1. 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

2. LONG-TERM LIABILITIES
CHAPTER 11
LONG-TERM LIABILITIES

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

4. Theories of Liabilities
Entity theory:
Proprietary theory:
Current GAAP:
APB Statement No. 4
SFAC No. 6
Assets
Equities =
Assets
Liabilities
Equities = -

5. Recognition and Measurement of Liabilities
Theoretical measurement criteria
Present value of future cash flows

6. 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

7. Consolidated Set of Decision Factors
Maturity date
Claim on assets
Claim on income
Market valuation
Voice in management
Maturity value
Intent of the parties

8. 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

9. 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

10. 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.

11. 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.

12. FASB Position on Debt and Equity
SFAS 150 (FASB ASC 480)
“Components” approach
Classifies certain freestanding financial instruments as liabilities

13. Major Classifications of Long Term Debt
Deferred Taxes
Pensions
Bonds Payable
Leases

14. 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

15. Bond Classifications
Mortgage
Debenture VS
Registered
Coupon VS

16. Bond Selling Prices Stated vs. effective interest rate
Premium or discount
How is a bond selling price determined?

17. 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

18. Example To calculate the bond selling price
PV of Principle $100,000 X = $ 42,241.10
PV of Interest $10,000 X = 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,

19. Bond Issue Costs Definition Accounting treatment
APB Opinion 21 (FASB ASC )
SFAC No. 6
SFAS No 159 (FASB ASC )

20. Bond Interest Expense
Straight line
Effective interest

21. Zero Coupon Bonds Definition $100,000 @12% for 10-years
Issue price is $32,197
Discount is $67,803
Accounting treatment
Why popular?

22. 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

23. Convertible Debt Reason for issuing Complex financial instrument
One treatment is to ignore conversion feature
Currently required under APB Opinion No. 14 (FASB ASC )
Understatement of interest expense & overstatement of bond indebtedness?

24. 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

25. 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.

26. 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

27. Short-Term Debt Expected to be Refinanced
To classify as long-term must meet two conditions:
Intent to refinance
Ability to refinance

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

29. Contingencies Gain Loss Accounting treatment SFAS No. 5 - conservatism
Probable
Reasonable Possible
Remote
Accounting treatment
SFAS No. 5 - conservatism

30. 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

31. Other Liability Measurement Issues
Derivatives
Definition
Types:
Forward
Future
Option
Swap
Hybrid

32. 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

33. 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?

34. Troubled Debt Restructuring
SFAS No 15 (FASB ASC and FASB ASC )
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

35. 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

36. Financial Analysis of Long-Term Debt
Goal is to assess
Liquidity (covered in Chapter 7)

37. 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

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

39. Long-Term Debt to Assets Ratios

40. Interest Coverage Ratios

41. Debt Service Coverage Ratios

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

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