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FINANCIAL ACCOUNTING
RICHARD G. SCHROEDER
MYRTLE W. CLARK JACK M. CATHEY
THEORY AND ANALYSIS:
TEXT AND CASES11TH EDITION
CHAPTER 11
LONG-TERMLIABILITIES
Introduction The importance of long-term debt analysis
Debt Equity
Theories of Liabilities
Entity theory:
Proprietary theory:
Current GAAP: APB Statement No. 4 SFAC No. 6
Assets EquitiesLiabilities
Assets Equities
Recognition and Measurement of Liabilities
Theoretical measurement criteria Present value of future cash flows
Debt vs. Equity
Definition requires classification of all right-hand side items into either liabilities or equity
Complex financial instruments now in existence make this difficult
Need additional criteria
Consolidated Set of Decision Factors
Maturity date Claim on assets Claim on income Market valuation Voice in management Maturity value Intent of the parties
Consolidated Set of Decision Factors
Preemptive right Conversion factor Potential dilution of EPS Right to enforce payment Good business reasons for
issuing Identity of interest between
security holders
FASB Position on Debt and Equity
FASB recognized that problems exist
Resurrected discussion memorandum: "Distinguishing between Liability and Equity Instruments and
Accounting for Instruments with Characteristics of Both. " The impetus is increasing use of complex financial
instruments Have both debt and equity characteristics
FASB Position on Debt and Equity
Tentative conclusions have led to development of an approach based on characteristics of liabilities and equity. Step 1: determine whether the component includes an
obligation. Financial-instrument components that embody
obligations that require settlement by a transfer of cash or other assets Classify as liabilities
Because they do not give rise to the possibility of establishing an ownership interest by the holder.
FASB Position on Debt and Equity
Obligations permitting or requiring settlement by the issuance of stock give rise to liability-equity classification questions. Classify component as liability if the relationship is that
of a debtor or creditor. The proceeds of issuance of a compound financial
instrument that includes both liability and equity components should be allocated to its liability and equity components using the relative fair-value unless that is impracticable.
FASB Position on Debt and Equity
SFAS 150 (FASB ASC 480) - 2003 “Components” approach Classifies certain freestanding
financial instruments as liabilities
Major Classifications of Long Term Debt
BondsPayable
Leases
Pensions
DeferredTaxes
Bonds Payable Why businesses issue bonds
1 Only available source of funds2 Debt financing has a relatively lower
cost3 Debt has a tax advantage4 Voting privilege not shared
Trading on the equity
Bond Classifications
Mortgage Debenture
Registered Coupon
Bond Selling Prices
Stated vs. effective interest rate
Premium or discount How is a bond selling price
determined?
Example XYZ Corporation sells
$100,000 of 10-year bonds Stated interest rate of 10% to yield 9% Interest on these bonds is payable annually each
December 31
Example
To calculate the bond selling pricePV of Principle
$100,000 X 0.422411 = $ 42,241.10PV of Interest $10,000 X 6.417658 = 64,176.58
Bond selling price $106,417.68
For 12%, the same type of calculation will result in a bond selling price of $88,699.53.
Bond Issue Costs Definition Accounting treatment
APB Opinion 21 (FASB ASC 470-35-10-2)
SFAC No. 6 SFAS No 159 (FASB ASC
825-10-25)
Bond Interest Expense
Straight line
Effective interest
Zero Coupon Bonds Definition $100,000 @12% for 10-years
Issue price is $32,197 Discount is $67,803
Accounting treatment Why popular?
Call Provisions Early extinguishment of debt
Debt retirement Debt refunding ARB No. 43 possibilities APB No. 26 requirements (FASB ASC 470-5)
SFAS No. 76 (superseded) Debtor has paid creditor Debtor legally released (legal defeasance) Debtor places assets in trust fund
(in-substance defeasance) SFAS No. 125 (superseded)
In-substance defeasance not longer acceptable
Convertible Debt
Reason for issuing Complex financial instrument One treatment is to ignore conversion feature
Currently required under APB Opinion No. 14 (FASB ASC 470-20)
Understatement of interest expense & overstatement of bond indebtedness?
Convertible Debt
2nd view:1. Conversion feature is equity
2. Should be separated from bond & included in SE
3rd View1. Classify according to governing characteristic
Convertible Debt
FASB suggested 4 alternative methods1 Classify based on the contractual terms in effect
at issuance. 2 Classify as a liability if the instrument embodies
an obligation to transfer financial instruments to the holder if the option were exercised.
