Debt Obligations: Long-Term Debt

Debt Obligations: Long-Term Debt

Long-term debt includes notes and bonds payable. Notes and bonds payable are contracts between borrowers and creditors. In the contract, the borrower agrees to repay the amount borrowed at specified dates and agrees to pay specified amounts of interest. Some companies issue debt that is secured by specific assets, such as land, building, or equipment. These obligations are referred to as secured debt or secured loans. If the company does not have the cash to pay back secured debt when it comes due, the company must sell those assets pledged as security to pay the debt or transfer ownership of the assets to the creditor. Other types of debt are unsecured, such as debentures which are unsecured bonds. If a company cannot repay this type of debt, it can be forced to liquidate (sell its non-cash assets). Here, debentures and other unsecured debts are repaid from the sale of assets that are not pledged as security for secured debt. Secured debt is typically less risky than unsecured debt.

Debt obligations have many different characteristics. Bond issues that require a portion of the bonds to be repaid each year are called serial bonds. Bond issues that require principal payments only at the end of the debt’s life are called term bonds. Callable bonds are bonds that a company can reacquire after the bonds have been outstanding for a specific period.

Debt Transactions

Assume a $100,000, five year bond is issued at an interest rate of 5%, paid annually at the end of each year. The $100,000 is the face or maturity value and represents the amount the company will pay creditors at the end of the five year period. The annual interest paid on the debt (5%) is the stated rate. Bonds are often sold to yield a return to creditors that is less than or greater than the stated rate. The actual rate of return earned by creditors is known as the market rate, the effective rate, or the yield. The effective rate of interest is determined by the amount creditors are willing to pay for the bonds and affects the amount of cash the company receives from its bonds when they are sold. When the effective rate is higher than the stated rate, bonds sell at a discount (less than face value). When bonds sell at maturity value, they are said to sell at par. When the effective rate is lower than the stated rate, bonds sell at a premium (more than face value).

The following table documents the relationship between effective and stated interest rates.

Interest Rate Comparison / Bonds Sell At / Relation Between Interest and Amount Paid / Effect on Principal Each Period
Effective Rate > Stated Rate / Discount / Interest Expense > Amount Paid / Increase
Effective Rate = Stated Rate / Par / Interest Expense = Amount Paid / No Change
Effective Rate < Stated Rate / Premium / Interest Expense < Amount Paid / Decrease

Financial Reporting of Debt

A corporation’s financial statements and accompanying notes provide useful information. They help readers calculate the amount of debt a company has outstanding. They also show changes in debt, interest rates, interest expense, and current and future cash flows associated with existing debt and interest payments.

Interest expense is reported each year on the income statement. For most companies, interest expense is a non-operating expense, and it is reported on the income statement after operating income.

The amount of interest paid is reported each year on the statement of cash flows as part of operating activities. When debt is issued, the amount of cash received is reported on the statement of cash flows as cash from financing activities. When debt is repaid, the amount of cash paid is listed there as cash paid for financing activities.

Other Obligations

Other types of obligations that involve financing activities are reported on the balance sheet or in the notes to the financial statements. Among these obligations are contingencies and commitments.

Contingencies

A contingency is an existing condition that may result in an economic effect if a future event occurs. Under certain circumstances, contingencies are reported as liabilities. If a contingency probably will result in a loss, and the amount of the loss can be reasonably estimated, it should be included as a liability on a company’s balance sheet. Also, the amount of the expected loss is recognized on the income statement in computing net income.

Commitments

A commitment is a promise to engage in some future activity that will have an economic effect. Commitments usually involve agreements to purchase or sell something in the future. These future payments are not liabilities and, if material, are reported in the notes to the financial statements.