LONG TERM LIABILITIES

A long term liability is an obligation that extends beyond one year from the current balance
sheet date or the operating cycle of the debtor (borrower), whichever is longer.
Debt capital is an attractive means of financing for the debtor. Creditors do not acquire
voting privileges, in the debtor comparing like holders of equity capital. Debt capital is
obtained more easily than equity capital by many new and risky firms. In some cases, the
overall cost of debt financing is lower than equity financing. Interest expenses, unlike
dividends are tax deductible. Furthermore, a successfully leveraged firm earns a return on
borrowed funds that exceeds the rate it must pay interest. Debt financing often supplies the
capital for expansion and take over activities when issuance of new stock is difficult.
Bonds Payable
A bond is a debt security issued by companies and government units to secure large
amounts of capital on a long-term basis. Bonds are legal documents representing a formal
promise in the issuing firm to pay principal and interest in return for the capital invested by
the bond holders (investors).
Bonds are marketed in several ways. Typically, an entire bond issue is sold to investment
bankers. Investment bankers underwrite (assist in selling and assume all or part of the risk)
the bond issue at a specified price and then market the bonds at a higher price to individual
investors thus realizing underwriter’s compensation. Alternatively, the underwriting firm
may agree to buy any unsold portions of the issue at a specified price. Private direct
placement with financial institutions and individual investors is an alternative to
underwriting.
Many bonds are issued through a prospectus. A prospectus is a document that includes
audited financial statements of the issuer, states the offering price, and describes the
securities offered, the issuing company’s business and the conditions under which the
securities will be sold. The investors receive bond certificates which represent the
contractual obligation of the issuer to the investors.
Valuation of Bonds Payable
Several bond features affect the valuation and accounting for bonds. To illustrate, assume
that late in 2022, Randolph Company plans to issue shs. 1,000,000 of 10% debentures dated
January 1, 2016. Each bond has a face value of shs. 10,000. The bonds mature December 31,
2025 and pay interest on June 30 and December 31.
Five features are generally noted and appear on the bond.
1. The face (maturity, principal or par) value of the bond is the amount payable when
the bond is due (sh. 10,000 for Randolph)
2. The maturity date is the end of the bond term and the due date for the face value
(December 31, 2024 for Randolph). The length of the bond term reflects the issuers
 long term cash needs, the purpose for which the bond will be used, and the issuers
expected ability to pay principal and interest.
3. The stated (coupon, nominal, contractual) interest rate is the rate applied to face
value to determine periodic interest payments. (10% for Randolph). This rate is
normally set to approximate the rate of interest on bonds of a similar risk class.
4. The interest payments dates are the dates the periodic interest payments are due
(June 30 and December 31 for Randolph). Semiannual interest payments are
common. Randolph pays shs. 500 on these dates for each bond (0.10 x shs 10,000 x
½), regardless of the issue price or market rate of interest at date of issue.
5. The bond (amortization) date is the earliest date the bond can be issued and
represents the planned issuance date of the bond issue (January 1, 2016 for
Randolph)
The other features that are necessary for valuation do not appear on the bond and
are dependent on market factors are
6. The market (effective, yield) interest rate is the true compounded rate that equates
the price of the bond issue to the present value of the interest payments and face
value. This rate is not necessarily the same as the stated rate. (assume this rate is
12% for the Randolph issue)
7. The bond issue date is the date the bonds are actually sold to investors. Bonds often
are issued after the bond date. (Assume the issue date is July 1, 2016, for the
Randolph issue).
The market interest rate depends on several interrelated factors including the
general rate of interest in the economy, the perceived risk of the bond issue, yields
on bonds of similar risks, inflation expectations, the overall supply of and demand for
bonds and the bond term.
Bond Prices
If the market and stated interest rates are equal, bonds sell at face value. In this case, the
interest payments yield a return equal to the market rate for bonds of similar duration and
risks. However, the stated and market rates are frequently not the same. Changes in the
market rate and issue price are inversely related. If the market rate (in this case 12%)
exceeds the stated rate (which is 10%) the issue price of the Randolph bonds sold at a
discount. When the stated rate exceeds the market rate the reverse is true and the bonds
sell at a premium (above face value). In this case, the bonds offer a stated rate above the
market rates, making them more attractive. The terms discount and premium do not imply
negative or positive qualities of the bond issue. They are the results of adjustments to the
selling price to bring the yield rate in line with market rate on similar bonds.
The investor buys two different types of cash flows when purchasing a bond: principal and
interest. The price of a bond issue (and valuation at issuance) equals the present value of
these payments discounted at the market rate of interest.

