Financial Instruments as Liabilities Revsine/Collins/Johnson/Mittelstaedt: Chapter 11 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies,

Financial Instruments as

Liabilities

Revsine/Collins/Johnson/Mittelstaedt: Chapter 11

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives

1. How liabilities are shown on the balance sheet.

2. Why and how bond interest and net carrying value change over time.

3. How and when floating-rate debt protects lenders.

4. How debt extinguishment gains and losses arise, and what they mean.

5. How the fair value accounting option can reduce earnings volatility.

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Learning objectives:Concluded

6. How to find the future cash payments for a company’s debt.

7. Why statement readers need to be aware of off-balance sheet financing and loss contingencies.

8. How futures, swaps, and options contracts are used to hedge financial risk.

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

10. How IFRS guidance for long-term debt, loss contingencies, and hedge accounting differs from U.S. GAAP.

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Overview of liabilities

The FASB says:

This means a financial statement liability is: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.

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.

Not all economic liabilities qualify as financial statement liabilities

Monetary liabilities

Nonmonetary liabilities

• Payable in fixed amount of future cash

• Satisfied by delivering goods or services

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Bonds payable:Illustration of bond issued at par

2011 2012 2013 2019 2020

$100 $100 $100 $100 $100

Years

$1,000

Promised interest payments

Promised principal payment

Bond cash flows (in $000):

$1,000 borrowed

Face value and cash proceeds are the same

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Bonds payable:Illustration of bond issued at a discount

On January 1, 2011, 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.

2011 2012 2013 2019 2020

$100 $100 $100 $100 $100

Years

$941,108 borrowed

$1,000

Promised interest payments

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, 2011, 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.

2011 2012 2013 2019 2020

$100 $100 $100 $100 $100

Years

$1,064,177 borrowed

$1,000

Promised interest payments

Promised principal payment

Bond cash flows ($1,000):

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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.

$1,000,000$944,630

$55,370

Carrying value Market value

Extinguishment gain

Journal entry at retirement:

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

Book valueMarket value

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Global Vantage Point

IFRS and U.S. GAAP are similar except for a couple of differences:

Debt Issue costs – are treated as a reduction in the proceeds of the debt received rather than recorded separately as an asset and amortized over the life of the bonds

Fair value option – IAS 39 permits companies to elect a fair value accounting option only

If the liabilities are actively managed on a fair value basis, or The use of fair value accounting eliminates or reduces the “mismatch” that

arises when different measurement bases are used for related financial instruments

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Hedging

Business are exposed to market risks from many sources:

Managing market risk is essential for most companies.

Most often, these risks are managed by hedging transactions that make use of derivative securities.

Interest rate risk

Foreign currencyexchange rate risk

Commodityprice 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

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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.

Figure 11.7

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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 options—unless 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 adjustment—the change in fair value—flows 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:

To accurately reflect the underlying economics of the hedge, the loss on the hedged item should be matched with the derivative’s offsetting gain in the income statement of the same period.

That’s what the GAAP rules (FASB ASC Topic 815: Derivatives and Hedging) for hedge accounting try to accomplish.

$500Economic gain on hedge derivative

$500Economic loss on hedged item

Derivative gain

Hedged item loss

Current period

Derivative gain

Hedged item loss

Future period

Derivative gain

Current period

Or But not

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Contingent liabilities

GAAP 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 estimated.

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

“Critical event” and “measurability” from Chapter 2

Figure 11.11

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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. Derivatives—whether used for hedging or speculation—pose special accounting problems.

4. For most companies, the most important long-term obligation is still traditional debt, and IFRS and U.S. 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. Firms may instead opt for fair value

accounting for their long-term debt.

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Summary concluded

5. Long-term debt accounting 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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