Long-Term Liabilities Slides

Long-term liabilities

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Long-term liabilities Page 2

Typical coverage of US GAAP

► Bonds payable:► Types of bonds► Valuation of bonds:

► Premiums and discounts► Effective interest method► Accruing interest► Balance sheet classification of discounts

and premiums

► Long-term notes payable

► Issuance costs

► Borrowing costs

► Debt modification and extinguishment

► Debt impairment

► Troubled debt restructurings

► Reporting long-term debt

► Disclosures



Executive summary

► IFRS requires that premiums or discounts on debt directly reduce the carrying value of the debt upon initial recognition. US GAAP requires that these amounts are recorded separately.

► IFRS requires that transaction (issuance) costs directly reduce the carrying value of the debt. US GAAP requires that these costs are deferred.

► IFRS requires third-party costs to be recognized as part of the gain or loss in a debt extinguishment. US GAAP permits the capitalization and amortization of these costs over the term of the new debt.

► For debt modifications, IFRS permits the entity to adjust the carrying amount of the liability and amortize costs over the term of the modified debt. US GAAP requires that these costs be expensed as incurred.



Executive summary

► IFRS allows upward revisions to the carrying value of an investment in a loan after a write-down. US GAAP does not permit upward revisions.

► In the event of a debt covenant violation, IFRS allows long-term debt to continue to be classified as long term as long as a waiver is received prior to year-end. US GAAP allows a waiver to be received until the time the financial statements are released, to retain the long-term classification.



Progress on convergence

► There are no significant convergence efforts at this time.



Bonds payableTypes of bonds

Bonds should be evaluated based on the underlying debt instrument.

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IFRSUS GAAP



Bonds payableValuation of bonds

Bonds are recorded at the present value of future interest and principal payments, which generally equal the cash received by the issuer.

Discounts and premiums on bonds are amortized over the life of the bond using the effective-interest method.

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IFRSUS GAAP

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Valuation of bondsDiscounts and premiums

IFRS

► Upon initial recognition, discounts and premiums are included directly in the carrying amount.

US GAAP

► Upon initial recognition, discounts and premiums are recorded separately.



Discounts and premiums example

Example 1On December 31, 2010, an airplane manufacturer, Airways, issued $1 million in bonds at 5% annual interest, due December 31, 2013, at a discount of $100,000.

► Show the journal entries to record the issuance of the bonds on December 31, 2010, using US GAAP and IFRS.



Solution:

US GAAP:

Cash $900,000Discount on bonds payable 100,000

Bonds payable $1,000,000

IFRS:

Cash $900,000Bonds payable $900,000

The discount directly reduces the carrying value for IFRS and is recorded separately for US GAAP.

Discounts and premiums example



Long-term notes payable

Notes are recorded at the present value of future interest and principal payments.

Discounts and premiums are amortized over the term of the note using the effective-interest method.

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Amounts due beyond one year of the balance sheet date are classified as long term.

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IFRSUS GAAP



Long-term notes payableDiscounts and premiums

IFRS

► Upon initial recognition, discounts and premiums are included directly in the carrying amount.

US GAAP

► Upon initial recognition, discounts and premiums are recorded separately.



Fair-value option

Upon initial recognition of a debt instrument, an accounting policy choice is allowed to measure the debt instrument at fair value with gains/losses recognized in income. This is referred to as the fair-value option.*

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IFRSUS GAAP

*Note that certain criteria must be met before the fair-value option is used and these differ between US GAAP and IFRS. See the Financial assets module for more details.



Issuance costs

Direct and incremental costs related to the issuance of debt, such as legal fees, accounting fees and banker fees, are not expensed.

Internal costs are generally excluded from consideration for capitalization.

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These costs are referred to as “issuance costs.” Referred to as “transaction costs.”

IFRSUS GAAP



Issuance costs

IFRS

► Per IAS 39, transaction costs directly reduce the carrying value of the debt.

US GAAP

► Issuance costs should be recorded as a deferred charge, per ASC 835-30-45-3.



Issuance costs example

Example 2In conjunction with the bonds issued in example 1, assume Airways incurred bank fees of $100,000, legal fees of $50,000 and salaries of $25,000 for its employees in conjunction with issuing the bonds.

► How should Airways record the issuance/transaction costs using US GAAP and IFRS?

► Show the journal entries to record the issuance/transaction costs on December 31, 2010, using US GAAP and IFRS.



