Lecture: Long-Term Liabilities
Lecture script · about 15–20 minutes spoken · Week 13
Opening
Picture three borrowers. A repair shop wants to expand. A farm cooperative needs a new harvester. A city wants a new school. None of them can pay for it out of one year's cash, and none of them wants to wait. So each one borrows for years. This lecture is about how a business records that kind of debt, and why lenders sometimes pay less, or more, than they will get back.
Let me remind you where we are. In Week 5 you split the balance sheet into current and long-term sections. In Week 11 you spread the van's cost evenly with the straight-line method. And in Week 12 you recorded a note payable from the borrower's side, plus the current portion of long-term debt.
Here's the plan. Our bicycle shop, the illustrative running case, needs $100,000 for five years. It's going to issue bonds. We'll read the bond's terms, price it, and record it three ways: at face, at a discount, and at a premium. We'll follow each period's interest, meet the effective-interest method and the installment note in words, and finish on the balance sheet. I'll stop along the way so you can check yourself.
1. What a bond is
Think about the city and its school again. No single bank wants to lend the whole cost. So the city sells thousands of small, identical promises to repay, with interest, and anyone can buy one. A business can do exactly the same thing.
That promise is a bond: a long-term note that a business or a government issues to many lenders at once, promising interest every period and the face value at maturity. The lenders who buy it are the bondholders. And the borrower records what it owes in Bonds Payable, the long-term liability account for the face value of the bonds it has issued.
So after its expansion, the shop issues $100,000 of bonds due in five years. It owes the money for years, not months. That makes Bonds Payable a long-term liability, not a current one.
Pause and try this. A friend says the shop sold a piece of itself to the bondholders. Is a bondholder an owner?
Think about what the shop owes them.
Here's the answer. No, a bondholder is a lender. The shop owes bondholders interest and their money back, and nothing more; owners come next week.
2. Reading the four terms
Every promise has terms, and a bond has four you need. Three are printed on the bond. The fourth is set by the market on the day it's sold.
The face value, also called par value, is the amount the bond promises to repay at maturity. For the shop, that's $100,000. The stated rate, also called the contract rate, is the annual rate printed in the bond's terms, and it sets the cash interest. The shop's stated rate is 6 percent a year. The maturity date is the day the face value is due. And the market rate is the return investors require on bonds like these on the day the bonds are sold.
The shop's bonds pay interest semiannually, twice a year. So each half-year is one period. The cash interest each period is $100,000 times 6 percent, divided by 2, which is $3,000. Five years at two periods a year gives 10 periods, and the $100,000 is due at the end of the 10th.
Here's the sentence I want you to carry all week. The stated rate sets the cash; the market rate sets the price.
Pause and try this. If the shop sells these bonds for less than $100,000, does its cash interest each period change?
Look at what the cash interest is figured on.
Here's the answer. No, it stays $3,000. Cash interest always comes from the face value times the stated rate, whatever the bonds sold for.
3. Pricing a bond by its present value
Suppose a friend offers to pay you a sum of money a year from now. Would you hand over that same sum right now? Probably not. Money you hold now can earn something, so you'd pay a little less for money that arrives later.
That idea is present value: what an amount due in the future is worth today at a given rate, found by discounting the amount for each period until it arrives. A bond's price is the present value of its cash flows at the market rate. The cash flows are the 10 interest payments plus the face.
Let's check it on the easy case, where the market rate equals the stated rate. That's 6 percent a year, or 3 percent a period. One $3,000 payment due in one period is worth $3,000 divided by 1.03, which is $2,912.62 now. The $100,000 face, due in 10 periods, gets divided by 1.03 once for every period. That leaves $74,409.39 now. The 10 interest payments, each discounted the same way, are worth $25,590.61 together. Add the two, and you get $100,000.00, the face value.
Now move the market rate. If investors want more than 6 percent, every cash flow is divided by a larger number, and the price falls below face. If they want less, the price rises above face. The shop's two other prices, $96,000 and $104,000, are illustrative, and we read only their direction.
Pause and try this. The shop's bonds sell for $96,000. Was the market rate higher or lower than 6 percent?
