Financial Instruments as Liabilities Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 11 Copyright © 2015 McGraw-Hill Education. All rights reserved.

Financial Instruments as

Liabilities

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 11

Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

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 • Payable in fixed amount of future cash

Nonmonetary liabilities • Satisfied by delivering goods or services

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Overview of liabilities:Balance sheet illustration, Oracle Corp.

Obligations due within

one year or within

operating cycle,

whichever is longer

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Total long-term

debt

Bonds payable:Characteristics of bond cash flows

A bond is a formal promise to repay both the amount borrowed as well as the interest on the amount borrowed.

Bonds come in many different varieties: debentures, mortgage bonds, convertible bonds, serial bonds are just some examples.

Face or maturity amount

1 2 3 9 10

$100 $100 $100 $100 $100

Time period

$1,000 borrowed

$1,000

Promised interest payments

Promised principal payments

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Issue price

Bonds payable:Illustration of bond issued at par

2014 2015 2016 2022 2023

$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:Journal entries for bond issued at par

$100,000

12=

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Here’s the entry to record the bonds on Huff’s books:

Huff’s monthly interest accrual:

Huff’s annual interest payment at year end:

1/(1.10)2 1/1(.10)10

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Bonds payable:Illustration of bond issued at a discount

On January 1, 2014, 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.

2014 2015 2016 2022 2023

$100 $100 $100 $100 $100

Years

$941,108 borrowed

$1,000

Promised interest payments

Promised principal payment

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Bonds payable:Journal entries for bond issued at a discount

Here’s the accounting entry made when the 10% bonds are issued at a price that yields 11% to investors.

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Huff’s entry to record interest expense for 2014:

Bonds payable:Discount amortization details

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Calculates to $1,000,000 – the

original bond price

Bonds payable:Illustration of bond issued at a premium

On January 1, 2014, 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.

2014 2015 2016 2022 2023

$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:Journal entries for bond issued at a premium

Here’s the accounting entry made when the 10% bonds are issued at a price that yields 9% to investors.

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Huff’s entry to record interest expense for 2014:

Computation is similar to that used for discount

Bonds payable:Premium amortization details

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Calculates to $1,000,000 – the

original bond price

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:

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Book value

Market value

Extinguishment of debt:A two-step retirement

Suppose Huff borrows the money needed to buy back the old debt.

Huff

Issues new 11% debt

Step 1$944,630

cash

Retires old10% debt

Step 2$944,630

cash

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In this case, the journal entries at retirement would be:

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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Managerial incentives:Debt-for-debt swaps

Reporting debt at amortized historical cost makes it easier to manipulate accounting numbers using transactions like a debt-for-debt swap:

Different book values

Identical market values

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Journal entry to record the swap on Shifty’s books:

Managerial incentives:Debt-for-equity swaps

Here debt is retired using shares of common stock:

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Journal entry to record the swap is:

Managerial incentives:Summary

Debt-for-debt swaps, debt-for-equity swaps, and other similar transactions often serve a valid economic purpose.

However, some analysts still believe that the dominant motivation for these transactions is to increase reported income.

No matter what the motivation is, the result is the same: The earnings boost may not reflect economic reality. Instead, it just represents the difference between book value and

market value of the debt.

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Imputed interest

Salton’s “non-interest bearing note” to Mr. Foreman:

2000 2001 2002 2003 2004

$22.750 $22.750

Years

$22.750 $22.750 $22.750 Payments

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Salton’s journal entries:

Present value at an “imputed” interest rate

Imputed interest:What interest rate did Salton use?

Here’s another approach to identifying Salton’s imputed interest rate:

Interest expense for 2000

Beginning bookvalue of note

=$6.3

$97.270 - $22.750 = 0.08454

about 8.5%Initial payment

Initial amount recorded

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Figure 11.5

Off-balance sheet debt Loan covenants often contain language that limits reported liabilities:

Debt

Equitycannot exceed 1.7As reported

No debt here

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Loan contract terms of this sort create incentives to minimize reported liabilities by keeping some debt off the balance sheet.

One approach to creating off-balance sheet debt is to use an unconsolidated subsidiary as the borrower:

Hedging

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

Interest rate risk• Banks that loan money at fixed rates of interest

Foreign currencyexchange rate risk

• Manufacturers that build products in one country but sell them in another

Commodityprice risk

• Fuel prices for an airline company

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Business are exposed to market risks from many sources:

Managing market risk is essential for most companies.

Typical derivative securities:Forward contract

Two parties agree to the sale of some asset on some future date at a price specified today:

Three elements of the contract are key:1. The agreed upon price to be paid in the future.2. The delivery date.3. The buyer will actually “take delivery”.

Notice that the contract itself (a derivative) has value to both parties.

