Long-Term Liabilities

1. Long-Term Liabilities

Figure 13.1 Car Purchase. Purchasing a vehicle can be an exciting experience. A vehicle is a significant financial investment and buyers want to ensure they are getting a good value for their money. (credit left: modification of "Auto" by unknown/Pixabay, CC0; credit right: modification of "Guy" by unknown/Pixabay, CC0)

Olivia is excited to be shopping for her very first car. She has saved up money from birthdays, holidays, and household chores and would like to get a vehicle so she can get a summer job. Her mother mentioned that a coworker is selling one of their vehicles.

Olivia and her family decide to go look at the vehicle and take it for a test drive. After inspecting the vehicle and taking it for a test drive, Olivia decides she would like to purchase the car. Olivia planned on spending up to $6,000 (the amount that she has saved), but the seller is asking $9,000 for this particular vehicle. Because the car has been well-maintained and has many extra features, Olivia decides it is worth spending the extra money in order to get reliable transportation. However, she is not sure how to come up with the additional $3,000. Olivia’s parents tell her she can get a bank loan of $3,000 to cover the difference, but she will have to repay the bank more than the $3,000 she is borrowing. This is because the loan will be repaid over a period of time, say twelve months, and the loan will require that she pay interest in addition to repaying the $3,000 in principal that she is borrowing. After meeting with the bank and signing the necessary paperwork to secure the $3,000 loan, a few days later Olivia returns to the seller with a check for $9,000 and is overjoyed to have purchased her first vehicle.

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Source: https://openstax.org/books/principles-financial-accounting/pages/13-why-it-matters
This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 License.

1.1. Explain the Pricing of Long-Term Liabilities

Businesses have several ways to secure financing and, in practice, will use a combination of these methods to finance the business. As you’ve learned, net income does not necessarily mean cash. In some cases, in the long-run, profitable operations will provide businesses with sufficient cash to finance current operations and to invest in new opportunities. However, situations might arise where the cash flow generated is insufficient to cover future anticipated expenses or expansion, and the company might need to secure additional funding.

If the extra amount needed is somewhat temporary or small, a short-term source, such as a loan, might be appropriate. Short-term (current) liabilities were covered in Current Liabilities. When additional long-term funding needs arise, a business can choose to sell stock in the company (equity-based financing) or obtain a long-term liability (debt-based financing), such as a loan that is spread over a period longer than a year.

Types of Long-Term Funding

If a company needs additional funding for a major expenditure, such as expansion, the source of funding would typically be repaid over several years, or in the case of equity-based financing, over an indefinite period of time. With equity-based financing, the company sells an interest in the company’s ownership by issuing shares of the company’s common stock. This financing option is equity financing, and it will be addressed in detail in Corporation Accounting. Here, we will focus on two major long-term debt-based options: long-term loans and bonds.

Debt as an option for financing is an important source of funding for businesses. If a company chooses a debt-based option, the business can borrow money on an intermediate (typically two to four years) or long-term (longer than four years) basis from lenders. In the case of bonds, the funds would be provided by investors. While loans and bonds are similar in that they borrow money on which the borrower will pay interest and eventually repay the lenders, they have some important differences. First, a company can raise funds by borrowing from an individual, bank, or other lender, while a bond is typically sold to numerous investors. When a company chooses a loan, the business signs what is known as a note, and a legal relationship called a note payable is created between the borrower and the lender. The document lists the conditions of the financial arrangement, a fixed predetermined interest rate (or, if the agreement allows, a variable interest rate), the amount borrowed, the borrowing costs to be charged, and the timing of the payments. In some cases, companies will secure an interest-only loan, which means that for the life of the loan the organization pays only the interest expense that has accrued and upon maturity repays the original amount that it borrowed and still owes. For individuals a student loan, car loan, or a mortgage can all be types of notes payable. For Olivia’s car purchase in Why It Matters, a document such as a promissory note is typically created, representing a personal loan agreement between a lender and borrower. Figure 13.2 shows a sample promissory note that might be used for a simple, relatively intermediate-term loan. If we were considering a loan that would be repaid over a several-year period the document might be a little more complicated, although it would still have many of the same components of Olivia’s loan document.

Figure 13.2 Promissary Note. A personal loan agreement is a formal contract between a lender and borrower. The document lists the conditions of the loan, including the amount borrowed, the borrowing costs to be charged, and the timing of the payments. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

If debt instruments are created with a variable interest rate that can fluctuate up or down, depending upon predetermined factors, an inflation measurement must also be included in the documentation. The Federal Funds Rate, for example, is a commonly used tool for potential adjustments in interest rates. To keep our discussion simple, we will use a fixed interest rate in our subsequent calculations.

Another difference between loans and bonds is that the note payable creates an obligation for the borrower to repay the lender on a specified date. To demonstrate the mechanics of a loan,with loans, a note payable is created for the borrower when the loan is initiated. This example assumes the loan will be paid in full by the maturity or due date. Typically, over the life of the loan, payments will be composed of both principal and interest components. The principal component paid typically reduces the amount that the borrower owes the lender. For example, assume that a company borrowed $10,000 from a lender under the following terms: a five-year life, an annual interest rate of 10%, and five annual payments at the end of the year.

Under these terms, the annual payment would be $2,637.97. The first year’s payment would be allocated to an interest expense of $1,000, and the remaining amount of the payment would go to reduce the amount borrowed (principal) by $1,637.97. After the first year’s payment, the company would owe a remaining balance of $8,362.03 ($10,000 – $1637.97.) Additional detail on this type of calculation will be provided in Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method.

Typical long-term loans have other characteristics. For example, most long-term notes are held by one entity, meaning one party provides all of the financing. If a company bought heavy-duty equipment from Caterpillar, it would be common for the seller of the equipment to also have a division that would provide the financing for the transaction. An additional characteristic of a long-term loan is that in many, if not most, situations, the initial creator of the loan will hold it and receive and process payments until it matures.

Returning to the differences between long-term debt and bonds, another difference is that the process for issuing (selling) bonds can be very complicated, especially for companies that are subject to regulation. The bond issue must be approved by the appropriate regulatory agency, and then outside parties such as investment banks sell the bonds to, typically, a large audience of investors. It is not unusual for several months to pass between the time that the company’s board of directors approves the bond offering, gets regulatory approval, and then markets and issues the bonds. This additional time is often the reason that the market rate for similar bonds in the outside business environment is higher or lower than the stated interest rate that the company committed to pay when the bond process was first begun. This difference can lead to bonds being issued (sold) at a discount or premium.