Solution:

Using both US GAAP and IFRS, Airways can capitalize the $100,000 of bank fees and $50,000 of legal fees. Salaries must be expensed as they are internal costs and are not direct and incremental.

US GAAP:

Unamortized bond issuance costs $150,000Cash $150,000

IFRS:

Bonds payable $150,000Cash $150,000

The transaction costs directly reduce the carrying value for IFRS and are recorded as a deferred charge for US GAAP.

Issuance costs example



Borrowing costs

Borrowing costs primarily include interest on borrowings and other costs to acquire debt.

Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset can be capitalized.

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The qualifying asset must take a period of time to complete.

IFRSUS GAAP

Similar, although the period of time to complete should be “substantial.”



Borrowing costs

Interest capitalization commences and continues as long as expenditures and progress are made to get the asset ready for its intended use.

Capitalizable interest is based on the specific borrowing, if available, or the weighted-average costs of the borrowings and cannot exceed actual interest for the period.

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IFRSUS GAAP



Borrowing costs

IFRS

► Per IAS 23, entities may choose to capitalize or expense borrowing costs when the related assets are carried at fair value.

► When funds borrowed to finance the acquisition of a qualified asset are temporarily invested, the interest cost should be reduced by any investment income earned on these funds.

US GAAP

► This issue is not discussed.

► Interest revenue cannot be netted against interest cost.



Borrowing costs

IFRS

► Exchange rate differences related to foreign currency borrowings, to the extent they are an adjustment to interest costs, can be capitalized according to IAS 23.

US GAAP

► Exchange rate differences on borrowing costs cannot be included in capitalizable interest costs.



Borrowing costs example

Example 3

A large UK-based retail company, Harold’s Department Stores, Inc. (HDS), wishes to build a US distribution center on the East Coast. HDS has purchased a suitable piece of land, has arranged for a general contractor to construct the facility and has arranged for a construction loan from a US bank.

The facility is expected to cost $30 million and take one year to build. The construction loan is $24 million, bears interest at 8% and borrowings commence at the first draw.

Ground is broken on April 1, 2008, and construction is expected to continue until March 31, 2009. The Company uses $6 million of its cash in the first two months of construction and begins borrowing under the construction loan based on the schedule on the next slide.

The US bank pays the draws on the loan to HDS in dollars. HDS carries its assets in pounds and the debt borrowings will be paid in pounds. HDS incurs exchange rate gains and losses as scheduled on the next slide.



HDS temporarily invests the loan borrowings and receives quarterly interest as scheduled below.

HDS secures permanent financing on April 1, 2009.


Cash draws from construction loan

Exchange rate loss

Quarterly interest income received on loan borrowings for

the previous quarter

June 1, 2008 $10,000,000 $(50,000)

September 1, 2008 $ 6,000,000 $(40,000) $50,000

January 1, 2009 $ 8,000,000 $(20,000) $75,000

April 1, 2009 $25,000

What borrowing costs should HDS capitalize in 2008 and in the first quarter of 2009 using US GAAP and IFRS?



Solution:

Calculation of interest costs:

2008

► First draw: $10,000,000 x 8% x 3/12 = $200,000► Second draw: $16,000,000 x 8% x 3/12 = 320,000

$520,000

2009

► Third draw: $24,000,000 x 8% x 3/12 = $480,000

US GAAP:

HDS should capitalize $520,000 of borrowing costs in 2008 and $480,000 in the first quarter of 2009.

IFRS:

HDS should capitalize $485,000 ($520,000 + $90,000 exchange rate losses - $125,000 of interest income) of borrowing costs in 2008 and $475,000 ($480,000 + $20,000 exchange rate losses - $25,000 of interest income) of borrowing costs in the first quarter of 2009.




Debt modification and extinguishment Modification

Debt is modified when there is a non-substantial modification of terms for the debt.

Modifications should be accounted for prospectively.

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IFRSUS GAAP

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Debt modification and extinguishment Extinguishment

If a modification of debt terms is considered to be substantial or debt is discharged, the debt is considered to be extinguished and the liability should be derecognized.

The difference between the reacquisition price or consideration paid, including any non-cash assets transferred, and the carrying amount of the extinguished debt should be recognized in income.

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IFRSUS GAAP

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Debt modification and extinguishmentModification

IFRS

► Costs incurred for a debt modification directly reduce the carrying amount of the debt and are amortized over the remaining term of the modified debt using the effective-interest method.

