978-0078025679 Chapter 11 Lecture Note

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

CHAPTER 11

FINANCIAL INSTRUMENTS AS LIABILITIES

CHAPTER OVERVIEW

A financial statement liability is (1) a currently existing obligation arising from past events,

which necessitates (2) payment of cash, or provision of goods and services, to some other entity at

a future date.

An astounding variety of financial instruments, derivatives, and nontraditional financing

arrangements is now used to fund corporate activities and to manage risk. Statement readers face

a daunting task when trying to fully grasp the economic implications of some financial

innovations. Off-balance sheet obligations and loss contingencies are difficult to evaluate

because the information needed is often not disclosed. Derivatives—whether used for hedging or

speculation—are problematic because of both their complexity and the involved details of hedge

accounting.

For many companies, however, the single most important long-term obligation is still

traditional debt financing. IFRS and U.S. GAAP guidance in this area is quite clear. Noncurrent

monetary liabilities are initially recorded at the discounted present value of the contractual cash

flows—that is, the issue price. The effective interest method is then used to compute interest

expense and net carrying value each period. Interest rate changes occurring after the debt has

been issued are ignored. Of course, firms may instead opt for fair value accounting for their

long-term debt.

Long–term debt accounting makes it possible to “manage” reported income statement and

balance sheet numbers when debt is retired before maturity. The opportunity to do so comes

from the difference between debt book value and market value when interest rates have changed.

The incentives for “managing” income statement and balance sheet numbers may be related to

debt covenants, compensation, regulation, or just the desire to paint a favorable picture of a

company’s performance and health.

Extinguishment gains and losses from early debt retirement and swaps—and those generated

by similar transactions—require careful scrutiny. Statement readers need to know whether real

economic benefits for the company and its shareholders are produced—or if such gains or losses

are just window dressing.

CHAPTER OUTLINE

I. BALANCE SHEET PRESENTATION

A. Most liabilities are monetary liabilities because they will be paid in cash.

1. Nonmonetary liabilities are satisfied by the delivery of things other than cash,

such as merchandise or services.

2. Monetary liabilities should be shown in the financial statements at the discounted

present value of the future cash outflows required to satisfy the obligation.

a. Current liabilities—obligations due within a year or operating cycle,

whichever is longer—are rarely discounted.

b. Noncurrent monetary liabilities are initially recorded at present value when

incurred.

c. Long-term debt is a noncurrent monetary liability and is reported at the

discounted present value of the amount due.

II. GLOBAL VANTAGE POINT

Even though there are exceptions, most foreign firms that use IFRS prepare classified balance

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

sheets where current liabilities are listed first, long-term liabilities are listed second, followed

by shareholders’ equity accounts. The exceptions report liabilities in the reverse order. Those

to be paid in the distant future are listed first. Some place the stockholders’ equity above the

liabilities. This format is acceptable under IAS 1, “Presentation of Financial Statements.”

III. DEBT OR EQUITY?

A. Financial instruments that possess both liability and equity characteristics present

challenges to accountants who must determine the proper balance sheet classification.

1. A transaction requiring future payment of a fixed value of common stock will be

classified as a liability since the value is fixed until payment occurs.

2. The issuance of preferred stock with a mandatory redemption feature will be

as a liability since the obligation to redeem makes the stock look more like debt.

3. The FASB and IASB are working jointly to clarify and converge reporting

requirements for financial instruments with equity characteristics.

IV. BONDS PAYABLE

A. A bond is a financial instrument that represents a formal promise to repay both the

amount borrowed and interest.

B. The bond indenture agreement specifies the precise terms of the borrowing.

C. Types of bonds include:

1. Debentures, the most common type of corporate bond, are backed by the general

credit of the company

2. Mortgage bonds have real estate as collateral for the repayment of the loan.

3. Serial bonds specify periodic payment of interest and mature in successive years.

4. Term bonds require payment of periodic interest payments and repayment of the

principal at the end of the term.

