usually have to raise some of the funds from external sources. Therefore, these companies are required to obtain longterm financing from banks and other financial institutions and we call this process as “external financing”.

External financing includes some combination of debt and equity financing. Corporations obtain cash for recurring business operations from stock issuances, profitable operations, and short-term borrowing (current liabilities). However, when situations arise that require large amounts of cash, such as the purchase of a land, building, or equipment, corporations also raise cash from long-term borrowing (obligations arising from debt financing is called as “long term liabilities”).

In a balance sheet, obligations related with external financing sources named as “liabilities”. Liabilities are first classified as “Current (Short- Term) Liabilities” and “Non-Current (Long- Term) Liabilities” based on the time period in which expected debt will be paid back. Short term liabilities consist of an expected outflow of resources arising from present obligations that are payable within a year or the operating cycle of the company whichever is longer. Whereas long term liabilities consist of an expected outflow of resources arising from present obligations that are not payable within a year or the operating cycle of the company whichever is longer.

Long-term liabilities are the most common way to finance the expansion of a business. Growth usually requires investment in long-term assets and in research and development and other activities that will generate income in coming years. To finance these assets and activities, a company needs long-term funds. The management issues related to long-term debt financing are whether to take on long-term debt, how much long-term debt to carry, and what types of long-term debt to incur.

Generally, long term liabilities have various covenants or restrictions for the protection of both lenders and borrowers. The covenants and other terms of the agreement between the borrower and the lender are stated in the bond indenture or note agreement.

To structure long-term financing to the best advantage of their companies, managers should know the characteristics of the various long-term debts. Bonds payable, long-term notes payable, mortgages payable, pension liabilities and lease liabilities can be given as the example to long term liabilities. In this chapter accounting, valuation and financial reporting of bonds and long term notes payable will be explained in detail.

Bonds and Types of Bonds

A bond is the most common type of long-term debt. Bond is a form of interest-bearing notes payable issued by corporations and governmental agencies. Like a note, a bond requires a promise to pay a sum of money at a designated maturity date, plus periodic interest at a specified rate on the maturity amount (face value). Bonds payable are the most common type of long term debts issued to multiple lenders called bondholders.

Each bondholder receives a bond certificate showing the name of the company that borrowed the money, exactly like a note payable. The certificate specifies the face value, which is the amount of the bond issue. The bond’s face value is also called maturity value, principal, or par value. A bond arises from a contract known as a bond indenture and represents a promise to pay:

• a sum of money at a designated maturity rate, plus
• periodic interest at a specified rate on the maturity amount (face value)

The interest rate written in the terms of the bond indenture (an ordinarily printed on the bond certificate) is known as the stated, coupon or nominal rate and this rate is set by the issuer and expressed as a percentage of the face value.

With respect to whether they are backed by a pledge of some collateral or not, bonds are classified as secured and unsecured bonds. A secured bond is a bond for which a company has pledged specific property to ensure its payment. For example, mortgage bonds are secured by a claim on real estate. A mortgage is a legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments. Bonds not backed by collateral are called “unsecured bonds” (also called debenture bonds). They are very risky and offer a high interest rate.

With respect to the way they mature, bonds are classified as term bonds, serial bonds and callable bonds. Bond issues that mature on a single date are called “term bonds”. Bond issues that mature in installments are called “serial bonds”. Bond issues that give the issuer the right to call and retire the bonds prior to maturity is called “callable bonds”.

Bonds issued in the name of the owner are called “registered bonds” and require surrender of the certificate and issuance of a new certificate to complete a sale. Bonds re not recorded in the name of the owner are called “bearer (coupon) bonds” and they can be transferred from one owner to another by mere delivery. The bondholder detaches the coupons from the bonds on the interest payment dates and submits them to a bank for collection.

Bonds which pay no interest unless the issuing company is profitable are called “income bonds”. Bonds which pay interest from specified revenue sources are called “revenue bonds”. They are usually issued by airports, tollroad authorities and governmental bodies.