Finally, while loans can normally be paid off before they are due, in most cases bonds must be held by an owner until they mature. Because of this last characteristic, a bond,such as a thirty-year bond, might have several owners over its lifetime, while most long-term notes payable will only have one owner.

Ethical Considerations

Bond Fraud

The U.S. Department of the Treasury (DOT) defines historical bonds as "those bonds that were once valid obligations of American entities but are now worthless as securities and are quickly becoming a favorite tool of scam artists". The DOT also warns against scams selling non-existent "limited edition" U.S. Treasury securities. The scam involves approaching broker-dealers and banks to act as fiduciaries for transactions. Further, the DOT notes: "The proposal to sell these fictitious securities makes misrepresentations about the way marketable securities are bought and sold, and it also misrepresents the role that we play in the original sale and issuance of our securities". Many fraudulent attempts are made to sell such bonds.

According to Business Insider, in the commonest scam, a fake bearer bond is offered for sale for far less than its stated cover price. The difference in the cost and the cover price entices the victim to buy the bond. Again, from Business Insider: "Another variation is a flavor of the ‘Nigerian prince’ scheme; the fraudster will ask for the victim’s help in depositing a recently obtained ‘fortune’ in bonds, promising the victim a cut in return".

A diligent accountant is both educated about the investments of their company or organization and is skeptical about any investment that looks too good to be true.

Your Turn

Current versus Long-Term Liabilities

Below is a portion of the 2017 Balance Sheet of Emerson, Inc. (shown in millions of dollars). There are several observations we can make from this information.

Notice the company lists separately the Current Liabilities (listed as "Short-term borrowings and current maturities of long-term debt") and Long-term Liabilities (listed as "Long-term debt"). Also, under the "Current liabilities" heading, notice the "Short-term borrowings and current maturities of long-term debt" decreased significantly from 2016 to 2017. In 2016, Emerson held $2.584 billion in short-term borrowings and current maturities of long-term debt. This amount decreased by $1.722 billion in 2017, which is a 67% decrease. During the same timeframe, long-term debt decreased $257 million, going from $4.051 billion to $3.794 billion, which is a 6.3% decrease.

Thinking about the primary purpose of accounting, why do you think accountants separate liabilities into current liabilities and long-term liabilities?

Solution

The primary purpose of accounting is to provide stakeholders with financial information that is useful for decision making. It is important for stakeholders to understand how much cash will be required to satisfy liabilities within the next year (liquidity) as well as how much will be required to satisfy long-term liabilities (solvency). Stakeholders, especially lenders and owners, are concerned with both liquidity and solvency of the business.

Fundamentals of Bonds

Now let us look at bonds in more depth. A bond is a type of financial instrument that a company issues directly to investors, bypassing banks or other lending institutions, with a promise to pay the investor a specified rate of interest over a specified period of time. When a company borrows money by selling bonds, it is said the company is "issuing" bonds. This means the company exchanges cash for a promise to repay the cash, along with interest, over a set period of time. As you’ve learned, bonds are formal legal documents that contain specific information related to the bond. In short, it is a legal contract-called a bond certificate (as shown in Figure 13.3) or an indenture-between the issuer (the business borrowing the money) and the lender (the investor lending the money). Bonds are typically issued in relatively small denominations, such as $1,000 so they can be placed in the market and are accessible to a greater market of investors compared to notes. The bond indenture is a contract that lists the features of the bond, such as the amount of money that will be repaid in the future, called the principal (also called face value or maturity value); the maturity date, the day the bond holder will receive the principal amount; and the stated interest rate, which is the rate of interest the issuer agrees to pay the bondholder throughout the term of the bond.

Figure 13.3 Bond Certificate. If you bought this $1,000 bond on July 1, 2018 and received this bond certificate, it had three important pieces of information: the maturity date (June 30, 2023, 5 years from the issue date when the company will pay back the $1,000; the principal amount ($1,000) which is the amount you will receive in 2023; and the stated annual interest rate (5%) which they will use to determine how much cash to send you each year (0.05 × $1,000 = $50 interest a year for 5 years). (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

For a typical bond, the issuer commits to paying a stated interest rate either once a year (annually) or twice a year (semiannually). It is important to understand that the stated rate will not go up or down over the life of the bond. This means the borrower will pay the same semiannual or annual interest payment on the same dates for the life of the bond. In other words, when an investor buys a typical bond, the investor will receive, in the future, two major cash flows: periodic interest payments paid either annually or semiannually based on the stated rate of the bond, and the maturity value, which is the total amount paid to the owner of the bond on the maturity date.

Link to Learning

The website for the nonprofit Kiva allows you to lend money to people around the world. The borrower makes monthly payments to pay the loan back. The companies Prosper and LendingClub let you borrow or lend money to people in the U.S. who then make monthly payments, with interest, to pay it back.

The process of preparing a bond issuance for sale and then selling on the primary market is lengthy, complex, and is usually performed by underwriters-finance professionals who specialize in issuing bonds and other financial instruments. Here, we will only examine transactions concerning issuance, interest payments, and the sale of existing bonds.

There are two other important characteristics of bonds to discuss. First, for most companies, the total value of bonds issued can often range from hundreds of thousands to several million dollars. The primary reason for this is that bonds are typically used to help finance significant long-term projects or activities, such as the purchase of equipment, land, buildings, or another company.

Concepts In Practice

Apple Inc. Issues Bonds

On May 11, 2017, Apple Inc. issued bonds to get cash. Apple Inc. submitted a form to the Securities and Exchange Commission (www.sec.gov) to announce their intentions.

On May 3 of the same year, Apple Inc. had issued their 10-Q (quarterly report) that showed the following assets.

Apple Inc. reported it had $15 billion dollars in cash and a total of $101 billion in Current Assets. Why did it need to issue bonds to raise $7 billion more?

Analysts suggested that Apple would use the cash to pay shareholder dividends. Even though Apple reported billions of dollars in cash, most of the cash was in foreign countries because that was where the products had been sold. Tax laws vary by country, but if Apple transferred the cash to a US bank account, they would have to pay US income tax on it, at a tax rate as high as 39%. So, Apple was much better off borrowing and paying 3.2% interest, which is tax deductible, than bringing the cash to the US and paying a 39% income tax.

However, it’s important to remember that in the United States, Congress can change tax laws at any time, so what was then current tax law when this transaction occurred could change in the future.

The second characteristic of bonds is that bonds are often sold to several investors instead of to one individual investor.

