Chapter 10

|  You Will Learn...

 

    1.    To understand the various classification and measurement issues associated with debt.  For example:

C      Debt is classified as either current or noncurrent.

C      Theoretically, all debt should be recognized at its present value.

C      Obligations that cannot be measured with certainty are estimated and recorded at an approximate amount.

 

    2.    To account for short-term debt obligations, including those expected to be refinanced, and describe the purpose of lines of credit.

C      Short-term debt obligations can result from operations or from nonoperating activities.

C      Examples are accounts payable, wages payable, interest payable, and taxes payable.

C      Notes payable involve a more formal credit arrangement than most accounts payable; they typically specify an interest rate and a payment date; and they can be classified as either trade or nontrade.

C      Short-term obligations expected to be refinanced on a long-term basis should be classified as noncurrent if certain criteria are met.

C      Negotiating a line of credit allows a company to arrange the source of its funding in advance of the time that the funds are actually needed.

 

    3.    To apply present value concepts to the accounting for long-term debts such as mortgages.

C      The present value of a long-term obligation is the amount of cash it would take today to completely satisfy the obligation.

C      In accounting for the repayment of mortgages, each payment amount must be divided between the amount paid for interest and the amount paid for principal.

 

    4.    To understand the various types of bonds, compute the price of a bond issue, and account for the issuance, interest, and redemption of bonds, as listed below:

C      Bonds are issued by governments and corporations, can be secured or unsecured, term or serial, registered or coupon.

C      All bonds involve the borrowing of money with some form of repayment.

C      Most bonds involve periodic interest payments.

C      The bond’s market price is determined using present value techniques that incorporate the market rate of interest and the stated rate of the bond (the difference between the market and stated rates will result in a premium or a discount, which will be amortized over time).

C      When bonds are retired, the debt is removed from the debtor’s books.

C      Bonds can be refinanced at or prior to maturity.

C      Any gain on the early retirement of debt is disclosed as an extraordinary item on the income statement.

    5.    To explain various types of off-balance-sheet financing, and understand the reasons for this type of financing.  Remember:

C      Off-balance-sheet financing is a method companies employ to avoid disclosing obligations in the financial statements.  Common examples include unconsolidated entities, joint ventures, research and development arrangements, and project financing arrangements.

C      Disclosure associated with the financing arrangement is often required in the notes to the financial statements.

 

    6.    To analyze a firm’s debt position using ratios.

C      Ratios such as the debt-to-equity ratio can be used to compare a firm’s debt position over time or at the same time across companies.

C      The debt-to-equity ratio compares a firm’s liabilities and its stockholders’ equity.

C      Times interest earned is another ratio often used to evaluate a firm’s debt position and is computed by dividing a firm’s income before interest expense and taxes by interest expense for the period.

 

    7.    To review the notes to financial statements, and understand the disclosure associated with debt financing.  Keep in mind:

C      Common disclosure associated with long-term debt includes information relating to maturities, interest rates, conversions privileges, and debt covenants.

C      The portion of long-term debt coming due in the current period is also disclosed.

 

    8.    To understand the conditions under which troubled debt restructuring occurs, and be able to account for troubled debt restructuring.

C      When a firm finds itself in financial trouble, one option is to retire the debt at a reduced amount or to restructure the terms of its debt.

C      Debt can be retired immediately at a reduced value with assets or by trading the debt for stock ownership.

C      Gains realized with an asset swap or an equity swap are reported on the income statement as an extraordinary item.

C      Another option for restructuring debt is to modify the terms of the debt.  Such modifications might include forgoing interest payments, reducing the interest rate on the debt, reducing the amount of the principal, or a combination of these options.

C    A gain is recognized if the total payments are less than the debt’s current carrying value.

 

 

 

 

|  Important Points

 

Accounting

Accounting for long‑term debt is conceptually straightforward, but complex in application. Extensive use of example calculations, exercises, and problems will enhance your learning.

 

Troubled Debt Restructurings

Recognition and classification of gains and losses from troubled debt restructuring may pose problems for you.  The debtor recognizes ordinary gains and losses from differences in carrying value and market value of assets given up.  The debtor recognizes extra­ordinary gains and losses arising from differences in market value of assets or stock given up and debt carrying value.

A modification of terms can be confusing.  It is often helpful to focus on the comparison of the total of the future cash payments related to the new terms and the carrying value of the old debt.  If the total payments exceed the carrying value, the debtor and creditor do not recognize a gain or loss.  Instead, the present value of the future cash payments must be equated to the carrying value of the debt by imputing an interest rate, i.e., the effective interest rate.  Conversely, if the payments are less than the carrying value, the debtor recognizes an extraordinary gain, and the creditor recognizes an ordinary loss.