Think about which way a bigger divisor pushes the price.
Here's the answer. Higher. A higher market rate divides every cash flow by a larger number, so the price falls below the $100,000 face.
4. Issued at face
Start with the calm day. Investors want exactly the 6 percent the bonds pay, so they pay exactly the face. Bonds issued at face are sold for exactly the face value, which happens when the market rate equals the stated rate.
Walk it the usual way. The shop receives $100,000 in cash, an asset going up, and it owes $100,000, a liability going up. So it debits Cash $100,000 and credits Bonds Payable $100,000. Every period after that, it pays $3,000 of interest. It debits Interest Expense $3,000 and credits Cash $3,000.
Over 10 periods, the interest expense adds up to $30,000. At face, the expense each period is exactly the cash the shop pays. Nothing is left over to spread.
Pause and try this. On the day the bonds are issued, is the $100,000 the shop receives revenue?
Ask whether the shop earned it or owes it back.
Here's the answer. No. The shop must repay every dollar, so the $100,000 is a liability, Bonds Payable, not revenue.
5. Issued at a discount
Now say investors want more than 6 percent on the day the shop sells. The bonds still pay only $3,000 a period, so investors pay less, $96,000. Bonds issued at a discount are sold for less than the face value, and the shortfall is the discount. Here it's $100,000 minus $96,000, which is $4,000.
The shop debits Cash $96,000 and debits Discount on Bonds Payable $4,000, and it credits Bonds Payable for the full $100,000. Discount on Bonds Payable is a contra liability account with a debit balance that holds the amount by which bonds sold below face value. It's subtracted from Bonds Payable, the way Accumulated Depreciation is subtracted from an asset.
That gives us the carrying value: Bonds Payable minus any unamortized discount, or plus any unamortized premium. On the day of issue, it's $100,000 minus $4,000, or $96,000.
Here's a wrong turn to avoid. A discount isn't a gain or a loss on the day of issue. The shop borrows $96,000 and repays $100,000, so that $4,000 is extra interest it pays later.
Pause and try this. The discount account has a debit balance. Does it make the shop's debt look bigger or smaller on the balance sheet?
Remember what a contra account does.
Here's the answer. Smaller. It's subtracted from Bonds Payable, so the bonds are carried at $96,000, not $100,000.
6. Amortizing the discount, straight-line
That $4,000 of extra interest is paid at maturity, but the shop uses the borrowed money in every period. So the cost belongs a little in each period. To amortize a discount or premium is to spread it over the periods of the bond's life.
You already know the simplest way to spread something evenly. In Week 11 you divided the van's depreciable cost by its years. Straight-line amortization does the same thing to the discount. Divide $4,000 by 10 periods, and you get $400 a period.
So each period the shop records $3,400 of interest expense: the $3,000 of cash plus the $400 of discount. It debits Interest Expense $3,400, credits Discount on Bonds Payable $400, and credits Cash $3,000. The discount account shrinks by $400, so the carrying value grows by $400. After the first period it's $96,400. After 10 periods it's $100,000, the face.
Check the total two ways. Ten periods of $3,400 is $34,000. And the shop pays $130,000 in all, the interest plus the face, after receiving $96,000. The difference is the same $34,000.
Pause and try this. The investors who paid $96,000 collect $3,000 a period. Do they earn the 6 percent stated rate?
Think about what else they collect at the end.
Here's the answer. No, they earn more. They also collect the $4,000 discount at maturity, which is why the shop's expense is $3,400, not $3,000.
7. Issued at a premium
Flip the story. Investors want less than 6 percent, so a bond paying $3,000 a period is worth more to them, and they pay $104,000. Bonds issued at a premium are sold for more than the face value, and the excess is the premium, $4,000 again.
The shop debits Cash $104,000, credits Bonds Payable $100,000, and credits Premium on Bonds Payable $4,000. That account has a credit balance, and it's added to Bonds Payable. So the carrying value starts at $104,000.
