Accounting for Debts

by Alfredo Garcia November 30, 2004 [Send a comment to Alfredo Garcia | Print View]

I. CLASSIFICATION AND MEASUREMENT ISSUES ASSOCIATED WITH DEBT. A. Definition of liabilities. 1. "Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events" (SFAC No. 6). 2. A result of past transactions or events; thus, not recognized until incurred. 3. Must involve a probable future transfer of assets or services. 4. The obligation of a particular entity. 5. The question of when a liability exists is sometimes problematic. a. Off-balance-sheet financing. b. Deferred income taxes. c. Leases. d. Pensions. e. Some equity securities, such as redeemable preferred stock. B. Classification of liabilities. 1. Classified as current or noncurrent. 2. Classification is important as it will impact a company's current ratio, the measurement of its liquidity or its ability to meet current obligations (total current assets / total current liabilities). 3. Current ratio a. Current ratios for successful companies are frequently less than 1.0. b. A comfortable margin of current assets over current liabilities suggests that a company will be able to meet maturing obligations in the event of unfavorable business conditions. c Exhibit 10-2 (p. 539) presents median current ratios for a set of diverse industries and for a few well-known companies. C. Measurement of liabilities. 1. The measurement used for liabilities is the present value of the future cash outflows to settle the obligation. 2. For noncurrent liabilities, the claim should either provide for interest to be paid on the debt or the obligation should be reported at the discounted value of its maturity amount. 3. For measurement purposes, liabilities can be divided into three categories: a. Liabilities that are definite in amount.

b. Estimated liabilities. (1) The liability is estimated so that the obligation is reflected in the current period, even though at an approximated value. (2) An example is a warranty obligation that is recorded on an accrual basis. c. Contingent liabilities. (1) Unlike the first two categories of liabilities, these are not recorded until it is probable that the contingent event will occur. (2) Even if the actual amount of the potential obligation is known, the actual existence of the liability is questionable since it is contingent upon a future event for which there is considerable uncertainty. (3) An example is a pending lawsuit. II. ACCOUNTING FOR SHORT-TERM DEBT OBLIGATIONS . A. Current liabilities are reported on the balance sheet at their face value (examples are accounts payable, notes payable, and miscellaneous operating payables--salaries, payroll taxes, property and sales taxes, and income taxes). B. Short-term operating liabilities. 1. Accounts payable refers to the amount due for the purchase of materials by a manufacturing company or merchandise by a wholesaler or retailer. 2. Usually not recorded when purchase orders are placed but when legal title to the goods passes to the buyer. 3. Reported at the expected amount of the payment (no recognition of interest is required as the payment period is normally short). 4. Reported net of any expected cash discount. C. Short-term debt. 1. Companies may borrow on a short-term basis for operating purposes other than for the purchase of materials or merchandise. 2. Evidenced by a promissory note; usually noted as Notes Payable. a. Trade notes payable--notes issued to trade creditors for the purchase of goods or services. b. Nontrade notes payable--notes issued to banks or to officers or stockholders for loans issued to the company and those issued to others for the purchase of noncurrent operating assets. 3. Recorded and reported at its present value (presuming that the note bears a reasonable rate of interest). a. If the note has no interest or if it is unreasonable, the face value of the note needs to be discounted to its present value to reflect the effective rate of interest implicit in the note.

b. Debit Discount on Notes Payable when the note is issued and write off the discount to Interest Expense over the life of the note. c. Discount on Notes Payable is a contra account to Notes Payable. 4. Short-term obligations expected to be refinanced. a. These should not be reported as current liabilities. b. This applies to the currently maturing portion of a long-term debt and to all other short-term obligations except those arising in the normal course of operations that are due in customary terms. c. It should not be assumed that a short-term obligation will be refinanced unless financing arrangements are secure and realistic. d. SFAS No. 6 contains the authoritative guidelines for classifying short-term obligations expected to be refinanced . e. If the obligation is paid prior to the actual refinancing, the obligation should be included in current liabilities on the balance sheet (refer to FASB Interpretation No. 8). f. If a short-term obligation is excluded from the current liabilities section of the balance sheet due to refinancing expectations, disclosure should be made in the notes. D. Lines of credit. 1. A line of credit is a negotiated arrangement with a lender where the terms are agreed to prior to the need for borrowing. 2. Once it exists, a company can access funds (borrow money) immediately without going through credit approval process. 3. A line of credit is not a liability. Once the line of credit is used to borrow money, a liability exists. III. PRESENT VALUE OF LONG-TERM DEBT . A. Long-term obligation is reported on a company's balance sheet at its present value, because the sum of the future cash payments is not a good measure of the actual economic obligation. B. A mortgage is an example of a secured loan. 1. If the borrower cannot repay the loan, the lender has a legal right to claim the mortgaged asset. 2. Mortgage payments are divided between principal and interest. C. Secured loans are common among companies experiencing financial difficulties. 1. Risk is reduced to the lender. 2. Interest cost is reduced to the borrower. IV. FINANCING WITH BONDS . A. Long-term financing is accomplished through the issuance of longterm debt instruments (bonds or notes) or through the sale of

