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, long-
term 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 CREDIT

Cash 100,000
Notes payable 100,000
To record the issuance of an interest bearning note at face value.

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 10,000

PV of $1, n=5, i=10% 0.62092
Present value 6,209

INTEREST AMORTIZATION CARRYING

DATE CASH PAID EXPENSE OF DISCOUNT VALUE
1/1/02 6,209
1/1/03 0 621 621 6,830
1/1/04 0 683 683 7,513
1/1/05 0 751 751 8,264
1/1/06 0 826 826 9,091
1/1/07 0 909 909 10,000
0 3,791 3,791

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Bonds and Long-Term Notes

The issuance of the note would be recorded in Spencer Companys accounting records as
follows:

ACCOUNT DEBIT CREDIT

Cash 6,209
Discount on note payable 3,791
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 CREDIT

Interest expense 621
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 100,000
PV of 1, n=5, i=10% 0.62092
PV of principal 62,092
Present value of interest:
Face value 100,000
Stated interest 8%
Interest payments 8,000
PVOA, n=5, i=10% 3.79079
PV of interest payments 30,326
Issue price of note 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.

INTEREST AMORTIZATION CARRYING

DATE CASH PAID EXPENSE OF DISCOUNT VALUE
1/1/03 92,418
1/1/04 8,000 9,242 1,242 93,660
1/1/05 8,000 9,366 1,366 95,026
1/1/06 8,000 9,503 1,503 96,529
1/1/07 8,000 9,653 1,653 98,182
1/1/07 8,000 9,818 1,818 100,000
40,000 47,582 7,582

The issuance of the note would be recorded on Spencer Companys books as follows:

ACCOUNT DEBIT CREDIT

Cash 92,418
Discount on note payable 7,582
Note payable 100,000
To record the issuance of a $100,000, 5-year, 10% at 12% effective interest

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 Companys books as
follows:

Future Value 50,000

FV of $1, n=5, i=8% 0.68058
Present value 34,029

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Bonds and Long-Term Notes

INTEREST AMORTIZATION CARRYING

DATE CASH PAID EXPENSE OF DISCOUNT VALUE
1/1/02 34,029
1/1/03 0 2,722 2,722 36,751
1/1/04 0 2,940 2,940 39,691
1/1/05 0 3,175 3,175 42,867
1/1/06 0 3,429 3,429 46,296
1/1/07 0 3,704 3,704 50,000
0 15,971 15,971

ACCOUNT DEBIT CREDIT

Cash 50,000
Discount on note payable 15,971
Note payable 50,000
Unearned revenue 15,971
To record the issuance of a zero-interest-bearing note
in exchance for cash and a sales discount.

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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Bonds and Long-Term Notes

PV of $1 = FV of $ * PV of $1, n=3, i=?

PV of $1, n=3, i=? = PV of $1 / FV of $
PV of $1, n=3, i=? = 200,000 / 245,000
PV of $1, n=3, i=? = 0.81630
Interest = 7%

INTEREST AMORTIZATION CARRYING

DATE CASH PAID EXPENSE OF DISCOUNT VALUE
1/1/02 200,000
1/1/03 0 14,000 14,000 214,000
1/1/04 0 14,980 14,980 228,980
1/1/05 0 16,020 16,020 245,000
0 45,000 45,000

If Spencer Company originally paid $50,000 for the piece of land the following journal entry
would be prepared to record the transaction.

ACCOUNT DEBIT CREDIT

Note receivable 245,000
Discount on note receivable 45,000
Land 50,000
Gain on sale of land 150,000
To record the sale of land in exchange for a $245,000 non-
interest-bearing note due in three years.

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 , select more functions and then select pmt. The window that
comes up asks requires you to input the:

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Bonds and Long-Term Notes

Question Box Input

Rate, the interest rate .08/12
Nper, total number of payments 180
Pv, present value 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.

Interest Carrying
Date Cash Paid Expense Principal Value
3/1/03 200,000
4/1/03 1,911 1,333 578 199,422
5/1/03 1,911 1,329 582 198,841
6/1/03 1,911 1,326 585 198,255
7/1/03 1,911 1,322 589 197,666
8/1/03 1,911 1,318 593 197,073
9/1/03 1,911 1,314 597 196,476
10/1/03 1,911 1,310 601 195,875
11/1/03 1,911 1,306 605 195,269
12/1/03 1,911 1,302 609 194,660
17,199 11,859 5,340

The journal entry to record the purchase of the property on March 1, 2003 would be as follows:

ACCOUNT DEBIT CREDIT

Real Estate 250,000
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 CREDIT

Installment note payable 578
Interest expense 1,333
Cash 1,911
To record the April 1 payment of principal and interest on the mortgage

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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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