13.8 Chapter Summary

LO 1: Describe long-term financial liabilities and their role in accounting and business.

Companies generate cash resources for future business opportunities from three basic sources: (a) internally from its sales, (b) from investors through issuing shares, (c) from borrowing from a creditor. Each source has its advantages and disadvantages. If a company decides to borrow from a creditor, the opportunity to leverage exists. Leveraging occurs when the interest cost of borrowing debt to purchase assets is lower than the return generated by the leveraged assets. However, increasing debt also increases liquidity and solvency risk. Long-term debt is defined as debt with due dates greater than one year. It can be notes payable, such as mortgages, or bonds payable. Both are financial liabilities as they both represent obligations fixed by contract.

LO2: Describe notes payable, and explain how they are classified and how they are initially and subsequently measured and reported.

A note payable is an obligation to pay a specified sum of money in the form of principal and interest through a formal written promissory note or agreement. Long-term notes are initially recorded at their fair value, which is calculated as the present value of the discounted cash flows. Cash flows are characterized by the size and timing of the debt repayment. Repayment can either be a single lump sum of principal and interest at maturity, a series of interest payments with a lump sum payment of principal at maturity, or a series of instalment payments combining both interest and principal over a specified period. The variables used to determine the present value of the note are the repayment cash flows, along with the market rate for a note of similar risk, and the timing of the cash flows. The present value of the note is the amount initially recorded as the note payable amount. The term zero-interest-bearing notes, or non-interest-bearing notes, is a misnomer because they do, in fact, include an interest component: the difference between the borrowed and the repaid amounts.

After issuance, long-term notes payable are subsequently measured at amortized cost. For example, if the note payable is issued at face value, the present value will be the same as the face value and there will be no premium or discount to amortize. If the stated rate is lower or higher than the market rate, the present value will be lower or higher and the note will be issued at a discount or at a premium, whichever the case. For IFRS companies, the discount or premium is to be amortized over the life of the note using the effective interest method. For ASPE companies, the choice is between the effective interest method and the straight-line method. For non-interest-bearing notes, the interest rate will usually be the rate that results in the correct interest component amount. The fair value for notes payable in exchange for property, goods, or services is usually determined by the fair value of the good or service given up; however, there can be some issues regarding what constitutes fair value for exchange transactions.

Other issues relating to subsequent measurement of notes payable are accounting for impairment and troubled debt restructurings. If a note subsequently becomes impaired, the creditor will estimate the present value of the impaired cash flow and will write down the note receivable accordingly. The debtor makes no such entry as there is still a legal obligation to fully repay the note. For troubled debt restructurings, there are several calculations and entries for the creditor and the debtor depending on whether there is a settlement of the debt, a modification of terms less than 10%, or a modification of terms for greater than 10%.

LO 3: Describe bonds payable, and explain how they are classified and how they are initially and subsequently measured and reported.

Bond issuance is typically the choice made by companies when the amount of funds needed is significant. Instead of having a single creditor, many bondholders purchase the bonds for investment purposes. A broker or underwriter plays a key role in this process. There are many types of bonds, each with different features that are identified in the bond indenture.

Like long-term notes payable, bonds are classified as long-term debt until they are within one year of their maturity, at which time they are classified as a current liability. They are initially recognized at their fair value, measured by the present value of their future cash flows, and are subsequently measured at amortized cost. Bonds can be issued at par or at either a discount or a premium. The discount or premium is amortized over the life of the bond using the effective interest method. For ASPE companies, straight-line method is also acceptable.

Bond issuers always pay interest according to the bond indenture, which often means payment every six months. For bonds purchased between interest dates, the bondholder will pay an additional sum on the purchase date, which covers the interest since the last interest payment date. When the first six-month interest payment is received, the net amount of the additional monies initially paid out at purchase for accrued interest, and the first interest income received in case, will represent the correct interest income from the date of purchase to the first interest payment received.

If interest rates should drop significantly while a bond issue is outstanding, the bond issuer will be motivated to repay the bondholders before the maturity date and subsequently re-issue the bonds at the lower rate. The slightly higher acquisition price paid to reacquire the bonds will be recorded as a loss on redemption.

LO 4: Define and describe other accounting and valuation issues such as the fair value option, defeasance, and off-balance sheet financing.

ASPE allows for an alternative measure for notes and bonds called the fair-value option. IFRS allows this only if it results in more relevant information or as part of a larger fair-value portfolio. Bond issuers’ credit ratings can drop, which will result in a corresponding increase in the interest rate. The resulting decrease in the fair value reduces the bond payable and the offsetting credit is recorded as an unrealized gain. Since these gains are currently reported in the income statement, it seems counter-intuitive for companies whose credit ratings have dropped to report an increase in net income. IFRS 9 has corrected this anomaly since its implementation in 2018.

Companies can be motivated to keep their reported debt at the lowest level legally possible. There are a couple of ways that this can be achieved. First, defeasance involves the debtor paying monies into a separate trust account ahead of time, and the creditor receiving payments directly from that trust. In this way, if done legally, the long-term debt can be removed from the debtor’s books. Second, off-balance sheet sources of financing are another way to avoid reporting debt on the balance sheet. An example is operating leases, where the monies paid for the lease are recorded as a rental expense and, therefore, no lease obligation or asset is reported. This will be discussed in further detail in a later chapter about leasing.

LO 5: Explain how long-term debt is disclosed in the financial statements.

There are specific and extensive reporting requirements for long-term debt, including the impact on reporting regarding refinancing agreements. Basic reporting requirements include disclosures of the interest rate, maturity date, security details, restrictive covenants required by creditors, and current portion of long-term debt, to name a few. Since IFRS companies are usually publicly traded, impacting many investors, the reporting requirements are extensive.

LO 6: Identify the different methods used to analyze long-term liabilities; calculate and interpret three specific ratios used to analyze long-term liabilities.

Notes and bonds payable affect the liquidity and solvency of companies since the debt must be repaid at some point. Companies’ cash positions must continually be monitored to ensure that there are enough cash reserves to repay maturing debt. Three common ratios that can trigger a further review, if unfavourable, are debt to equity, debt to total assets, and times interest earned. Comparable benchmarks make ratios a useful monitoring tool.

LO 7: Explain the similarities and differences between ASPE and IFRS regarding recognition, measurement, and reporting of long-term payables.

In this case, IFRS and ASPE are quite similar. A difference between them is the choice of amortization method used for bonds and notes that were issued at a discount or premium. ASPE has the added option to amortize the premium or discount using either the straight-line method or the effective method. Additionally, ASPE disclosures are less than those required by IFRS.