When establishing the stated rate of interest the business will pay on a bond, bond underwriters consider many factors, including the interest rates on government treasury bonds (which are assumed to be risk-free), rates on comparable bond offerings, and firm-specific factors related to the business’s risk (including its ability to repay the bond). The more likely the possibility that a company will default on the bond, meaning they either miss an interest payment or do not return the maturity amount to the bond’s owner when it matures, the higher the interest rate is on the bond. It is important to understand that the stated rate will not change over the life of any one bond once it is issued. However, the stated rate on future new bonds may change as economic circumstances and the company’s financial position changes.

Bonds themselves can have different characteristics. For example, a debenture is an unsecured bond issued based on the good name and reputation of the company. These companies are not pledging other assets to cover the amount in case they fail to pay the debt, or default. The opposite of a debenture is a secured bond, meaning the company is pledging a specific asset as collateral for the bond. With a secured bond, if the company goes under and cannot pay back the bond, the pledged asset would be sold, and the proceeds would be distributed to the bondholders.

There are term bonds, or single-payment bonds, meaning the entire bond will be repaid all at once, rather than in a series of payments. And there are serial bonds, or bonds that will mature over a period of time and will be repaid in a series of payments.

A callable bond (also known as a redeemable bond) is one that can be repurchased or "called" by the issuer of the bond. If a company sells callable bonds with an 8% interest rate and the interest rate the bank is offering subsequently drops to 5%, the company can borrow at that new rate of 5%, call the 8% bonds, and pay them off (even if the purchaser does not want to sell them back). In essence, the institution would be lowering its rate of interest to borrow money from 8% to 5% by calling the bond.

Putable bonds give the bondholder the right to decide whether to sell it back early or keep it until it matures. It is essentially the opposite of a callable bond.

A convertible bond can be converted to common stock in a one-way, one-time conversion. Under what conditions would it make sense to convert? Suppose the face-value interest rate of the bond is 8%. If the company is doing well this year, such that there is an expectation that shareholders will receive a significant dividend and the stock price will rise, the stock might appear to be more valuable than the return on the bond.

Think It Through

Callable versus Putable Bonds

Which type of bond is better for the corporation issuing the bond: callable or putable?

Ethical Considerations

Junk Bonds

Junk bonds, which are also called speculative or high-yield bonds, are a specific type of bond that can be attractive to certain investors. On one hand, junk bonds are attractive because the bonds pay a rate of interest that is significantly higher than the average market rate. On the other hand, the bonds are riskier because the issuing company is deemed to have a higher risk of defaulting on the bonds. If the economy or the company’s financial condition deteriorates, the company will be unable to repay the money borrowed. In short, junk bonds are deemed to be high risk, high reward investments.

The development of the junk bond market, which occurred during the 1970s and 1980s, is attributed to Michael Milken, the so-called "junk bond king". Milken amassed a large fortune by using junk bonds as a means of financing corporate mergers and acquisitions. It is estimated that during the 1980s, Milken earned between $200 million and $550 million per year. In 1990, however, Milken’s winning streak came to an end when, according to the New York Times, he was indicted on "98 counts of racketeering, securities fraud, mail fraud and other crimes". He later pleaded guilty to six charges, resulting in a 10-year prison sentence, of which he served two, and was as also forced to pay over $600 million in fines and settlements.

Today, Milken remains active in philanthropic activities and, as a cancer survivor, remains committed to medical research.

Pricing Bonds

Imagine a concert-goer who has an extra ticket for a good seat at a popular concert that is sold out. The concert-goer purchased the ticket from the box office at its face value of $100. Because the show is sold out, the ticket could be resold at a premium. But what happens if the concert-goer paid $100 for the ticket and the show is not popular and does not sell out? To convince someone to purchase the ticket from her instead of the box office, the concert-goer will need to sell the ticket at a discount. Bonds behave in the same way as this concert ticket.

Bond quotes can be found in the financial sections of newspapers or on the Internet on many financial websites. Bonds are quoted as a percentage of the bond’s maturity value. The percentage is determined by dividing the current market (selling) price by the maturity value, and then multiplying the value by 100 to convert the decimal into a percentage. In the case of a $30,000 bond discounted to $27,591.94 because of an increase in the market rate of interest, the bond quote would be $27,591.24/$30,000 × 100, or 91.9708. Using another example, a quote of 88.50 would mean that the bonds in question are selling for 88.50% of the maturity value. If an investor were considering buying a bond with a $10,000 maturity value, the investor would pay 88.50% of the maturity value of $10,000, or $8,850.00. If the investor was considering bonds with a maturity value of $100,000, the price would be $88,500. If the quote were over 100, this would indicate that the market interest rate has decreased from its initial rate. For example, a quote of 123.45 indicates that the investor would pay $123,450 for a $100,000 bond.

Figure 13.4 shows a bond issued on July 1, 2018. It is a promise to pay the holder of the bond $1,000 on June 30, 2023, and 5% of $1,000 every year. We will use this bond to explore how a company addresses interest rate changes when issuing bonds.

Figure 13.4 Bond Certificate. A bond certificate shows the terms of the bond. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

On this bond certificate, we see the following:

• The $1,000 principal or maturity value.
• The interest rate printed on the face of the bond is the stated interest rate, the contract rate, the face rate, or the coupon rate. This rate is the interest rate used to calculate the interest payment on bonds.

Issuing Bonds When the Contract and Market Rates Are the Same

If the stated rate and the market rate are both 5%, the bond will be issued at part value, which is the value assigned to stock in the company’s charter, typically set at a very small arbitrary amount, which serves as legal capital; in our example, the part value is $1,000. The purchaser will give the company $1,000 today and will receive $50 at the end of every year for 5 years. In 5 years, the purchaser will receive the maturity value of the $1,000. The bond’s quoted price is 100.00. That is, the bond will sell at 100% of the $1,000 face value, which means the seller of the bond will receive (and the investor will pay) $1,000.00. You will learn the calculations used to determine a bond’s quoted price later; here, we will provide the quoted price for any calculations.

Link to Learning

The Securities and Exchange Commission website Investor.gov provides an explanation of corporate bonds to learn more.

Issuing Bonds at a Premium

The stated interest rate is not the only rate affecting bonds. There is also the market interest rate, also called the effective interest rate or bond yield. The amount of money that borrowers receive on the date the bonds are issued is influenced by the terms stated on the bond indenture and on the market interest rate, which is the rate of interest that investors can earn on similar investments. The market interest rate is influenced by many factors external to the business, such as the overall strength of the economy, the value of the U.S. dollar, and geopolitical factors.