additional stock. 1. Bonds or notes may be preferred because: a. Present owners remain in control. b. Interest is a deductible expense while dividends are not. c. Current market rates of interest may be favorable relative to stock market prices. d. The charge against earnings for interest may be less than the amount of dividends that might be expected by shareholders. 2. There are certain limitations and disadvantages of such financing. a. Debt financing is possible only when a company is in satisfactory financial condition and can offer adequate security to creditors. b. Interest obligations must be paid regardless of earnings and the company's financial situation. 3. Distinction between debt and equity securities. a. A debt instrument has a fixed interest rate and a definite maturity date when the principal must be repaid. b. Holders of debt instruments generally have no voting privileges. c. An equity security has no fixed repayment obligation or maturity date; and dividends on stock become obligations only after being formally declared by a firm's board of directors. d. Common stockholders generally have voting and other ownership privileges. B. Accounting for bonds. 1. Trust indenture--associated with bonds, provides more extensive detail than the contract terms of a note, often including restrictions on the payment of dividends or incurrence of additional debt. 2. Three main considerations: a. Recording the issuance or purchase. b. Recognizing the applicable interest during the life of the bonds. c. Accounting for the retirement of bonds, either at maturity or prior to the maturity date. C. Nature of bonds. 1. Involves the issuance of certificates of indebtedness (bond certificates). 2. Face value, par value, or maturity value--the amount to be paid on a bond at the maturity date. 3. Bond indenture--the contract between the corporation and the bondholders. 4. Bonds may be sold directly to investors or underwritten by investment bankers or a syndicate. 5. Issuers of bonds. a. Issued by private corporations; the U.S. government; state, county, and local governments; school districts, and government-

sponsored organizations. b. Municipal debt--debt securities issued by state, county, and local governments and agencies. 6. Types of bonds. a. Term versus serial bonds. (1) Term--mature on a single date. (2) Serial--mature in installments. b. Secured versus unsecured bonds. (1) Secured--offer protection to investors by providing some form of security. (2) Collateral trust bond--usually secured by stocks and bonds of other corporations owned by the issuing company. (3) Unsecured--not protected by the pledge of any specific assets (sometimes called debenture bonds or debentures). (4) Quality ratings are published by both Moody's and Standard and Poor's. c. Registered versus bearer (coupon) bonds. (1) Registered bonds call for the registry of the owner's name on the corporation books. (2) Bearer or coupon bonds are not recorded in the name of the owner; title to such bonds passes with delivery. d. Zero-interest bonds and bonds with variable interest rates. (1) Bonds that bear no interest but rather are sold at significant discounts, providing the investor with a total interest payoff at maturity. (2) Another type delays interest payments for a period of time. e. Junk bonds. (1) High-risk, high-yield bonds issued by companies that are heavily in debt or in an otherwise weak financial condition. (2) Can be issued by companies that once had high credit ratings but have fallen on hard times. (3) Can be issued by emerging growth companies that lack adequate cash flow, credit history, or diversification. (4) Or, issued by companies undergoing restructuring, often in conjunction with a leveraged buyout. f. Convertible and commodity-backed bonds. (1) Bonds that provide for their conversion into some other security at the option of the bondholder. (2) Generally they are permitted to be traded for common stock. (3) Commodity-backed bonds or asset-linked bonds--bonds redeemable in terms of commodities. g. Callable bonds. (1) Bonds for which the issuer reserves the right to pay the obligation prior to the maturity date. (2) Called by a corporation wishing to reduce its outstanding indebtedness.

