FINANCIAL

ACCOUNTING
THEORY AND
ANALYSIS:
TEXT AND CASES
11TH EDITION

RICHARD G.
SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY

CHAPTER 11
LONG-TERM
LIABILITIES

Introduction

The importance of long-term debt analysis

Debt

VS

Equity

Theories of
Liabilities

Entity theory:

Assets

Proprietary theory:

Assets

Equities

Liabilities

Current GAAP:

APB Statement No. 4

SFAC No. 6

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.

FASB Position on
Debt and Equity

SFAS 150 (FASB ASC 480) 2003

Components approach
Classifies certain freestanding
financial instruments as liabilities

Major Classifications
of Long Term Debt
Deferred
Taxes

Pensions

Bonds
Payable

Leases

Bonds Payable

Why businesses issue bonds

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

Bond Classifications
Mortgage

VS

Debenture

Registered

VS

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 price
PV of Principle
$100,000 X 0.422411
PV of Interest
$10,000 X 6.417658
Bond selling price

= $ 42,241.10
=

64,176.58

$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

APB Opinion 21 (FASB ASC

470-35-10-2)
SFAC No. 6
SFAS No 159 (FASB ASC
825-10-25)

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

SFAS No. 76 (superseded)

Debt retirement
Debt refunding
ARB No. 43 possibilities
APB No. 26 requirements (FASB ASC 470-5)
Debtor has paid creditor
Debtor legally released (legal defeasance)
Debtor places assets in trust fund
(in-substance defeasance)

SFAS No. 125 (superseded)

In-substance defeasance not longer acceptable

Convertible Debt

Reason for issuing

Complex financial instrument
One treatment is to ignore conversion feature

Currently required under APB Opinion No. 14 (FASB

ASC 470-20)
Understatement of interest expense
& overstatement of bond indebtedness?

Convertible Debt

2nd view:
1.
2.

Conversion feature is equity

Should be separated from bond & included in
SE

3rd View
1.

Classify according to governing characteristic

Convertible Debt

FASB suggested 4 alternative

methods

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.

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:

Intent to refinance
Ability to refinance

Deferred Credits

Question: Are they liabilities?

Usually based on the
necessities of double-entry
accounting

Contingencies

Gain
Loss

Probable
Reasonable Possible
Remote

Accounting treatment
SFAS No. 5 - conservatism

Other Liability
Measurement Issues

Off balance sheet financing

SFAS No. 105 (superseded by FASB

133 FASB ASC 815)
SFAS No. 107 (FASB ASC 825)

Requires disclosure of fair value

SFAS No. 133 FASB ASC 815

Risks of loss due to credit risk and

market risk
Disclosures

Other Liability
Measurement Issues

Derivatives

Definition
Types:

Forward
Future
Option
Swap
Hybrid

SFAS No. 133 (FASB ASC

815)

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

Troubled Debt
Restructurings

FASB study on arrangements between

debtors to avoid bankruptcy.
Questions:
1.

2.

3.

Do these arrangements require reductions in

original carrying amount of debt?
If so when should the effect be reported in the
financial statements?
Should interest on the new amount t of the debt
be recognized before it is payable?

Troubled Debt Restructuring

SFAS No 15 (FASB ASC 310-40 and FASB ASC

470-60)

Defines a troubled debt restructuring as an

arrangement that grants a concession by a creditor to
a debtor that it might not otherwise consider.

These concessions include:

1.
2.
3.

Modification of terms
Granting of equity interest by the debtor to the creditor
Transfer of receivables from the debtor to the creditor

Troubled Debt
Restructurings

Accounting :

Modification of terms
Determine if gain has occurred for debtor
or loss by creditor.

Debtor gain is extraordinary = calculated as

total future payments compared to current
carrying value
Creditor loss is determined by calculating present value of all
future payments compared to original carrying value

If not, determine effective interest rate

Asset or equity swap

Compare fair market value of item exchanged and recorded

(if any) gain by debtor and bad debt expense by creditor

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 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
Interest expense

Financial Analysis of LongTerm Debt

Financial flexibility

Performa financial statements

Long-Term Debt to Assets Ratios

Interest Coverage Ratios

Debt Service Coverage Ratios

International Accounting
Standards

The IASC addressed the following issues relating

to long-term liabilities:

4.

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
IFRS No. 7, Financial Instruments: Disclosures

5.

IFRS No. 9 Financial Instruments

1.

2.

3.

IAS No 32: Financial

Instruments: Disclosure
and Presentation

Disclosure provisions replaced by

IFRS No. 7
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.

2.

3.

4.

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 enterprises
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 :

Recognized entirely in net profit or loss for the

period

Recognized in net profit or loss for

only financial liability held for trading purposes
IAS No. 39 expected to be replaced by IFRS No. 9
in 2015

IFRS No. 7

Requires disclosure of

Balance sheet and income statement disclosures:

Financial liabilities at fair value

Financial liabilities at amortized cost

Quantitative disclosures

Significance of entitys financial instruments

Nature and extent of risks

Credit, liquidity and market risk

Concentration of risk

Risk-based disclosures

Maturity analysis
Description of entitys approach to risk management
Sensitivity analysis

IFRS No. 9

Measure financial liability at fair value if:

Reduces inconsistency (accounting mismatch), or

Liability is part of group that is measured at fair
value

New requirements for recognitions of gains

and losses

End of Chapter 11
Prepared by Kathryn Yarbrough, MBA
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