This market interest rate is the rate determined by supply and demand, the current overall economic conditions, and the credit worthiness of the borrower, among other factors. Suppose that, while a company has been busy during the long process of getting its bonds approved and issued (it might take several months), the interest rate changed because circumstances in the market changed. At this point, the company cannot change the rate used to market the bond issue. Instead, the company might have to sell the bonds at a price that will be the equivalent of having a different stated rate (one that is equivalent to a market rate based on the company’s financial characteristics at the time of the issuance (sale) of the bonds).

If the company offers 5% (the bond rate used to market the bond issue) and the market rate prior to issuance drops to 4%, the bonds will be in high demand. The company is scheduled to pay a higher interest rate than everyone else, so it can issue them for more than face value, or at a premium. In this example, where the stated interest rate is higher than the market interest rate, let’s say the bond’s quoted price is 104.46. That is, the bond will sell at 104.46% of the $1,000 face value, which means the seller of the bond will receive and the investor will pay $1,044.60.

Issuing Bonds at a Discount

Now let’s consider a situation when the company’s bonds prior to issuance are scheduled to pay 5% and the market rate jumps to 7% at issuance. No one will want to buy the bonds at 5% when they can earn more interest elsewhere. The company will have to sell the $1,000 bond for less than $1,000, or at a discount. In this example, where the stated interest rate is lower than the market interest rate, the bond’s quoted price is 91.80. That is, the bond will sell at 91.80% of the $1,000 face value, which means the seller of the bond will receive (and the investor will pay) $918.00.

Sale of Bonds before Maturity

Let’s look at bonds from the perspective of the issuer and the investor. As we previously discussed, bonds are often classified as long-term liabilities because the money is borrowed for long periods of time, up to 30 years in some cases. This provides the business with the money necessary to fund long-term projects and investments in the business. Due to unanticipated circumstances, the investors, on the other hand, may not want to wait up to 30 years to receive the maturity value of the bond. While the investor will receive periodic interest payments while the bond is held, investors may want to receive the current market value prior to the maturity date. Therefore, from the investor’s perspective, one of the advantages of investing in bonds is that they are typically easy to sell in the secondary market should the investor need the money before the maturity date, which may be many years in the future. The secondary market is an organized market where previously issued stocks and bonds can be traded after they are issued.

If a bond sells on the secondary market after it has been issued, the terms of the bond (a particular interest rate, at a determined time frame, and a given maturity value) do not change. If an investor buys a bond after it is issued or sells it before it matures, there is the possibility that the investor will receive more or less for the bond than the amount the bond was originally sold for. This change in value may occur if the market interest rate differs from the stated interest rate.

Continuing Application

Debt Considerations for Grocery Stores

Every company faces internal decisions when it comes to borrowing funds for improvements and/or expansions. Consider the improvements your local grocery stores have made over the past couple of years. Just like any large retail business, if grocery stores don’t invest in each property by adding services, upgrading the storefront, or even making more energy efficient changes, the location can fall out of popularity.

Such investments require large amounts of capital infusion. The primary available investment funds for privately-owned grocery chains are bank loans or owners’ capital. This limitation often restricts the expansions or upgrades such a company can do at any one time. Publicly-traded grocery chains can also borrow funds from a bank, but other options, like issuing bonds or more stock can also help fund development. Thus publicly-traded grocery chains have more options to fund improvements and can therefore expand their share of the market more easily, unlike their private smaller counterparts who must decide what improvement is the most critical.

Fundamentals of Interest Calculation

Since interest is paid on long-term liabilities, we now need to examine the process of calculating interest. Interest can be calculated in several ways, some more common than others. For our purposes, we will explore interest calculations using the simple method and the compounded method. Regardless of the method involved, there are three components that we need when calculating interest:

1. Amount of money borrowed (called the principal).
2. Interest rate for the time frame of the loan. Note that interest rates are usually stated in annual terms (e.g., 8% per year). If the timeframe is excluded, an annual rate should be assumed. Pay particular attention to how often the interest is to be paid because this will affect the rate used in the calculation:




For example, if the rate on a bond is 6% per year but the interest is paid semi-annually, the rate used in the interest calculation should be 3% because the interest applies to a 6-month timeframe (6% ÷ 2). Similarly, if the rate on a bond is 8% per year but the interest is paid quarterly, the rate used in the interest calculation should be 2% (8% ÷ 4).

Let’s explore simple interest first. We use the following formula to calculate interest in dollars:

Principal is the amount of money invested or borrowed, interest rate is the interest rate paid or earned, and time is the length of time the principal is borrowed or invested. Consider a bank deposit of $100 that remains in the account for 3 years, earning 6% per year with the bank paying simple interest. In this calculation, the interest rate is 6% a year, paid once at the end of the year. Using the interest rate formula from above, the interest rate remains 6% (6% ÷ 1). Using 6% interest per year earned on a $100 principal provides the following results in the first three years (Figure 13.5):

• Year 1: The $100 in the bank earns 6% interest, and at the end of the year, the bank pays $6.00 in interest, making the amount in the bank account $106 ($100 principal + $6 interest).
• Year 2: Assuming we do not withdraw the interest, the $106 in the bank earns 6% interest on the principal ($100), and at the end of the year, the bank pays $6 in interest, making the total amount $112.
• Year 3: Again, assuming we do not withdraw the interest, $112 in the bank earns 6% interest on the principal ($100), and at the end of the year, the bank pays $6 in interest, making the total amount $118.

Figure 13.5 Simple Interest. Simple interest earns money only on the principal. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

With simple interest, the amount paid is always based on the principal, not on any interest earned.

Another method commonly used for calculating interest involves compound interest. Compound interest means that the interest earned also earns interest. Figure 13.6 shows the same deposit with compounded interest.

Figure 13.6 Compound Interest. Compound interest earns money on the principal plus interest earned in a previous period. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

In this case, investing $100 today in a bank that pays 6% per year for 3 years with compound interest will produce $119.10 at the end of the three years, instead of $118.00, which was earned with simple interest.

At this point, we need to provide an assumption we make in this chapter. Since financial institutions typically cannot deal in fractions of a cent, in calculations such as the above, we will round the final answer to the nearest cent, if necessary. For example, the final cash total at the end of the third year in the above example would be $119.1016. However, we rounded the answer to the nearest cent for convenience. In the case of a car or home loan, the rounding can lead to a higher or lower adjustment in your final payment. For example, you might finance a car loan by borrowing $20,000 for 48 months with monthly payments of $469.70 for the first 47 months and $469.74 for the final payment.

Link to Learning

Go to the Securities and Exchange Commission website for an explanation of US Savings Bonds to learn more.

