Long-Term Debt and Bonds: Your Company’s Big Promises 🏦
The Big Picture: Borrowing for the Future
Imagine you want to build a treehouse, but you don’t have enough allowance right now. Your parents say, “We’ll lend you $100, and you can pay us back $10 every month for a whole year.”
That’s exactly what long-term liabilities are! They’re promises a company makes to pay back money over a long time (more than one year).
1. Long-Term Liabilities Overview
What Are They?
Long-term liabilities = Money you owe that you don’t have to pay back for more than one year.
Think of it like this:
| Short-Term Debt | Long-Term Debt |
|---|---|
| Pay back in < 1 year | Pay back in > 1 year |
| Like borrowing $5 until Friday | Like a car loan over 5 years |
| Called “Current Liabilities” | Called “Long-Term Liabilities” |
Common Types:
- Bonds payable (IOUs to many people)
- Long-term bank loans (borrowing from the bank)
- Lease obligations (renting stuff for years)
- Pension liabilities (money promised to retired workers)
Example: ABC Company borrows $500,000 from a bank to buy new machines. They’ll pay it back over 10 years. This is a long-term liability!
2. Bonds Payable Concepts
What’s a Bond?
A bond is like a fancy IOU.
Imagine you need to borrow $1,000 from 100 different people. Instead of asking each person individually, you create 100 “IOUs” for $10 each. Each IOU says:
- “I promise to pay you back $10 in 10 years”
- “I’ll also give you a little extra ($1) every year as a thank-you”
That’s a bond!
Key Bond Terms (Made Simple):
| Term | What It Means | Example |
|---|---|---|
| Face Value | The amount printed on the bond | $1,000 |
| Coupon Rate | The yearly “thank you” percentage | 5% = $50/year |
| Maturity Date | When you pay back the full amount | 10 years from now |
| Bondholder | The person who lent you money | Investor |
| Issuer | The company borrowing money | Your company |
Why Do Companies Issue Bonds?
- Need big money fast - Easier than asking one bank for millions
- Spread the risk - Owe small amounts to many people
- Fixed payments - Know exactly what you’ll pay each month
Example: XYZ Company issues 1,000 bonds at $1,000 each with a 6% coupon rate, maturing in 5 years.
- Total borrowed: $1,000,000
- Annual interest paid: $60,000 (6% × $1,000,000)
- At maturity: Pay back $1,000,000
3. Bond Pricing: Why Bonds Don’t Always Sell at Face Value
Here’s where it gets interesting!
The Magic of Interest Rates
Imagine two lemonade stands:
- Stand A gives you 5 cups for $1
- Stand B gives you 6 cups for $1
Which would you choose? Stand B, right?
Bonds work the same way!
Three Pricing Scenarios:
┌─────────────────────────────────────────────┐
│ BOND PRICING SCENARIOS │
├─────────────────────────────────────────────┤
│ │
│ Coupon Rate > Market Rate │
│ → PREMIUM (Sell above $1,000) │
│ "Your bond is better than average!" │
│ │
│ Coupon Rate = Market Rate │
│ → PAR VALUE (Sell at $1,000) │
│ "Your bond is exactly average" │
│ │
│ Coupon Rate < Market Rate │
│ → DISCOUNT (Sell below $1,000) │
│ "Your bond is worse than average" │
│ │
└─────────────────────────────────────────────┘
Real Example:
Scenario: Market interest rate is 8%. You issue a bond with 6% coupon rate.
- Your bond pays LESS than the market expects
- Nobody wants to buy at $1,000 (they’d lose money!)
- You must DISCOUNT the bond (sell for less, like $950)
Scenario: Market interest rate is 4%. You issue a bond with 6% coupon rate.
- Your bond pays MORE than the market expects
- Everyone wants it!
- You can charge a PREMIUM (sell for more, like $1,050)
4. Bond Issuance Accounting
Recording the Bond Sale
When you sell bonds, you need to write it down in your books!
At Par Value (Face Value = Selling Price)
Example: Issue $100,000 bonds at par value.
Debit: Cash $100,000
Credit: Bonds Payable $100,000
Simple! You got $100,000 and owe $100,000.
At a Discount (Selling Price < Face Value)
Example: Issue $100,000 bonds for only $95,000.
Debit: Cash $95,000
Debit: Discount on Bonds $5,000
Credit: Bonds Payable $100,000
You got $95,000 but still owe $100,000. The $5,000 difference is the “discount.”
At a Premium (Selling Price > Face Value)
Example: Issue $100,000 bonds for $105,000.
