Liabilities are obligations of the entity that require future payment or the rendering of services.
Examples of liabilities :
- Accounts Payable
- Taxes Payable
- Accrued Expenses
- Unearned Revenue
- Bonds Payable
- Mortgages Payable
- Leases Payable.
Liabilities may be of a current or non-current nature.
Non-current liabilities are sometimes used to finance non-current assets. The expectation is that the return generated from the long-term asset will be sufficient to meet the interest and principal payment of the debt. Long-term liabilities include:
Bonds Payable: A bond is a written promise by the company to pay the face amount at the maturity date.
Periodic interest payments are required, typically on a semiannual basis. Bonds are usually stated in $1,000 denominations. Debt financing has several advantages compared to equity financing. Interest expense is tax deductible, whereas dividend payments are not. During inflation, the debt is being paid back in cheaper dollars.
However, there are drawbacks to debt financing, including the risk M not being able to meet the fixed interest charges and principal at maturity, and restrictions placed on the company under the bond agreement such as minimum working capital requirements.
Long- Term Notes Payable:
When a note is issued, funds are obtained from a specific lender rather than through the issuance of bonds payable to the public at large.
Mortgage Payable: A mortgage has as its security the property financed. It represents a lien on the property in case of default.
Leases: The lessee uses the property in return for periodic rental payments to the lesser. In the case of a capital lease, the lessee shows as a long-term liability the present value of future minimum rental payments to be made. A capital lease is one in which one of the following four criteria is met:
- The lessee receives title to the property at the end of the lease term.
- The lessee can acquire the property under a ‘bargain purchase option.
- The life of the lease is 75 percent or more of the life of the property.
- At the date of lease, the present value of the future minimum lease payments equals or exceeds 90 percent of the fair market value of the property
If at least one of the criteria is not met, an operating lease is indicated. This is accounted for
as a regular rental.
Types of Bonds
A trustee such as a bank is selected by the company to safeguard the creditors’ interest. The agreement (indenture)
between the trustee and corporation spells out the particulars of the bond issue. The trustee may hold collateral as security against default on the bonds. Collateral trust bonds have as their collateral the firm’s investments in other companies. Sinking fund bonds require the company to make annual deposits with the trustee. At maturity, the amount in the sinking fund (consisting of principal and interest) should be sufficient to pay the face of the bonds. Unsecured bonds (debentures) may be issued by credit-worthy companies. For these, no collateral is required.
There are registered and coupon bonds. A registered bond has the owner’s name on the face of the bond and interest is paid directly to him – or her. A coupon bond does not indicate the owner’s name and interest is paid to the individual who presents a dated coupon. Convertible bonds may be exchanged by the holder for other securities of the company at a later date. Callable bonds may be reacquired at the option of the issuing company prior to their maturity. Serial bonds mature in installments rather than at a fixed maturity date.
Accounting for Bonds
When bonds are issued at their face value, the entry is to debit cash and credit bonds payable. The entry to record the interest each period is to debit interest expense and credit cash.
Interest is equal to: Face of bond x Annual interest rate x Period between last interest date
The market price of a bond will most likely be different than its face value (maturity value). A bond’s market value depends upon a number of factors, such as its interest rate, years left to maturity, and the financial soundness of the company. For example, if a bond’s interest rate is much lower than the going interest rate in the marketplace, the market price of the bond will be considerably lower than its face value. The difference between the sales price of a bond and its face value is recorded as Premium on Bonds Payable (when issue price exceeds face value) or as Discount on Bonds Payable (when issue price is less than face value). The face value of a bond is stated as 100 percent. Therefore, a bond issued at a premium would be sold at more than 100 percent. A bond issued at a discount would be sold at less than 100 percent.
Premium on Bonds Payable
A bond would normally be sold at a premium if its face (nominal) interest rate exceeds the current market rate for a comparable quality bond. The premium should not be considered income but rather interest received in advance that will serve to adjust the contract rate of interest. The premium “Account is amortized over the life of the bond as a reduction of interest expense. The entry is to debit premium on bonds payable and credit interest expense. The true interest expense (net cost of borrowing) for a given year is therefore the face interest less the adjustment for the premium amortization. In the balance sheet, the un-amortized premium is added to the face value of the bonds payable in order to derive the current carrying value (present value) of the bond. At the maturity date, the carrying value of the bond will equal its face value since the principal of the bond ‘must be paid at that time.
Discount on Bonds Payable
A bond would normally be sold at a discount when its face interest is below the market interest rate. The discount is considered an incremental interest expense, which is amortized over the life of the bond. The entry is ‘to debit interest expense and credit discount on bonds payable. The true interest expense (net borrowing cost) for a given year
is therefore the face interest plus the discount amortization. In the balance sheet, the un-amortized discount is subtracted from bonds payable to arrive at the current carrying value of the bond. Un-amortized discount is a contra account. At maturity, the un-amortized discount account will be reduced to zero and hence the carrying value of the bond will equal its face value.
Bonds Sold at Face Value between Interest Dates
When bonds are sold between interest dates the purchaser must pay the interest that has been accrued subsequent
to the last interest payment date. This is because at the next interest date the purchaser will receive the interest for the full period. The net effect is that the purchaser will earn the interest he or she is entitled to for the period he
or she held the bond.
Bonds Sold at a Premium or Discount between Interest Dates When bonds are sold between interest dates at
a premium or discount, the entry to record the issuance reflects the accrued interest and the premium or discount. Assuming a premium is involved, the entry is
- Bonds Payable
- Premium on Bonds Payable
- Interest Expense
The premium or discount is amortized over a period between the issuance date and the maturity date. The date of the bonds is not used in determining the amortization period. The amortization per year is based on the number of months that the bonds are outstanding.
Early Extinguishment of Bonds
Where a callable option exists, a company may redeem its bonds prior to maturity. This may be the choice
when the interest rate on the debt is considerably higher than the current market interest rate. In this case, the company will profit by issuing new bonds at a lower interest rate and use the funds to reacquire the original, higher interest bonds.
The call price is usually a few points above face value. Even if a call provision does not exist, the company may still retire its bonds early by purchasing them in the open market.
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