1.2. Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method

In our discussion of long-term debt amortization, we will examine both notes payable and bonds. While they have some structural differences, they are similar in the creation of their amortization documentation.

Pricing of Long-Term Notes Payable

When a consumer borrows money, she can expect to not only repay the amount borrowed, but also to pay interest on the amount borrowed. When she makes periodic loan payments that pay back the principal and interest over time with payments of equal amounts, these are considered fully amortized notes. In these timed payments, part of what she pays is interest. The amount borrowed that is still due is often called the principal. After she has made her final payment, she no longer owes anything, and the loan is fully repaid, or amortized. Amortization is the process of separating the principal and interest in the loan payments over the life of a loan. A fully amortized loan is fully paid by the end of the maturity period.

In the following example, assume that the borrower acquired a five-year, $10,000 loan from a bank. She will repay the loan with five equal payments at the end of the year for the next five years. The bank’s required interest rate is an annual rate of 12%.

Interest rates are typically quoted in annual terms. Since her interest rate is 12% a year, the borrower must pay 12% interest each year on the principal that she owes. As stated above, these are equal annual payments, and each payment is first applied to any applicable interest expenses, with the remaining funds reducing the principal balance of the loan.

After each payment in a fully amortizing loan, the principal is reduced, which means that since the five payment amounts are equal, the portion allocated to interest is reduced each year, and the amount allocated to principal reduction increases an equal amount.

We can use an amortization table, or schedule, prepared using Microsoft Excel or other financial software, to show the loan balance for the duration of the loan. An amortization table calculates the allocation of interest and principal for each payment and is used by accountants to make journal entries. These journal entries will be discussed later in this chapter.

The first step in preparing an amortization table is to determine the annual loan payment. The $10,000 loan amount is the value today and, in financial terms, is called the present value (PV). Since repayment will be in a series of five equal payments, it is an annuity. Look up the PV from an annuity table for 5 periods and 12% interest. The factor is 3.605. Dividing the principal, $10,000, by the factor 3.605 gives us $2,773.93, which is the amount of each yearly payment. For the rest of the chapter, we will provide the necessary data, such as bond prices and payment amounts; you will not need to use the present value tables.

When the first payment is made, part of it is interest and part is principal. To determine the amount of the payment that is interest, multiply the principal by the interest rate ($10,000 × 0.12), which gives us $1,200. This is the amount of interest charged that year. The payment itself ($2,773.93) is larger than the interest owed for that period of time, so the remainder of the payment is applied against the principal.

Figure 13.7 shows an amortization table for this $10,000 loan, over five years at 12% annual interest. Assume that the final payment will be $2,774.99 in order to eliminate the potential rounding error of $1.06.

Figure 13.7 Amortization Table. An amortization table shows how payments are applied to interest in principal for the life of the loan. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Your Turn

Creating Your Own Amortization Table

You want to borrow $100,000 for five years when the interest rate is 5%. You will make yearly payments of $23,097.48 for 5 years. Fill in the blanks in the amortization table below. Assume that the loan was created on January 1, 2018 and totally repaid by December 31, 2022, after five equal, annual payments.

Solution

Multiply the $100,000 by the 5% interest rate and $5,000 is the amount of interest you owe for year 1. Subtract the interest from the payment of $23,097.48 to find $18,097.48 is applied toward the principal ($100,000), leaving $81,902.52 as the ending balance. In year 2, $81,902.52 is charged 5% interest ($4,095.13), but the rest of the 23,097.48 payment goes toward the loan balance. Follow the same process for years 3 through 5.

Bonds Payable

As you’ve learned, each time a company issues an interest payment to bondholders, amortization of the discount or premium, if one exists, impacts the amount of interest expense that is recorded. Amortization of the discounts increases the amount of interest expense and premiums reduce the amount of interest expense. There are two methods used to amortize bond discounts or premiums: the effective-interest method and the straight-line method.

Our calculations have used what is known as the effective-interest method, a method that calculates interest expense based on the carrying value of the bond and the market interest rate. Generally accepted accounting principles (GAAP) require the use of the effective-interest method unless there is no significant difference between the effective-interest method and the straight-line method, a method that allocates the same amount of the bond discount or premium for each interest payment. The effective interest amortization method is more accurate than the straight-line method. International Financial Reporting Standards (IFRS) require the use of the effective-interest method, with no exceptions.

The straight-line method doesn’t base its calculation of amortization for a period based on a changing carrying value like the effective-interest method does; instead, it allocates the same amount of premium or discount amortization for each of the bond’s payment periods.

For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of payments, in this case four, giving a $10,000 per year amortization of the premium. Figure 13.8 shows the effects of the premium amortization after all of the 2019 transactions are considered. The net effect of creating the $40,000 premium and writing off $10,000 of it gives the company an interest expense of $40,000 instead of $50,000, since the $50,000 expense is reduced by the $10,000 premium write down at the end of the year.

Figure 13.8 Premium Amortization Using the Straight-Line Method. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Issued When Market Rate Equals Contract Rate

Assume a company issues a $100,000 bond with a 5% stated rate when the market rate is also 5%. The bond was issued at par, meaning it sold for $100,000. There was no premium or discount to amortize, so there is no application of the effective-interest method in this example.

Issued at a Premium

The same company also issued a 5-year, $100,000 bond with a stated rate of 5% when the market rate was 4%. This bond was issued at a premium, for $104,460. The amount of the premium is $4,460, which will be amortized over the life of the bond using the effective-interest method. This method of amortizing the interest expense associated with a bond is similar to the amortization of the note payable described earlier, in which the principal was separated from the interest payments using the interest rate times the principal.

Begin by assuming the company issued all the bonds on January 1 of year 1 and the first interest payment will be made on December 31 of year 1. The amortization table begins on January 1, year 1, with the carrying value of the bond: the face value of the bond plus the bond premium.

On December 31, year 1, the company will have to pay the bondholders $5,000 (0.05 × $100,000). The cash interest payment is the amount of interest the company must pay the bondholder. The company promised 5% when the market rate was 4% so it received more money. But the company is only paying interest on $100,000—not on the full amount received. The difference in the sale price was a result of the difference in the interest rates so both rates are used to compute the true interest expense.

The interest on the carrying value is the market rate of interest times the carrying value: 0.04 × $104,460 = $4,178. If the company had issued the bonds with a stated rate of 4%, and received $104,460, it would be paying $4,178 in interest. The difference between the cash interest payment and the interest on the carrying value is the amount to be amortized the first year. The complete amortization table for the bond is shown in Figure 13.9. The table is necessary to provide the calculations needed for adjusting the journal entries.