Randolph bonds
Present value of principal
Shs.1,000,000 (PV1,6* %, 19+) = Shs. 1,000,000 (0.33051) = Shs. 330,510
Present value of interest payments
Shs. 1,000,000 (0.10) ( ½ ) (PVA,6%,19)
= Sh 50,000 (11.15812) Shs. 557,910
Price of Randolph bonds, July 2016 Shs. 888,420
Discount on bonds (1,000,000-888,420) 111,580
*Market rate of interest 12% (6% per semi annual period)
+ Bond term”: July 1, 2016 through December 31, 2025 (19 semi annual periods).
Investors who purchase the Randolph bonds (at a discount) and hold them for the entire
term earn 6% compounded semi annually on their original investment of shs. 888,420
To demonstrate account for bonds, several case examples are used to illustrate different
reporting situations. In case 1, bonds are issued on the bond date and at the beginning of
the fiscal year. Three different effective market interest rates are illustrated.
Bonds issued on Bond date, the beginning of fiscal year
On January 1, 2018, Gresham Company issued shs. 1,000,000 of 7% debentures dated
January 1, 2018, which pay interest each December 31. The bonds matured on December
31, 2022. Elm Company purchased the entire bond issue. Both companies have calendar
fiscal years.
Part A: effective interest rate = 7%
Part B: effective interest rate = 6%
Part C: effective interest rate = 8%
Part A: Bonds sell at face value, effective and stated rate= 7%
Price = shs 1,000,000 (PV 1, 7%, 5) + shs. 1,000,000 (0.07) (PVA, 7%, 5)
= 1,000,000 (0.71299) + Shs. 70,000 (4.10020)
= Shs. 1,000,000
When a bond is issued, the bond is issuer records the maturity value of the bond in bonds
payable, a long–term liability account. The investor records the cash equivalent paid for the
bond in an investment account. In this case, the maturity value equals the amount paid. The
following entries are made during the bond term, assuming Elm Co. holds the bond to
maturity

GRESHAM COMPANY
(Issuer)
January 1,2018
Cash 1,000,0000
Bonds payable 1,000,000
To record issue of Bonds
December 31, 2018 - 2022
Interest expense 70,000
Cash (0.07 x 1000000) 70,000
Adjusting entry for interest paid pr annum
December 31,2022
Bonds payable 1,000,000
Cash 1,000,000
To record maturity of bond

ELM COMPANY
(Investor)

January 1,2018

Bond Investment 1,000,0000

Cash 1,000,000

To record amount paid for Bond investment

December 31, 2018- 2022

Cash (0.07 x shs 1,000,000) 70,000

Interest revenue 70,000

To record receipt of interest revenue from Bond per annum

December 31,2022
Cash 1,000,000
Bond investment 1,000,000

To record maturity of bond and receipt of bond proceeds

Interest expense for bonds issued at face value equals the amount of the interest payment.
The book value of the bonds remains shs. 1,000,000 to maturity for both firms. Subsequent
changes in the market rate of interest are ignored for journal entry purposes. At maturity,
bonds payable and the investment account are closed as shown in the last entries above.
Matured bonds are cancelled to prevent reissuance.
Part B: Bonds sell at a premium, effective rate= 6%
Price = shs 1,000,000 (PV 1, 6%, 5) + shs. 1,000,000 (0.07) (PVA, 6%, 5)
= 1,000,000 (0.74726) + Shs. 70,000 (4.21236)
= Shs. 1,042,130
The bonds sell at a premium because they pay a stated rate that exceeds the yield rate on
similar bonds. The initial shs. 42,130 premium is recorded in premium on bonds payable
account. The premium increases the net bond liability. The present value (which equals
book value) at issue date (shs 1,042,130) is the amount that, if invested by the issuing
company at the effective interest rate, satisfies all payments required on the bond issue,
including the face value. The following entry is made to record the issue.
GRESHAM COMPANY
(Issuer)
January 1,2018

Cash 1,042,130

Bonds payable 1,000,000

Premium on bonds payable 42,130

To record issue of Bonds at a premium

ELM COMPANY
(Investor)

January 1,2018

Bond Investment 1,042,130

Cash 1,042,130

To record amount paid for Bond Investment

Total interest expense over the term of a bond issue equals total cash payments, required
by the bond (face value and interest) less the aggregate issue price. Total interest expense is
not equal to total cash interest paid over the term for a bond sold at a premium or discount
as shown for Gresham Company.
Shs.
Face value 1,000,000
Total cash interest 0.07 (1,000,00) (5 yrs) 350,000
Total cash payments required by bond 1,350,000
Issue price 1,042,130
Total interest expense for bond term 307,870

Gresham received shs. 42,130 more than face value but will only pay face value at maturity,
and the effective rate is less than the stated rate, therefore, total interest expense for
Gresham over the bond term is less than total interest paid.
Subsequent to issue, the premium or discount is amortized over the bond term. Amortized
premium reduces periodic interest expense relative to interest paid and amortized discount
increases interest expense. Two amortization methods are in use: the interest method and
the straight line method.
Effective Interest method
The interest method is preferable because it applies the correct yield rate to the liability
balance at the beginning of each period. That liability balance represents the true present
value of the obligation at that date. The straight line method amortizes an equal amount of
premium or discount per month. The effective interest method is illustrated first, using he
entries for the first two years.
GRESHAM COMPANY
(Issuer)
December 31, 2018
Interest Expense 62,530*
Premium on Bonds payable 7,470
Cash (1,000,000 x 0.07) 70,000
Adjusting entry for interest paid per annum
*shs 62,530= shs 1,042,130 (0.06)
December 31, 2019
Interest expense 62,080*
Premium on Bonds payable 7,920
Cash (1,000,000 x 0.07) 70,000
 Adjusting entry for interest paid per annum
Shs.62,080 = (1,042,130-7,470) (0.06)

ELM COMPANY
(Investor)

December 31,2018

Cash 70,000

Bond investment 7,470

Interest revenue 62,530

To record annual payment received for bond investment

December 31,2019

Cash 70,000

Bond investment 7,920

Interest revenue 62,080

To record annual payment received for Bond Investment

After two year, Gresham’s balance sheet would report

GRESHAM COMPANY
Portion of long term liability section of Balance Sheet
Shs.

Bonds payable 1,000,000

Unamortized premium on Bonds payable

(42,130 - 7,470 - 7,920) 26,740

Net book value of bonds payable 1,026,740

Interest expense under the interest method is the product of the effective interest rate (6%)
and net liability balance at the beginning of the period. Interest expense is therefore a
constant percentage of beginning book value. The investor receives part of the original
investment back with each interest payment. In 2018 this is shs.7470, which reduces the net
investment and net bond liability at the beginning of 2019. Consequently, 2019 interest
expense is less than that for 2018.
The book value of the bonds at December 31, 2019 is the present value of remaining cash
flows.
Shs.1,026,740 = shs 1,000,000 (PV 1, 6%, 3) + shs. 1,000,000 (0.07) (PVA, 6%, 3)
= 1,000,000 (0.83962) + Shs. 70,000 (2.67301) (rounded)
In practice, most firms do not separately disclose the unamortized premium or discount as a
separate line item in the balance sheet, unamortized discount or premium typically is
disclosed in a footnote or parenthetically in the balance sheet.
An amortization table often is prepared by the issuer to support bond journal entries. The
table gives all the data necessary to make the journal entries, over the term of the bond,
and each year ending net liability balance.
An amortization table for Gresham is shown below.
Date Interest Interest Premium Unamortized Net Bond
Payment Expense Amortization Premium Liability
(Shs) (Shs) (a) (Shs) (b) (shs) (c) (Shs) (d)
1/1/2018 0 0 0 42,130 1,042,130

12/31/2018 70,000 62,530 7,470 34,660 1,034,660

12/31/2019 70,000 62,080 7,920 26,740 1,026,740

12/31/2020 70,000 61,600 8,400 18,340 1,018,340

12/31/2021 70,000 61,100 8,900 9,440 1,009,440

12/31/2022 70,000 60,560 9,440 0 1,000,000

350000 307870 42130

(a) (previous net liability balance) (0.06)