US GAAP

► Costs incurred for a debt modification are expensed as incurred.



Debt modification and extinguishmentExtinguishment

IFRS

► IFRS does not specifically address troubled debt restructuring, but according to IAS 39, paragraph 40, the treatment for a substantial modification is the same as an extinguishment “whether or not attributable to the financial difficulty of the debtor.”

US GAAP

► US GAAP distinguishes treatment for a significant debt modification when the debtor is viable as compared to non-viable. When the company is non-viable, it may be accounted for as a troubled-debt restructuring as discussed below.



Debt modification and extinguishmentExtinguishment

IFRS

► IFRS permits extinguishment costs to be recognized as part of the gain or loss on the extinguishment.

US GAAP

► Costs incurred to extinguish debt in exchange for significantly modified debt or new debt are deferred and amortized over the remaining term of the modified debt or the term of the new debt, respectively, using the effective-interest method. If no new debt is issued, these costs are expensed as incurred.



Debt modification and extinguishmentCosts to third parties

Modification costs Extinguishment costs

US GAAP

Costs are expensed as incurred.

Costs are deferred and amortized over the remaining term of the modified debt or term of the new debt if new debt is issued; otherwise, costs are expensed as incurred.

IFRS

Costs adjust the carrying amount of the modified debt and are amortized over the remaining term of the modified debt.

Costs are recognized as part of the gain or loss.



Debt extinguishment example

Example 4

The Tempe Company (Tempe) is a viable entity. On January 1, 2009, Tempe intends to extinguish some long-term notes by calling the long-term notes under the provisions of the note agreement. These notes are for $10 million at 10% annual interest due December 31, 2010. Tempe also has $50,000 in unamortized discount on notes payable, but no other deferred costs attributable to the borrowing or accrued interest. Management issues new debt with a new lender for the same amount and maturity date at 9% annual interest. Management has incurred $100,000 in legal costs to negotiate the extinguishment of the long-term notes payable.

► Prepare the journal entries to record the extinguishment of the debt using US GAAP and IFRS.

► Prepare the journal entries to record the interest expense for 2009 using US GAAP and IFRS (round to the nearest thousand).



Solution:

US GAAP:

The unamortized discount on the 10% notes is included in the calculation of the gain or loss on extinguishment. The issuance costs on the 9% notes are recorded as a deferred charge.

Long-term notes payable – 10% $10,000,000Loss on extinguishment of note 50,000Unamortized note issuance costs 100,000

Unamortized discount on notes payable $ 50,000Cash 100,000Long-term notes payable – 9% 10,000,000




Solution (continued):

The issuance costs of $100,000 are amortized over the life of the new debt, which is two years using the effective-interest method. Below is an amortization table showing the new effective-interest rate on the note of 9.5729% and related interest expense.


Beginning carrying value

of note*

Interest expense

at 9.5729%Interest paid

at 9%

Ending carrying value

of note

2009 $ 9,900,000 $ 948,000 $ 900,000 $ 9,948,000

2010 $ 9,948,000 $ 952,000 $ 900,000 $10,000,000

*The carrying value is the long-term note payable balance net of the balance of unamortized issuance costs.

Interest expense $948,000Cash $900,000Unamortized note issuance costs 48,000




IFRS:

The carrying amount of the 10% bonds of $9,950,000 along with the issuance costs on the 9% notes of $100,000 are both included in the calculation of the gain or loss on extinguishment.

Long-term notes payable – 10% $9,950,000Loss on extinguishment of note 150,000

Cash $ 100,000Long-term notes payable – 9% 10,000,000

The effective-interest is the same as the stated interest at 9%, resulting in recording the interest expense as follows:

Interest expense $900,000Cash $900,000




Debt modification example

Example 5

Assume the same debt situation as in the previous example except that management has been able to modify the interest rate to 9% with the same lender to reflect current market rates. The same legal costs of $100,000 are incurred.

► Prepare the journal entries to record the modification of the debt using US GAAP and IFRS.

► Prepare the journal entries to record the interest expense for 2009 using US GAAP and IFRS (round to the nearest dollar).



