Accounting Principles II – Long-Term Liabilities | Accounting

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Study GuideAccounting PrinciplesII–Long-Term Liabilities1. Long-Term Liabilities DefinedDefinition: Long-Term LiabilitiesLong-term liabilitiesare debts or obligations that a business doesnot have to pay back within thenext year.More specifically, they are amounts owed that are dueafter one year or after the operating cycle,whichever is longer.Quick note:Anoperating cycleis the time it takes a company to buy inventory, sell it, and collectcash from customers. Some businesses have operating cycles longer than one year, so the ruleadjusts for that.Where They Appar on the Balance SheetOn a company’sbalance sheet, long-term liabilities are listed:1.After total current liabilities2.Before owners’ equitySo thebalance sheet generally shows this order:Current Liabilities → Long-Term Liabilities → Owners’ EquityCommon Examples of Long-Term LiabilitiesHere 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 taxesThese are all commitments a company has to pay in the future, usually over several years.Why “Present Value” Is ImportantMany long-term liabilities are recorded based on something calledpresent value.Present valuemeans:the amount of money you would need to investtoday, at a given interest rate, to grow into aspecific amountin the future.In other words, it helps accountants measure what future payments areworth right now.2.Notes PayableWhat Are Notes Payable?Notes payableare amounts a business owes to abank or another lender, based on aformalwritten agreement(called a note).A note payable usually includes:•Theamount borrowed•A specificinterest rate•Therepayment 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 thematching principle, which means:Expenses should be recorded in the same period they are incurred, even if they have not beenpaid yet.

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Study GuideSo, if interest has been earned by the lender but the company hasn’t paid it yet, the business mustaccrue the interestbefore preparing financial statements.That’s why we recordInterest ExpenseandInterest Payableat the end of each reporting period.Example: The Flower Lady’s Note PayableThe Note DetailsAssumeThe Flower Ladysigns a$10,000 note payablefor3 yearsonJuly 1.•Principal (amount borrowed):$10,000•Interest rate:10%•Date signed:July 1•Purpose:to purchase equipment•Interest is duequarterlyon:○Oct. 1○Jan. 1○April 1○July 1•The business uses acalendar year(January–December)•Financial statements are preparedat the end of each quarterBecause this is athree-year note, it is treated as along-term liabilitywhen it is first issued.

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Study Guide2.Journal Entries for the Current Year1) July 1—Record the note payable and purchase of equipmentThe business receives equipment worth$10,000and promises to pay later under the note.Journal entry:•Debit Equipment→ 10,000•Credit NotesPayable→ 10,000This records that the business gained equipment (an asset) and now owes money (a liability).2) Sept. 30—Accrue interest for the 3rd quarterBy September 30, the business has used the borrowed money for3 months, so interest has beenincurred, even though it hasn’t been paid yet.

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Study GuideJournal entry:•Debit Interest Expense→ 250•Credit Interest Payable→ 250This records the interest cost for the quarter and shows that the company still owes that interest.3) Oct. 1—Pay thequarterly interestOn Oct. 1, The Flower Lady pays the interest that was due.Journal entry:•Debit Interest Payable→ 250•Credit Cash→ 250This removes the liability because the interest has now been paid.4) End of the next quarter—Continue accruing interestAt 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 inthe image: “To accrue 4th quarter interest”)3.Entries in the Final Year (When the Note is Paid Off)

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Study Guide1) June 30—Accrue interest for the quarterThe interest for the quarter is calculated the same way:Journal entry:•Debit Interest Expense→ 250•Credit Interest Payable→ 250This makes sure interest expense is recorded in the correct time period.2) July 1—Pay off the note and the interest dueOn July 1, the company pays:•the full note principal ($10,000)•plus the interest owed ($250)

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Study GuideJournal entry:•Debit Notes Payable→ 10,000•Debit Interest Payable→ 250•Credit Cash→ 10,250This clears both liabilities and shows the full cash payment.When Interest Is Not Paid Until MaturitySometimes, interest isnot paid every quarter. Instead, it may be paid only when the note is due (atmaturity).In that case:interest is often calculated usingcompounding.That means interest builds on:•the original principal,plus•any previously accrued interest (unpaid interest)AnnualInterest Expense with CompoundingThe yearly interest expense would be based on:Beginning-of-year principal + accrued interest payablemultiplied by theannual interest rateIs the Interest Rate Always “Fair”?In most real business situations (arm’s length transactions), accountants assume:the interest rate written on the note is afair market rate.This means both sides agreed on a reasonable rate.

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Study GuideWhat 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 thefair value of what was received(goods or services)Any difference between:•theface amountof the note, and•thevalue of what was receivedis treated asinterest.That difference is consideredinterest expense over time, even if it isn’t written on the note.3.Mortgage PayableWhat Is a Mortgage Payable?Amortgageis a type oflong-term loanused to buyproperty(like land or a building).The amount a company still owes on that loan is calledMortgage Payable.Important detail: Theproperty itself is used as collateral.That means if the borrower does not make payments, the lender can take the property to recover themoney.How Mortgage Payments WorkMost mortgages requireequal payments(the same amount every month) for the entire loan term.Each payment includestwo 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 GuideAt the beginning of the mortgage, theloan balance is large, so the interest calculated on it is alsolarge.That’s why early payments contain:More interestLess principalWhat Happens Over TimeAs the borrower keeps paying, theprincipal balance gets smaller.So each month:•theinterest portion decreases•theprincipal portion increasesThis happens becauseinterest is always calculated on the outstanding principal balance, andthat balance goes down over time.Example: The Stats Man’sMortgageThe Stats Man takes out a mortgage with these terms:•Mortgage amount:$175,000•Loan term:15 years•Interest rate:7.5%•Monthly payment:$1,622.281.Recording the Mortgage in AccountingWhen the business receives the loan cash, cashincreases and a liability is created.Cash increases →Debit CashMortgage Payable increases →Credit Mortgage Payable

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