Shs 62,530 = shs 1,042,130 (0.06)
(b) (interest payment) - (interest expense)
Shs. 70,000 - 62,530 = shs.7,470
 (c) (previous unamortized premium) - ( current period amortization)
Shs. 42,130- sh. 7,470= 34,660
(d) Shs. 1,000,00 + (current unamortized premium)
Shs. 1,034,660 = shs 1,000,000+ 34,660
Straight line method
This popular alternative to the interest method directly determines the amortization of
premium or discount.
An equal amount of discount or premium is amortized each interest period. Interest
expense equals the cash interest paid less premium amortized or plus the discount
amortized. The following entry is recorded each period by Gresham (premium example)
under this method.
GRESHAM COMPANY
(Issuer)

December 31, 2018-2022

Interest expense 61,570

Premium on bonds payable 8,430*

Cash (shs. 1,000,000 x 0.7) 70,000

Adjusting entry for interest paid per annum

* shs.8,430= shs.42,130/ 5 years

ELM COMPANY
(Investor)

December 31, 2018-2022

Cash 70,000

Bond Investment 8,430

Interest revenue 61,570

To record annual payment received for investment in bonds

The straight line method recognizes the average amount of interest each year (shs.61,570 =
shs.307,870/5) , while the interest method reflects the changing debt balance.
The straight line method is allowed only when interest expense is not materially different
under the two methods. The use of the straight line method is questionable when the
discount or premium is material, or when the bond term is exceptionally long.

Part C: Bonds sell at a discount, effective rate = 8%

Price = shs 1,000,000 (PV 1, 8%, 5) + shs. 1,000,000 (0.07) (PVA, 8%, 5)
= 1,000,000 (0.68058) + Shs. 70,000 (3.99271)
= Shs. 960,070
The Gresham bond sells at a discount because the stated rate is less than the yield rate on
similar bonds. The discount is recorded in the discount on bonds payable account.
This account is a contra liability valuation account, which is subtracted from bonds payable
to yield the net liability at present value.
The entries for the first two years follow along with an amortization table for the entire
bond term and the relevant portion of the balance sheet after two years.
GRESHAM COMPANY
(Issuer)
January 1, 2018
Cash 960,070
Discount on bonds payable 39,930
Bonds payable 1,000,000
To record issue of bonds at a discount
December 31, 2018
Interest expense 76,810*
Discount on bonds payable 6,810
Cash (0.07 x 100,000) 70,000
Adjusting entry for intense paid and interest expense per annum
* Shs 76,810 = shs.960,070 (0.08)

December 31,2019
Interest expense 77,350*

Discount on bonds payable 7,350

Cash (1,000,000 x 0.07) 70,000

Adjusting entry for interest paid and interest expense per annum

* shs 77,350 = (shs. 960,070 + shs. 6,810 ) (0.08)

ELM COMPANY
(Investor)
January 1,2018
Bond investment 960,070
Cash 960,070

To record amount paid for investment in bond

December 31,2018
Cash 70,000
Bond investment 6,810
Interest revenue 76,810
To record annual payment received for bond investment

December 31,2019
Cash 70,000

Bond investment 7,350

Interest revenue 77,350

To record annual payment received for bond investment.

Date Interest Interest Discount Unamortized Net Bond
Payment Expense Amortization Discount Liability
(Shs) (Shs) (a) (Shs) (b) (shs) (c) (Shs) (d)
1/1/2018 39,930 960,070

12/31/2018 70,000 76,810 6,810 33,120 966,880

12/31/2019 70,000 77,350 7,350 25,770 974,230

12/31/2020 70,000 77,940 7,940 17,830 982,170

12/31/2021 70,000 78,570 8,570 9,260 990,740

12/31/2022 70,000 79,260 9,260 0 1,000,000

350000 389930 39930

(a) (previous net liability balance) (0.08)

Shs 76,810 = shs 960,070 (0.08)
(b) (interest expense) - (interest payment)
shs.7,470 =Shs. 76,810-70,000
(c) (previous unamortized discount) - ( current period amortization)
Shs. 33,120 = shs.39,930- sh. 6,810
(d) Shs. 1,000,00 - (current unamortized discount)
Shs. 966,880= shs 1,000,000 - 33,120
 GRESHAM COMPANY
Portion of long-term liability section of balance sheet
December 31, 2019

Shs.