5. Convertible bonds give investors the opportunity but not the obligation to

exchange the bond for the company’s common stock.

D. Characteristics of bond cash flows:

1. Bonds are usually issued with a principal amount—also called the par value,

maturity value, or face value—of $ 1,000 per bond certificate.

2. The bond certificate also displays the stated interest rate—sometimes called the

coupon or nominal rate.

3. The cash interest payments on the bond are computed by multiplying the principal

amount by the stated interest rate translated into periodic interest charges.

E. Bonds Issued at Par:

1. When the issue price of the bonds equals its par value, the yield (effective yield) to

investors is exactly equal to the coupon rate (stated rate).

2. The bond is recorded at its issue price (which is equal to par value).

a. The issue price is also the discounted present value of the future cash flows

provided by the bond.

b. The cash interest payments form an annuity, which just means a series of

payments made at specified equally spaced time intervals.

i. If the first payment is made at the start of period 1, then it is an

annuity due.

ii. If the first payment is made at the end of year 1, then it is called an

ordinary annuity.

3. Interest expense or accrued interest payable is equal to the amount of cash that is

paid or is payable for interest.

F. Bonds issued at a discount:

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

1. When the issue price of the bonds is less than its par value, the market interest

rate is greater than the coupon rate.

2. The discount rate is the effective yield on the bonds at the issuance date, since the

price is determined by discounting the contractual cash flows at the market

interest rate.

3. The bond is recorded at its issue price (which is less than par value).

a. The bonds payable liability is recorded at par value.

b. The excess of the par value over the issue price is debited to a liability

valuation account called “bond discount” that is deducted from the

bonds payable account. The bond discount is a liability valuation

account that is deducted from the Bonds Payable account for financial

reporting purposes.

c. The net balance sheet value, or carrying value, of the bonds is the net of these

two amounts.

4. Interest expense or accrued interest payable is equal to the carrying value of the

bond since the last interest payment, multiplied by the effective interest rate. This

is referred to as the effective interest basis.

a. The excess of interest expense over cash interest paid is bond discount

amortization.

b. Bond discount amortization increases the carrying value of the bonds

payable, such that the carrying value will equal par value at maturity.

c. Interest expense increases over time since amortization of the

bond discount increases the net carrying value.

G. Bonds issued at a premium:

1. When the issue price of the bonds is greater than its par value, the market

interest rate is less than the coupon rate.

2. The discount rate is the effective yield on the bonds at the issuance date, since

the price is determined by discounting the contractual cash flows at market

interest rate.

3. The bond is recorded at its issue price (which is greater than par value).

a. The bonds payable liability is recorded at par value.

b. The excess of the issue price over the par value is credited to a liability

valuation account called “bond premium” that is added to the bonds payable

account.

c. The net balance sheet value, or carrying value, of the bonds is the sum of

these two amounts.

4. Interest expense or accrued interest payable is equal to the carrying value of the

bond since the last interest payment, multiplied by the effective interest rate. This

is referred to as the effective interest basis.

a. The excess of cash paid over interest expense is bond premium amortization.

b. Bond premium amortization decreases the carrying value of the bonds

payable, such that the carrying value will equal par value at maturity.

c. Interest expense decreases over time since amortization of the bond

premium decreases the carrying value.

H. Book Value versus Market Value after Issuance:

1. Bonds payable are carried on the books at amortized cost.

a. Bonds are shown at their market (present) value when first issued.

b. Reported book values after issuance will not necessarily equal the market

value of the bonds, since market interest rates fluctuate over time.

c. Market price changes are not explicitly recorded on the financial statements

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

for debt that is not retired before maturity.

2. Floating-Rate Debt – Bonds continue to be shown at market value when

floating-rate debt is issued, even when market interest rates change.

a. Investors benefit from floating-rate debt when interest rates increase since

additional cash interest payments exactly offset the decline in the present

value of the future cash receipts.

b. Issuing corporations benefit from floating rate debt when market interest rates

fall because the contractual cash interest payments would fall.

