The course builds on my Introduction to Financial Accounting course, which you should complete first. In this course, you will learn how to read, understand, and analyze most of the information provided by companies in their financial statements. These skills will help you make more informed decisions using financial information.
Video 7.2.1: Long-Term Debt and Bonds I
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From the course by University of Pennsylvania
More Introduction to Financial Accounting
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From the lesson
Week 007: Liabilities and Long-term Debt
We move to the right-hand side of the Balance Sheet this week with a look at Liabilities. We will start by covering time-value of money, which is the idea that $1 today is not worth the same as $1 in the future. Almost all liabilities involve a consideration of the time-value of money, so this will be an important foundation piece for you to understand. Then, we will cover accounting for bank debt, mortgages, and bonds. Next, we will move into the topic of "off-balance-sheet" liabilities with a discussion of Leases.
Meet the Instructors
Brian J BusheeThe Geoffrey T. Boisi Professor
Accounting
Hello, I'm Professor Bushee.
Welcome back.
Now that we have the basics of time value of money under our belt, we're going to
apply those to accounting for various kinds of long-term liabilities,
like bank debt, mortgages, leases, and bonds, a lot of bonds.
Let's get started.
So we're going to start our look at long-term liabilities by
contrasting them to current liabilities.
Current liabilities are anything due within one year, less than one year.
And these are pretty much most of the liabilities that we have been seeing so
far in the course, so
things like accounts payable and interest payable, taxes payable, wages payable.
Those are all very short-term liabilities.
We have to repay somebody within a couple of months.
Those liabilities are booked at their nominal value.
In other words, how much money you owe.
We don't try to figure out the present value.
So for accounts payable, we don't try to figure out the present value of
paying something off two months later.
But we talk about long-term liabilities, so liabilities due beyond one year, now
we're going to book those liabilities at the present value of future cash payments.
After we record those long-term liabilities, in some cases,
we continue to mark them to fair value.
But in most cases that we'll talk about, they're recorded at something called
amortized cost, which is you book the liability initially at present value.
And then you may make adjustments based on inter, interim cash payments, or
premiums or discounts, which we'll talk about later, but
you don't mark at the fair value every period.
So as a result, when you look at liabilities on a balance sheet,
what you're oftentimes seeing is a mix of fair values and
then these amortized costs, which are like old historical costs.
>> Now that you have made us watch 69 minutes of video about time value of
money, I sure hope we will use those calculations in this video.
Those were 69 minutes of my life that I will never get back again.
>> Oh yeah, we'll be doing time value of money calculations, not for
the first few minutes of the video, but toward the end, you'll be seeing them.
Don't worry.
The liabilities that we're going to focus on for
most of the next two videos are different types of debt.
So we're going to talk first about bank loans.
This is a kind of liability where you borrow some principal up front, so
maybe you borrow a $1,000.
You make periodic interest payments on that $1,000 and
then you repay the $1,000 principal at the end of the loan.
A mortgage will be something where, again, you borrow principal, so
you borrow, I guess we should make it a million dollars.
Then you make periodic interest and principal payments over the loan period
such that by the end of the loan period, you've fully paid back the principal.
There's not necessarily that lump sum payment of principal at the end.
And then we'll talk about corporate bonds.
Corporate bonds are where a company promises to pay periodic cash flows,
which we're going to call coupons, plus a lump sum at maturity,
which we are going to call the principal.
What the company does is offer these to the public and then investors offer the,
to pay the company the present value of the coupons and the principal.
So that's how much cash the company raises from issuing the bond.
Investors can then sell the bond to other people freely until
the maturity of the bond.
And there's a special case called the zero-coupon bond,
where the coupon payment is zero.
So there's no periodic cash flows, but you just pay back a lump sum at maturity.
So you borrow now and then you pay back at maturity.
>> My favorite type of debt are loans from my parents.
I borrow principal, make no interest payments, and make no principal payments.
Will we cover the accounting for these type of loans?
>> no. We won't be working on accounting for
parent loans.
Those actually sound more like donated capital than actual liabilities.
First, let's look at how we do the accounting for the bank loan.
So in this example, on January 1st, 2010,
KP incorporated is going to borrow $10,000 from a bank on a three-year loan.
The bank changes the firm 5% interest per year.
So it's always helpful to look at a timeline of payments to try to
figure out when we're going to get cash and
pay cash and that'll help guide the journal entries.
So, on January 1st, 2010, we're going to receive $10,000 cash.
Then on December 31st, we're going to pay $500 of interest.
The $500 is 5% of 10,000.
We pay the same amount on December 31, 2011.
It's the same amount because at that point, we still owe $10,000.
We pay 5% interest on that.
And then at maturity, December 31,
2012, we pay the last interest payment plus the principal that we owe.