Figure 13.9 Bond Amortization Table. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Issued at a Discount

The company also issued $100,000 of 5% bonds when the market rate was 7%. It received $91,800 cash and recorded a Discount on Bonds Payable of $8,200. This amount will need to be amortized over the 5-year life of the bonds. Using the same format for an amortization table, but having received $91,800, interest payments are being made on $100,000.

The cash interest payment is still the stated rate times the principal. The interest on carrying value is still the market rate times the carrying value. The difference in the two interest amounts is used to amortize the discount, but now the amortization of the discount amount is added to the carrying value.

Figure 13.10 illustrates the relationship between rates whenever a premium or discount is created at bond issuance.

Figure 13.10 Stated Rate and Market Rate. When the stated rate is higher than the market rate, the bond is issued at a premium. When the stated rate is lower than the market rate, the bond is issued at a discount. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Concepts In Practice

Bond Ratings

Investors intending to purchase corporate bonds may find it overwhelming to decide which company would be the best to invest in. Investors are concerned with two primary factors: the return on the investment (meaning, the periodic interest payments) and the return of the investment (meaning, payment of the face value on the maturity date). While there are risks with any investment, attempting to maximize the return on the investment and maximizing the likelihood of receiving the return of the investment would take a significant amount of time for the investor. To become informed and make a wise investment, the investor would have to spend many hours analyzing the financial statements of potential companies to invest in.

One resource investors find useful when screening investment opportunities is through the use of rating agencies. Rating agencies specialize in analyzing financial and other company information in order to assess and rate a company’s riskiness as an investment. A particularly useful website is Investopedia which highlights the rating system for three large rating agencies—Moody’s, Standard & Poor’s, and Fitch Ratings. The rating systems, shown below, are somewhat similar to academic grading scales, with rankings ranging from A (highest quality) to D (lowest quality):

Rating Agencies

Credit Risk	Moody's	Standard & Poor's	Fitch Ratings
Investment Grade	__	__	__
Highest Quality	Aaa	AAA	AAA
High Quality	Aa1, Aa2, Aa3	AA+, AA, AA-	AA+, AA, A-
Upper Medium	A1, A2, A3	A+, A, A-	A+, A, A-
Medium	Baa1, Baa2, Baa3	BBB+, BBB, BBB-	BBB+, BBB, BBB-
Not Investment Grade	Ba1	BB+	BB+
Speculative Medium	Ba2, Ba3	BB, BB-	BB, BB-
Speculative Lower Grade	B1, B2, B3	B+, B, B-	B+, B, B-
Speculative Risky	Caa1	CCC+	CCC
Speculative Poor Standing	Caa2, Caa3	CCC, CCC-	__
No Payments / Bankruptcy	Ca / C	__	__
In Default	__	D	DDD, DD, D

Table 13.1

1.3. Prepare Journal Entries to Reflect the Life Cycle of Bonds

Recall from the discussion in Explain the Pricing of Long-Term Liabilities that one way businesses can generate long-term financing is by borrowing from lenders.

In this section, we will explore the journal entries related to bonds. Earlier, we found that cash flows related to a bond include the following:

1. The receipt of cash when the bond is issued
2. Payment of interest each period
3. Repayment of the bond at maturity

A journal entry must be made for each of these transactions. As we go through the journal entries, it is important to understand that we are analyzing the accounting transactions from the perspective of the issuer of the bond. These are considered long-term liabilities. The investor would make the opposite journal entries. For example, on the issue date of a bond, the borrower receives cash while the lender pays cash.

A final point to consider relates to accounting for the interest costs on the bond. Recall that the bond indenture specifies how much interest the borrower will pay with each periodic payment based on the stated rate of interest. The periodic interest payments to the buyer (investor) will be the same over the course of the bond. It may help to think of personal loan examples. For example, if you or your family have ever borrowed money from a bank for a car or home, the payments are typically the same each month. The interest payments will be the same because of the rate stipulated in the bond indenture, regardless of what the market rate does. The amount of interest cost that we will recognize in the journal entries, however, will change over the course of the bond term, assuming that we are using the effective interest.

IFRS Connection

Defining Long-Term Liabilities

Under both IFRS and US GAAP, the general definition of a long-term liability is similar. However, there are many types of long-term liabilities, and various types have specific measurement and reporting criteria that may differ between the two sets of accounting standards. With two exceptions, bonds payable are primarily the same under the two sets of standards.

The first difference pertains to the method of interest amortization. Beyond FASB’s preferred method of interest amortization discussed here, there is another method, the straight-line method. This method is permitted under US GAAP if the results produced by its use would not be materially different than if the effective-interest method were used. IFRS does not permit straight-line amortization and only allows the effective-interest method.

The second difference pertains to how the bonds are reported on the books. Under US GAAP, bonds are recorded at face value and the premium or discount is recorded in a separate account. IFRS does not use "premium" or "discount" accounts. Instead, under IFRS, the carrying value of bonds issued at either a premium or discount is shown on the balance sheet at its net. For example, $100,000 bonds issued at a discount of $4,000 would be recorded under US GAAP as

Under IFRS, these bonds would be reported as

Obviously, the above example implies that, in the subsequent entries to recognize interest expense, under IFRS, the Bonds Payable account is amortized directly for the increase or reduction in bond principal. Suppose in this example that the cash interest was $200 and the interest expense for the first interest period was $250. The entry to record the transaction under the two different standards would be as follows:

Under US GAAP:

Under IFRS:

Note that under either method, the interest expense and the carrying value of the bonds stays the same.

Issuance of Bonds

Since the process of underwriting a bond issuance is lengthy and extensive, there can be several months between the determination of the specific characteristics of a bond issue and the actual issuance of the bond. Before the bonds can be issued, the underwriters perform many time-consuming tasks, including setting the bond interest rate. The bond interest rate is influenced by specific factors relating to the company, such as existing debt balances and the ability of the company to repay the funds, as well as the market rate, which is influenced by many external economic factors.

Because of the time lag caused by underwriting, it is not unusual for the market rate of the bond to be different from the stated interest rate. The difference in the stated rate and the market rate determine the accounting treatment of the transactions involving bonds. When the bond is issued at par, the accounting treatment is simplest. It becomes more complicated when the stated rate and the market rate differ.

Issued When Market Rate Equals Contract Rate

First, we will explore the case when the stated interest rate is equal to the market interest rate when the bonds are issued.