3. Extinguishment of Debt – Market price changes are recorded on the financial

statements when debt is retired before maturity.

a. The accounting gain or loss at retirement (extinguishment) is the difference

between the cash paid (market value) to extinguish the debt and the book

(carrying) value of the debt.

b. Any extinguishment gain or loss undergoes the same criteria used to

determine whether other gains and losses qualify as discussed in Chapter 2.

It has to be unusual and infrequent to be reported as an extraordinary gain or

loss on the income statement.

I. Option to Use Fair Value Accounting

1. This option now allowed under GAAP, allows firms to choose to measure

eligible financial instruments at fair value rather than amortized historical cost.

2. This is available for most basic financial assets and liabilities, including bonds.

3. The fair value option is not available for nonfinancial assets and liabilities

4. The election can be made for a single instrument without electing it for others.

5. Once the fair value option is elected it must be maintained until the asset is sold

or the liability is extinguished.

6. The gain or loss on revaluation is reported on the income statement and the value

of the asset or liability is also adjusted to fair value.

7. While this is controversial, proponents believe this option eliminates artificial

earnings volatility, it may present opportunities for firms to dress up their

balance sheets.

J. Opposing Views on the Fair Value Accounting Option

1. GAAP does not limit the use of the fair value option to situations in which the

financial assets and liabilities are related. Critics argue that this could create an

opportunity for companies to use fair value accounting to dress up their balance

sheets and manage earnings.

2. Analysts and investors must rethink how they evaluate a company’s debt–to–

equity ratio.

V. GLOBAL VANTAGE POINT

Even though IFRS and U.S. GAAP are quite similar in approaches on the most

important elements of long-term debt accounting, there are several areas of divulgence

such as:

1. Debt Issue Costs – These costs under GAAP are recorded separately as an asset

and amortized over the bond life. The IFRS approach is to reduce the recorded

amount of the debt (reduction in the proceeds received) – causing a higher

effective interest rate.

2. Fair Value Option – IAS 39 permits election of fair value accounting for

liabilities under two circumstances:

a. liabilities are actively managed on a fair value basis as part of the

company’s management or investment strategy

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

b. use of fair value accounting eliminates or significantly reduces the

“mismatch” that arises when different measurement bases are used for

related financial instruments.

3. In May 2010, the FASB issued a controversial proposed accounting standard

update that would require nearly all financial instruments to be measured at fair

value in the statement of financial position rather than amortized cost.

Amortized cost information would be presented as a supplemental disclosure.

4. In responding to the complaints, the FASB has now altered its view in ways

consistent with the IASB.

VI. MANAGERIAL INCENTIVES AND FINANCIAL REPORTING FOR DEBT

A. Some analysts contend that reporting debt at amortized cost makes it easier to

manipulate accounting numbers.

1. Debt Carried at Amortized Historical Cost: Debt-for-debt swaps and debt-

for–equity swaps may be driven more by the financial statement effects they elicit

than by any underlying economic benefits.

2. Debt-for-debt swaps gives investors the opportunity to exchange (old) debt for

new debt issued by the company

3. debt-for–equity swaps give investors the opportunity to exchange old debt for the

company’s common stock.

4. The belief persists that the dominant motivation for these transactions is to

increase reported income.

5. Critics of historical cost accounting raise the possibility that managers whose

bonuses are tied to reported earnings might use swap gains to boost their firm’s

earnings (and therefore their bonuses) in years of poor operating performance.

6. Debt extinguishment gains are generally taxable in addition to fees. These added

costs further increase the potential disparity between the reported accounting gain

and the economic effects of the swap.

7. Some debt-for-debt exchanges generate real economic benefits even after

factoring transaction costs.

8. Debt-for equity swaps alter the company’s capital structure and undoubtedly

precipitate real economic effects even though companies use the security swaps to

smooth unexpected and transitory decreases in quarterly earnings per share or to

relax otherwise binding covenant constraints.