So first, I want to do the journal entry for
issuing the debt, so when we first borrow from the bank.
And I'm going to throw up the pause sign and
see if you can do the journal entry for first borrowing from the bank.
Okay. So, on January 1st,
2010, we're going to receive cash, $10,000, so we debit cash $10,000.
And we want to credit a liability for what we owe the bank, so
we credit notes payable $10,000.
>> Wait, you forgot to record the interest payable!
>> Finally a legitimate question.
So, remember we don't book interest payable until we've
incurred interest expense without paying any cash.
So there's no interest payable on the day that we get the proceeds of this loan
because we can in theory just turn around, pay it back immediately and
not owe any interest.
So, interest payable and interest expense are only going to accrue over time.
Next, we need to do the journal entry for the two periodic interest payments, so
the interest payment on December 31, 2010 and December 31, 2011.
So, I'll put up the pause sign and
you can try to think of what those journal entries would be.
'Kay, so we are debiting interest expense for
500 because that's a cost of having the loan outstanding.
That goes on the income statement as an expense.
Credit cash for 500 because we're paying $500 cash.
December 31, 2011, we make the same journal entry.
We debit interest expense and we credit cash.
The last journal entry that we need to do is when we repay the principal and
pay that last interest payment on December 31, 2012.
So I'll put up the pause sign and
try to do the journal entry that we do on December 31, 2012.
' Kay, so we're paying off our notes payable.
To get rid of the notes payable liability, we debit notes payable 10,000,
so that goes to zero.
We debit interest expense because we had another $500 of interest expense for
the year.
And then we credit cash for 10,500, which is the total cash for paying.
Now, you could have also split this into two journal entries.
Debit interest expense 500, credit cash 500, and
then debit notes payable 10,000, credit cash 10,000.
Either one is okay just as long as your debits equal your credits.
Now we're going to look at accounting for a mortgage.
So on January 1,
2010, KP Incorporated borrows $10,000 from a bank on a three-year mortgage.
The bank charges KP 5% interest per year on the mortgage.
The required payment is $3,672 per year.
>> Do you know how long it takes to write $3,672 in words on a check?
>> A check?
Wow, you are old.
>> Anyway, why doesn't the bank just make the payment a nice round
number like $3,700?
>> I'm sure the bank would be happy to give you a nice, round number as
a payment, but if they would be rounding up, then they're cheating you.
They're charging you too much.
This 3,672 is not an arbitrary number pulled out of thin air, but
it actually represents a payment based on an annuity calculation.
Let me show you.
So here's where we get the payment number.
It's a present value calculation and
specifically it's an present value of an annuity.
But in this case, we actually know the present value.
What's missing is the payment because we know the present value's $10,000.
That's how much we're getting now.
There's no future value.
There's no money that's going to change hands at the end.
It's an annual payment, so we use the annual interest rate of 5% for
the rate, three years, n is 3, we don't know the payment.
We can use Excel or a calculator or PV table to try to solve it.
The payment comes up to be 3,672.
Easiest way to solve this is Excel, so
let me pop out to Excel and show you how to do that.
So going into Excel, we hit the little Function button.
We look for the payment function, PMT.
We put in the annual interest rate,which is 5%, for three periods, three years.
The present value is 10,000.
There's no future value and it's an ordinary annuity, so we hit OK.
It shows us the negative.
If you want to see it as positive, you put that in there, and we get 3,672.
So, coming back into the PowerPoint, what it's always helpful to look at
when accounting for a mortgage is what's called an amortization schedule,
which tracks the principal and interest payments over time.
So at the end of that first year, December 31,
2010, the amount of principal that we owe is $10,000.
Then we're going to make a payment on that day of 3,672.
Now, that payment is going towards principal and interest.
So first, you calculate the interest portion of the payment.
You take the beginning balance, which is 10,000, times the 5% annual interest rate.
And so, we're owe in terms of interest for the first year is $500.
So, how much principal are we paying?
It's the difference between 3,672 and
500 of interest, which means we're paying 3,172 of principal.
So if we're paying that much principal, that means that after the payment,
the ending balance in our principal, our mortgage payable,
will be 6,828, which is 10,000 minus 3,172.
Then at the end of 2011, the beginning balance is what we
ended with last time, 6,828.
We make the same payment of 3,672, but this time, the interest component is last.
It's calculated as the beginning balance times 5%, so
it's 6,828 times 5%, which is 341.
Since we're paying a little bit less interest with the same payment,
we pay off more principal.
That's calculated as 3,672 minus 341, so that's 3,331.
And so, since we're paying back that principal,
the balance in the mortgage principal at the end of the year is 3,497.
That's 6,828 minus 3,331, gives you 3,497.
And then we get to December 31, 2012, which is the end of the mortgage.
So coming in, the balance is 3,497.