Returning to our example of a $1,000, 5-year bond with a stated interest rate of 5%, at issuance, the market rate was 5% and the sales price was quoted at 100, which means the seller of the bond will receive (and the investor will pay) 100% of the $1,000 face value of the bond. The journal entry to record the sale of 100 of these bonds is:

Since the book value is equal to the amount that will be owed in the future, no other account is included in the journal entry.

Issued at a Premium

If, during the timeframe of establishing the bond stated rate and issuing the bonds, the market rate drops below the stated interest, the bonds would become more valuable. In other words, the investors will earn a higher rate on these bonds than if the investors purchased similar bonds elsewhere in the market. Naturally, investors would want to purchase these bonds and earn a higher interest rate. The increased demand drives up the bond price to a point where investors earn the same interest as similar bonds. Earlier, we found that the sale price of a $1,000, 5-year bond with a stated rate of 5% and a market rate of 4% is 104.46. That is, the bond will sell at 104.46% of the $1,000 face value, which means the seller of the bond will receive (and the investor will pay) $1,044.60.

Selling 100 of these bonds would yield $104,460.

The financial statement presentation looks like this:

On the date that the bonds were issued, the company received cash of $104,460.00 but agreed to pay $100,000.00 in the future for 100 bonds with a $1,000 face value. The difference in the amount received and the amount owed is called the premium. Since they promised to pay 5% while similar bonds earn 4%, the company received more cash up front. In other words, they sold the bond at a premium. They did this because the cost of the premium plus the 5% interest on the face value is mathematically the same as receiving the face value but paying 4% interest. The interest rate was effectively the same.

The premium on a bonds payable account is a contra liability account. It is contra because it increases the amount of the Bonds Payable liability account. It is "married" to the Bonds Payable account on the balance sheet. If one of the accounts appears, both must appear. The Premium will disappear over time as it is amortized, but it will decrease the interest expense, which we will see in subsequent journal entries.

Taken together, the Bond Payable liability of $100,000 and the Premium on Bond Payable contra liability of $4,460 show the bond’s carrying value or book value-the value that assets or liabilities are recorded at in the company’s financial statements.

The effect on the accounting equation looks like this:

It looks like the issuer will have to pay back $104,460, but this is not quite true. If the bonds were to be paid off today, the full $104,460 would have to be paid back. But as time passes, the Premium account is amortized until it is zero. The bondholders have bonds that say the issuer will pay them $100,000, so that is all that is owed at maturity. The premium will disappear over time and will reduce the amount of interest incurred.

Issued at a Discount

Bonds issued at a discount are the exact opposite in concept as bonds issued at a premium. If, during the timeframe of establishing the bond stated rate and issuing the bonds, the market rate rises above the stated interest on the bonds, the bonds become less valuable because investors can earn a higher rate of interest on other similar bonds. In other words, the investors will earn a lower rate on these bonds than if the investors purchased similar bonds elsewhere in the market. Naturally, investors would not want to purchase these bonds and earn a lower interest rate than could be earned elsewhere. The decreased demand drives down the bond price to a point where investors earn the same interest for similar bonds. Earlier, we found the sale price of a $1,000, 5-year bond with a stated interest rate of 5% and a market rate of 7% is 91.80. That is, the bond will sell at 91.80% of the $1,000 face value, which means the seller of the bond will receive (and the investor will pay) $918.00. On selling 100 of the $1,000 bonds today, the journal entry would be:

Today, the company receives cash of $91,800.00, and it agrees to pay $100,000.00 in the future for 100 bonds with a $1,000 face value. The difference in the amount received and the amount owed is called the discount. Since they promised to pay 5% while similar bonds earn 7%, the company accepted less cash up front. In other words, they sold the bond at a discount. They did this because giving a discount but still paying only 5% interest on the face value is mathematically the same as receiving the face value but paying 7% interest. The interest rate was effectively the same.

Like the Premium on Bonds Payable account, the discount on bonds payable account is a contra liability account and is "married" to the Bonds Payable account on the balance sheet. The Discount will disappear over time as it is amortized, but it will increase the interest expense, which we will see in subsequent journal entries.

The effect on the accounting equation looks like this:

First and Second Semiannual Interest Payment

When a company issues bonds, they make a promise to pay interest annually or sometimes more often. If the interest is paid annually, the journal entry is made on the last day of the bond’s year. If interest was promised semiannually, entries are made twice a year.

Concepts In Practice

Municipal Bonds

Municipal bonds are a specific type of bonds that are issued by governmental entities such as towns and school districts. These bonds are issued in order to finance specific projects (such as water treatment plants and school building construction) that require a large investment of cash. The primary benefit to the issuing entity (i.e., the town or school district) is that cash can be obtained more quickly than, for example, collecting taxes and fees over a long period of time. This allows the project to be completed sooner, which is a benefit to the community.

Municipal bonds, like other bonds, pay periodic interest based on the stated interest rate and the face value at the end of the bond term. However, corporate bonds often pay a higher rate of interest than municipal bonds. Despite the lower interest rate, one benefit of municipal bonds relates to the tax treatment of the periodic interest payments for investors. With corporate bonds, the periodic interest payments are considered taxable income to the investor. For example, if an investor receives $1,000 of interest and is in the 25% tax bracket, the investor will have to pay $250 of taxes on the interest, leaving the investor with an after-tax payment of $750. With municipal bonds, interest payments are exempt from federal tax. So the same investor receiving $1,000 of interest from a municipal bond would pay no income tax on the interest income. This tax-exempt status of municipal bonds allows the entity to attract investors and fund projects more easily.

Interest Payment: Issued When Market Rate Equals Contract Rate

Recall that the Balance Sheet presentation of the bond when the market rate equals the stated rate is as follows:

In this example, the company issued 100 bonds with a face value of $1,000, a 5-year term, and a stated interest rate of 5% when the market rate was 5% and received $100,000. As previously discussed, since the bonds were sold when the market rate equals the stated rate, the carrying value of the bonds is $100,000. These bonds did not specify when interest was paid, so we can assume that it is an annual payment. If the bonds were issued on January 1, the company would pay interest on December 31 and the journal entry would be:

The interest expense is calculated by taking the Carrying Value ($100,000) multiplied by the market interest rate (5%). The stated rate is used when calculating the interest cash payment. The company is obligated by the bond indenture to pay 5% per year based on the face value of the bond. When the situation changes and the bond is sold at a discount or premium, it is easy to get confused and incorrectly use the market rate here. Since the market rate and the stated rate are the same in this example, we do not have to worry about any differences between the amount of interest expense and the cash paid to bondholders. This journal entry will be made every year for the 5-year life of the bond.