9. In response to these types of criticisms, FASB requires note disclosure of the fair

value of all financial instruments – both financial liabilities and assets.

B. Analysts will have to use footnote disclosures to ascertain whether operating cash flows

will be sufficient to meet scheduled debt interest and principal payments.

VII. IMPUTED INTEREST ON NOTES PAYABLE

Installment notes that make no mention of an interest rate must impute the interest rate.

IV. INCENTIVES FOR OFF–BALANCE SHEET LIABILITIES

A. Covenants restricting the amount of debt create incentives for managers to minimize

reported financial statement liabilities.

B. Reducing the amount of reportable liabilities reduces the probability of covenant

violations.

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

C. The FASB has tightened the rules governing the consolidation of special purpose

entitites (now called Variable interest entities).

D. Analysts must know how to adjust the reported financial statement numbers for off-

balance sheet liabilities to better reflect economic reality.

V. HEDGES

A. In response to financial risks, many companies use derivative securities as a form of

hedging—business transactions designed to insulate them from commodity price,

interest, or exchange rate risk.

B. Derivative securities have no inherent value but instead represent a claim against some

other asset.

1. Typical Derivative Instruments and the Benefits of Hedging: In a forward

contract, two parties agree to the sale of some asset or commodity on some future

date—called the settlement date—at a price specified today.

a. A futures contract is a variation of a forward contract that is traded daily on

financial exchanges like the New York Mercantile Exchange (NYMEX).

b. Futures contracts exist for commodities like corn, wheat, live hogs and cattle,

cotton, copper, crude oil, lumber, and even electricity.

c. Here is how a futures contract works.

i. By “writing” (meaning selling) a contract, the selling party is

obligated to deliver the commodity at the agreed-upon price during

the delivery month.

ii. The buyer (or contract counterparty) is obliged to pay the fixed price and

take delivery of the commodity during the delivery month. Note that

futures contracts do not have a predetermined settlement date—the seller

can choose to deliver the commodity on any day during the delivery

month.

iii. When the seller decides to deliver the commodity, the buyer is notified to

be ready to accept delivery within the next several days.

iv. However, since futures contracts are actively traded on an exchange,

they have an added advantage over forward contracts. This means the

buyer can avoid delivery by writing a futures contract to create a zero

net position.

v. The first contract obligates the buyer to accept delivery of the

commodity, but the second contract obligates the buyer to deliver the

commodity to someone else. One contract cancels the other.

d. A futures contract “locks in” a future price and eliminates downside exposure

to a decline in commodity prices, resulting in predictable cash flows and gross

profits.

2. Swap contracts are a popular way to hedge interest rate or foreign exchange risk.

a. Fixed-rate debt can be replaced with a floating-rate loan using a debt-for-debt

exchange offer.

b. An interest rate swap can be used to create synthetic floating-rate debt.

i. A “swap dealer” locates a third party, referred to as a counterparty, who

would like to make fixed-rate interest payments in exchange for floating–

rate interest receipts.

ii. The company “creating” the synthetic debt and the counterparty agree to

swap interest payments on a certain amount of debt for a certain period

of time, effectively transforming the counterparty’s debt into a fixed-rate.

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

iii. The swap dealer gets a fee for arranging the swap transaction.

3. A foreign exchange (currency) swap has the same structural features as the

synthetic swap outlined above, except that the loans are denominated in different

currencies.

a. A swap dealer helps the company identify a counterparty willing to accept

foreign-denominated payments for dollar-denominated payments.

b. Foreign exchange exposure on the loan is then hedged.

