Bonds and Long-Term Notes
LONG-TERM NOTES
Long-term notes payable are due beyond one year or the operating cycle whichever is longer.
Unlike bonds payable there is normally no secondary market for long-term notes. These
instruments do have a maturity date and carry a stated or implicit interest rate. Like bonds, longterm notes payable are valued at the present value of the future interest and principle cash flows.
The premium or discount is amortized over the life of the note.
Notes issued for Cash
When the stated interest rate of a note is equal to the market interest rate, the present value of the
note is the same as the face value of the note. The journal entry to record a $100,000 note at
12% interest when the market interest rate is 12% is as follows:
ACCOUNT
DEBIT
100,000
CREDIT
Cash
Notes payable
To record the issuance of an interest bearning note at face value.
100,000
Zero-Interest-Bearing Notes
A zero-interest-earning note is issued for cash. The amount of cash (the present value) is less
than the face value (the future value) of the note. The difference between the face value and the
cash is the discount which reflects the interest that will be amortized over the life of the note.
Example: Spencer Company issued a five-year note with a face value of $10,000. At the time
of issuance the market interest rate was 10% per annum. The cash received by Spencer
Company was $6,209. The discount of $3,791 will be amortized over the life of the loan using
the effective interest method. The following provides the calculation of the present value of the
future payment of $10,000 and the amortization schedule for the five years.
Future Value
PV of $1, n=5, i=10%
Present value
DATE
1/1/02
1/1/03
1/1/04
1/1/05
1/1/06
1/1/07
10,000
0.62092
6,209
INTEREST
CASH PAID EXPENSE
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0
0
0
0
0
0
621
683
751
826
909
3,791
1
AMORTIZATION
OF DISCOUNT
621
683
751
826
909
3,791
CARRYING
VALUE
6,209
6,830
7,513
8,264
9,091
10,000
Bonds and Long-Term Notes
The issuance of the note would be recorded in Spencer Company’s accounting records as
follows:
ACCOUNT
DEBIT
6,209
3,791
CREDIT
Cash
Discount on note payable
Note payable
10,000
To record the issuance of a zero-interest-bearing note payable discounted at 10%
At the end of each year Spencer Company will prepare a journal entry to record the interest
expense associated with this zero-interest-bearing note. The journal entry at December 31, 2002
would be as follows:
ACCOUNT
DEBIT
621
CREDIT
Interest expense
Discount on note payable
621
To record the amortization of discount on zero-interest-bearing note payable due
on January 1, 2007
Interest-Bearing Notes
There are times when a note is issued at an interest rate other than market. In such a situation the
effective rate must be imputed. The difference between the imputed interest rate (market) and
the stated rate will be treated as a discount or premium on notes payable which is amortized over
the life of the note using the effective interest method.
Example: Spencer Company issued a $100,000 five-year note bearing interest at 8%. The
market rate of interest is 10% for a similar risk instrument. Because the market rate of interest is
greater than the stated interest rate the note will be issued at a discount. The issue price of the
note would be calculated as follows:
Present value of principal:
Face value
PV of 1, n=5, i=10%
PV of principal
Present value of interest:
Face value
Stated interest
Interest payments
PVOA, n=5, i=10%
PV of interest payments
Issue price of note
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100,000
0.62092
62,092
100,000
8%
8,000
3.79079
30,326
92,418
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Bonds and Long-Term Notes
Assuming that the note was issued on January 1, 2003 the following amortization schedule
reflects the amortization of the discount over the life of the note.
DATE
1/1/03
1/1/04
1/1/05
1/1/06
1/1/07
1/1/07
INTEREST
CASH PAID EXPENSE
8,000
8,000
8,000
8,000
8,000
40,000
9,242
9,366
9,503
9,653
9,818
47,582
AMORTIZATION
OF DISCOUNT
1,242
1,366
1,503
1,653
1,818
7,582
CARRYING
VALUE
92,418
93,660
95,026
96,529
98,182
100,000
The issuance of the note would be recorded on Spencer Company’s books as follows:
ACCOUNT
DEBIT
92,418
7,582
CREDIT
Cash
Discount on note payable
Note payable
To record the issuance of a $100,000, 5-year, 10% at 12% effective interest
100,000
Notes Issued for Cash and Other Rights
If a note is issued with rights other than the right to receive market interest and the principal at
the maturity date the right must be valued and treated as a discount on the note.
Example: Spencer Company issued a five-year $50,000 zero-interest-bearing note to a customer
in exchange for the cash and an agreement that gives the customer the right to purchase
merchandise at a discount for the five year period of time. The market rate of interest on similar
notes would be 8% per annum. The note should be recorded on Spencer Company’s books as
follows:
Future Value
FV of $1, n=5, i=8%
Present value
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50,000
0.68058
34,029
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Bonds and Long-Term Notes
DATE
1/1/02
1/1/03
1/1/04
1/1/05
1/1/06
1/1/07
CASH PAID
INTEREST
EXPENSE
AMORTIZATION
OF DISCOUNT
0
0
0
0
0
0
2,722
2,940
3,175
3,429
3,704
15,971
2,722
2,940
3,175
3,429
3,704
15,971
ACCOUNT
Cash
Discount on note payable
Note payable
Unearned revenue
To record the issuance of a zero-interest-bearing note
in exchance for cash and a sales discount.