D. Market price of bonds. 1. The stated (contract) rate--the rate of interest printed on the bond. 2. The bond premium or bond discount is the amount needed to adjust the stated rate of interest to the actual market rate of interest or yield for that particular bond. 3. The market, yield, or effective interest rate--the actual rate of interest earned or paid on a bond. E. Issuance of bonds. 1. Bonds can be sold directly to investors by the issuer or they may be sold on the open market through securities exchanges or investment bankers. a. Bond prices are quoted in the market as a percentage of face value. b. The issuer then records the receipt of cash and recognizes the long-term liability. c. The purchaser records the payment of cash and the bond investment. 2. The market price of a bond at any date is determined by discounting the maturity value of the bond and each remaining interest payment at the market rate of interest for similar debt on that date. 3. Bonds issued or acquired in exchange for noncash assets or services are recorded at the fair market value of the bonds, unless the value of the exchanged assets or services is more clearly determinable. 4. Bonds issued at par on interest date. 5. Bonds issued at discount on interest date. 6. Bonds issued at premium on interest date. 7. Bonds issued at par between interest dates. 8. Bond issuance costs. a. Either summarized as bond issuance costs, classified as deferred charges and charged to expense over the life of the bonds, or b. Offset against any premium or added to any discount arising on the issuance and thus netted against the face value of the bonds. F. Accounting for bond interest. 1. With coupon bonds, cash is paid by the issuing company in exchange for interest coupons on the interest dates. 2. Amortization--an adjustment to interest expense to reflect the effective interest being incurred on bonds. 3. Straight-line method. a. Provides for the recognition of an equal amount of premium or discount amortization each period. b. The amount of monthly amortization is determined by dividing the premium or discount at purchase or issuance date by the number of

months remaining to the bond maturity date. 4. Effective-interest method. a. Uses a uniform interest rate based on a changing loan balance and provides for an increasing premium or discount amortization each period. b. Effective interest rate--rate of interest at bond issuance that discounts the maturity value of the bonds and the periodic interest payments to the market price of the bonds. c. Used to determine the amount of revenue or expense to be recorded on the books. d. The amount of interest to be recognized each period is computed at a uniform rate on an increasing balance; this results in an increasing discount amortization over the life of the bonds. e. Because this method adjusts the stated interest rate to an effective interest rate, it is more accurate as an amortization method than is the straight-line method. G. Cash flow effects of amortizing bond premiums and discounts. 1. The amortization of a bond discount or premium does not involve the receipt or payment of cash and must be considered when preparing a statement of cash flows. 2. When a bond discount is amortized, interest expense reported on the income statement is higher than interest paid, and net income, on a cash basis, is understated. 3. The amount of bond premium amortization is subtracted from net income to arrive at cash flow from operations. 4. Using the direct method requires conversion of individual accrualbasis revenue and expense items to a cash basis. H. Retirement of bonds at maturity. 1. There is no recognition of any gain or loss on retirement as the carrying value is equal to the maturity value, which is also equal to the market value of the bonds at that point. 2. Any bonds not presented for payment at their maturity date should be removed from the bonds payable balance on the issuer's books and reported separately as Matured Bonds Payable; these are reported as a current liability except when they are to be paid out of a bond retirement fund. 3. Interest does not accrue on matured bonds not presented for payment. I. Extinguishment of debt prior to maturity. 1. Classified as an early extinguishment of debt; according to FASB No. 4, it is to be reported as an extraordinary item on the income statement. 2. Redemption by purchase of bonds on the market

a. Purchase by the issuer calls for the cancellation of the bond's face value together with any related premium, discount, or issue costs as of the purchase date. b. If redemption occurs between interest dates, must accrue for interest expense. 3. Redemption by exercise of call provision. a. Gives the issuer the option of retiring bonds prior to maturity. b. When bonds are called, the difference between the amount paid and the bond carrying value is reported as a gain or a loss on both the issuer's and investor's books. 4. Convertible bonds. a. Have the following features: (1) An interest rate lower than the issuer could establish for nonconvertible debt. (2) An initial conversion price higher than the market value of the common stock at time of issuance. (3) A call option retained by the issuer. b. Accounting for convertible debt issuance when the conversion feature is nondetachable. (1) Common practice is to allocate all proceeds to the bond and zero to equity. (2) Theory supports an allocation of proceeds between debt and equity. c. Accounting for convertible debt issuance when the conversion feature is detachable. (1) Bonds are sometimes issued with detachable stock warrants. (2) Allocate proceeds off issuance between debt and equity (warrants). d. Accounting for convertible debt issuance under IAS 32. (1) Proceeds should be allocated to debt and equity. (2) Does not distinguish between detachable and nondetachable conversion feature. e. Accounting for conversion. (1) Most common practice is to recognized no gain or loss for book or tax purposes. (2) It seems inconsistent with theory. 5. Bond refinancing. a. Issuing new bonds to replace outstanding bonds, either at maturity or prior to maturity. b. If done before the maturity date of the old issue, the question arises as to how to dispose of the call premium and unamortized discount and issue costs of the original bonds. c. Three positions are taken: (1) Such charges are considered a gain or loss on bond retirement. (2) Such charges are considered deferrable and are to be amortized systematically over the remaining life of the original issue. (3) Such charges are considered deferrable and are to be amortized systematically over the life of the new issue.