When performing these calculations, the rate is adjusted for more frequent interest payments. If the company had issued 5% bonds that paid interest semiannually, interest payments would be made twice a year, but each interest payment would only be half an annual interest payment. Earning interest for a full year at 5% annually is the equivalent of receiving half of that amount each six months. So, for semiannual payments, we would divide 5% by 2 and pay 2.5% every six months.

Concepts In Practice

Mortgage Debt

According to Statista the amount of mortgage debt-debt incurred to purchase homes in the United States was $14.9 trillion in 2017. This value does not include the interest cost-the cost of borrowing-related to the debt.

A common loan term for those borrowing money to buy a house is 30 years. Each month, the borrower must make payments on the loan, which would add up to 360 payments for a 30-year loan. Recall from previous discussions on amortization that each payment can be divided into two components: the interest expense and the amount that is applied to reduce the principal.

In order to calculate the amount of interest and principal reduction for each payment, banks and borrowers often use amortization tables. While amortization tables are easily created in Microsoft Excel or other spreadsheet applications, there are many websites that have easy-to-use amortization tables. The popular lending website Zillow has a loan calculator to calculate the monthly payments of a loan as well as an amortization table that shows how much interest and principal reduction is applied for each payment.

For example, borrowing $200,000 for 30 years at an interest rate of 5% would require the borrower to repay a total $386,513. The monthly payment on this loan is $1,073.64. This amount represents the $200,000 borrowed and $186,513 of interest cost. If the borrower chose a 15-year loan, the total payments drop significantly to $266,757, but the monthly payments increase to $1,581.59.

Because interest is calculated based on the outstanding loan balance, the amount of interest paid in the first payment is much more than the amount of interest in the final payment. The pie charts below show the amount of the $1,073.64 payment allocated to interest and loan reduction for the first and final payments, respectively, on the 30-year loan.

Interest Payment: Issued at a Premium

Recall that the Balance Sheet presentation of the bond when the market rate at issue is lower than the stated rate is as follows:

In this scenario, the sale price of a $1,000, 5-year bond with a stated rate of 5% and a market rate of 4% was $1,044.60. If the company sold 100 of these bonds, it would receive $104,460 and the journal entry would be:

Again, let’s assume that the bonds pay interest annually. At the end of the bond’s year, we would record the interest expense:

The interest expense determination is calculated using the effective interest amortization interest method. Under the effective-interest method, the interest expense is calculated by taking the Carrying (or Book) Value ($104,460) multiplied by the market interest rate (4%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate.

Since the market rate and the stated rate are different, we need to account for the difference between the amount of interest expense and the cash paid to bondholders. The amount of the premium amortization is simply the difference between the interest expense and the cash payment. Another way to think about amortization is to understand that, with each cash payment, we need to reduce the amount carried on the books in the Bond Premium account. Since we originally credited Bond Premium when the bonds were issued, we need to debit the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the company received more for the bonds than face value, but it is only paying interest on $100,000.

The partial effect of the first period’s interest payment on the company’s accounting equation in year one is:

And the financial-statement presentation at the end of year 1 is:

The journal entry for year 2 is:

The interest expense is calculated by taking the Carrying (or Book) Value ($103,638) multiplied by the market interest rate (4%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate (5%). Since the market rate and the stated rate are different, we again need to account for the difference between the amount of interest expense and the cash paid to bondholders.

The partial effect on the accounting equation in year two is:

And the financial-statement presentation at the end of year 2 is:

By the end of the 5th year, the bond premium will be zero, and the company will only owe the Bonds Payable amount of $100,000.

Link to Learning

A mortgage calculator provides monthly payment estimates for a long-term loan like a mortgage. To use the calculator, enter the cost of the house to be purchased, the amount of cash to be borrowed, the number of years over which the mortgage is to be paid back (generally 30 years), and the current interest rate. The calculator returns the amount of the mortgage payment. Mortgages are long-term liabilities that are used to finance real estate purchases. We tend to think of them as home loans, but they can also be used for commercial real estate purchases.

Interest Payment: Issued at a Discount

Recall that the Balance Sheet presentation of the bond when the market rate at issue was higher than the stated rate is as follows:

We found the sale price of a $1,000, 5-year bond with a stated interest rate of 5% and a market rate of 7% was $918.00. We then showed the journal entry to record sale of 100 bonds:

At the end of the bond’s first year, we make this journal entry:

The interest expense is calculated by taking the Carrying Value ($91,800) multiplied by the market interest rate (7%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) and multiplying it by the stated rate (5%). Since the market rate and the stated rate are different, we need to account for the difference between the amount of interest expense and the cash paid to bondholders. The amount of the discount amortization is simply the difference between the interest expense and the cash payment. Since we originally debited Bond Discount when the bonds were issued, we need to credit the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the company received less for the bonds than face value but is paying interest on the $100,000.

The partial effect on the accounting equation in year one is:

And the financial-statement presentation at the end of year 1 is:

The journal entry for year 2 is:

The interest expense is calculated by taking the Carrying Value ($93,226) multiplied by the market interest rate (7%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate (5%). Again, we need to account for the difference between the amount of interest expense and the cash paid to bondholders by crediting the Bond Discount account.

The partial effect on the accounting equation in year two is:

And the financial statement presentation at the end of year 2 is:

By the end of the 5th year, the bond premium will be zero and the company will only owe the Bonds Payable amount of $100,000.

Retirement of Bonds When the Bonds Were Issued at Par

At some point, a company will need to record bond retirement, when the company pays the obligation. Often, they will retire bonds when they mature. For example, earlier we demonstrated the issuance of a five-year bond, along with its first two interest payments. If we had carried out recording all five interest payments, the next step would have been the maturity and retirement of the bond. At this stage, the bond issuer would pay the maturity value of the bond to the owner of the bond, whether that is the original owner or a secondary investor.

This example demonstrates the least complicated method of a bond issuance and retirement at maturity. There are other possibilities that can be much more complicated and beyond the scope of this course. For example, a bond might be callable by the issuing company, in which the company may pay a call premium paid to the current owner of the bond. Also, a bond might be called while there is still a premium or discount on the bond, and that can complicate the retirement process. Situations like these will be addressed in later accounting courses.

To continue with our example, assume that the company issued 100 bonds with a face value of $1,000, a 5-year term, and a stated interest rate of 5% when the market rate was 5% and received $100,000. It was recorded in this way:

At the end of 5 years, the company will retire the bonds by paying the amount owed. To record this action, the company would debit Bonds Payable and credit Cash. Remember that the bond payable retirement debit entry will always be the face amount of the bonds since, when the bond matures, any discount or premium will have been completely amortized.