4. Option contracts give the holder an “option”—the right but not the obligation—to

do something.

a. In contrast to option contracts, futures and swaps require each party to engage

in the agreed-upon transaction.

b. Call options give the holder the right to buy a specific underlying asset at a

specified price during a specified time.

i. By purchasing a call option, instead of a future, the buyer can protect

against commodity cost increases without sacrificing potential gains if

commodity prices decline.

ii. See Figure 11.10 for graphical depiction of the value of a call option.

c. Put options give the holder the option to sell a specified asset at a specified

price during a specified period of time.

C. Financial Reporting for Derivative Instruments:

1. All derivatives must be carried on the balance sheet at fair value.

2. Generally, changes in the fair value of derivatives must be recognized in income

when they occur. The only exception is derivatives that qualify as hedges according

to GAAP.

a. The following accounting entries apply to all types of derivatives—forwards,

futures,

swaps, and options—unless the special “hedge accounting” rules apply.

b. Derivative contracts represent balance sheet assets and liabilities and are

recorded at cost.

c. The carrying value of the derivative is adjusted to fair value at each balance

sheet date.

d. The amount of the adjustment—the change in fair value—flows to the

income statement as a holding gain or loss.

e. Speculative investments in derivative contracts can increase the volatility of

reported earnings, but the earnings volatility mirrors the derivative’s inherent

economic risk.

D. Hedge Accounting: Companies may use hedge accounting rules when they use

derivative securities to successfully hedge financial risk rather than for speculation.

1. These rules eliminate or reduce the earnings volatility that would otherwise result

from reporting the derivative’s fair value change in income.

2. The type of special hedge accounting to be applied varies depending on the

nature of the exposure that is being hedged.

a. In some cases, changes in the fair value of the derivatives are reported in

current earnings as they occur, but adjusting the carrying value of the asset or

liability that is being hedged offsets the impact.

b. In other cases, earnings volatility is avoided by recording changes in the fair

value of the derivative directly in shareholders’ equity as part of

comprehensive income.

3. Whether hedge accounting can be used depends on four considerations.

a. The hedged item can be an existing asset or liability on the company’s books,

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

a firm commitment, or an anticipated (forecasted) transaction.

b. The hedging instrument is most often a derivative security.

i. Qualifying instruments include options to purchase or sell an exchange-

traded security, futures and forward contracts, and interest-rate and

currency swaps.

ii. Insurance contracts, options to purchase real estate, equity and debt

securities, and financial guarantee contracts do not qualify as hedging

instruments.

c. The risk being hedged falls into one of three categories:

i. Fair value hedge is a hedge of the exposure to changes in the fair

market value of an existing asset, liability, or a firm commitment.

a. It is carried at market value on the balance sheet as an asset or a

liability.

b. Gain (loss) is recognized in current earnings.

ii. Cash flow hedge is a hedge of the exposure to changes in cash flows of

an existing asset or liability or an anticipated transaction.

a. It is carried at market value on the balance sheet as an asset or a

liability.

b. Gain (loss) is recognized as a component of other comprehensive

income,

iii. Foreign currency exposure hedge is a hedge of the exposure to

changes in currency exchange rates of a firm commitment or available-

for–sale security (see Chapter 16), a forecasted transaction, or a

multinational company’s net investment in a foreign operation (see

Chapter 16).

a. It is carried at market value on the balance sheet as an asset or a

liability.

b. The portion of the fair value change equal to the translation

adjustment on the net investment is recognized as a component of

other comprehensive income.

c. Any remaining change in fair value is taken to earnings.

d. Hedge effectiveness is the relationship between the hedging instrument

and the hedged item.

i. GAAP requires the hedge to be highly effective in offsetting changes in

those fair values or cash flows that are due to the hedged risk, both at the

inception of the hedge and on an ongoing basis.

ii. A hedge is highly effective if the hedging instrument offsets between

80% and 125% of the hedged item’s fair value or cash flow changes

attributable to the hedged risk

iii. GAAP distinction between highly effective and ineffective hedges

determines when gains and losses on the hedging instrument flow to

current income.

iv. For cash flow hedges, the mark–to–market adjustment is split

into two components—the highly effective portion of the

derivative’s gain or loss (which flows to other comprehensive

income) and the ineffective portion (which flows to earnings).

v. Critics of hedge accou nting cla im that addi tional i ncome

statement and balance sheet volatility is created when the gains

and losses on the hedging instrument exceed the losses and

gains on the hedged item – forcing management to engage in

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

less efficient risk management approaches.