Solution:

US GAAP:

The unamortized discount on the 10% notes continues to be offset against the carrying value of the 9% notes as a deferred charge. The issuance costs on the 9% notes are recorded as an expense as follows:

Legal expense $100,000Cash $100,000





The unamortized discount on the notes payable continues to be amortized using the effective-interest method. Below is an amortization table showing the effective-interest rate on the note of 9.28535% and related interest expense.



of note*

Interest expense


at 9%


of note

2009 $ 9,950,000 $ 924,000 $ 900,000 $ 9,974,000

2010 $ 9,974,000 $ 926,000 $ 900,000 $10,000,000

*The carrying value is the long-term note payable balance net of the balance of unamortized discount.

Interest expense $924,000Cash $900,000Unamortized discount on notes payable 24,000




IFRS:

The legal costs of $100,000 would be directly charged against the carrying amount of the note and thus would be amortized over the remaining term of the modified debt.

Long-term notes payable – 10% $9,950,000Cash $ 100,000Long-term notes payable – 9% 9,850,000

On the next slide is an amortization table showing the effective-interest rate on the note of 9.8627% and related interest expense. Note that amounts are rounded to the nearest thousand.






of note

Interest expense


at 9%


of note

2009 $ 9,850,000 $ 971,000 $ 900,000 $ 9,921,000

2010 $ 9,921,000 $ 979,000* $ 900,000 $10,000,000

*Rounded up for presentation purposes.

Interest expense $971,000Cash $900,000Long-term notes payable – 9% 71,000




Debt impairment Debtor

A debtor may not reduce the carrying amount of its debt due to the inability to pay, unless its contractual obligations have been legally reduced.

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IFRSUS GAAP



Debt impairment Creditor

A write-down is required for the difference between the investment in the loan (principal and interest) and one of the following:

► The expected future cash flows discounted at the loan’s historical effective-interest rate.

► The market price of the loan. This can be the fair value of the collateral, if secured.

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IFRSUS GAAP



Debt impairmentCreditor

IFRS

► Upward revisions to the carrying value of the investment in the loan are allowed after a write-down if an improvement in credit quality occurs; however, the revised carrying value cannot exceed the cost amount prior to the write-down.

US GAAP

► Upward revisions to investments in loans are not allowed.



Example 6

Part I:

On January 1, 2009, the Desert Bank of Arizona (DBA) extended a three-year loan of $16 million to Royal Resorts Incorporated (RRI), a golf resort in southern Arizona, at a 4% interest rate. Interest is due quarterly on March 31, June 30, September 30 and December 31, with the final balance of the loan ($16 million), plus interest, due on December 31, 2011. The note is secured by a golf resort in southern Arizona with a fair value of $18 million as of January 1, 2009.

Interest was paid in 2010 and through March 31, 2011. In the second quarter of 2011, RRI informed DBA that it had significant cash flow problems and would not be able to make the remaining contractual interest payments in 2011, and possibly 2012 or the principal due on December 31, 2012.

Debt impairment example

At June 30, 2011, DBA determined that its loan was impaired because the loan balance outstanding of $16 million, plus accrued interest of $160,000 ($16,000,000 x 4% x 3/12), was not collectible at the current time and the balance of the loan exceeded the fair value of the loan, which was deemed to be $14 million based on the underlying value of the secured collateral.

► Using US GAAP and IFRS, how should DBA and RRI reflect the asset and liability, respectively, in their accounting records at June 30, 2011?

► What are the corresponding journal entries?



Part II:

Use the same facts as part I but assume that on December 31, 2011, RRI was able to obtain a significant cash infusion and able to pay the interest due to DBA, and thus bring the loan current. Also, assume the prospects of its payment of the principal and interest were not in doubt for 2012.


► Show the journal entries to record the payment at December 31, 2011, for both DBA and RRI using US GAAP and IFRS.



Part I – solution:

DBA

DBA should determine what is the best determination of fair value. In the above situation, fair value is deemed to be the collateral value of the golf resort. DBA should write down the asset for both US GAAP and IFRS, but use a valuation allowance for IFRS to allow for any possible future increase in value (so as not to exceed the carrying amount at June 30, 2010).

US GAAP:

Loss on loan to RRI $2,000,000Interest income 160,000

Loan receivable from RRI $2,000,000Interest receivable 160,000

To write down the loan receivable from RRI to fair value and to reverse the accrued interest through June 30, 2010.

IFRS:

Loss on loan to RRI $2,000,000Interest income 160,000

Allowance for loan receivable from RRI $2,000,000Interest receivable 160,000

To write down the loan receivable from RRI to fair value and to establish a corresponding allowance and to reverse the accrued interest through June 30, 2010.