The interest portion is 3,497 times 5% or 175.
So we're making the same payment of 3,672,
which means that the principal portion is 3,497.
3,672 minus 175 and viola, that's exactly how much principal we owe.
So after we make the last payment, the principal balance is 0.
So, instead of paying back the principal in one lump sum at the end, we're paying
back some principal every period so that by the time we get to the end of the loan,
we've paid back all the principal in addition to annual interest.
>> Wait, why does the interest change each year?
And why is it highest in the first year?
No wonder everyone hates banks!
>> Now, now, now, I used to work for a bank.
Some of my best friends are bankers.
Let's go easy on them.
So there's a rational explanation why interest is highest at the beginning and
then goes down over time.
Interest is always based on the balance of principal at that point in time.
And what we're doing in each payment is we're not only paying interest, but
we're paying down principal.
As we pay down principal,
then the interest charge on that principal is going to be lower.
This is a natural feature of a mortgage.
If you ever buy a house with a 30-year mortgage,
you'll notice that [LAUGH] almost all of your first payment goes to interest.
You pay a little bit down in principal.
As you pay more and more principal down over time,
the interest portion of the payment drops, the principal portion increases.
Now that we've laid out the amortization schedule, we're going to go through and
do the journal entries so
we can take our amortization schedule and represent it in a timeline.
So, on the day that we borrow from the bank for
the mortgage January 1st, we get $10,000 cash coming in.
And then we're going to make our three payments of 3,672,
which are split into interest and principal.
So let me throw up the pas, the pause sign and
have you try to do the journal entry on January 1, 2010,
which is when that mortgage is issued to the company, so when KP borrows the money.
So our receiving cash, KP is receiving cash from the bank, so
we debit cash 10,000.
And we credit mortgage payable, a liability for what we owe back the bank.
Then at the end of 2010, December 31, we have to make our payment.
So I'm going to throw up the pause sign again and
try to make the journal for 12/31/2010.
So here, we're going to reduce the principal balance in mortgage payable by
3,172, so reduce the liability with a debit.
We're going to debit interest expense for 500 to represent the cost of
the interest during the year, which needs to go in the income statement.
And then we credit cash for the amount of the payment 3,672.
So let's try it again with the 2011 payment and here is the pause sign.
So it's going to be the same entry, different amounts.
So on December 31, we're going to debit mortgage payable again for
the reduction in principal, which is now 3,331.
We're going to debit interest expense to recognize the interest cost in
the income statement this period, 341, and put a cash for 3,672.
Last payment, 12/31/2012.
Why don't you give it a shot?
Again, same entry, different numbers.
Debit mortgage payable to reduce the principal balance by 3,497.
Debit interest expense to recognize the cost of the interest on
the income statement, 175, and then credit cash for the 3,672.
And at this point, the mortgage is fully paid off, so
there are no more journal entries.
So that's what what goes on with the accounting firm mortgage where you
have this situation of equal payments and the payments are partially for
interest and partially for
principal so that by the end of the payment stream, you've paid off the loan.
Now we're going to look at bonds payable,
which is a very common way that companies raise money to finance their operations.
So, bonds payable, as we talked about a little bit at the beginning of the video,
these are coupon bonds,
which means that they're going to require semiannual coupon payments.
So there's going to be a payment of cash every six months plus payment of
the face value of the bond at maturity, so at the end of its time period.
So, the terminology that we're going to use with bonds are the following and
what I'm going to do in parentheses is note how they would map
into our present value calculations.
So, the price or proceeds of the bond is what the company receives when they
issue the bond to the public.
That's going to be the same as the present value in a time value of
money calculation.
The face value or par value is the amount that the bond is going to pay at maturity.
That's also going to be represented as the future value when we do time value money
calculations and you can easily remember because face value, future value, both FV.
The market interest rate or effective interest rate or
yield-to maturity, those are all synonyms.
That's the rate r that we're going to use to calculate present values.
That's what rate the, the investors are willing to lend money to the company at.
We're going to have the coupon rate, which is stated in the bond agreement, and
that's going to determine the coupon payment,
which is the payment in our present value calculations,
which equals the face value of the bond times the coupon rate.
And then the number of periods to maturity is going to be n.
And so, we're going to go through examples and see how all of this works.
But the key thing to remember is that bonds have semiannual payments,
which means we need to do semiannual compounding.
So we have to double the number of periods and
divide the rates by two when we do present value calculations.
So, if it was a ten-year bond with a 10% interest rate,
we would do 20 periods, 20 semiannual periods, at 5% per period.
And the bond price is going to be equal to the present value of
that face value amount or
future value amount plus the present value of the stream of payments, that annuity.
>> But this sounds like it is going to be the most boring Bond video
since GoldenEye.