E. Global Vantage Point

Despite some important differences in the details, there are striking similarities

between IFRS and U.S. GAAP for derivatives and hedge accounting such as:

1. Freestanding derivative contracts – a derivative contract represents a balance

sheet asset or liability whose carrying value is adjusted to fair value at balance

sheet date and whose adjustment amount flows to the income statement.

2. IFRS, as in U.S. GAAP, recognizes the existence of both a fair value hedge and

a cash flow hedge.

3. Both standards require that the derivative be marked-to–market at each balance

sheet date with the fair value change flowing either to current earnings (for fair

value hedges) or to other comprehensive income (for cash flow hedges).

A hedge must be “highly effective” to qualify for special IFRS hedge accounting

and the hedging relationship must be fully disclosed in the financial statements.

4. In 2013, IASB published an amendment of IFRS 9 with two key provisions:

a. elimination of the requirement that a hedging transaction must be “highly

effective” but rather the existence of an “economic relationship” between

the hedging instrument and the hedged item such that the values move in

opposite directions.

b. allow companies to designate a specified portion of an nonfinancial item

as the hedged risk as long as that risk is separately identifiable and

measurable.

VI. CONTINGENT LIABILITIES

A. A loss contingency occurs when there is an event that raises the possibility of future loss.

B. Measuring and Recognizing Loss Contingencies – Loss contingencies need to be

measured and recognized in the financial statements when both of the following

conditions are met.

1. It is probable that an asset has been impaired or a liability has been incurred at the

date of the financial statements.

2. The amount of the loss can be reasonably estimated.

C. Under what circumstances do loss contingencies need to be disclosed?

1. When a loss contingency has been accrued, companies also frequently disclose

separately other information regarding the loss.

2. Footnote disclosure of loss contingencies is necessary when the loss is both

reasonably possible and can be estimated.

3. Contingencies arising from remote possibilities must be disclosed in certain

circumstances.

C. Recording Gain Contingencies – A gain contingency occurs when there is an

event which raises the possibility of a future gain.

1. These are not recorded until the event actually occurs and is confirmed.

2. This is an example of conservatism, the notion that it’s desirable to anticipate

losses, but gain recognition should wait until confirmation and realization.

3. Loan Guarantees – FASB ASC Topic 460 Guarantees views loan guarantees

as having two components:

a. a certain “stand ready obligation” to meet the terms of the guarantee –

recorded at fair value

b. the uncertain contingent obligation to make future payments

depending on future events – initially handled as an ordinary

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

contingent loss.

VII. GLOBAL VANTAGE POINT

A. Even though IFRS guidance on accounting for contingencies is quite similar to U.S.

GAAP. A few points are worth noting:

1. IFRS emphasizes a balance sheet perspective where contingent liability and asset

recognition takes center stage. U.S. GAAP relies on the income statement

perspective in its emphasis on contingent loss and gain recognition.

2. IFRS requires recognition of a contingent liability called a provision

3. IFRS defines probable as more likely than not – a lower threshold than is for U.S.

GAAP

4. As in U.S. GAAP, IFRS does not allow recognition of contingent assets and the

associated gains

5. While U.S. GAAP uses the term contingent liability to refer to both recognized

and unrecognized contingent loss obligations, IFRS uses the term to refer to

possible (but unrecognized) contingent obligations.

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

CHAPTER QUIZ

1. Which of the following best characterizes the differences between operating and

financing liabilities?

a. Operating liabilities are the result of prior financing cash inflows.

b. Financing liabilities arise from the normal course of business activities and represent

the operating capital for a given level of production and sales.

c. Operating liabilities are reported at the expected (undiscounted) cash flow.

d. A shift from financing liabilities to operating liabilities may signal the beginning of a

liquidity crisis.