Bonds payable 1,000,000

Unamortized discount on bonds payable

(shs. 39,930 - shs. 6,810 - shs.7,350) 25,770
Net Book Value of Bonds payable 974,230

The initial shs. 39,930 discount is the amount in excess of the total bond price that the
issuer must pay the investor at maturity. Therefore, the discount represents interest, in
addition to cash interest payments required over the bond term. A portion of the discount is
recognized (amortized) each period, causing both interest expense and the net bond liability
to increase. When completely amortized, the net bond liability has increased to shs.
1,000,000, the maturity amount. Total interest expense over the bond term is shs. 389,930,
the sum of the cash interest payments (shs. 350,000) and the discount (shs. 39,930).
Cost of Issuing Bonds
The issuance of bonds involves engraving and printing costs, legal and accounting fees,
commissions, promotional costs and other similar charges. According to accounting
principles these items should be debited to a deferred charge account (asset) for
unamortized bond issue costs and amortized over the life of the debt, in a similar manner to
that used for discount on bonds.
To illustrate the accounting for costs of issuing bonds, assume that Microchip Corporation
sold shs. 20,000,000 of 10 year debentures bonds for shs. 20,795,000 on January 1, 2022
(also the date of the bonds). Costs of issuing the bonds were shs. 245,000. The entries at
January 1, 2022 and December 31, 2022, for issuance of the bonds and amortization of bond
issue costs would be as follows:
January 1, 2022
Cash 20,550,000
Unamortized bond issue costs 245,000
Premium on Bonds payable 795,000
Bonds payable 20,000,000

To record issuance of bonds

December 31, 2022
Bond issue expense 24,500
Unamortized bond issue costs 24,500
To amortize one year of bond issue costs- straight line method

While the bond issue costs should be amortized using the interest method, the straight line
method is generally used in practice because it is easier and the results are not materially
different
Early Retirement of Bonds Payable
Bonds are sometimes retired before the maturity date. The principal reason for retiring
bonds early is to relieve the issuing corporation of the obligation to make future interest
payments. If interest rates, that is, market interest rates, decline to the point that a
corporation can borrow at an interest rate below that being paid on a particular bond issue
the corporation may benefit from retiring those bonds and issuing new bonds at a lower
interest rate.
If the bonds can be purchased by the issuing company at less than their carrying value, a
gain is realized on the retirement of the debt. If the bonds are reacquired by the issuing
company at a price in excess of their carrying value, a loss must be recognized.
Most bond issues contain a call provision, permitting the corporation to redeem the bonds
by paying a specified price, usually a few points above par. Even without a call provision, the
corporation may retire its bonds before maturity by purchasing them in the open market.
For example, assume that Briggs Corporation has an outstanding 13% shs. 10 million bond
issue, callable on any interest date at price of 104. Assume also that the bonds were issued
at par and will not mature for nine years. Recently, however, market interest rates have
declined to less than 10% and the market price of Briggs Co. bonds has increased to 106.
Regardless of the market price, Briggs can call these bonds at 104. If the company exercises
this call provision for 10% of the bonds (shs. 1,000,000 face value) the entry will be:

Bonds payable 1,000,000

Loss on early retirement of bonds 40,000
Cash 1,040,000

To record the call of shs. 1,000,000 in bonds payable at a call price of 104

Mortgage Notes Payable

The most common form of long term notes payable is a mortgage note secured by a
document called a mortgage that pledges title to property as security for the loan. Mortgage
notes payable are used more frequently by sole proprietorships and partnerships than by
corporations, as corporations usually find that bond issue offer advantages in obtaining
large loans. On the balance sheet, the liability should be reported using a title such as
“Mortgage notes payable” or “ Notes payable- secured” with a brief disclosure of the
property pledged in notes to the financial statements.
The borrower usually receives cash in the face amount of the mortgage note. In that case
the face amount of the note is the true liability and no discount or premium is involved.
When “points” are assessed by the lender, however, the total amount paid by the borrower
exceeds the face amount of the note. Points raise the effective interest above the rate
specified in the note. A point is 1% of the face of the note. Mortgages may be payable in full
at maturity or in installments, over the life of the loan. If payable at maturity, the mortgage
payable is shown as a long term liability on the balance sheet until such time as the
approaching maturity date warrants showing it as a current liability. If it is payable in
installments, the current installments due are shown as current liabilities with the
remainder shown as a long term liability. Because of unusually high, unstable interest rates
and tight money supply, the traditional fixed rate mortgage has been replaced by variable
rate mortgages. These feature interest rates tied to changes in the functioning market rate.