Financial Instruments as Liabilities Revsine/Collins/Johnson/Mittelstaedt: Chapter 11 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives 1.How liabilities are shown on the balance sheet. 2.Why and how bond interest and net carrying value change over time. 3.How and when floating-rate debt protects lenders. 4.How debt extinguishment gains and losses arise, and what they mean. 5.How the fair value accounting option can reduce earnings volatility. 11-2

Learning objectives: Concluded 6.How to find the future cash payments for a company’s debt. 7.Why statement readers need to be aware of off-balance sheet financing and loss contingencies. 8.How futures, swaps, and options contracts are used to hedge financial risk. 9.When hedge accounting can be used, and how it reduces earnings volatility. 10.How IFRS guidance for long-term debt, loss contingencies, and hedge accounting differs from U.S. GAAP. 11-3

Overview of liabilities  The FASB says:  This means a financial statement liability is: 1. An existing obligation arising from past events, which calls for 2. Payment of cash, delivery of goods, or provision of services to some other entity at some future date. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or to provide services to other entities in the future as a result of past transactions or events. Not all economic liabilities qualify as financial statement liabilities Monetary liabilities Nonmonetary liabilities Payable in fixed amount of future cash Satisfied by delivering goods or services 11-4

Bonds payable: Illustration of bond issued at par $100 Years $1,000 Promised interest payments Promised principal payment Bond cash flows (in $000): $1,000 borrowed Face value and cash proceeds are the same 11-5

Bonds payable: Illustration of bond issued at a discount On January 1, 2011, Huff Corp. issued $10,000,000 face value of 10% per year bonds at a time when the market demanded an 11% return. To provide an 11% return to the bondholders, these bonds must be discounted. The selling price for these bonds that will result in an 11% return to the bondholders is $941, $100 Years $941,108borrowed $1,000 Promised interest payments Promised principal payment 11-6

Bonds payable: Discount amortization details 11-7

Bonds payable: Illustration of bond issued at a premium On January 1, 2011, Huff Corp. issued $10,000,000 face value of 10% per year bonds at a time when the market only demanded a 9% return. To provide a 9% return to the bondholders, these bonds may be marked upwards. The selling price for these bonds that will result in a 9% return to the bondholders is 1,064, $100 Years $1,064,177 borrowed $1,000 Promised interest payments Promised principal payment Bond cash flows ($1,000): 11-8

Bonds payable: Premium amortization details 11-9

Extinguishment of debt  When fixed-rate debt is retired before maturity, book value and market value are not typically equal at the retirement date.  In such cases, retirement generates an accounting gain or loss. $1,000,000 $944,630 $55,370 Carrying valueMarket value Extinguishment gain  Journal entry at retirement: DR Bonds payable $1,000,000 CR Cash $944,630 CR Gain on debt extinguishment 55,370 Book value Market value 11-10

Global Vantage Point  IFRS and U.S. GAAP are similar except for a couple of differences: Debt Issue costs – are treated as a reduction in the proceeds of the debt received rather than recorded separately as an asset and amortized over the life of the bonds Fair value option – IAS 39 permits companies to elect a fair value accounting option only If the liabilities are actively managed on a fair value basis, or The use of fair value accounting eliminates or reduces the “mismatch” that arises when different measurement bases are used for related financial instruments 11-11

Hedging  Business are exposed to market risks from many sources:  Managing market risk is essential for most companies.  Most often, these risks are managed by hedging transactions that make use of derivative securities. Interest rate risk Foreign currency exchange rate risk Commodity price risk Banks that loan money at fixed rates of interest Manufacturers that build products in one country but sell them in another Fuel prices for an airline company 11-12

Typical derivative securities: Interest rate swaps Kistler Manufacturing has issued $100 million of long-term 8% fixed-rate debt and wants to protect itself from a decline in market interest rates… One way to do so is to create synthetic floating-rate debt using an interest rate swap. Figure

Accounting for derivative securities  In the absence of a hedging transaction, GAAP says: All derivatives must be carried on the balance sheet at fair value. Changes in the fair value of derivatives must be recognized in income when they occur.  Special “hedge accounting rules” apply when derivatives are used to hedge certain market risks

Accounting for derivative securities: Summary  These accounting entries are used for all types of derivatives— forwards, futures, swaps and options—unless the special “hedge accounting” rules apply.  Three key points about derivatives and their GAAP accounting rules you should remember: 1. Derivative contracts represent balance sheet assets and liabilities. 2. The carrying value of the derivative is adjusted to fair value at each balance sheet date. 3. The amount of the adjustment—the change in fair value—flows to the income statement as a holding gain (or loss)

Hedge accounting: Overview  When a company successfully hedges its exposure to market risk:  To accurately reflect the underlying economics of the hedge, the loss on the hedged item should be matched with the derivative’s offsetting gain in the income statement of the same period.  That’s what the GAAP rules (FASB ASC Topic 815: Derivatives and Hedging) for hedge accounting try to accomplish. $500 Economic gain on hedge derivative $500 Economic loss on hedged item Derivative gain Hedged item loss Current period Derivative gain Hedged item loss Future period Derivative gain Current period Or But not 11-16

Contingent liabilities  GAAP says that a loss contingency should be accrued by a charge to income if both: 1. It is probable that an asset has been impaired or a liability incurred at the financial statement date. 2. The amount of the loss can be reasonably estimated.  Gain contingencies, on the other hand, are not recorded until the event actually occurs and the obligation is confirmed. “Critical event” and “measurability” from Chapter 2 Figure

Summary 1.An astounding variety of financial instruments, derivatives, and nontraditional financing arrangements are now used. 2.Off-balance sheet obligations and loss contingencies are difficult for analysts to evaluate. 3.Derivatives—whether used for hedging or speculation—pose special accounting problems. 4.For most companies, the most important long-term obligation is still traditional debt, and IFRS and U.S. GAAP is quite clear: Noncurrent monetary liabilities are initially recorded at the discounted present value of the contractual cash flows (the issue price). The effective interest method is then used to compute interest expense and net carrying value each period. Interest rate changes are ignored. Firms may instead opt for fair value accounting for their long-term debt

Summary concluded 5.Long-term debt accounting makes it possible to “manage” reported income statement and balance sheet numbers when debt is retired before maturity. 6.The incentives for doing so may be related to debt covenants, compensation, regulation, or just the desire to paint a favorable picture of company performance and health. 7.Extinguishment gains and losses from early debt retirements and swaps require careful scrutiny because they might just be “window dressing.” 11-19