BU.210.620 Chap.7 Long-Term Liabilities: Notes and Bonds
Long-Term Liabilities: Notes and Bonds
Debt in the capital structure
Module 7 turns to the claims that finance a company. Debt is cheaper to control than equity, since lenders do not vote and interest is tax deductible, but it is riskier for the company because payments are legal obligations.
A liability is a probable future sacrifice from a past transaction, classified as current when due within a year and long-term otherwise, and measured at the amount a creditor would accept today to settle it. For notes payable, interest equals principal times the annual rate times the fraction of the year outstanding, and it is accrued at period end whether or not it has been paid.
Installment notes split each payment into interest on the opening carrying value and a principal reduction.
Bond vocabulary
A bond's face value is repaid at maturity and is the base for coupon payments at the stated rate. Bonds may be unsecured debentures, secured, callable by the issuer or convertible into shares, and the indenture sets out covenants that a trustee monitors.
Rating agencies grade default risk, with BBB or Baa the lowest investment grade.
Par, discount and premium
A bond sells for the present value of its cash flows at the market rate; in this course the price is given. If the coupon rate equals the market rate the bond sells at par, below it at a discount and above it at a premium, and investors earn the market rate in every case.
The issue is recorded at the cash received.
The effective-interest method
Each period, interest expense is the beginning book value times the market rate per period, cash paid is face value times the coupon rate per period, and the difference adjusts the bond's book value. Discount bonds climb towards face and premium bonds fall towards it, reaching face exactly at maturity.
Interest expense is a financing cost, so it is reported after operating income rather than among operating expenses.
What this chapter covers
- 01
Capital structure and the liability definition
- 02
Notes payable and accrued interest
- 03
Bond terms, types, covenants and ratings
- 04
Issue price at par, discount or premium
- 05
Effective-interest amortisation schedules
Worked example · free
First two periods of a discount bond
- 3Period 1: expense 486,000 × 3% = $14,580; cash 500,000 × 2% = $10,000; book value rises by $4,580 to $490,580.
- 3Period 2: expense 490,580 × 3% = $14,717; cash $10,000; book value rises by $4,717 to $495,297.
Key terms
- Face value
- Face value is the principal a bond repays at maturity and the base on which coupon interest is calculated.
- Coupon rate
- The coupon rate is the annual interest rate stated on a bond, used with face value to compute each cash interest payment.
- Bond discount
- A bond discount arises when a bond sells below face value because its coupon rate is lower than the market rate.
- Debt covenant
- A debt covenant is a condition in a loan or bond agreement, such as a limit on new borrowing or a minimum ratio, that protects lenders.
- Callable bond
- A callable bond gives the issuer the right to retire the bond before its maturity date, usually when interest rates have fallen.
- Carrying value
- Carrying value is the amount at which a bond or note appears on the balance sheet; for a bond it starts at the issue price and moves towards face value each period.
Long-Term Liabilities: Notes and Bonds FAQ
Why is a bond recorded at the cash received rather than its face value?
A liability is measured at what it would take to settle it today, which on the issue date is the cash raised. Recording face value for a discount bond would overstate what the company borrowed; the gap is recognised gradually as extra interest expense.
Does a change in a bond's market price affect the issuer's books?
No. After issue, trades happen between investors in the secondary market, so the issuer receives and pays nothing extra. It keeps following its effective-interest schedule based on the market rate on the issue date.
How is interest on a note accrued at year-end?
Multiply the principal by the annual rate and by the months outstanding divided by twelve. Record it with a debit to interest expense and a credit to interest payable, even though no cash is paid until later.
Exam move
Build one schedule for a discount bond and one for a premium bond with the same face value, then write the journal entry for the first period of each. Finish by explaining, in one sentence, why each book value moves the way it does.
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