Financial Instruments as Liabilities

Revsine/Collins/Johnson/Mittelstaedt: Chapter 11

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, All Rights Reserved.

Learning objectives
1. How to compute a bonds issue price from its effective yield to investors. 2. How to construct an amortization table for calculating bond interest expense and the net carrying value.

3. Why and how bond interest and net carrying value change over time.
4. How and when floating-rate debt protects lenders. 5. How the Fair Value option in SFAS #159 can reduce earnings volatility.
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Learning objectives:
Concluded
6. How debt extinguishment gains and losses arise, and what they mean. 7. How to find the future cash payments for a companys debt. 8. Why statement readers need to be aware of off-balance sheet financing and loss contingencies. 9. How futures, swaps, and options contracts are used to hedge financial risk.

10. When hedge accounting can be used, and how it reduces earnings volatility.

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Overview of liabilities
The FASB says:
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or to provide services to other entities in the future as a result of past transactions or events.

This means a financial statement liability is:

Not all economic liabilities qualify as financial statement liabilities

1. An existing obligation arising from past events, which calls for 2. Payment of cash, delivery of goods, or provision of services to some other entity at some future date.
Monetary liabilities
Payable in fixed amount of future cash

Non-monetary liabilities Satisfied by delivering goods or services

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Bonds payable:

Illustration of bond issued at par

Face value and cash proceeds are the same

Bond cash flows (in $000):

$1,000 borrowed 2008 2009 2010 $100 2016 2017 Years

$100

$100

$100

$100 Promised interest payments $1,000 Promised principal payment

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Bonds payable:

Illustration of bond issued at a discount

On January 1, 2008, Huff Corp. issued $10,000,000 face value of 10% per year bonds at a time when the market demanded an 11% return. To provide an 11% return to the bondholders, these bonds must be discounted. The selling price for these bonds that will result in an 11% return to the bondholders is $941,108.

$941,108 borrowed 2008 2009 2010 $100 2016 2017 Years

$100

$100

$100

$100 Promised interest payments $1,000 Promised principal payment

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Bonds payable:

Discount amortization details

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Bonds payable:

Illustration of bond issued at a premium

On January 1, 2008, Huff Corp. issued $10,000,000 face value of 10% per year bonds at a time when the market only demanded a 9% return. To provide a 9% return to the bondholders, these bonds may be marked upwards. The selling price for these bonds that will result in a 9% return to the bondholders is 1,064,177.

Bond cash flows (10 $000):

$1,064,177 borrowed 2005 2006 2007 $100 2013 2014

Years

$100

$100

$100

$100 Promised interest payments $1,000 Promised principal payment

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Bonds payable:

Premium amortization details

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Extinguishment of debt
When fixed-rate debt is retired before maturity, book value and market value are not typically equal at the retirement date. In such cases, retirement generates an accounting gain or loss.
$55,370
$1,000,000 $944,630 Market value
Extinguishment gain

Carrying value

Journal entry at retirement:

DR Bonds payable CR Cash CR Gain on debt extinguishment
Book value $1,000,000 Market value $944,630 55,370

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Hedging
Business are exposed to market risks from many sources:
Interest rate risk
Banks that loan money at fixed rates of interest Manufacturers that build products in one country but sell them in another Fuel prices for an airline company

Foreign currency exchange rate risk

Commodity price risk

Managing market risk is essential for most companies. Most often, these risks are managed by hedging transactions that make use of derivative securities.

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Typical derivative securities:

Interest rate swaps
Kistler Manufacturing has issued $100 million of long-term 8% fixed-rate debt and wants to protect itself from a decline in market interest rates One way to do so is to create synthetic floating-rate debt using an interest rate swap.

Interest rate swap

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Accounting for derivative securities

In the absence of a hedging transaction, GAAP says:

All derivatives must be carried on the balance sheet at fair value. Changes in the fair value of derivatives must be recognized in income when they occur.

Special hedge accounting rules apply when derivatives are used to hedge certain market risks.

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Accounting for derivative securities:

Summary
These accounting entries are used for all types of derivatives forwards, futures, swaps and optionsunless the special hedge accounting rules apply. Three key points about derivatives and their GAAP accounting rules you should remember:
1. Derivative contracts represent balance sheet assets and liabilities. 2. The carrying value of the derivative is adjusted to fair value at each balance sheet date. 3. The amount of the adjustmentthe change in fair valueflows to the income statement as a holding gain (or loss).

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Hedge accounting:
Overview
When a company successfully hedges its exposure to market risk:
$500
Economic loss on hedged item Economic gain on hedge derivative

$500

To accurately reflect the underlying economics of the hedge, the loss on the hedged item should be matched with the derivatives offsetting gain in the income statement of the same period.
Current period Hedged item loss Or Derivative gain Derivative gain Future period Hedged item loss But not Current period

Derivative gain

Thats what the GAAP rules (SFAS No. 133 and No. 138) for hedge accounting try to accomplish.

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Contingent liabilities
SFAS No. 5 says that a loss contingency should be accrued by a charge to income if both:
1. It is probable that an asset has been impaired or a liability incurred at the financial statement date. 2. The amount of the loss can be reasonably determined.
Critical event and measurability from Chapter 2

SFAS No.5 Loss Probability Continuum

Gain contingencies, on the other hand, are not recorded until the event actually occurs and the obligation is confirmed.

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Summary
1. An astounding variety of financial instruments, derivatives, and nontraditional financing arrangements are now used. 2. Off-balance sheet obligations and loss contingencies are difficult for analysts to evaluate. 3. Derivativeswhether used for hedging or speculationpose special accounting problems. 4. For most companies, the most important long-term obligation is still traditional debt, and GAAP is quite clear:

Noncurrent monetary liabilities are initially recorded at the discounted present value of the contractual cash flows (the issue price). The effective interest method is then used to compute interest expense and net carrying value each period. Interest rate changes are ignored.
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Summary concluded
5. GAAP accounting for long-term debt makes it possible to manage reported income statement and balance sheet numbers when debt is retired before maturity. 6. The incentives for doing so may be related to debt covenants, compensation, regulation, or just the desire to paint a favorable picture of company performance and health. 7. Extinguishment gains and losses from early debt retirements and swaps require careful scrutiny because they might just be window dressing.

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