RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 11TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY 4

LONG-TERM LIABILITIES CHAPTER 11 LONG-TERM LIABILITIES

Introduction The importance of long-term debt analysis Equity VS Debt

Theories of Liabilities Entity theory: Proprietary theory: Current GAAP: APB Statement No. 4 SFAC No. 6 Assets Equities = Assets Liabilities 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 Trading on the equity 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 VS Registered Coupon VS

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 = $ 42,241.10 PV 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 SFAS No. 76 (superseded) 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: 3rd View Conversion feature is equity Should be separated from bond & included in SE 3rd View Classify according to governing characteristic

Convertible Debt FASB suggested 4 alternative methods 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: Intent to refinance Ability to refinance

Deferred Credits Question: Are they liabilities? Usually based on the necessities of double-entry accounting

Contingencies Gain Loss Accounting treatment SFAS No. 5 - conservatism 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: 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: 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: 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: 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

Financial Analysis of Long-Term Debt Financial flexibility Performa financial statements

Long-Term Debt to Assets Ratios

Interest Coverage Ratios

Debt Service Coverage Ratios

International Accounting Standards The IASC addressed the following issues relating to long-term liabilities: 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” 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: 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 : Recognized entirely in net profit or loss for the period 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

Prepared by Kathryn Yarbrough, MBA End of Chapter 11 Prepared by Kathryn Yarbrough, MBA 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.