Long-Term Liabilities & Bonds Payable

Time Value of Money Overview

The time value of money (TVM) is the principle that a dollar received today is worth more than a dollar received in the future because of its earning potential. Two fundamental calculations underpin long-term liability accounting:

$$\text{Present Value of a Single Sum} = \frac{FV}{(1 + r)^n}$$ $$\text{Present Value of an Ordinary Annuity} = PMT \times \frac{1 - (1 + r)^{-n}}{r}$$

Where:

• $FV$ = future value
• $PMT$ = periodic payment
• $r$ = interest rate per period
• $n$ = number of periods
  info

  Bond pricing combines both formulas: the PV of the face value (single sum) plus the PV of the interest payments (annuity).

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Long-Term Liabilities Defined

A long-term liability is an obligation not expected to be settled within one year or the operating cycle. Examples include bonds payable, long-term notes payable, lease obligations, and pension liabilities.

Notes Payable at Present Value

Long-term notes payable are recorded at the present value of future cash flows using the market rate of interest at issuance. Bear Co. issues a 3-year, $100,000 note at 8% annual interest when the market rate is also 8%:

$$\text{PV} = \$100{,}000 \times \frac{1}{(1.08)^3} + \$8{,}000 \times \frac{1 - (1.08)^{-3}}{0.08} = \$100{,}000$$

When stated rate equals market rate, the note is issued at face value.

Debit

Credit

Cash

$100,000

Notes payable

$100,000

Noninterest-Bearing Notes

A noninterest-bearing note carries no stated interest rate. The market rate must be imputed to determine the present value. The difference between face value and PV is recorded as a discount. Gies Co. issues a 2-year, $50,000 noninterest-bearing note when the market rate is 10%:

$$\text{PV} = \frac{\$50{,}000}{(1.10)^2} = \$41{,}322$$

Debit

Credit

Cash

$41,322

Discount on notes payable

8,678

Notes payable

$50,000

Interest expense in Year 1: $41,322 × 10% = $4,132

Debit

Credit

Interest expense

$4,132

Discount on notes payable

$4,132

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Debt Covenants and Technical Default

Debt agreements often include covenants — restrictions such as maintaining a minimum current ratio or limiting dividend payments. Violation of a covenant constitutes a technical default.

warning

If a long-term debt covenant is violated at the balance sheet date and the lender has not waived the violation, the entire debt must be reclassified as a current liability — even if the lender later grants a waiver.

An exception exists if the lender provides a waiver before the financial statements are issued (or available to be issued), and the company is expected to cure the violation within a specified grace period.

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Bonds Payable — Introduction

A bond is a formal debt instrument in which the issuer promises to pay the holder:

1. The face (par) value at maturity
2. Periodic interest payments (coupons) at the stated rate

Types of Bonds

Type	Description
Debenture	Unsecured; backed only by issuer's credit
Secured	Backed by specific collateral
Convertible	Can be converted into common stock
Callable	Issuer can retire early at a call price
Zero-coupon	No periodic interest; issued at deep discount

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Bond Terminology

Term	Meaning
Face value	Par amount, typically $1,000 per bond
Coupon (stated) rate	Rate used to compute periodic cash interest
Effective (market/yield) rate	Rate investors demand; used for PV calculations
Maturity date	Date the face value is repaid

The relationship between the coupon rate and the effective rate determines pricing:

Coupon vs. Market	Issued At	Carrying Value
Coupon = Market	Par	Face value
Coupon > Market	Premium	Above face value
Coupon < Market	Discount	Below face value

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Bond Pricing

MAS Inc. issues $500,000 of 5-year, 8% bonds (semiannual payments) when the market rate is 10%.

• Semiannual coupon: $500,000 × 8% ÷ 2 = $20,000
• Periods: 5 × 2 = 10
• Market rate per period: 10% ÷ 2 = 5% $$\text{PV of face} = \frac{\$500{,}000}{(1.05)^{10}} = \$306{,}957$$ $$\text{PV of annuity} = \$20{,}000 \times \frac{1 - (1.05)^{-10}}{0.05} = \$154{,}434$$ $$\text{Issue price} = \$306{,}957 + \$154{,}434 = \$461{,}391$$ The bond is issued at a discount of $38,609.

Debit

Credit

Cash

$461,391

Discount on bonds payable

38,609

Bonds payable

$500,000

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Carrying Value

$$\text{Carrying Value} = \text{Face Value} - \text{Unamortized Discount}$$

or

$$\text{Carrying Value} = \text{Face Value} + \text{Unamortized Premium}$$

Over time, carrying value moves toward face value as the discount or premium is amortized.

Bond Issue Costs

Under current GAAP (ASU 2015-03), bond issue costs are presented as a direct deduction from the carrying amount of the bond (similar to a discount), not as a deferred asset.

