plant assets, the purchase of another company, or refinancing an existing long-term obligation that is about to mature. Thus transactions involving long-term liabilities are relatively few in number but often involve large dollar amounts.
In contrast, current liabilities usually arise from routine operating transactions. Many businesses regard long-term liabilities as an alternative to owners equity as a source of permanent financing. Although long-term liabilities eventually mature, they often are refinanced-that is, the maturing obligation simply is replaced with a new long term liability.
Maturing Obligations Intended to’ Be Refinanced’ One special type of long-term liability is an obligation that will mature in the current period but that is expected to be refinanced on a long-term basis. For example, a company may have a bank loan that poorness due each -year but is routinely .extended. for the following year. Both the company and the bank may intend for this arrangement to continue on a long-term basis.
If management has both the intent and the ability to refinance soon-to-mature obligations on a long-term basis, these obligations are classified as long-term liabilities. In this situation, the accountant looks to the economic substance of the situation.rather than to its legal form.
When the economic substance of a transaction differs from its legal form or its outward appearance, financial statements should reflect the economic substance.
Accountants summarize this concept with the phrase “Substance takes precedence over form Today’s business world is characterized by transactions of ever-increasing complexity.Recognizing those situations in which the substance of a transaction differs from its form . is one of the greatest challenges confronting the accounting profession. Installment Notes Payable .
Purchases of real estate and certain types of equipment often are financed by the issuance of long-term notes that call for a series of installment payments. These payments (often called debt service) may be due monthly, quarterly,semiannually, or at any other interval. If these installments continue until the debt is completely repaid, the loan is said to be “fully amortizing,”
Often.however, installment notes contain a due date at which the’ remaining unpaid balance is to be repaid in a single “balloon” payment. Some installment notes call for installment payments equal to the periodic interest charges (an “interest-only” note): Under these terms, the principal amount of toll loan is .payable at a specified maturity date.
More often. however, the installment payments are greater than the amount of interest accruing during the period. Thus only a portion each installment payment represents interest expense, and the remainder of the payment reduces the principal amount of the liability.
The amount owed ‘is reduced by each payment. the portion of each successive payment representing interest expense will decrease, and the portion going toward repayment of principal will increase. Allocating Installment Payments tweet’;n
Interest and Principal In accounting for;an installment note, the accountant must determine the portion of each’ payment that rep” presents interest expense and the portion that reduces the principal amount of the liability. This distinction is made In advance by preparing an amortization table.To illustrate, assume that on October 15, Year 1, King’s Inn purchases furnishings at a total cost’ of $16,398. In payment, the company issues an installment note payable for this amount. plus interest at 12% per annul (or 1% per month). This note will be paid in 18.monthly installments of $1,000 each, beginning en November 15.
An amortization table for this installment note payable is shown on the following page (amounts of interest expense are rounded to the nearest dollar).Preparing an Amortization Table Let us explore the content of this table. First, notice that the payments are made on a monthly basis. Therefore, the amounts of the payments (column A), int~st expense (column B), and reuction in the unpaid balance (column C) are all monthly amounts. .
The ‘interest rate used in the table is of special importance; this rate must coincide with the period of time between payment dates-in this case. one month: Thus, if payments are made monthly, column B must be based on the monthly rate of interest. If payments were made quarterly, this column would use the quarterly rate of interest.
An amortization table begins with the original amount of the liability ($16,398) listed at the top of the Unpaid Balance column.The amounts of the monthly payments. shown ” in column A are ..specified by the installment contract
The monthly interest expense, shown in column B, is computed for each month by applying the monthly interest ate to the unpaid balance at the beginning of that month. The portion of each ‘payment that . reduces the amount of the liability (column C) is simply the remainder of the payment (column A minus column B). Finally, the unpaid balance of the liability (column D) is reduced each month by the amount indicated in column C.