DEBIT
50,000
15,971
CARRYING
VALUE
34,029
36,751
39,691
42,867
46,296
50,000
CREDIT
50,000
15,971
The discount on the note payable will be amortized over the term of the note using the effective
interest method. The unearned revenue will be amortized over the same period against sales to
the customer in relation to total sales to the customer for the five year period.
Notes Issued for Property, Goods and Services
In an arms-length exchange where an interest-bearing note is issued in exchange for property it is
assumed that the stated interest rate is the appropriate market rate. There are three circumstance
where this might not be the case:
1. It there is no stated interest rate
2. If the stated interest is clearly unreasonable
3. If the face amount is materially different from the cash sales price of the item
If one of the above three circumstances exists the present value of the note is measured by the
fair value of the property exchanged. The difference between the face amount and the fair value
of the property is the interest element of the note.
Example: Spencer Company exchanged a piece of land with an appraised value of $200,000 for
a three-year non-interest-bearing note with a face value of $245,000. The fair value of the
property will determine the discount rate on the note. The following are the computations of the
discount and the amortization of the discount over the three year period.
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4
Bonds and Long-Term Notes
PV of $1
PV of $1, n=3, i=?
PV of $1, n=3, i=?
PV of $1, n=3, i=?
Interest
DATE
1/1/02
1/1/03
1/1/04
1/1/05
=
=
=
=
=
FV of $
PV of $1
200,000
0.81630
7%
CASH PAID
* PV of $1, n=3, i=?
/
FV of $
/
245,000
INTEREST
EXPENSE
AMORTIZATION
OF DISCOUNT
14,000
14,980
16,020
45,000
14,000
14,980
16,020
45,000
0
0
0
0
CARRYING
VALUE
200,000
214,000
228,980
245,000
If Spencer Company originally paid $50,000 for the piece of land the following journal entry
would be prepared to record the transaction.
ACCOUNT
Note receivable
Discount on note receivable
Land
Gain on sale of land
To record the sale of land in exchange for a $245,000 noninterest-bearing note due in three years.
DEBIT
245,000
CREDIT
45,000
50,000
150,000
Installment Notes
Installment notes payable are long-term notes that are secured by personal property or real estate.
The amount of the installment note is normally used to pay for some or the entire purchase price
of the property. The liability associated with a installment note is normally the face amount so
there is no premium or discount. If the borrower is required to pay points (a loan service fee to
the financial institution) the points should be amortized over the life of the installment note.
Because the amount involved is so small in relation to the installment note the points are
normally amortized using the straight-line method.
Example: Spencer Company purchase land and building on March 1, 2003 for $250,000. The
made a $50,000 down payment on the property and obtained a mortgage for $200,000 with the
Bank of the West. The mortgage is for 15 years at the rate of 8% interest per annum. Payments
are to be made at the beginning of each month starting on April 1, 2003.
We can calculate the monthly payment using Excel. If you bring up a blank Excel spreadsheet
and click on the functions button Σ, select more functions and then select pmt. The window that
comes up asks requires you to input the:
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5
Bonds and Long-Term Notes
Question Box
Rate, the interest rate
Nper, total number of payments
Pv, present value
Input
.08/12
180
200,000
Excel will give you a monthly payment of $1,911.30. For the purposes of keeping it simple we
will use even amounts so our amortization table will be based on $1,911 payment per month.
The following is the amortization of the installment note (mortgage) for the calendar year of
2003.
Date
3/1/03
4/1/03
5/1/03
6/1/03
7/1/03
8/1/03
9/1/03
10/1/03
11/1/03
12/1/03
Cash Paid
1,911
1,911
1,911
1,911
1,911
1,911
1,911
1,911
1,911
17,199
Interest
Expense
1,333
1,329
1,326
1,322
1,318
1,314
1,310
1,306
1,302
11,859
Principal
578
582
585
589
593
597
601
605
609
5,340
Carrying
Value
200,000
199,422
198,841
198,255
197,666
197,073
196,476
195,875
195,269
194,660
The journal entry to record the purchase of the property on March 1, 2003 would be as follows:
ACCOUNT
DEBIT
250,000
CREDIT
Real Estate
Installment note payable
200,000
Cash
50,000
To record the purchase of real estate with a $50,000 down payment and a 15-year, 8%
mortgage of $200,000
The journal entry to record the first payment on April 1, 2003 would be as follows:
ACCOUNT
DEBIT
Installment note payable
578
Interest expense
1,333
Cash
To record the April 1 payment of principal and interest on the mortgage
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6
CREDIT
1,911
Bonds and Long-Term Notes
At the December 31, 2003, when Spencer Company prepares it financial statements the
mortgage balance that will be reported on the balance sheet will be $194,660.
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7