FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
11TH EDITION
RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 11
LONG-TERM
LIABILITIES
Introduction
The importance of long-term debt analysis
Debt
Equity
Theories of Liabilities
Entity theory:
Assets
Proprietary theory:
Assets
Equities
Liabilities
Current GAAP:
APB Statement No. 4
SFAC No. 6
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
Deferred
Taxes
Pensions
Bonds
Payable
Leases
Bonds Payable
Why businesses issue bonds
1
2
3
4
Only available source of funds
Debt financing has a relatively lower
cost
Debt has a tax advantage
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 price
PV of Principle
$100,000 X 0.422411
PV of Interest
$10,000 X 6.417658
Bond selling price
= $ 42,241.10
=
64,176.58
$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
SFAS No. 76 (superseded)
Debt retirement
Debt refunding
ARB No. 43 possibilities
APB No. 26 requirements (FASB ASC 470-5)
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.
2.
Conversion feature is equity
Should be separated from bond & included in
SE
3rd View
1.
Classify according to governing characteristic
Convertible Debt
FASB suggested 4 alternative
methods
1
2
3
4
Classify based on the contractual terms in effect
at issuance.
Classify as a liability if the instrument embodies
an obligation to transfer financial instruments to
the holder if the option were exercised.
Classify in accordance with the fundamental
financial instrument having the highest value.
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
2
Intent to refinance
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
2
3
4
5
Forward
Future
Option
Swap
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
b
c
Fair value hedge
Cash flow hedge
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.
2.
3.
Do these arrangements require reductions in
original carrying amount of debt?
If so when should the effect be reported in the
financial statements?
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.
2.
3.
Modification of terms
Granting of equity interest by the debtor to the creditor
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 ratio
Long-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
60.0%
53.62%
47.66%
50.0%
40.0%
30.0%
20.0%
15.57%
15.39%
10.0%
0.0%
2010
Hershey
2011
Tootsie Roll
Interest Coverage Ratios
453.46
433.09
500
400
300
200
100
10.97
11.11
0
2010
Hershey
2011
Tootsie Roll
Debt Service Coverage Ratios
912.23
1000
805.63
800
600
400
200
13.82
10.25
0
2010
Hershey
2011
Tootsie Roll
International Accounting Standards
The IASC addressed the following issues relating
to long-term liabilities:
4.
Debt and equity classifications in IAS No. 32, "Financial
Instruments: Disclosure and Presentation."
Contingencies in IAS No. 37, “Provisions, Contingent Liabilities
and Contingent Assets”
Financial instruments in IAS No. 39, “Financial Instruments Recognition and Measurement”
IFRS No. 7, “Financial Instruments: Disclosures”
5.
IFRS No. 9 Financial Instruments
1.
2.
3.
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.
2.
3.
4.
How they might affect the amount, timing, and
certainty of future cash flows
The associated accounting policies and basis of
measurement applied.
The exposure of an enterprise's liabilities to
interest rate risk
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
2
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
Balance sheet and income statement disclosures:
Financial liabilities at fair value
Financial liabilities at amortized cost
Quantitative disclosures
Significance of entity’s financial instruments
Nature and extent of risks
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
End of Chapter 11
Prepared by Kathryn Yarbrough, MBA
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