Stice | Stice | Skousen Intermediate Accounting,17E Debt Financing PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2010 Cengage Learning Definition of Liabilities The FASB defined liabilities as “probable future sacrifices of economic benefits arising from present obligations to a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” 12-2 Classification of Liabilities • Liabilities are usually classified as current or noncurrent • If a liability arises in the course of an entity’s normal operating cycle, it is considered current if: current assets are used to satisfy the obligation within one year or one operating cycle, whichever period is longer 12-3 Classification of Liabilities • When debt that has been classified as noncurrent will mature within the next year, the liability should be reported as a current liability • The distinction between current and noncurrent is important because of the impact on a company’s current ratio 12-4 Measurement of Liabilities For measurement purposes, liabilities can be divided into three categories: Liabilities that are definite in amount Estimated liabilities Contingent liabilities 12-5 Short-Term Operating Liabilities • The term account payable usually refers to the amount due for the purchase of materials by a manufacturing company or the purchase of merchandise by a wholesaler or retailer • No recognition of interest is required 12-6 Short-Term Debt • In most cases, debt is evidenced by a promissory note, which is a formal written promise to pay a sum of money in the future • Notes issued to trade creditors for the purchase of goods or services are called trade notes payable • Nontrade notes payable include notes issued to banks or to officers and stockholders 12-7 Short-Term Obligations Expected to be Refinanced • A short-term obligation that is expected to be refinanced on a long-term basis should not be reported as a current liability • The FASB issued Statement No 6, which contains the authoritative guidelines for classifying short-term obligations expected to be refinanced (continues) 12-8 FASB Statement No According to Statement No 6, both of the following conditions must be met before a short-term obligation can be properly excluded from the current liability classification Management must intend to refinance the obligation on a long-term basis Management must demonstrate an ability to refinance the obligation (continues) 12-9 FASB Statement No Concerning the second point, the ability to refinance may be demonstrated by either of the following: Actually refinancing the obligation during the period between the balance sheet date and the date the statements are issued Reaching a firm agreement that clearly provides for refinancing on a long-term basis 12-10 Accounting for Conversion Investor’s Books Investment in HiTec Co Common Stock (carrying value on books) Bond Investment—HiTec Co 9,850 9,850 Issuer’s Books Bonds Payable Loss on Conversion of Bonds Common Stock, $1 par Paid-In Capital in Excess of Par Discount on Bonds Payable 10,000 550 400 10,000 150 12-54 Bond Refinancing • Cash for the retirement of a bond issue is frequently raised through the “sale of a new issue” and is referred to as bond refinancing • When refinancing before the maturity date of the old issue, the APB selected the immediate recognition of a gain or loss for all early extinguishment of debt 12-55 Fair Value Option • SFAS No 159 allows a company to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair market value on the balance sheet date • The FASB reasoned that the objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings 12-56 Off-Balance-Sheet Financing • Off-balance-sheet financing procedures to avoid disclosing all debt on the balance sheet in order to make the company’s financial position look stronger • Common techniques used: Leases Unconsolidated subsidiaries Variable interest entities (VIEs) Joint ventures Research and development arrangements Project financing arrangements 12-57 Leases Leases are considered to be either rentals (operating leases) or asset purchases with borrowed money (capital leases) The four classification criteria are as follows: Lease transfers ownership Lease includes a bargain purchase option Lease covers 75% or more of the economic life of the asset Present value of lease payments is 90% or more of the asset value 12-58 Unconsolidated Subsidiaries • The FASB issued Statement No 94 in 1987, effectively eliminating one opportunity that companies have used for off-balance-sheet financing • Companies are able to avoid recognizing debt associated with subsidiaries that are less than 50% owned by the company 12-59 Joint Ventures • When companies join forces with other companies to share the costs and benefits associated with specifically defined projects, it is called a joint venture • Because the benefits of joint ventures are uncertain, companies could incur substantial liabilities with few, if any, assets resulting from their efforts 12-60 Research and Development Arrangements • These arrangements involve situations in which an enterprise obtains the results of research and development activities funded partially or entirely by others • Accounting issue: Is this arrangement, in essence, a means of borrowing to fund research and development or is it simply a contract to research for others? 12-61 Analyzing a Firm’s Debt Position The term leverage refers to the relationship between a firm’s debt and assets or its debt and stockholders’ equity A common measure of a firm’s leverage is the debt-to-equity ratio Total Liabilities Debt-to-Equity = Ratio Total Stockholders’ Equity 12-62 Analyzing a Firm’s Debt Position Another measure of a company’s performance relating to debt is the number of times interest is earned Times interest earned is calculated using the following formula: Times Interest Earned Income Before Taxes + Interest Expense = Interest Expense 12-63 Accounting for Troubled Debt Restructuring • A significant accounting problem is created when economic conditions make it difficult for an issuer of long-term debt to make the payments under the terms of the debt instrument • The revision of debt terms to avoid bankruptcy proceedings or foreclosure on the debt is referred to as troubled debt restructuring 12-64 Transfer of Assets in Full Settlement (Asset Swap) A debtor that transfers assets, such as real estate or inventories, to a creditor to fully settle a payable will recognize two types of gains or losses: A gain or loss on disposal of the asset A gain arising from the concession granted in the restructuring of the debt (continues) 12-65 Transfer of Assets in Full Settlement (Asset Swap) The computation of these gains and/or losses is made as follows: Carrying value of assets being transferred Major value of asset being transferred Carrying value of debt being liquidated Difference represents gain or loss on disposal Difference represents gain on restructuring (continues) 12-66 Transfer of Assets in Full Settlement (Asset Swap) An investor always recognizes a loss on the restructuring due to concessions granted Carrying value of investment liquidated Market value of asset being transferred Difference represents loss on restructuring 12-67 Modification of Debt Terms 12-68 ... ($200,000 × 1 /12 × 0 .12) The balance, $57, is applied to the principal On March 1, the interest is $1,999 [$200,000 – $57 (1 /12 × 0 .12) ] This pattern continues throughout the mortgage 12- 13 Financing... note 12- 15 Accounting for Bonds There are three main considerations in accounting for bonds: Recording the issuance or purchase Recognizing the applicable interest during the life of the bonds Accounting. .. $250,000 and makes a down payment of $50,000 The remainder is financed with a 12% , 30-year mortgage (continues) 12- 12 Present Value of LongTerm Debt As the $2,057 monthly mortgage payment is made,