13.5: Summary
- Page ID
- 2831
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13.1 Explain the Pricing of Long-Term Liabilities
- Businesses can obtain financing (cash) through profitable operations, issuing (selling) debt, and by selling ownership (equity).
- Notes payable and bonds payable are specific types of debt that businesses issue in order to generate financial capital.
- Liabilities are categorized as either current or noncurrent based on when the liability will be settled relative to the operating period of the business.
- A bond indenture is a legal document containing the principal amount, maturity date, stated interest rate and other requirements of the bond issuer.
- Bonds can be issued under different structures and include different features.
- Periodic interest payments are based on the amount borrowed, the interest rate, and the time period for which interest is calculated.
- Bond selling prices are determined by the market interest rate at the time of the sale and the stated interest rate of the bond.
- Bonds can be sold at face value, at a premium, or at a discount.
13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
- The effective-interest method is a common method used to calculate the interest expense for a given interest payment.
- There is an inverse relationship between the price of a bond and the market interest rate.
- The carrying value of a bond sold at a discount will increase during the life of a bond until the maturity or face value is reached.
- The carrying value of a bond sold at a premium will decrease during the life of a bond until the maturity or face value is reached.
- The amount of cash to be paid, the interest expense, and the premium or discount amortization (when applicable) with each periodic payment are calculated based on an amortization table or schedule.
13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
- When a company issues a bond, the specific terms of the bond are contained in the bond indenture.
- Journal entries are recorded at various stages of a bond, including when the bond is issued, for periodic interest payments, and for payment of the bond at maturity.
- The difference between the face value of a bond and the cash proceeds are recorded in the discount (when the proceeds are lower than the face value) and premium (when the proceeds are higher than the face value) accounts.
- The carrying or book value of a bond is determined by the balances of the Bond Payable and Discount and/or Premium accounts.
- Interest expense associated with a bond interest payment is calculated by the bond’s carrying or book value multiplied by the market interest rate.
Key Terms
- amortization
- allocation of the costs of intangible assets over their useful economic lives; also, process of separating the principal and interest in loan payments over the life of a loan
- bond
- type of financial instrument that a company issues directly to investors, bypassing banks or other lending institutions, with a promise to pay the investor a specified rate of interest over a specified period of time
- bond indenture
- contract that lists the features of the bond, such as the principal, the maturity date, and the interest rate
- bond retirement
- when the company that issued the bonds pays their obligation
- book value
- difference between the asset’s value (cost) and accumulated depreciation; also, value at which assets or liabilities are recorded in a company’s financial statements
- callable bond
- (also, redeemable bond) bond that can be repurchased or “called” by the issuer of the bond before its due date
- carrying value
- (also, book value) value that assets or liabilities are recorded at in the company’s financial statements
- compound interest
- in a loan, when interest earned also earns interest
- convertible bond
- bond that can be converted into common stock at the option of the bond holder
- coupon rate
- (also, stated interest rate or face rate) interest rate printed on the certificate, used to determine the amount of interest paid to the holder of the bond
- debenture
- bond backed by the general credit worthiness of a company rather than specific assets
- debt financing
- borrowing money that will be repaid on a specific date in the future in order to finance business operations
- default
- failure to pay a debt as promised
- discount on bonds payable
- contra liability account associated with a bond that has a stated rate that is lower than the market rate and is sold at a discount
- effective-interest method
- method of calculating interest expense based on multiplying the carrying value of the bond by the market interest rate
- equity financing
- selling part of the business to obtain money to finance business operations
- fully amortized notes
- periodic loan payments that pay back the principal and interest over time with payments of equal amounts
- interest-only loan
- type of loan that only requires regular interest payments with all the principal due at maturity
- long-term liability
- debt settled outside one year or one operating cycle, whichever is longer
- market interest rate
- (also, effective interest rate) rate determined by supply and demand and by the credit worthiness of the borrower
- maturity date
- date a bond or note becomes due and payable
- maturity value
- amount to be paid at the maturity date
- note payable
- legal document between a borrower and a lender specifying terms of a financial arrangement; in most situations, the debt is long-term
- par value
- value assigned to stock in the company’s charter, typically set at a very small arbitrary amount; serves as legal capital
- premium on bonds payable
- contra account associated with a bond that has a stated rate that is higher than the market rate and is sold at a premium
- principal
- face value or maturity value of a bond (the amount to be paid at maturity); also, initial borrowed amount of a loan, not including interest
- promissory note
- represents a personal loan agreement that is a formal contract between a lender and borrower
- putable bond
- bond that give the bondholder the right to decide whether to sell it back early or keep it until it matures
- secondary market
- organized market where previously issued stocks and bonds can be traded after they are issued
- secured bond
- bond backed by specific assets as collateral for the bond
- serial bond
- bond that will mature over a period of time and will be repaid in a series of payments
- stated interest rate
- (also, contract interest rate) interest rate printed on the face of the bond that the issuer agrees to pay the bondholder throughout the term of the bond; also known as the coupon rate and face rate
- straight-line method
- method of calculating interest expense that allocates the same amount of premium or discount amortation for each of the bond’s payment periods
- term bond
- bond that will be repaid all at once, rather than in a series of payments