Difficulty: Intermediate | Prerequisites: Part 1 of these notes (notes at market rate, non-interest bearing notes, notes for assets/services), present value of annuities.
This second half of Chapter 14 covers installment notes (the structure behind car loans, mortgages, and most bank lending), then moves to how long-term debt appears on the financial statements, how fair value is measured and disclosed, and why debt levels matter for risk analysis. It finishes with off-balance sheet financing, a topic that ties into broader questions about financial statement transparency. If you are comfortable with the effective interest method from Part 1, the installment note section adds one new wrinkle: each payment blends principal and interest, and the split shifts over time.
Installment notes require equal periodic payments that include both principal and interest, with the interest portion shrinking and the principal portion growing over time. On the balance sheet, long-term debt is reported net of any discount or premium, with the portion due within one year classified as a current liability. Fair value must be disclosed using a three-level hierarchy, and companies sometimes structure transactions to keep debt off the balance sheet.
Installment note
A note repaid through a series of equal periodic payments (usually monthly), each containing both principal and interest. Think of it as a car payment or a mortgage: the total payment stays the same, but the interest-vs-principal split changes every month.
Current portion of long-term debt
The amount of principal on long-term debt that is due within the next 12 months. It is reclassified from long-term liabilities to current liabilities on the balance sheet. In simple terms, it is next year's slice of the principal.
Fair value (of debt)
The price at which the debt could be exchanged in an orderly transaction between market participants. Companies must disclose this, even if the debt is not traded.
Fair value hierarchy
A three-level ranking system under GAAP (ASC 820) that classifies the inputs used to measure fair value by reliability. Level 1 is the most objective (quoted prices), Level 3 is the least (management assumptions).
Leverage
Using borrowed money to amplify returns on equity. Favourable leverage occurs when the return on assets purchased with debt exceeds the interest rate on that debt. In simple terms, borrowing to earn more than the borrowing costs.
Debt-to-equity ratio
Total liabilities divided by shareholders' equity. A higher ratio signals more financial risk because the company is more reliant on borrowed funds.
Times interest earned (TIE)
EBIT divided by interest expense. Measures how comfortably a company can cover its interest obligations from operating earnings. A higher number means more cushion.
Off-balance sheet financing
Arrangements that create real economic obligations for a company without those obligations appearing as liabilities on the balance sheet. Think of it as debt the company owes but that does not show up in the standard liability accounts.
Installment notes are repaid through equal periodic payments (usually monthly), each containing both principal and interest. Car loans, home mortgages, and most bank loans follow this structure.
Payment = Loan Amount / PV annuity factor (for i per period, n periods)
Example: $10,000 loan, 12% annual interest (1% per month), 12 monthly payments.
PV annuity factor for i = 1%, n = 12 is 11.25508.
Monthly payment = $10,000 / 11.25508 = $888 (rounded).
Each payment has two components:
Interest portion = Outstanding balance x periodic interest rate.
Principal portion = Total payment minus interest portion.
With each successive payment, the outstanding balance falls, so the interest portion shrinks and the principal portion grows. The last payment brings the balance to zero.
Account | Debit | Credit |
|---|---|---|
Cash (or other asset) | 10,000 | |
Notes Payable | 10,000 |
When the stated rate equals the market rate, there is no discount.
Account | Debit | Credit |
|---|---|---|
Interest Expense | 100 | |
Notes Payable | 788 | |
Cash | 888 |
Interest = $10,000 x 1% = $100. Principal reduction = $888 - $100 = $788. After this payment, the note's carrying amount is $10,000 - $788 = $9,212.
Date | Cash Payment | Interest | Principal | Outstanding Balance |
|---|---|---|---|---|
Issuance | 10,000 | |||
Month 1 | 888 | 100 | 788 | 9,212 |
Month 2 | 888 | 92 | 796 | 8,416 |
Month 3 | 888 | 84 | 804 | 7,612 |
Month 4 | 888 | 76 | 812 | 6,800 |
The final (12th) payment is typically adjusted by a few dollars to bring the balance to exactly zero due to rounding.
Long-term debt (bonds and notes payable) is reported on the balance sheet net of any discount or premium. The discount or premium account is combined with the debt account for each instrument, and all notes and bonds are often aggregated into a single line called "Long-term debt."
The portion of principal that is due within the next 12 months is reclassified as a current liability. Only principal counts here, not upcoming interest payments. The remainder stays in long-term liabilities.
For an installment loan, the current portion is the total principal that will be repaid during the following year (the sum of principal components of the next 12 monthly payments).
Nature of the debt, interest rate, maturity date, and other relevant terms.
A schedule showing the total amount of long-term debt maturing in each of the next five years.
Fair value of the debt (see next section).
GAAP requires fair value disclosure for both assets and liabilities. Fair value may appear on the face of the balance sheet or in the notes to the financial statements. Because some inputs are more objective than others, GAAP specifies a hierarchy:
Level 1: Quoted prices in active markets for identical assets or liabilities. This is the most reliable. Example: a publicly traded corporate bond with daily market quotes.
Level 2: Observable inputs other than Level 1 quotes, such as prices of similar assets or liabilities. Example: a company holds stock in a private packaging firm, but similar packaging companies are publicly traded, so their market data informs the valuation.
Level 3: Unobservable inputs based on the company's own assumptions and the best information available. This is the least reliable and most subjective. Example: a unique piece of real estate with no comparable recent sales.
Companies must disclose which level they use for each type of asset and liability. As GAAP and IFRS evolve, disclosure requirements continue to expand.
