Judgment Case 14–9
Requirement 1
The debt to equity ratio is computed by dividing total liabilities by total
shareholders’ equity. The ratio summarizes the capital structure of the company as a
mix between the resources provided by creditors and those provided by owners. For
example, a ratio of 2.0 means that twice as many resources (assets) have been
provided by creditors as those provided by owners.
In general, debt increases risk. Debt places owners in a subordinate position
relative to creditors because the claims of creditors must be satisfied first in case of
liquidation. In addition, debt requires payment, usually on specific dates. Failure to
Requirement 2
Debt also can be used to enhance the return to shareholders. This concept is
known as leverage. If a company earns a return on borrowed funds in excess of the
cost of borrowing the funds, shareholders are provided with a total return greater than
what could have been earned with equity funds alone. This desirable situation is
Debt to equity ratio = Total liabilities
Shareholders’ equity
Case 14–9 (continued)
AGF has experienced favorable leverage, as demonstrated by calculating and
comparing the return on assets and the return on shareholders’ equity for 2016:
Requirement 3
Creditors generally demand interest payments as compensation for the use of
their capital. Failure to pay interest as scheduled may cause several adverse
Rate of return on = Net income
assets Average total assets
14–136 Intermediate Accounting, 8/e
Case 14–9 (concluded)
Two points about this ratio are important. First, because interest is deductible for
income tax purposes, income before interest and taxes is a better indication of a
Times interest earned = Net income + interest + taxes
Interest
Real World Case 14–10
The following is from Macy’s annual report:
February 1, February 2,
2014 2013
Requirement 3 ($ in millions)
Total current liabilities $ 5,726 $ 5,075
Long-term debt 6,728 6,806
Requirement 4
Total debt $15,385 $14,940
Shareholders’ equity 6,249 6,051
Case 14–10 (concluded)
Requirement 5
The vast majority is in the form of notes. Aggregate required payments of maturities
of long-term debt for the next five fiscal years are as follows:
Requirement 6
FASB ASC 470–10–45–14: “Debt–Overall–Other Presentation Matters–Intent and
Ability to Refinance on a Long-Term Basis”
Case 14–10 (concluded)
b. Financing agreement. Before the balance sheet is issued or is available to be
issued (as discussed in Section 855-10-25), the entity has entered into a financing
agreement that clearly permits the entity to refinance the short-term obligation
on a long-term basis on terms that are readily determinable.
1. The agreement does not expire within one year (or operating cycle from the date of the
entity’s balance sheet and during that period the agreement is not cancelable by the
lender or the prospective lender or investor (and obligations incurred under the
2. No violation of any provision in the financing agreement exists at the balance sheet
3. The lender or the prospective lender or investor with which the entity has entered into
14–140 Intermediate Accounting, 8/e
Analysis Case 14–11
Requirement 1
Earnings are not affected by conversion under the book value method. On the
other hand, a gain or loss is recorded and thus earnings are affected by
Requirement 2
The 7% bonds were issued at a discount (less than face amount). We know this
Requirement 3
The amount of interest expense would be less in the first year of the term to
Requirement 4
We determine gain or loss on early extinguishment of debt by comparing the
Analysis Case 14–12
Requirement 1
We compute the debt to equity ratio by dividing a company’s total liabilities by
total shareholders’ equity. The ratio summarizes the capital structure of the company
Generally, debt increases risk. Debt places owners in a subordinate position
Debt to equity ratio = Total liabilities
Shareholders’ equity
14–142 Intermediate Accounting, 8/e
Case 14–12 (concluded)
Requirement 2
Lenders demand interest payments as compensation for the use of their capital.
Inability to pay interest as scheduled may cause several adverse consequences,
Note two points about this ratio. First, because interest is deductible for income
tax purposes, income before interest and taxes is a better indication of a company’s
Times interest earned = Net income + interest + taxes
Interest
Air France-KLM Case
Requirement 1
Using IFRS, as Air France does, companies use the “net method” to record notes
and other borrowings. A discount on notes would be recorded only using the “gross
14–144 Intermediate Accounting, 8/e
Air France (continued)
Requirement 2
From Note 32.2.1, we see that in April 2005, Air France, a subsidiary of the Air
France-KLM Group (AF and KLM merged subsequent to 2005), issued convertible
Upon issue of this convertible debt, Air France-KLM recorded a debt of €379
million, corresponding to the present value of future payments of interest and face
Air France (concluded)
Requirement 3