1. LONG-TERM LIABILITIES
CHAPTER 11
LONG-TERM LIABILITIES

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

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

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

5. 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

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

7. 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

8. 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

9. 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.

10. 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.

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

12. 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

13. Bond Classifications
Mortgage
Debenture VS
Registered
Coupon VS

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

15. 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

16. 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,

17. Bond Issue Costs
Definition
Accounting treatment

18. Bond Interest Expense
Straight line
Effective interest

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

20. 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

21. Convertible Debt Reason for issuing Complex financial instrument
Current treatment is to ignore conversion feature

22. 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.

23. 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

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

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

26. Contingencies
Gain
Loss
Accounting treatment

27. 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

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

29. 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

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

31. 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

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

33. Long-Term Debt to Assets Ratios

34. Interest Coverage Ratios

35. Debt Service Ratios

36. 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”

37. 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

38. 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

39. 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

40. 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

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