More debt means more risk of bankruptcy, but debt also creates leverage. When borrowed money is invested in assets that earn a return higher than the interest rate on the debt, the leverage is favourable and boosts return on equity. When the cost of debt exceeds the return on assets, leverage amplifies losses.
Ratio | Formula | What It Tells You |
|---|---|---|
Debt to equity | Total liabilities / Shareholders' equity | How much the company relies on debt vs. owner funding |
Return on equity (ROE) | Net income / Shareholders' equity | Profitability relative to owners' investment |
Return on assets (ROA) | Net income / Total assets | Profitability relative to total resources |
Times interest earned (TIE) | EBIT / Interest expense | Ability to cover interest from operating earnings |
Financial statement users need to understand that companies may manage these ratios by structuring transactions to minimise reported debt.
Off-balance sheet financing refers to arrangements where a company has real economic obligations that do not appear as liabilities on its balance sheet. Common methods include:
Non-consolidated subsidiaries (equity method investments): If Company ABC owns less than 50% of Company XYZ, ABC does not consolidate XYZ's assets and liabilities. However, ABC might still be exposed to a significant portion of XYZ's liabilities if XYZ has to liquidate.
Operating leases: Historically, operating leases kept the lease obligation off the balance sheet (covered in Chapter 15, where new standards have since changed much of this).
Other business arrangements: Various structures can effectively hide debt from the balance sheet.
Financial statement users and auditors need to be alert to these arrangements. Accounting standards continue to evolve to require clearer disclosure and limit opportunities for off-balance sheet financing.
Students often think each installment payment is entirely principal. It is not. Every payment includes both interest and principal, and the mix changes with each payment.
Students sometimes classify the entire outstanding balance of an installment note as long-term. The principal portion due within 12 months must be reclassified as a current liability.
Students confuse carrying value with fair value. Carrying value is the amortised cost on the books (face minus unamortised discount). Fair value is what the debt could be exchanged for in the market, and the two are rarely identical.
Students sometimes assume Level 1 fair value measurement is always available. For debt that is not publicly traded, companies must use Level 2 or Level 3 inputs, which involve judgement.
Know how to calculate the monthly payment on an installment note using the PV annuity factor.
Be able to split an installment payment into interest and principal components, and explain why the interest portion decreases over time.
The current portion of long-term debt = the principal due within the next year. Interest payments due are not included in this reclassification.
Know the three levels of the fair value hierarchy and be able to classify a given scenario into the correct level. The Smith Corp clicker question (stock in a private company with similar publicly traded peers) is a classic Level 2 example.
Understand that leverage is a double-edged sword: favourable when ROA exceeds the cost of debt, unfavourable when it does not.
Be aware of the main off-balance sheet financing techniques (non-consolidated subsidiaries, operating leases, special arrangements) and why standard-setters are tightening rules around them.
True or False: In an installment note, each payment consists of interest only.
False. Each payment includes both interest and principal.
Fill in the blank: The portion of long-term debt principal due within 12 months is reported as a ______ liability.
Current.
True or False: Level 2 fair value uses quoted prices in active markets for identical assets.
False. That is Level 1. Level 2 uses observable inputs such as prices of similar assets.
Fill in the blank: Leverage is favourable when the return on assets exceeds the ______ on the debt.
Interest rate (cost of debt).
True or False: Off-balance sheet financing creates real obligations that appear as liabilities on the balance sheet.
False. The obligations are real but do not appear on the balance sheet, which is the concern.
Q: A company borrows $10,000 at 12% annual interest (1% monthly), repaid in 12 equal monthly installments. What is the monthly payment?
A: $10,000 / 11.25508 (PV annuity factor for i = 1%, n = 12) = $888 per month (rounded).
Q: For the loan above, what journal entry records the first monthly payment?
A: Debit Interest Expense $100 (10,000 x 1%), debit Notes Payable $788, credit Cash $888.
Q: At the end of 2017, an amortisation schedule for a 5-year installment loan shows an outstanding balance of $90,000. The total principal repayment in 2018 is $29,928. How much of the outstanding balance is a current liability?
A: $29,928. The current portion of long-term debt is the principal due within the next year.
Q: Smith Corp holds stock in a private packaging company. Similar packaging companies are publicly traded. What level of the fair value hierarchy applies?
A: Level 2, because the valuation uses observable inputs from similar (but not identical) assets traded in active markets.
Q: What is the times interest earned ratio if EBIT is $500,000 and interest expense is $100,000?
A: 5.0 times ($500,000 / $100,000). The company earns five times enough to cover its interest obligations.
Installment note accounting connects to Chapter 15 (leases), where lease payments are structured the same way: each payment blends interest on the lease liability with a reduction of that liability. The fair value hierarchy (Levels 1, 2, 3) applies to every financial instrument in the course, including investments, derivatives, and pension obligations. The debt-and-risk discussion ties into financial statement analysis topics, where ratios like debt-to-equity and TIE are used to evaluate creditworthiness.
Installment note, installment loan, amortisation schedule, monthly payments, principal and interest split, current portion of long-term debt, current maturity, fair value hierarchy, Level 1, Level 2, Level 3, ASC 820, leverage, financial leverage, debt-to-equity ratio, return on equity, return on assets, times interest earned, TIE ratio, off-balance sheet financing, non-consolidated subsidiary, equity method, operating lease, FS presentation, disclosure notes, ACCTG 472, intermediate accounting, Chapter 14, Penn State.