Accounting for Bond Issues

A bond can be issued at any price agreed upon by the issuer and the bondholders. The issue price of a bond is considered as the present value of its future cash flows which is calculated by interest rate and principal (the face value). In other words, selling price of a bond can be calculated as the present value of the face value plus the present value of periodic interest payments.

To calculate the selling price of bonds we need to know the face value of the bond (the principal amount borrowed), the interest payment pattern (annually, semiannually, etc.), the market interest rate per period and number of periods to maturity. Based on the relationship between stated and market interest rates we can easily understand whether bonds should be sold at its face value (at par), or should be sold at a price different from their face value before making any calculations.

Bonds issued at face value (at par value) means stated interest rate is equal to market interest rate and no premium and discount exists. Without making any calculations we can say that bonds are issued at face value (at par) because the stated interest rate is equal to the market interest rate. Bonds issued at premium means, market interest rate is less than the stated interest rate of the bond issued. In other words, since the stated interest rate is more than the interest rate offered by any other investment instrument in the market, investors will pay more than the face value of the bond.

Bonds issued at discount means, market interest rate is more than the stated interest rate of the bond issued. In other words, since the stated interest rate is less than the interest rate offered by any other investment instrument in the market, investors will pay less than the face value of the bond.

Amortization of Bond Discounts and Premiums

As it has been already mentioned, by paying more or less at the issuance, investors earn a rate different than the stated rate on the bond. Remember that, the issuing company pays the stated interest rate over the term of the bonds but also must pay the face value at maturity. If the bond is issued at a discount, the amount paid at maturity is more than the selling price. If issued at premium, the company pays less at maturity relative to the selling price. The company records this adjustment to the cost as bond interest expense over the life of the bonds through a process called amortization. Amortization of a discount increases bond interest expense. Amortization of a premium decreases bond interest expense.

The method used for amortization of a discount or premium is called effective interest method.

Under effective-interest method, we have to do the followings:

1. Compute bond interest expense:
   Bond Interest Expense = Carrying Value of Bonds x Effective Interest Rate at The Beginning of Period
2. Determine the bond discount or premium amortization:
   Bond Interest Paid = Face Amount of Bonds x Stated Interest Rate
   Amortization Amount = Bond Interest Expense – Bond Interest Paid

If bond issuer offers more interest rate than the market interest rate, they have to sell at premium to offer the same effective interest return to their investors. Recall that if bond issuer offers less interest rate than the market interest rate, they have to sell at premium to offer the same effective interest return to their investors.

Long Term Notes Payable

A long-term note is a promissory note that represents a loan from a bank or other creditor. Long-term notes payable is similar to short-term notes payable except that the term of the notes exceeds one year. The basic difference between short term notes payable and long-term notes payable is the maturity date. As we have already mentioned before long term liabilities consist of an expected outflow of resources arising from present obligations that are not payable within a year or the operating cycle of the company whichever is longer. Long-term notes payable is typically reported in the longterm liabilities section of the balance sheet.

Most of the long-term notes payable are paid in installments which include some part of principal and accrued interest together.

Beginning Balance × Interest Rate × Time

The total cash payment is the principal payment plus interest expense. The principal portion of the payment is then computed as the difference between the total installment note payment (cash paid) and the interest component.

After the final payment, the carrying amount on the note is zero, indicating that the note has been paid in full.
Installment notes are generally used to purchase specific assets such as equipment, and typically secured by the purchased asset. When a note is secured by an asset, it is called a mortgage note. If the borrower cannot pay the mortgage note, the lender has the right to take ownership of the pledged asset and sell it to pay back the debt. Mortgages payable are very similar to long-term notes payable. The main difference is the mortgages payable is secured with specific assets, whereas long-term notes are not secured with specific assets.

The nature of long term notes payable is quite similar in substance to bonds. A long-term note is a promissory note that represents a loan from a bank or other creditor, while a bond is usually a more complex financial instrument that represent a debt to many creditors. Additionally, notes do not trade as readily as bonds in the organized public securities markets.

Accounting for notes and bonds are also similar. Companies, compute the present value of bonds by calculating present value of its future interest and principal cash flows and amortizes any discount or premium over the life of the note. Inevitably accounting and financial reporting of long term notes payable are quite similar to bonds payable.