Today Future date

You order a $39.95 book

The book arrives, you pay $39.95 and take

delivery

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Typical derivative securities:Futures contract

Two parties agree to the sale of some asset on some indefinite future date at a price specified today:

Futures contracts are like forward contracts except that:1. They do not have a predetermined settlement date.2. They are actively traded on financial exchange.

Settlement can occur through delivery or by creating a “zero net position”.

October 5

Anytime in February

You sell a February copper contract to Smythe

for 10 million pounds at $0.95 per pound

Symthe pays $0.95 per pound and takes

delivery

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Typical derivative securities:Rombaurer Metal’s copper futures

On October 1, 2014, Rombaurer has 10 million pounds of copper inventory on hand at an average cost of 65 cents per pound. The “spot” (current delivery) price for copper on October 1 is 90 cents a pound…Rombaurer has decided to hold on to its copper until February 2015 when management believes the price of copper will return to normal levels of 95 cents per pound.

If the copper is sold on October 1 at 90¢ per pound:

RevenueCost of goods sold

Gross profit

$9.0 million 6.5 million$2.5 million

If the copper is sold next February at the estimated price of 95¢ per pound:

RevenueCost of goods sold

Gross profit

$9.5 million 6.5 million$3.0 million

$500,000 upside potential to not selling now

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Typical derivative securities:How futures contracts benefit Rombaurer

The futures contracts “lock in” a February price of 95¢ and eliminate the company’s downside exposure to a decline in copper prices.

February cash receipts will be a predictable $9.5 million, and gross profits will total $3.0 million regardless of what the February “spot” price actually turns out to be.

However, the company has given up the cash flow and gross profit opportunity that could result if February spot price is above 95¢.

The futures contracts eliminate both downside risk and upside potential.

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Typical derivative securities:How futures contracts benefit Rombaurer

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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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Typical derivative securities:Options contracts

Ridge Development is a real estate company that simultaneously contracts many single family-homes. In January, it needs 10 million board feet of lumber on hand in three months (April) to construct homes the company has pre-sold to residential home buyers. Lumber currently sells for $250 per 1,000 board feet, so Ridge would have to purchase $2.5 million of lumber at the current (January) price to meet its April construction needs. But the company has no place to store the lumber now until the construction season begins. Ridge can use options contracts to eliminate the commodity price risk from its anticipated lumber purchases three months from now.

Because Ridge has already sold the unbuilt homes, the company is exposed to the risk that lumber costs might increase by April.

By using options instead of futures, Ridge can protect against lumber cost increases without sacrificing potential gains if lumber prices decline.

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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

Or

Derivative gain

Current period

But not

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Hedge accounting:When can it be used?

The answer depends on four considerations:

Hedged item

• An existing asset or liability• A firm commitment• An anticipated (forecasted) transaction

Hedging instrument• Usually a derivative (e.g., futures, swaps, options)• But not all derivatives qualify• Insurance contracts and options to buy real estate do not qualify

Risk being hedged

• Risk of changes in the FMV of an existing asset or liability or a firm commitment• Risk of changes in cash flows of an existing asset or liability or an anticipated transaction• Risk of changes in currency exchange rates

Hedge effectiveness• Ability to generate offsetting changes in the fair value or cash flows of the hedged item• Partially effective hedge transactions may not always qualify

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Financial reporting rules:Derivatives that qualify for hedge accounting

Figure 11.10

Always “marked to market”

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Financial reporting rules:Derivatives that do not qualify

Figure 11.10

Always “marked to market”

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Hedge accounting:Forecasted transaction

The contracts are designated as a cash flow hedge of forecasted lumber purchases with commodity price volatility being the source of market risk.

The contracts are first recorded as an asset. Then “marked-to-market” at each balance sheet date. The change in fair value flows to “other comprehensive income”, then transfers to income as homes are completed.

April 1 Nov. 30

Vintage buys future contracts

for lumbers

Construction season

Vintage buys lumber needed

Futures contracts are settled

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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 2Figure 11.11

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Loan GuaranteesKrispy Kreme

No loss contingency has been recorded.

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Companies sometimes provide loan guarantees that require them to make payments to a lender on behalf of a borrower based on some future event.

Global Vantage Point

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IFRS guidance on accounting for contingencies is found in IAS 37.

Similar to U.S. GAAP except:

U.S. GAAP

Relies on income statement perspective

Probable means “likely to occur”

IFRS

Centers on the balance sheet Probable means “more likely

than not”

Amount of contingent loss to be recognized is also different. Suppose the probable loss is estimated by management to range between $450,000 and $650,000. No amount is a better estimate than any other.

U.S. GAAP: low end of $450,000

IFRS: midpoint of $550,000

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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