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LONG-TERM LIABILITIES
CHAPTER 11 LONG-TERM LIABILITIES
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Introduction The importance of long-term debt analysis Debt Equity VS
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Theories of Liabilities
Entity theory: Proprietary theory: Current GAAP: APB Statement No. 4 SFAC No. 6 Assets Equities = Assets Liabilities Equities = -
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Recognition and Measurement of Liabilities
Theoretical measurement criteria Present value of future cash flows
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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
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Consolidated Set of Decision Factors
Maturity date Claim on assets Claim on income Market valuation Voice in management Maturity value Intent of the parties
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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
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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
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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.
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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.
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Major Classifications of Long Term Debt
Deferred Taxes Pensions Bonds Payable Leases
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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
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Bond Classifications Mortgage Debenture VS Registered Coupon VS
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Bond Selling Prices Stated vs. effective interest rate
Premium or discount How is a bond selling price determined?
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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
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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,
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Bond Issue Costs Definition Accounting treatment
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Bond Interest Expense Straight line Effective interest
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Zero Coupon Bonds Definition $100,000 @12% for 10-years
Issue price is $32,197 Discount is $67,803 Accounting treatment Why popular?
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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
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Convertible Debt Reason for issuing Complex financial instrument
Current treatment is to ignore conversion feature
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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.
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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
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Short-Term Debt Expected to be Refinanced
To classify as long-term must meet two conditions: Intent to refinance Ability to refinance
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Deferred Credits Question: Are they liabilities?
Usually based on the necessities of double-entry accounting
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Contingencies Gain Loss Accounting treatment
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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
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Other Liability Measurement Issues
Derivatives Definition Types: Forward Future Option Swap Hybrid
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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
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Financial Analysis of Long-Term Debt
Goal is to assess Liquidity (covered in Chapter 7)
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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
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Financial Analysis of Long-Term Debt
Financial flexibility Performa financial statements
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Long-Term Debt to Assets Ratios
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Interest Coverage Ratios
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Debt Service Ratios
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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”
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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
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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
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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
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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
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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.
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