Long-term liabilities
Businesses borrow for the long term through loans, bonds, and leases. Accounting for them involves interest, discounts, and premiums.
Long-term debt
Long-term liabilities are obligations due beyond one year: long-term notes, mortgages, bonds payable, lease liabilities, and pension obligations. Borrowing lets businesses invest in growth but adds fixed interest costs and repayment risk.
Installment notes
Many long-term loans are repaid in equal installments that include both interest and principal. Early payments are mostly interest; later payments are mostly principal. An amortisation schedule shows, for each payment, the interest portion (balance x rate), the principal portion, and the remaining balance.
Bonds
A bond is a long-term debt security issued to many investors. It has a face (par) value repaid at maturity and a stated (coupon) rate determining periodic interest payments. Corporations issue bonds to raise large sums without diluting ownership.
Issuing at par, discount, or premium
If the market interest rate equals the coupon rate, bonds sell at face value (par). If the market rate is higher than the coupon rate, bonds sell at a discount (below face value). If the market rate is lower, they sell at a premium. The discount or premium adjusts investors' effective return to the market rate.
Amortising discounts and premiums
A bond discount is amortised over the bond's life, increasing interest expense above the cash interest paid; a premium is amortised to reduce interest expense. The effective interest method, required by GAAP when the difference is material, calculates interest expense as carrying value x market rate.
Leases
Under current standards (ASC 842 in the US, effective 2019 for public companies, and IFRS 16), lessees record most leases longer than 12 months on the balance sheet as a right-of-use asset and a lease liability. This change brought trillions of dollars of previously off-balance-sheet lease obligations onto company balance sheets worldwide.
Debt ratios
Analysts assess debt with ratios: the debt-to-equity ratio (total liabilities / total equity) shows reliance on borrowing; the times interest earned ratio (earnings before interest and taxes / interest expense) shows how easily a company covers interest. Low times interest earned signals higher risk of default.
Worked example
A company issues 100,000 dollars of 5-year bonds with a 6% annual coupon when the market rate is 8%. Because investors can earn 8% elsewhere, they pay less than face value, about 92,000 dollars. The company pays 6,000 cash interest each year, but its interest expense is higher, about 8% of the carrying value, as the 8,000 discount is amortised until carrying value reaches 100,000 at maturity.
Key takeaways
Long-term liabilities include notes, mortgages, bonds, leases, and pensions. Installment loan payments shift from mostly interest to mostly principal. Bonds have a face value and coupon rate; they sell at par, a discount (market rate above coupon), or a premium (market rate below coupon). Discounts raise and premiums lower interest expense as they are amortised, using the effective interest method. Most leases now appear on balance sheets. Debt-to-equity and times interest earned assess debt risk.
Flashcard
Due beyond one year
Check your understanding
A company issues bonds with a 5% coupon when the market rate is 7%. The bonds will sell: