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Accounting Principles II – Long-Term Liabilities

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    Study Guide Accounting Principles II – Long - Term Liabilities 1. Long-Term Liabilities Defined Definition: Long - Term Liabilities Long - term liabilities are debts or obligations that a business does not have to pay back within the next year . More specifically, they are amounts owed that are due after one year or after the operating cycle , whichever is longer . Quick note: An operating cycle is the time it takes a company to buy inventory, sell it, and collect cash from customers. Some businesses have operating cycles longer than one year, so the rule adjusts for that. Where They Appar on the Balance Sheet On a company’s balance sheet , long - term liabilities are listed: 1. After total current liabilities 2. Before owners’ equity So the balance sheet generally shows this order: Current Liabilities → Long - Term Liabilities → Owners’ Equity Common Examples of Long - Term Liabilities Here are some typical types of long - term liabilities businesses may have: • Notes payable • Mortgage payable • Obligations under long - term capital leases • Bonds payable

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    Study Guide • Pension and other post - employment benefit obligations • Deferred income taxes These are all commitments a company has to pay in the future, usually over several years. Why “Present Value” Is Important Many long - term liabilities are recorded based on something called present value . Present value means: the amount of money you would need to invest today , at a given interest rate, to grow into a specific amount in the future . In other words, it helps accountants measure what future payments are worth right now . 2. Notes Payable What Are Notes Payable? Notes payable are amounts a business owes to a bank or another lender , based on a formal written agreement (called a note). A note payable usually includes: • The amount borrowed • A specific interest rate • The repayment terms (when and how it will be paid) These are more official than regular accounts payable because they are written contracts. 1. Interest and the Matching Principle (Why We Accrue Interest) In accounting, we follow the matching principle , which means: Expenses should be recorded in the same period they are incurred , even if they have not been paid yet.

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    Study Guide So, if interest has been earned by the lender but the company hasn’t paid it yet, the business must accrue the interest before preparing financial statements. That’s why we record Interest Expense and Interest Payable at the end of each reporting period. Example: The Flower Lady’s Note Payable The Note Details Assume The Flower Lady signs a $10,000 note payable for 3 years on July 1 . • Principal (amount borrowed): $10,000 • Interest rate: 10% • Date signed: July 1 • Purpose: to purchase equipment • Interest is due quarterly on: ○ Oct. 1 ○ Jan. 1 ○ April 1 ○ July 1 • The business uses a calendar year (January – December) • Financial statements are prepared at the end of each quarter Because this is a three - year note , it is treated as a long - term liability when it is first issued.

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    Study Guide 2. Journal Entries for the Current Year 1) July 1 — Record the note payable and purchase of equipment The business receives equipment worth $10,000 and promises to pay later under the note. Journal entry: • Debit Equipment → 10,000 • Credit Notes Payable → 10,000 This records that the business gained equipment (an asset) and now owes money (a liability). 2) Sept. 30 — Accrue interest for the 3rd quarter By September 30, the business has used the borrowed money for 3 months , so interest has been incurred , even though it hasn’t been paid yet.

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    Study Guide Journal entry: • Debit Interest Expense → 250 • Credit Interest Payable → 250 This records the interest cost for the quarter and shows that the company still owes that interest. 3) Oct. 1 — Pay the quarterly interest On Oct. 1, The Flower Lady pays the interest that was due. Journal entry: • Debit Interest Payable → 250 • Credit Cash → 250 This removes the liability because the interest has now been paid. 4) End of the next quarter — Continue accruing interest At the end of each quarter, the same idea applies: • If interest has been earned by the lender but not paid yet → accrue it again . So, the business would record another: • Interest Expense • Interest Payable (Like the final line shown in the image: “To accrue 4th quarter interest”) 3. Entries in the Final Year (When the Note is Paid Off)

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    Study Guide 1) June 30 — Accrue interest for the quarter The interest for the quarter is calculated the same way: Journal entry: • Debit Interest Expense → 250 • Credit Interest Payable → 250 This makes sure interest expense is recorded in the correct time period. 2) July 1 — Pay off the note and the interest due On July 1, the company pays: • the full note principal ( $10,000 ) • plus the interest owed ( $250 )

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    Study Guide Journal entry: • Debit Notes Payable → 10,000 • Debit Interest Payable → 250 • Credit Cash → 10,250 This clears both liabilities and shows the full cash payment. When Interest Is Not Paid Until Maturity Sometimes, interest is not paid every quarter . Instead, it may be paid only when the note is due (at maturity). In that case: interest is often calculated using compounding . That means interest builds on: • the original principal, plus • any previously accrued interest (unpaid interest) Annual Interest Expense with Compounding The yearly interest expense would be based on: Beginning - of - year principal + accrued interest payable multiplied by the annual interest rate Is the Interest Rate Always “Fair”? In most real business situations ( arm’s length transactions ), accountants assume: the interest rate written on the note is a fair market rate . This means both sides agreed on a reasonable rate.

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    Study Guide What If the Note Has No Stated Interest Rate? Sometimes a note doesn’t clearly list an interest rate. In that case: • the exchange value is based on the fair value of what was received (goods or services) Any difference between: • the face amount of the note, and • the value of what was received is treated as interest . That difference is considered interest expense over time , even if it isn’t written on the note. 3. Mortgage Payable What Is a Mortgage Payable? A mortgage is a type of long - term loan used to buy property (like land or a building). The amount a company still owes on that loan is called Mortgage Payable . Important detail: The property itself is used as collateral . That means if the borrower does not make payments, the lender can take the property to recover the money. How Mortgage Payments Work Most mortgages require equal payments (the same amount every month) for the entire loan term. Each payment includes two parts : 1. Interest (the cost of borrowing money) 2. Principal (the part that reduces the loan balance) Why Early Payments Have More Interest

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    Study Guide At the beginning of the mortgage, the loan balance is large , so the interest calculated on it is also large. That’s why early payments contain: More interest Less principal What Happens Over Time As the borrower keeps paying, the principal balance gets smaller . So each month: • the interest portion decreases • the principal portion increases This happens because interest is always calculated on the outstanding principal balance , and that balance goes down over time. Example: The Stats Man’s Mortgage The Stats Man takes out a mortgage with these terms: • Mortgage amount: $175,000 • Loan term: 15 years • Interest rate: 7.5% • Monthly payment: $1,622.28 1. Recording the Mortgage in Accounting When the business receives the loan cash, cash increases and a liability is created. Cash increases → Debit Cash Mortgage Payable increases → Credit Mortgage Payable

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