2. Which of the following best characterizes the role of the coupon rate and the market rate

in the accounting for bonds payable?

a. The proceeds recorded at issuance depend only on the stated rate of interest for

bonds of a similar maturity and risk as well as the payment stream.

b. The market rate tells one the stated cash interest that will be received.

c. The market rate must be less than the stated rate.

d. The market rate at issuance determines the allocation of total cash receipts between

interest and principal.

3. Total interest expense over the life of bonds issued at a premium equals:

a. The total cash interest that is paid.

b. The total bond premium at issuance.

c. The total cash interest that is paid plus the bond premium at issuance.

d. The total cash interest that is paid minus the bond premium at issuance.

4. Which of the following best characterizes the carrying value of debt?

a. At any point in time, the balance sheet liability equals the present value of the

remaining payments discounted at the market rate at the issuance date.

b. At any point in time, the balance sheet liability equals the present value of the

remaining payments discounted at the current market rate.

c. Variable-rate debt does not mitigate the effects of interest rate risk.

d. It is not possible to calculate the amount by which the balance sheet liability differs

from the current market value of the debt.

5. On March 1, 2015, Eva Corporation issued 300 $1,000 notes that mature in five years. The

coupon (stated) rate was 11% and the market (effective) rate was 10%. Interest is payable

on March 1 and September 1. After the payment for interest, Eva retired 150 of the notes on

September 1, 2016, for $158,000. Calculate the gain or loss on early extinguishment of

debt.

a. $3,660.50 loss.

b. $3,660.50 gain.

c. $8,000.00 loss.

d. $8.000.00 gain.

6. Which of the following correctly characterizes the presentation of bonds issued at a discount on

the statement of cash flows?

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

a. The statement of cash flows correctly describes the economics of bonds issued at a

discount.

b. Operating cash flow is understated and financing cash flow is overstated by the amount

of discount amortization.

c. Operating cash flow is overstated and financing cash flow is understated by the amount

of discount amortization.

d. The cash flow classification of the debt payments depends on the market interest rate,

not the stated rate.

7. The following footnote disclosure from the 2004 Annual Report of American Home

Products reports its hedge of anticipated financing of its acquisition of American Cyanamid.

That acquisition (for $9.6 billion) was completed on November 21, 2003. A $4.75 billion

swap agreement was entered into the previous month. When the acquisition was

completed, it was financed with (variable rate) commercial paper. The swap had the effect

of fixing the interest rate on $4.75 billion of the commercial paper.

In October 2003, the Company entered into $4.75 billion notional amount of

simple, unleveraged interest rate swap agreements as a means of (l) locking in the

underlying U.S. treasury security rates to be paid in connection with long-term debt

planned to be issued during 2004 and (2) converting a portion of the commercial paper

issued in connection with acquisition of American Cyanamid from a floating rate

obligation to a fixed rate obligation.

The swap agreements are contracts under which the Company pays a fixed rate

of interest and receives a floating rate of interest over the term of the swap agreements

without the exchange of the notional amounts. During 2004, the weighted average

interest rates paid and received on these agreements were 7.8% and 6.0%,

respectively. The swap agreements have maturities ranging from 2005 to 2014.

In February 2004, the Company terminated $2.0 billion of interest rate swap

agreements in connection with the $2.0 billion issuance of 5- and 10-year notes, as

discussed above. The effect of terminating these swap agreements was deferred and is

being amortized to interest expense over the five- and 10-year terms of the related

notes. At December 31, 2004, the fair value of the remaining $2.75 billion of interest

rate swap agreements was a payable of $216,906,000.

Excluding the portion of the swap terminated, calculate the estimated increase in interest

expense resulting from the swap.

a. $26.8 million.

b. $49.5 million.

c. $165.0 million.

d. $214.5 million.

