LONG-TERM LIABILITIES CHAPTER 11 LONG-TERM LIABILITIES

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

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.

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

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 SFAS No. 125 Debt retirement Debt refunding ARB No. 43 possibilities APB No. 26 requirements SFAS No. 76 Debtor has paid creditor Debtor legally released (legal defeasance) Debtor places assets in trust fund (in-substance defeasance) SFAS No. 125 In-substance defeasance not longer acceptable

Convertible Debt Reason for issuing Complex financial instrument Current treatment is to ignore conversion feature

Convertible Debt Exposure draft suggested: 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

Other Liability Measurement Issues Off balance sheet financing SFAS No. 105 SFAS No. 107 Examples 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 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

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 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”

IAS No 32: Financial Instruments: Disclosure and Presentation 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

Prepared by Kathryn Yarbrough, MBA End of Chapter 11 Prepared by Kathryn Yarbrough, MBA Copyright © 2009 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.