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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
Promised interestpayments
Promised principalpayment
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Bonds payable:Discount amortization details
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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
Promised interestpayments
Promised principalpayment
Bond cash flows (10 $000):
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Bonds payable:Premium amortization details
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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
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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
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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
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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.
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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).
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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
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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
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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.
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