Straight-line amortization gives $400 a period, but this time it lowers the expense. Interest expense is $3,000 minus $400, or $2,600. The shop debits Interest Expense $2,600, debits Premium on Bonds Payable $400, and credits Cash $3,000. After the first period the carrying value is $103,600. Over 10 periods the expense totals $26,000, which is the $130,000 paid minus the $104,000 received.
Pause and try this. Does a premium add to the shop's interest expense or reduce it?
Ask who paid the extra $4,000.
Here's the answer. It reduces it. The investors paid the extra, so the shop's expense each period, $2,600, is less than its $3,000 of cash.
8. The effective-interest method, in words
Straight-line keeps the arithmetic clean, with the same $400 every period. But the shop's debt isn't the same size every period. In the discount case, it grows from $96,000 toward $100,000.
The effective-interest method is the amortization method GAAP calls for, and straight-line is acceptable when its results are not materially different. Under it, each period's interest expense is the carrying value at the start of the period times the market rate for one period. The amortization is whatever that expense is above the cash interest.
So in the discount case, the expense starts a little below $3,400 and ends a little above it, because the carrying value it's figured on keeps growing. In this course you'll compute straight-line and describe the effective-interest method in words. And either way, the shop amortizes the same $4,000 and reaches the $100,000 face at maturity. On that last day, it debits Bonds Payable $100,000 and credits Cash $100,000.
Pause and try this. Do the two methods give the shop different total interest over the bonds' life?
Think about what each method spreads in total.
Here's the answer. No. Both spread the same $4,000 and end at the same face; they only split it differently among the periods.
9. Installment notes, in words
Not every long-term debt is repaid all at once. Think of a car loan, paid in the same amount every month until it's gone.
That's an installment note: a loan repaid in a series of payments over its term. When the payments are equal, each one covers that period's interest, and the rest reduces the principal.
Picture the farm cooperative paying off its harvester. At the start, the balance it owes is large, so the interest on it is large, and most of each payment is interest. As the balance shrinks, so does the interest, and more of the same payment goes to principal. Near the end, almost all of it is principal. And the part due within the next year is the current portion of long-term debt, from Week 12.
Pause and try this. Early in an installment note, is most of each equal payment interest or principal?
Think about how big the balance is at the start.
Here's the answer. Mostly interest. The balance is largest at the start, so its interest is largest, and it shrinks as the balance does.
10. Debt on the balance sheet
Last stop: the number a lender reads. Bonds go in the long-term liabilities section, at their carrying value.
Take the discount case after the first period. The shop has amortized $400 of the $4,000 discount, so $3,600 remains. The balance sheet shows Bonds Payable, $100,000, less Discount on Bonds Payable, $3,600, for a carrying value of $96,400. That matches the carrying value we reached a moment ago. For the premium case, the remaining premium is added instead.
And when the bonds come within a year of maturity, they move to current liabilities. It's the same line you drew in Week 5. The debt doesn't change; only its classification does.
Pause and try this. After the first period, does the shop's balance sheet show its discounted bonds at $100,000?
Remember which value the balance sheet uses.
Here's the answer. No, it shows the $96,400 carrying value: the $100,000 face less the $3,600 of discount still unamortized.
Closing
Let me pull it together in the order we built it. A bond is a long-term note sold to many bondholders, and the shop records it in Bonds Payable. Face value times the stated rate sets the cash interest, $3,000 a period. The price is the present value of the cash flows at the market rate, and at face it comes to exactly $100,000. A higher market rate means a discount; a lower one means a premium. A discount adds to interest expense, $3,400 a period, and a premium reduces it, to $2,600. The carrying value moves to face by maturity. GAAP calls for the effective-interest method, with straight-line acceptable when the results are close. An installment note's payments shift from interest to principal. And bonds stay long-term until they come due within a year. One sentence holds it all: the same $100,000 face costs the shop $30,000, $34,000, or $26,000 of interest, depending on what it received.
Next in this module, read the Readings & Resources page, then work the lecture tutorial and the practice set before the quiz, the discussion, and the assignment. Next week, in Stockholders' Equity, you'll turn from what the shop owes its lenders to what it owes its owners.
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