Debit: Cash $105,000
Credit: Premium on Bonds $5,000
Credit: Bonds Payable $100,000
You got $105,000 but only owe $100,000. The extra $5,000 is the “premium.”
5. Bond Amortization Methods
What is Amortization?
Remember that discount or premium? You can’t just forget about it! You need to spread it out over the life of the bond.
Think of it like eating a big cake. You don’t eat it all at once – you eat a slice each day until it’s gone!
Two Methods:
Method 1: Straight-Line (The Easy Way)
Divide the total discount/premium by the number of periods.
Example: $5,000 discount over 5 years
- Amortization per year = $5,000 ÷ 5 = $1,000
Each year, the discount shrinks by $1,000. Simple!
Year 1: $5,000 → $4,000
Year 2: $4,000 → $3,000
Year 3: $3,000 → $2,000
Year 4: $2,000 → $1,000
Year 5: $1,000 → $0
Method 2: Effective Interest (The Accurate Way)
This method calculates the REAL interest expense based on the actual bond value.
Formula:
Interest Expense =
Carrying Value × Market Interest Rate
Example: $95,000 bond, 8% market rate
Year 1 Interest Expense = $95,000 × 8% = $7,600
This is more accurate because it considers the changing value of the bond!
Comparison Table:
| Method | Pros | Cons |
|---|---|---|
| Straight-Line | Easy to calculate | Less accurate |
| Effective Interest | More accurate | More complex |
6. Bond Retirement
Ways to Get Rid of Bonds
Sometimes companies want to pay off their bonds early. It’s like paying off your allowance debt to your parents early!
Option 1: At Maturity (The Normal Way)
Wait until the bond expires and pay the face value.
Example: At maturity, pay off $100,000 bond.
Debit: Bonds Payable $100,000
Credit: Cash $100,000
Done! No gain or loss.
Option 2: Early Retirement (The Impatient Way)
Buy back bonds before maturity.
Scenario A: Buy back $100,000 bonds for $95,000 (Gain!)
Debit: Bonds Payable $100,000
Credit: Cash $95,000
Credit: Gain on Retirement $5,000
You saved $5,000!
Scenario B: Buy back $100,000 bonds for $108,000 (Loss!)
Debit: Bonds Payable $100,000
Debit: Loss on Retirement $8,000
Credit: Cash $108,000
You paid $8,000 extra. Oops!
Why Retire Early?
- Interest rates dropped (can borrow cheaper elsewhere)
- Company has extra cash
- Want to reduce debt
7. Lease Obligations
What’s a Lease?
A lease is like a long-term rental agreement.
Instead of buying a car for $30,000, you rent it for $500/month for 5 years.
Two Types of Leases:
Operating Lease (Short-Term Rental)
- Like renting an apartment
- You don’t own it
- Just record rent expense each month
- Doesn’t appear as liability on balance sheet
Finance Lease (Long-Term Commitment)
- Like rent-to-own
- Acts like you bought it
- DOES appear as liability on balance sheet
How to Tell the Difference:
A lease is a Finance Lease if ANY of these are true:
- Ownership transfers at the end
- Bargain purchase option (can buy cheap later)
- Lease term ≥ 75% of asset’s useful life
- Present value ≥ 90% of asset’s fair value
Recording a Finance Lease:
Example: Sign a 5-year lease for equipment worth $50,000.
At Start:
Debit: Right-of-Use Asset $50,000
Credit: Lease Liability $50,000
Each Payment:
Debit: Lease Liability $8,000
Debit: Interest Expense $2,000
Credit: Cash $10,000
Quick Summary: The Journey Map
graph TD A["Long-Term Liabilities"] --> B["Bonds Payable"] A --> C["Lease Obligations"] B --> D["Issue at Par/Premium/Discount"] D --> E["Amortize over time"] E --> F["Retire at maturity or early"] C --> G["Operating Lease"] C --> H["Finance Lease"] G --> I["Expense each period"] H --> J["Record as Asset & Liability"]
You Did It! 🎉
You now understand:
✅ Long-term liabilities are debts lasting over 1 year
✅ Bonds are fancy IOUs sold to many investors
✅ Bonds can sell at par, premium, or discount
✅ Bond discounts/premiums get amortized over time
✅ Bonds can be retired early (with gains or losses)
✅ Leases can be operating (rent) or finance (almost like buying)
Remember the treehouse analogy: Long-term debt is just borrowing money and promising to pay it back slowly, with a little extra “thank you” (interest) along the way!
Now go balance those books with confidence! 💪📚