Long-Term Liabilities: Bonds Payable, Amortization, and Leverage in Financial Accounting

Long-Term Liabilities

Bonds Payable: An Introduction

Bonds are a common form of long-term debt issued by companies to raise capital. A bond certificate contains essential information about the debt agreement.

• Debts of an issuing company: Bonds represent a formal contract to repay borrowed money with interest at fixed intervals.

• Bond certificate states:

  • Issuing company’s name

  • Principal (face value, maturity value, par value)

  • Maturity date

  • Annual interest rate

  • Interest payment dates

Types of Bonds

Bonds can be classified based on their maturity structure and security features.

• Term Bonds: All bonds in the issue mature at the same time.

• Serial Bonds: Bonds mature in installments over time.

• Secured Bonds: Bondholders have rights to specific assets if the issuer defaults.

• Unsecured Bonds (Debentures): Backed only by the issuer’s general creditworthiness.

Bond Prices

The price of a bond is determined by market conditions and is quoted as a percentage of its maturity value.

• Bond Premium: Issued above face value (credit balance).

• Bond Discount: Issued below face value (debit balance).

• Time Value of Money: The present value of future cash flows affects bond pricing.

Interest Rates and Bond Prices

Bond prices are influenced by the relationship between the stated interest rate and the market interest rate.

• Stated Interest Rate (Coupon Rate): The rate printed on the bond certificate.

• Market Interest Rate (Effective Interest Rate): The rate investors demand in the market.

• Bonds are always sold at market price, which is the present value of future payments.

Exhibit 9-1: How Stated and Market Interest Rates Affect Bond Pricing

Case	Stated Rate	Market Rate	Issue Price
A	Equals	Equals	Par (face value)
B	Less than	Greater than	Discount (below face value)
C	Greater than	Less than	Premium (above face value)

Issuing Bonds Payable at Par

When bonds are issued at par, the stated rate equals the market rate. The accounting entries reflect the receipt of cash and the creation of a liability.

• Example: Southwest Airlines issues $100,000 of 9% bonds, maturing in 5 years, at par.

• Journal Entry at Issuance:

  • Debit Cash $100,000; Credit Bonds Payable $100,000

• Interest Payment Entry:

  • Debit Interest Expense $4,500; Credit Cash $4,500

  Formula: $100,000 imes 0.09 imes rac{6}{12} = 4,500$

• Year-End Accrual:

  • Debit Interest Expense $4,500; Credit Interest Payable $4,500

• At Maturity:

  • Debit Bonds Payable $100,000; Credit Cash $100,000

Effective-Interest Amortization of Bonds

The effective-interest method is the preferred approach for amortizing bond discounts and premiums, as it reflects the time value of money and results in varying interest expense each period.

• Steps:

  1. Determine the exact price at issuance (present value of future cash flows).

  2. Build an amortization table to allocate interest expense and discount/premium amortization over the bond’s life.

Exhibit 9-2: Amortization of Bond Discount

Period	Interest Payment	Interest Expense	Discount Amortization	Bond Carrying Value
1	$4,500	$4,807	$307	$96,456
2	$4,500	$4,823	$323	$96,779
...	...	...	...	...

As the bond approaches maturity, the carrying value increases to face value, and interest expense rises due to discount amortization.

Exhibit 9-3 & 9-4: Graphical Representation

• Interest payment remains constant.

• Interest expense increases as discount is amortized.

• Bond carrying value rises to face value at maturity.

Issuing Bonds Payable at a Discount

Bonds issued below face value result in a discount, which is amortized over the bond’s life.

• Journal Entry for Interest Payment and Discount Amortization:

  • Debit Interest Expense $4,807; Debit Discount on Bonds Payable $307; Credit Cash $4,500

• Year-End Accrual:

  • Debit Interest Expense $4,823; Debit Discount on Bonds Payable $323; Credit Interest Payable $4,500

• At Maturity:

  • The discount is fully amortized; carrying value equals face value.

Issuing Bonds Payable at a Premium

Bonds issued above face value result in a premium, which is amortized over the bond’s life, reducing interest expense each period.

• Example: Southwest issues $100,000 of 9% bonds at a market rate of 8%, receiving $104,100.

• Journal Entry at Issuance:

  • Debit Cash $104,100; Credit Bonds Payable $100,000; Credit Premium on Bonds Payable $4,100

• Balance Sheet Presentation:

  Long-term liabilities	Amount
  Bonds Payable	$100,000
  Premium on Bonds Payable	$4,100
  Total	$104,100

• Amortization Table (Exhibit 9-5):

  Period	Interest Payment	Interest Expense	Premium Amortization	Bond Carrying Value
  1	$4,500	$4,164	$336	$103,764
  2	$4,500	$4,155	$345	$103,419
  ...	...	...	...	...

• Journal Entry for Interest Payment and Premium Amortization:

  • Debit Interest Expense $4,164; Debit Premium on Bonds Payable $336; Credit Cash $4,500

• Graphical Representation (Exhibits 9-6 & 9-7):

  • Interest expense decreases as premium is amortized.

  • Bond carrying value decreases to face value at maturity.

Leverage and Financial Statement Analysis

The Leverage Ratio

Leverage ratios measure the extent to which a company uses debt to finance its assets, impacting risk and return.

• Debt Ratio: Proportion of total liabilities to total assets. $\text{Debt ratio} = \frac{\text{Total debt (liabilities)}}{\text{Total assets}}$

• Equity Multiplier (Leverage Ratio): Shows total assets per dollar of stockholders’ equity. $\text{Leverage ratio} = \frac{\text{Average total assets}}{\text{Average common stockholders' equity}}$

• Example Comparison: Southwest Airlines vs. United Airlines Holdings (2022): Southwest has a lower leverage ratio and debt ratio, indicating lower risk to creditors.

Company	Average Total Assets	Average Common Stockholders' Equity	Leverage Ratio	Total Liabilities	Debt Ratio
Southwest	$35,845	$10,551	3.40	$24,682	68.8%
United	$67,766.50	$5,962.50	11.37	$60,462	89.2%

Reporting Long-Term Liabilities

Financial Statement Presentation

Long-term liabilities are reported on the balance sheet and disclosed in detail in the notes to financial statements.

• Example (Exhibit 9-8): Southwest Airlines lists various notes and loans with maturity dates and amounts.

• Current maturities and unamortized discounts/premiums are also disclosed.

Disclosing the Fair Value of Long-Term Debt

U.S. GAAP encourages companies to report the fair value of long-term debt, which is based on quoted market prices and may differ from carrying amounts due to market fluctuations.

• Fair Value: The price at which the debt could be exchanged in the market.

• Fair values can be higher or lower than the carrying value depending on interest rate changes and market conditions.

Statement of Cash Flows (Partial)

The statement of cash flows reports cash inflows and outflows related to operating, investing, and financing activities, including transactions involving long-term liabilities.

• Example (Exhibit 9-9): Southwest Airlines reports cash flows from the issuance and repayment of long-term debt and payment of interest.

Summary

• Bonds payable are a key component of long-term liabilities, with accounting for issuance, interest, and amortization depending on whether bonds are issued at par, discount, or premium.

• The effective-interest method provides a more accurate allocation of interest expense over the life of the bond.

• Leverage ratios help assess a company’s financial risk and capital structure.

• Long-term liabilities must be properly reported and disclosed in financial statements, including fair value information.

Additional info: Academic context and formulas have been expanded for clarity and completeness.