Debit

Credit

Discount on bonds payable

$12,000

Cash

$12,000

These costs are amortized over the life of the bond using the effective interest method.

Amortization Methods

Straight-Line Method

Allocates equal discount or premium amortization each period. Permitted only if results are not materially different from the effective interest method.

$$\text{Amortization per period} = \frac{\text{Total Discount (or Premium)}}{\text{Number of Periods}}$$

Using MAS Inc.'s discount of $38,609 over 10 periods:

$$\text{Per period} = \frac{\$38{,}609}{10} = \$3{,}861$$

Debit

Credit

Interest expense

$23,861

Discount on bonds payable

$3,861

Cash

20,000

Effective Interest Method (Required by GAAP)

This method produces a constant interest rate each period.

$$\text{Interest Expense} = \text{Carrying Value} \times \text{Market Rate per Period}$$ $$\text{Amortization} = \text{Interest Expense} - \text{Cash Interest Paid}$$

Period 1 for MAS Inc.:

$$\text{Interest Expense} = \$461{,}391 \times 5\% = \$23{,}070$$ $$\text{Amortization} = \$23{,}070 - \$20{,}000 = \$3{,}070$$

Debit

Credit

Interest expense

$23,070

Discount on bonds payable

$3,070

Cash

20,000

New carrying value = $461,391 + $3,070 = $464,461. :::tip Exam Tip

For a discount, interest expense increases each period because the carrying value grows. For a premium, interest expense decreases because carrying value shrinks.

:::

Bonds Issued Between Interest Dates

When bonds are issued between interest payment dates, the buyer pays the issuer accrued interest from the last interest date to the issue date. BIF Partners issues $200,000 of 6% bonds (semiannual, Jan 1 and Jul 1) at par on March 1: Accrued interest: $200,000 × 6% × 2/12 = $2,000

Debit

Credit

Cash

$202,000

Bonds payable

$200,000

Interest payable

2,000

On July 1, BIF Partners pays full semiannual interest of $6,000:

Debit

Credit

Interest payable

$2,000

Interest expense

4,000

Cash

$6,000

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Year-End Accrual

If the fiscal year-end does not coincide with an interest payment date, interest must be accrued. Bear Co. has $300,000 of 8% bonds (semiannual, Apr 1 and Oct 1) with a December 31 year-end. Accrued interest for Oct 1 – Dec 31 (3 months):

$$\$300{,}000 \times 8\% \times \frac{3}{12} = \$6{,}000$$

Debit

Credit

Interest expense

$6,000

Interest payable

$6,000

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Troubled Debt Restructuring

A troubled debt restructuring (TDR) occurs when a creditor grants a concession to a debtor in financial difficulty that it would not otherwise consider.

Debtor: Transfer of Assets

Kingfisher Industries settles a $500,000 note by transferring land with a book value of $300,000 and fair value of $350,000:

Debit

Credit

Notes payable

$500,000

Land

$300,000

Gain on disposition of land

50,000

Gain on restructuring

150,000

Debtor: Equity Transfer

If equity is issued instead, the shares are recorded at fair value, and the difference from the carrying amount of the debt is a restructuring gain.

Modification of Terms

When terms are modified (lower rate, extended maturity, reduced principal), the debtor compares the total future cash flows under the new terms to the carrying amount of the debt:

• If future cash flows exceed carrying amount → no gain recognized; adjust effective interest rate prospectively
• If future cash flows are less than carrying amount → recognize gain for the difference; no future interest expense

Creditor Impairment

The creditor measures the impairment as:

$$\text{Impairment Loss} = \text{Carrying Amount} - \text{PV of Expected Future Cash Flows}$$

The PV is calculated using the original effective interest rate of the loan.

Extinguishment / Retirement of Debt

When bonds are retired before maturity (called or repurchased on the open market), the difference between the reacquisition price and the net carrying amount is a gain or loss.

$$\text{Gain (Loss)} = \text{Net Carrying Amount} - \text{Reacquisition Price}$$

Illini Entertainment retires $100,000 face value bonds (carrying value $97,200) at 102: Reacquisition price = $100,000 × 102% = $102,000

Debit

Credit

Bonds payable

$100,000

Discount on bonds payable

$2,800

Cash

102,000

Loss on extinguishment

4,800

Corrected entry:

Debit

Credit

Bonds payable

$100,000

Loss on extinguishment

4,800

Discount on bonds payable

$2,800

Cash

102,000

note

The gain or loss on extinguishment is reported in income from continuing operations, not as an extraordinary item (ASU 2015-01 eliminated extraordinary item classification).

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Summary

:::note Chapter Checklist

• Calculate PV for notes and bonds using TVM formulas
• Distinguish premium from discount issuances
• Apply straight-line and effective interest amortization
• Record bonds issued between interest dates and year-end accruals
• Account for troubled debt restructurings from debtor and creditor perspectives
• Calculate gain or loss on early extinguishment of debt :::