CHAPTER 11

LONG-TERMLIABILITIES

Introduction The importance of long-term debt analysis

Debt Equity

Theories of Liabilities

Entity theory:

Proprietary theory:

Current GAAP: APB Statement No. 4 SFAC No. 6

Assets EquitiesLiabilities

Assets 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

BondsPayable

Leases

Pensions

DeferredTaxes

Bonds Payable Why businesses issue bonds

1 Only available source of funds2 Debt financing has a relatively lower

cost3 Debt has a tax advantage4 Voting privilege not shared

Trading on the equity

Bond Classifications

Mortgage Debenture

Registered Coupon

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 pricePV of Principle

$100,000 X 0.422411 = $ 42,241.10PV 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

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:1 Classify based on the contractual terms in effect

at issuance. 2 Classify as a liability if the instrument embodies

an obligation to transfer financial instruments to the holder if the option were exercised.

3 Classify in accordance with the fundamental financial instrument having the highest value.

4 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:1 Intent to refinance2 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:

1 Forward2 Future3 Option4 Swap5 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:a Fair value hedgeb Cash flow hedgec 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 ratioLong-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

Interest expense

Financial Analysis of Long-Term Debt

Financial flexibility Performa financial statements

Long-Term Debt to Assets Ratios

36.50%

19.60%

40.90%

10.20%

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%40.0%45.0%

2004 2005

Her shey Tootsie

Interest Coverage Ratios

14.6

99.6

9.6

43.9

0.0

20.0

40.0

60.0

80.0

100.0

2004 2005

Her shey Tootsie

Debt Service Ratios

17.2

120.7

8.6

44.1

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

2004 2005

Her shey Tootsie

International Accounting Standards

The IASC addressed the following issues relating to long-term liabilities:1 Debt and equity classifications in IAS No. 32,

"Financial Instruments: Disclosure and Presentation."2 Contingencies in IAS No. 37, “Provisions, Contingent

Liabilities and Contingent Assets”3 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:

1. How they might affect the amount, timing, and certainty of future cash flows

2. The associated accounting policies and basis of measurement applied.

3. The exposure of an enterprise's liabilities to interest rate risk

4. 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 :

1 Recognized entirely in net profit or loss for the period

2 Recognized in net profit or loss for only financial liability held for trading purposes

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Prepared by Kathryn Yarbrough, MBA