Chapter 12 19th Edition Debt Financing Intermediate Accounting James D Stice Earl K Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2014 Cengage Learning 12-1 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.” The FASB is currently considering a revision of this liability definition (continued) 12-2 Classification of Liabilities • For reporting purposes 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 (continued) 12-3 Classification of Liabilities • The classification of a liability as current or noncurrent can impact significantly a company’s ability to raise additional funds • When debt 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 (continued) 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 The measurement of liabilities always involves some uncertainty because a liability, by definition, involves a future outflow of resources 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 • Accounts payable are not recorded when purchase orders are placed but instead when legal title to the goods passes to the buyer 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, and is usually reflected on the debtor’s books as Notes Payable • Notes issued to trade creditors for the purchase of goods or services are called trade notes payable (continued) 12-7 Short-Term Debt • Nontrade notes payable include notes issued to banks or to officers and stockholders for loans to the company • If a note has no stated rate of interest, or if the stated rate is unreasonable, then the face value of the note would be discounted to the present value to reflect the effective rate of interest implicit in the note 12-8 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 This applies to the currently maturing portion of a long-term debt and to all other short-term obligations except those arising in the normal course of operations that are due in customary terms (continued) 12-9 Short-Term Obligations Expected to be Refinanced According to FASB ASC Topic 470 (Debt), 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 (continued) 12-10 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? • R&D arrangements may take a variety of forms, including a limited partnership 12-73 Research and Development Arrangements • At times, companies become involved in long-term commitments that are related to project financing arrangements • The arrangement should be disclosed in a note to the financial statements 12-74 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 (continued) 12-75 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 The number of times interest is earned reflects the company’s ability to meet interest payments and the degree of safety afforded the creditors 12-76 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, and can take many different forms (continued) 12-77 Accounting for Troubled Debt Restructuring • • The major issue addressed by FASB ASC Subtopic 470-60 is whether a troubled debt restructuring agreement should be viewed as a significant economic transaction If it is considered to be a significant economic transaction, entries should be made on the issuer’s books to reflect any gain or loss If not considered significant, no entries are required 12-78 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: 1) a gain or loss on disposal of the asset and 2) a gain arising from the concession granted in the restructuring of the debt (continued) 12-79 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 The gain or loss on disposal of an asset is usually reported as an ordinary income item (continued) 12-80 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 The classification of this loss depends on the criteria being used to recognize irregular or extraordinary items (continued) 12-81 Transfer of Assets in Full Settlement (Asset Swap) Realty, Inc holds $40,000 face value of Stanton’s bonds Because of the troubled financial condition of Stanton Industries, Realty Inc has previously recognized as a loss a $5,000 decline in the value of the debt, plus interest receivable of $4,000 The entries for Stanton and Realty are on Slides 12-131 and 12-132 (continued) 12-82 Transfer of Assets in Full Settlement (Asset Swap) Stanton StantonIndustries Industries(Issuer) (Issuer) Interest Payable 50,000 Bonds Payable 500,000 Discount on Bonds Payable 5,000 Long-Term Investment—Worth Common Stock 350,000 Gain on Disposal of Worth Common Stock 50,000 Gain on Restructuring of Debt 145,000 Carrying value of Worth common $350,000 Market value of Worth common $400,000 Carrying value of debt liquidated $545,000 (continued) $50,000 gain on disposal $145,000 gain from restructuring 12-83 Transfer of Assets in Full Settlement (Asset Swap) Realty RealtyInc Inc.(Investor) (Investor) Long-Term Investments—Worth Common Stock 32,000 Loss on Restructuring of Debt 7,000 Bond Investments—Stanton Industries Interest Receivable 35,000 4,000 Percentage of debt held by Realty Inc.: $40,000/$500,000 = 8% Market value of long-term investment received in settlement of debt: 0.08 × $400,000 = $32,000 12-84 Modification of Debt Terms • There are many ways debt terms may be modified to aid a troubled debtor • Modification may involve either the interest or the maturity value or both • Interest concessions may involve a reduction of the interest rate, forgiveness of unpaid interest, or a moratorium on interest payments for a period of time (continued) 12-85 Chapter 12 ₵ The The End End $ 12-86 12-87 ... (continued) 12- 17 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. .. (continued) 12- 27 Market Price of Bonds Yield Bond Stated Interest Rate 10% 8% Premium 10% 10 Face Value 12% Discount (continued) 12- 28 Issuance of Bonds • Bonds may be sold directly to investors by the... liability, by definition, involves a future outflow of resources 12- 5 Short-Term Operating Liabilities • The term account payable usually refers to the amount due for the purchase of materials by a