>> I actually thought A View to a Kill was much worse than
GoldenEye although the cool Duran Duran theme song sort of redeemed it.
In case [LAUGH] you're wondering what we're talking about,
these are James Bond movies.
You can't teach bond accounting without having James Bond jokes.
Here's another one.
What is the favorite James Bond movie of all time for accountants?
It's this one, debit no.
>> Excuse me, I would appreciate it if you stopped with the dumb bond jokes.
I am sick and tired of always hearing dumb bond jokes.
>> Did you say dumb bond jokes?
[LAUGH] Let's move on.
Okay, so the example we're going to go through is on January 1st, 2010,
KP Incorporated issues a three-year 5% coupon, $10,000 face value bond.
Investors price the bond using an effective market interest rate of 5%,
which means that KP is going to receive proceeds from the bond of $10,000.
So, basically KP specifies all the terms of the bond, puts it out to the market.
The investors in the market figure out the present value and
then are willing to give KP $10,000 of proceeds to get that bond.
Where do they get that from?
Well, it's, they do a present value calculation to get the bond price.
So remember we have to double the number of periods and
divide the interest rate by 2.
So the present value of the face value part,
the 10,000, you calculate looking for present value.
We'll have a face value or future value of 10,000.
We use an interest rate of 0.25, which is half of 5%.
The number of periods is six.
A three-year bond, but we double the number periods to get semiannual.
And then there's no payment because we're just doing a face val,
face value future value.
So you come up with a present value of 8,623.
And I'll bring this up in Excel in a little bit to show you all of this.
We have to do the present value of the payment, so here we're looking for
the present value.
We set the future value equal to zero.
We use the same semiannual interest rate, number of semiannual periods.
The payment is 250.
That's the $10,000 face value times the semiannual rate of 2.5%,
so that's where we get 250 from.
If you use Excel, calculator or PV table to solve, you wind up with 1,377.
So we add those two up, 8,623 plus 1,377, to get the price of 10,000.
Or, if you're using Excel, you can just put in all of the elements.
Face value, 10,000.
Payment, 250.
Six periods, 2, 2.5% to get the, calculate the present value and
you will also get 10,000.
So let me pop out to Excel and show you all these calculations.
Okay, so to price the bond, there are two components.
There's the present value of the $10,000 face value of the bond.
So we bring up our function, PV.
We have a rate of 2.5% for six months, six semiannual periods.
We're not going to do anything with the tenit, payment at this point and
we have a $10,000 face value.
So that give us 8,623, if you'll allow me to round.
And then we do the same thing for the coupon payment.
So, present value, we've got 0.025, six semiannual periods,
$250 payment, no future value, 1,377.03, sum those up, $10,000.
But then, as I said, you could also do present value where you put in the rate,
the number of periods, and put in both the payment and the face value.
And what Excel will do is value them for you together and
come up with the same bond price of 10,000.
>> I have a strong feeling of deja vu.
Have we seen something like this before?
>> Yes, this is the exact example I used at the end of the Time Value of
Money video.
So hopefully, it made a lot more sense when you saw it the second time.
So now let's go ahead and do the journal entries.
So as we have done before, I've laid out all of the payments across the timeline.
We get 10,000 when we issue the bond on January 1st, 2010.
Every six months, we pay a 250 coupon payment.
The end, we make the last coupon payment plus the principal.
So let me throw up the pause sign and try to do the journal entry for
when the bond is issued on January 1, 2010.
So on this date we're receiving cash of $10,000, so we debit cash.
We credit bonds payable, liability of $10,000.
Now let's look at the journal entry for the periodic coupon payments and
those five payments in the middle are all identical journey entries, so
just try to do one of those and it'll apply to all of them.
So here is the pause sign.
'Kay, so we're debiting interest expense for 250 because this is
a cost of interest, cost of doing business, goes onto the income statement.
And then we credit cash for
250 to represent the cash that pay for the coupon.
So we're going to do that for those five intermediate six-months periods.
Then the last entry we're going to look at is December 31, 2012,
when we have to repay at maturity.
So let me one last time throw up the pause sign and try to do this journal entry.
Okay, so we're paying off the principal, so we debit bonds payable to
reduce the liability by 10,000, so it makes the liability zero.
We do one more coupon payment of interest expense, so
we debit interest expense for 250, and then credit cash for the 10,250.
And, of course, you could have also split this into two entries,
debit interest expense, credit cash of 250 each.
Debit bonds payable, credit cash for $10,000 each.
>> This seems very easy.
I thought bonds was going to be difficult, so I am kind of disappointed.
>> Yeah, if only all bonds were this straightforward and easy.
Unfortunately, they're not.
And in the next video, we will crank up the difficulty when we look at
discount bonds, premium bonds and retirement before maturity.
I'll see you then.
>> See you next video!
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