Part I – solution (continued):

RRI

US GAAP and IFRS:

At June 30, 2010, RRI would not change the accounting for the loan, but would recognize the quarterly interest payable of $160,000 and maintain the loan balance outstanding of $16 million because RRI has not discharged its legal obligation on the note to DBA.

Interest expense $160,000Interest payable $160,000




Part II – solution:

DBA

US GAAP:

Cash $480,000Interest income $480,000

To record the interest from RRI from April 1, 2010 through December 31, 2010 ($16,000,000 x 4% x 9/12).

IFRS:

Cash $ 480,000Allowance for loan receivable from RRI 2,000,000 Interest income $ 480,000

Loss on loan to RRI 2,000,000

To record the interest from April 1, 2010 through December 31, 2010, and to reverse the allowance established at June 30, 2010.

RRI

US GAAP and IFRS:

RRI would pay off the accrued interest for the three quarters in 2010.

Interest payable $480,000Cash $480,000




Troubled debt restructuring

A debtor may be relieved for part or all of its obligations due to financial hardships from the transfer of assets or equity securities to the creditor or through the modification of debt terms (reducing the interest rate or accrued interest, extending the maturity date or reducing the principal obligation).

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IFRSUS GAAP




IFRS

► As discussed previously, IFRS does not specifically address troubled debt restructuring and, thus, follows the treatment noted for debt extinguishments.

US GAAP

► Relief of obligations due to financial hardship is referred to as a troubled debt restructuring.

► SFAS No. 15 (ASC 470-60) requires the following treatment for each type of debt restructuring:

► Transfer of assets – a gain or loss is recognized to the extent the fair value of assets transferred exceeds the amount payable, including accrued interest.




IFRSUS GAAP

► Debt restructuring treatment (continued):

► Transfer of equity securities – the difference between the fair value of the equity and the carrying amount of debt is recognized as a gain or loss.

► Modification of terms (whether substantial or non-substantial) – no gain or loss is recorded and a new effective-interest rate is computed. Creditors would follow the guidance using SFAS No. 114 (ASC 310-10-35).



Example 7

Mike’s Industrial Company (MIC) has an unused factory in one of the Midwest states that has a book value and fair value of $8.0 million. MIC obtained a mortgage on the factory five years ago from a New York-based bank and the current balance due to the bank totals $10 million. Interest is being paid currently by MIC; however, MIC currently does not have use for the factory or the revenues to support the debt. After a lengthy negotiation process, MIC will be transferring the underlying property to the bank, along with the payment of $1.5 million. This will discharge MIC from the debt. This is considered a troubled debt restructuring for US GAAP purposes.

Troubled debt restructuring example

► Using US GAAP and IFRS, what journal entries would MIC and the bank prepare to record this transaction?




The journal entry would be as follows:

Mortgage notes payable $10,000,000Facility $8,000,000Cash 1,500,000Gain on discharge of debt 500,000

To record the settlement of the mortgage note payable to the New York bank and the accompanying transfer of the property.

Solution:

This transaction would be accounted for in the same manner using US GAAP or IFRS.

MIC

Under this scenario, MIC would have a gain on the restructuring, calculated as follows:

Mortgage note payable $10,000,000Less: carrying value of the building (8,000,000)Less: cash to the bank (1,500,000)Gain on discharge of debt $ 500,000




Bank

The bank would record a loss on the restructuring calculated as follows:

Mortgage receivable $10,000,000Less: fair value of the building (8,000,000Less: cash received (1,500,000)Loss on restructuring $ 500,000


The journal entry to record the restructuring and loss would be as follows:

Facility $8,000,000Cash 1,500,000Loan loss 500,000

Mortgage loans receivable $10,000,000

To record the payment and settlement of the mortgage loan from MIC and the transfer of the property.



Reporting long-term debt

Long-term debt is classified as a non-current liability.

Debt is classified as long term as long as any debt violations are cured by year-end.

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IFRSUS GAAP

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Reporting long-term debt

IFRS

► The violation must be cured by year-end to classify the debt as long term.

US GAAP

► The debt can be classified as long term if the violation is cleared before the audited financial statements are issued.



Disclosures

A detailed listing and description of each significant issue is required, including the amounts outstanding, the type of borrowing, the interest rate, payment terms and final maturity date.

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Long-Term Liabilities Slides