8. Assume Helton, Inc. issued at a premium of $60 a $1,000 bond convertible into 10

shares of common stock (par value $10). At the time of conversion the unamortized

premium is $50, the market value of the bond is $1,200, and the stock is quoted on the

market at $120 per share. Which of the following is correct?

a. The loss on conversion of bonds payable if the market value approach is used is $100.

b. The increase in owners’ equity if the book value approach is used is $1,050.

c. Analysts will treat the convertible bonds as debt until they are converted.

d. Analysts ignore convertible bonds since they have both debt and equity features.

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

9. A corporation recorded an extraordinary loss on the early extinguishment of debt when it

replaced old debt with new debt. At the same time, the same corporation announced an

increase in its quarterly dividends to shareholders. Which of the following is correct?

a. Increasing interest rates caused this firm to record a loss on the early extinguishment of

the old debt.

b. This is a classic example of a transfer of wealth from shareholders to bondholders.

c. Dividend payout ratios and interest costs are independent from one another.

d. The ability to issue debt at lower rates allowed this corporation to transfer these

cash flow savings to shareholders in the form of higher dividend payments.

10. A loan with a 12% coupon rate, a face value of $100,000, and three years remaining to

maturity is restructured. The interest rate is reduced to 8%. The effective interest rate at the

time the original note was issued was also 12%. Assume annual interest payments.

Calculate the loss to the creditor assuming that the present value is now $90,390.

a. $9,610.

b. $13,610.

c. $19,320.

d. $24,000.

QUIZ ANSWERS:

1. c. Operating liabilities arise from the normal course of business activities and represent the

required operating capital for a given level of production and sales. Operating liabilities are

reported at the expected (undiscounted) cash flow. This is an important exception to the rule

that liabilities are recorded at present value. This treatment is justified by the short period

between incurrance of the debt and its payment, rendering the adjustment to present value

immaterial. Financing liabilities are the result of prior financing cash inflows that indicate a

need for either cash or a means of refinancing debt. A shift from operating liabilities to

financing liabilities may signal the beginning of a liquidity crisis.

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

9/1/17 16,500 15,381 1,119 306,494

Financial Reporting and Analysis 6e Financial Instruments as Liabilities

the loan and the present value of the restructured payment stream discounted at the original

discount rate. Thus, the creditor recognizes a loss of $9,610 (100,000 – 90,930). Does the

debtor record a gain on this restructuring? Standard setters are reluctant to allow debtors to

record gains resulting from financial distress. Accounting standards provide that debtors’

carrying amount of debt be compared with the undiscounted cash flows (principal and

interest) due after restructuring. As long as the gross cash flows exceed the carrying

amount, the debtor will not recognize a gain. In this example, the future payments are

$124,000 ($100,000 + 3 x $8,000). No gain is recognized.

RECOMMENDED EXHIBITS

Exhibit 11.2—Demonstration that the Yield on Bonds Issued at Par Equals the Stated Interest

Rate (here 10%)

Exhibit 11.3—Determining the Price of 10% Stated Interest Rate Bonds When the Market Rate is

11%.

Exhibit 11.4—Bond Discount Amortization Schedule.

Exhibit 11.6—Determining the Issue Price for 10% Stated Interest Rate Bonds When the Market

Rate is 9%.

Figure 11.2(a) – Cash Interest Payment and Interest Expense

Figure 11.2(b) – Carrying Value for 10% Stated Interest Rate Bonds Sold at Discount

Figure 11.3—Shifty Corporation Debt-for-Debt Swap.

Figure 11.4—The Sequence of Events in a Debt-for-Equity Swap.

Figure 11.7—An Interest Rate Swap that Creates Synthetic Floating-Rate Debt for Kistler

Manufacturing.

Figure 11.8—Using a Swap to Hedge Interest Rate Risk for Kistler Manufacturing.

Figure 11.10 – Financial Reporting for Derivative Instruments