d. The FASB considered the nature of this gain or loss and defined it as being an extraordinary item requiring separate income statement disclosure (refer to APB Opinion No. 26). V. OFF-BALANCE-SHEET FINANCING. A. Financing procedures used by companies to avoid disclosing all their debt on the balance sheet in order to make their financial position look stronger. B. Unconsolidated entities. 1. In 1987, FASB Statement No. 94 required all majority-owned subsidiaries to be consolidated. 2. The tremendous debt associated with these financing subsidiaries was not disclosed on the balance sheets of their parent companies because the subsidiaries were involved in nonhomogeneous operations. 3. This effectively eliminated one opportunity for using off-balancesheet financing. 4. Companies still can avoid reporting debt associated with subsidiaries that are less than 50% owned. E. Project financing arrangements. 1. Companies may become involved in long-term commitments that are related to project financing arrangements. 2. This allows the two firms to guarantee repayment of the debt without having to show the liability from the borrowing on its balance sheet. F. Reasons for off-balance-sheet financing. 1. It may allow a company to borrow more than it otherwise could due to debt-limit restrictions. 2. If the company's financial position looks strong, it can usually borrow at a lower cost. 3. Many investors and lenders aren't sophisticated enough to see through the off-balance-sheet financing tactics and therefore make ill-informed decisions. VII. DISCLOSING DEBT IN THE FINANCIAL STATEMENTS. A. All significant related matters should be disclosed: 1. Nature of the liabilities, maturity dates, interest rates, methods of liquidation, conversion privileges, sinking fund requirements, borrowing restrictions, assets pledged, and dividend limitations. 2. The portion of long-term debt coming due in the current period.

B. Bond liabilities are often combined with other long-term debt on the balance sheet, with supporting details in a note. Expanded Material VIII. ACCOUNTING FOR TROUBLED DEBT RESTRUCTURING . A. To avoid bankruptcy proceedings or foreclosure on debt, investors may agree to make concessions and revise the terms of the debt to permit the issuer to recover from financial problems. 1. Troubled debt restructuring can take many forms--there may be a suspension of interest payments for a period of time, a reduction in the interest rate, an extension of the maturity date of the debt, or even an exchange of assets of equity securities for the debt. 2. The accounting question is whether a gain or loss should be recognized upon the restructuring of the debt on the books of both the issuer and the investor. 3. Refer to Statement No. 15. B. Transfer of assets in full settlement (asset swap). 1. A debtor that transfers assets to a creditor to settle a payable usually will recognize two types of gains or losses: a. Gain or loss on disposal of the asset. b. Gain arising from the concession granted in the restructuring of the debt. 2. The gain/loss on restructuring is considered to arise from an early extinguishment of debt and must be reported as an extraordinary item. 3. An investor always recognizes a loss (ordinary) on the restructuring due to the concession granted. C. Grant of equity interest (equity swap). 1. A debtor that grants an equity interest to the investor as a substitute for a liability must recognize an extraordinary gain equal to the difference between the fair market value and the carrying value of the liquidated liability. 2. A creditor (investor) must recognize a loss equal to the difference between the same fair market value of the equity interest and the carrying value of the debt as an investment. D. Modification of debt terms. 1. Modification may involve either the interest rate, forgiveness of unpaid interest, or a moratorium on interest payments for a period of time. 2. Maturity value concessions may involve an extension of the maturity date or a reduction in the amount to be repaid at

maturity. 3. The FASB decided that most modifications do not result in a significant economic transaction. a. Therefore, these modifications do not give rise to a gain or loss at the date of restructuring. b. The only exception occurs if the total payments to be made under the new structure are less than the carrying value of the debt. 4. When terms are modified the amount recognized as interest expense or interest revenue in the remaining periods is based on a computed implicit interest rate. a. The implicit interest rate is the rate that equates the present value of all future debt payments to the present carrying value of the debt. b. The interest expense or revenue for each period is equal to the carrying value of the debt for the period involved times the implicit interest rate. E. When cash to be received after the restructuring is less than the carrying value of the debt. 1. The implicit interest rate is negative. 2. To raise the rate to zero, the carrying value must be reduced to the cash to be realized and a gain recognized for the difference. 3. All future interest payments are offset directly to the debt account. 4. The balance remaining at the maturity date will be the maturity value of the debt.