chap011 financial reporting analysis

8/2/2019 Chap011 Financial Reporting Analysis

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Financial Instruments asLiabilities

Revsine/Collins/Johnson/Mittelstaedt: Chapter 11

Copyright 2009 by The McGraw-Hill Companies, All Rights Reserved.McGraw-Hill/Irwin


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RCJM: Chapter 11 2009 2

Learning objectives

1. How to compute a bonds issue price from its effective yield toinvestors.

2. How to construct an amortization table for calculating bond

interest expense and the net carrying value.

3. Why and how bond interest and net carrying value change overtime.

4. How and when floating-rate debt protects lenders.

5. How the Fair Value option in SFAS #159 can reduce earningsvolatility.


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Learning objectives:Concluded

6. How debt extinguishment gains and losses arise, and what they mean.

7. How to find the future cash payments for a companys debt.

8. Why statement readers need to be aware of off-balance sheet financingand loss contingencies.

9. How futures, swaps, and options contracts are used to hedge financialrisk.

10. When hedge accounting can be used, and how it reduces earningsvolatility.


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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 someother entity at some future date.

Liabilities are probable future sacrifices of economic benefits arising from presentobligations of a particular entity to transfer assets or to provide services to otherentities in the future as a result of past transactions or events.

Not all economic liabilities qualifyas financial statement liabilities

Monetary liabilities

Non-monetary liabilities

Payable in fixed amount of future cash

Satisfied by delivering goods or services


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Bonds payable:Illustration of bond issued at par

Face value andcash proceedsare the same

2008 2009 2010 2016 2017

$100 $100 $100 $100 $100Years

$1,000

Promised interestpayments

Promised principalpayment

Bond cash flows (in $000):

$1,000 borrowed


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Bonds payable:Illustration of bond issued at a discount

On January 1, 2008, Huff Corp. issued $10,000,000 face value of 10% peryear bonds at a time when the market demanded an 11% return. Toprovide an 11% return to the bondholders, these bonds must bediscounted. The selling price for these bonds that will result in an 11%return to the bondholders is $941,108.

2008 2009 2010 2016 2017

$100 $100 $100 $100 $100

Years

$941,108 borrowed

$1,000




7/18RCJM: Chapter 11 2009 7

Bonds payable:Discount amortization details



Bonds payable:Illustration of bond issued at a premium

On January 1, 2008, Huff Corp. issued $10,000,000 face value of 10% peryear bonds at a time when the market only demanded a 9% return. Toprovide a 9% return to the bondholders, these bonds may be markedupwards. The selling price for these bonds that will result in a 9% returnto the bondholders is 1,064,177.

2005 2006 2007 2013 2014

$100 $100 $100 $100 $100

Years

$1,064,177 borrowed

$1,000



Bond cash flows (10 $000):



Bonds payable:Premium amortization details


10/18RCJM: Chapter 11 2009 10

Extinguishment of debt

When fixed-rate debt is retired before maturity, book value andmarket 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

Extinguishmentgain

Journal entry at retirement:

DR Bonds payable $1,000,000CR Cash $944,630CR Gain on debt extinguishment 55,370

Book value

Market value


11/18RCJM: Chapter 11 2009 11

Hedging

Business are exposed to market risks from many sources:

Managing market risk is essential for most companies.

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

Interest rate risk

Foreign currencyexchange rate risk

Commodityprice risk

Banks that loan moneyat fixed rates of interest

Manufacturers that build productsin one country but sell them in another

Fuel prices for anairline company


12/18RCJM: Chapter 11 2009 12

Typical derivative securities:Interest rate swaps

Kistler Manufacturing has issued $100 million of long-term 8% fixed-ratedebt and wants to protect itself from a declinein market interest ratesOne way to do so is to create synthetic floating-rate debt using aninterest rate swap.

Interest rate swap


13/18RCJM: Chapter 11 2009 13

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 inincome when they occur.

Special hedge accounting rules apply when derivatives are

used to hedge certain market risks.


14/18RCJM: Chapter 11 2009 14

Accounting for derivative securities:Summary

These accounting entries are used for all types of derivativesforwards, futures, swaps and optionsunlessthe special hedgeaccounting 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 adjustmentthe change in fair valueflows tothe income statement as a holding gain (or loss).


15/18RCJM: Chapter 11 2009 15

Hedge accounting:Overview

When a company successfully hedges its exposure to market risk:

To accurately reflect the underlying economics of the hedge, the loss onthe hedged item should be matched with the derivatives offsetting gain inthe income statement of the same period.

Thats what the GAAP rules (SFAS No. 133and No. 138) for hedgeaccounting try to accomplish.

$500Economic gain onhedge derivative

$500Economic loss onhedged item

Derivative gain

Hedged item loss

Current period

Derivative gain

Hedged item loss

Future period

Derivative gain

Current period

Or

But

not


16/18RCJM: Chapter 11 2009 16

Contingent liabilities

SFAS No. 5says that a loss contingency should be accrued by a chargeto income if both:

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

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

Gain contingencies, on the other hand, are not recorded until the eventactually occurs and the obligation is confirmed.

Critical event and

measurability from Chapter 2

SFAS No.5Loss Probability Continuum


17/18RCJM: Chapter 11 2009 17

Summary

1. An astounding variety of financial instruments, derivatives, andnontraditional financing arrangements are now used.

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

3. Derivativeswhether used for hedging or speculationpose specialaccounting problems.

4. For most companies, the most important long-term obligation is still

traditional debt, and 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 andnet carrying value each period.

Interest rate changes are ignored.


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Summary concluded

5. GAAP accounting for long-term debt makes it possible to managereported income statement and balance sheet numbers when debt isretired 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 ofcompany performance and health.

7. Extinguishment gains and losses from early debt retirements and swapsrequire careful scrutiny because they might just be window dressing.

chap011 financial reporting analysis

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