3 Classify in accordance with the fundamental financial instrument having the highest value.
4 Classify based on the most probable outcome.
Long-Term Notes Payable
Notes exchanged solely for cash are presumed to carry an appropriate rate of interest
Exchanges of notes for property, goods and services cannot be recorded at an inappropriate rate of interest
If interest rate is clearly inappropriate FMV of property exchanged FMV of note Impute an interest rate
Short-Term Debt Expected to be Refinanced To classify as long-term must meet two
conditions:1 Intent to refinance2 Ability to refinance
Deferred Credits
Question: Are they liabilities? Usually based on the
necessities of double-entry accounting
Contingencies Gain Loss
Probable Reasonable Possible Remote
Accounting treatment SFAS No. 5 - conservatism
Other Liability Measurement Issues
Off balance sheet financing SFAS No. 105 (superseded by FASB
133 – FASB ASC 815) SFAS No. 107 (FASB ASC 825)
Requires disclosure of fair value
SFAS No. 133 – FASB ASC 815 Risks of loss due to credit risk and
market risk Disclosures
Other Liability Measurement Issues
Derivatives Definition Types:
1 Forward2 Future3 Option4 Swap5 Hybrid
SFAS No. 133 (FASB ASC 815)
Derivative instrument: Any financial contract that provides the holder with the right (or
obligation) to participate in the price change of an underlying asset Must recognize all derivatives as assets and liabilities and measure them
at fair value Derivative may be specified as:
a Fair value hedgeb Cash flow hedgec Hedge of foreign currency exposure
Gains or losses for hedges of net investments in foreign subsidiaries reported as translation adjustments in OCI
All others as income
Troubled Debt Restructurings FASB study on arrangements between
debtors to avoid bankruptcy. Questions:
1. Do these arrangements require reductions in original carrying amount of debt?
2. If so when should the effect be reported in the financial statements?
3. Should interest on the new amount t of the debt be recognized before it is payable?
Troubled Debt Restructuring
SFAS No 15 (FASB ASC 310-40 and FASB ASC 470-60) Defines a troubled debt restructuring as an
arrangement that grants a concession by a creditor to a debtor that it might not otherwise consider.
These concessions include:1. Modification of terms2. Granting of equity interest by the debtor to the creditor3. Transfer of receivables from the debtor to the creditor
Troubled Debt Restructurings Accounting :
Modification of terms Determine if gain has occurred for debtor
or loss by creditor. Debtor gain is extraordinary = calculated as
total future payments compared to current carrying value
Creditor loss is determined by calculating present value of all future payments compared to original carrying value
If not, determine effective interest rate Asset or equity swap
Compare fair market value of item exchanged and recorded (if any) gain by debtor and bad debt expense by creditor
Financial Analysis of Long-Term Debt
Goal is to assess Liquidity (covered in Chapter 7)
Financial Analysis of Long-Term Debt
Solvency
Long term debt to assets ratioLong-term debt Total assets
Interest coverage ratio Operating income before interest and taxes
Interest expense
Debt service coverage ratio Cash flow from operating activities before interest and taxes
Interest expense
Financial Analysis of Long-Term Debt
Financial flexibility Performa financial statements
Long-Term Debt to Assets Ratios
47.66%
15.39%
53.62%
15.57%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
2010 2011
Her shey Tootsie Rol l
Interest Coverage Ratios
10.97
433.09
11.11
453.46
0
100
200
300
400
500
2010 2011
Her shey Tootsie Rol l
Debt Service Coverage Ratios
13.82
912.23
10.25
805.63
0
200
400
600
800
1000
2010 2011
Her shey Tootsie Rol l
International Accounting Standards
The IASC addressed the following issues relating to long-term liabilities:1. Debt and equity classifications in IAS No. 32, "Financial
Instruments: Disclosure and Presentation."
2. Contingencies in IAS No. 37, “Provisions, Contingent Liabilities and Contingent Assets”
3. Financial instruments in IAS No. 39, “Financial Instruments - Recognition and Measurement”
4. IFRS No. 7, “Financial Instruments: Disclosures”
5. IFRS No. 9 Financial Instruments
IAS No 32: Financial Instruments: Disclosure and Presentation
Disclosure provisions replaced by IFRS No. 7
Financial liabilities: Contractual obligations to deliver
cash or another financial asset to another enterprise
Or to exchange financial instruments with another enterprise under conditions that are potentially unfavorable
Equity instruments Contracts that evidence a residual
interest in the assets of an enterprise after deducting all of its liabilities
IAS No 32: Financial Instruments: Disclosure and Presentation
Requires companies to disclose information about their financial liabilities including:
1. How they might affect the amount, timing, and certainty of future cash flows
2. The associated accounting policies and basis of measurement applied.
3. The exposure of an enterprise's liabilities to interest rate risk
4. Information about the fair value of an enterprise’s financial liabilities
IAS No. 37: Provisions, Contingent Liabilities and Contingent Assets
Recognize a contingency when it is probable (more likely than not)
that resources will be required to settle an obligation
and that the amount can be reasonably estimated
IAS No 39: Financial Instruments – Recognition and Measurement Financial liabilities are recognized and
initially measured at cost
Subsequently, most are amortized derivatives and liabilities are remeasured at fair
market value Remeasured liabilities may either be :
1 Recognized entirely in net profit or loss for the period
1 Recognized in net profit or loss for only financial liability held for trading purposes
IAS No. 39 expected to be replaced by IFRS No. 9 in 2015
IFRS No. 7 Requires disclosure of
Significance of entity’s financial instruments Nature and extent of risks
Balance sheet and income statement disclosures: Financial liabilities at fair value Financial liabilities at amortized cost
Quantitative disclosures Credit, liquidity and market risk Concentration of risk
Risk-based disclosures Maturity analysis Description of entity’s approach to risk management Sensitivity analysis
IFRS No. 9
Measure financial liability at fair value if: Reduces inconsistency (accounting mismatch), or Liability is part of group that is measured at fair
value New requirements for recognitions of gains
and losses
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved.Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
Prepared by Kathryn Yarbrough, MBA
End of Chapter 11