In previous chapters of this section “Financial Instruments”, we have studied the accounting of financial assets. Now, we’ll learn the accounting of financial liabilities. Let’s start by recalling the definition of financial liabilities:
Financial liability definition
Any liability that is either:
- Contractual obligation to pay cash
- Contractual obligation to transfer another financial asset
- Contractual obligation to exchange a financial instrument under unfavorable conditions, or
- Contractual obligation that will or may be settled in the form of an entity’s own equity instruments (for example, convertible loan)
Examples of financial liabilities include accounts payable, loans payable, debentures, bonds payable, redeemable preference shares etc.
Financial liabilities can be short term such as payable to suppliers, salaries payable etc. and long term such as bonds payable, debentures etc. Long term financial liabilities such as bonds or debentures are issued by an entity to raise funds without diluting the ownership interest.
Long term debt explained
When an entity needs capital but does not want to dilute the ownership interests by issuing new shares, it opts to raise funds by issuing loan instruments such as bonds or debentures. These instruments are often traded in open markets and their market value keeps on changing. For instance, an entity issues 10 years bond with a nominal interest rate of 7% per annum. If interest rates in the market are increased and become more than 7%, this bond’s value will decrease in the eyes of investors and vice versa.
Interest is paid to the investor by applying this nominal interest rate to the instrument’s face value. Payment intervals vary from instrument to instrument, such as quarterly, semi-annual, or annual payment terms. In addition to the interest, the entity issuing the loan instrument to borrow funds promises to repay the principal as well. This principal can be paid on premium, on discount or at the same value depending on the terms agreed. So, the future cash flows associated with the loan instrument are interest payments and principal payments. The rate (IRR) that makes the present value of these future cash flows equal to the initially recognized value of loan is known as effective interest rate. This is actually the interest rate that is being offered to the investor. Therefore, in accounting, finance cost is calculated using effective interest rate.
Following are some commonly used terms associated with loan instruments such as bonds and debentures.
Interest payments of loan
Following terms are often used to describe the loan instrument’s contractual interest rate, which is used to determine the interest payments:
- Nominal interest rate
- Coupon interest rate
- Contractual interest rate
Principal amount of loan
Following terms are often used to describe the loan instrument’s principal amount:
- Face value
- Par value
In the next chapters, we’ll discuss the classification and measurement of financial liabilities.