Flashcards in FAR 26 - LT Debt (Financial Liab) 3 - Refinancing/Retirement/Troubled Debt/Debt Covenants Deck (30):
Cali, Inc., had a $4,000,000 note payable due on March 15, 2006. On January 28, 2006, before the issuance of its 2005 financial statements, Cali issued long-term bonds in the amount of $4,500,000. Proceeds from the bonds were used to repay the note when it came due.
How should Cali classify the note in its December 31, 2005, financial statements?
A. As a current liability, with separate disclosure of the note refinancing.
B. As a current liability, with no separate disclosure required.
C. As a noncurrent liability, with separate disclosure of the note refinancing
D. As a noncurrent liability, with no separate disclosure required
C. The note was refinanced (replaced) with a long-term liability (bonds) between the balance sheet date and the balance sheet issuance date. This is one of the conditions under which a current liability can be reclassified as long term at the balance sheet date. Another is to enter into an irrevocable refinancing agreement (FAS 6).
The details of the refinancing must be disclosed in the notes. The note is not to be classified as a current liability because it will cause no reduction in current assets or increase in current liabilities during the coming period.
What are the two criteria for reclassifying current Liabilities as Non-current Liabilities?
Intent - intent to refinance must be proven.
Ability - the firm must be able to refinance the obligation and demonstrate that ability before the issuance of the FS. 3 ways to meet this requirement are: actually refinance, sign a non-cancelable refinancing agreement, or issuing equity securities to replace the debt.
T/F: FAS 47 requires the disclosure of the aggregate amount of maturities and sinking fund requirements for all long-term debt for each of the five years following the balance sheet date. The detail for each year is disclosed by the amount of both the sinking fund requirement and the maturity.
Ames, Inc. has $500,000 of notes payable due June 15, 2003.
Ames signed an agreement on December 1, 2002 to borrow up to $500,000 to refinance the notes payable on a long-term basis with no payments due until 2004. The financing agreement stipulated that borrowings may not exceed 80% of the value of the collateral Ames was providing.
At the date of issuance of December 31, 2002 financial statements, the value of the collateral was $600,000 and is not expected to fall below this amount during 2003.
In Ames' December 31, 2002 balance sheet, the obligation for these notes payable should be classified as
Short term = $20,000
Long term = $480,000
Ames has successfully refinanced a short-term note on a long-term basis before the issuance of the 2002 financial statements (FAS 6).
The borrowings on a long-term basis are limited to $480,000 (.80 x $600,000 collateral provided by Ames). Thus, $480,000 of the note is reclassified as long term, and the remaining $20,000 of the note is classified as current.
T/F: A note payable due within one year of the balance sheet is extinguished by issuing stock between the balance sheet date and the issuance of the financial statements. The note is classified as long-term.
T/F: A firm wants to reclassify a current liability as long-term. It pays the liability after the balance sheet date but then issues bonds to replenish the cash used to pay the current liability. The firm has been successful in achieving its goal.
Because the liability was paid with cash, the liability would be classified as current, even with the issuance of bonds used to replenish the cash.
On June 30, 2000, after amortization was recorded for the period, the unamortized bond premium and bond issue costs were $30,000 and $50,000, respectively. On that date, King acquired all its outstanding bonds on the open market at 98 and retired them.
On redemption of the bonds at June 30, 2000, what amount should King recognize as gain before income taxes?
A journal entry illustrates the calculation:
dr. Bonds payable 5,000,000
dr. Bond premium 30,000
cr. Bond issue costs 50,000
cr. Cash .98($5,000,000) 4,900,000
cr. Gain 80,000
The unamortized bond issue costs reduce the gain because they are an asset that has no further benefit. The write-off simply reduces the gain. Had there been a net loss, the removal of the bond issue costs would have increased that loss.
On January 1, 2000, Fox Corp. issued 1,000 of its 10%, $1,000 bonds for $1,040,000. These bonds were to mature on January 1, 2010 but were callable at 101 any time after December 31, 2003. Interest was payable semi-annually on July 1 and January 1.
On July 1, 2005, Fox called all of the bonds and retired them.
The bond premium was amortized on a straight-line basis. Before income taxes, Fox's gain or loss in 2005 on this early extinguishment of debt was
The portion of the bond term that remains is 4 1/2 years as of July 1, 2005, because the bonds have been outstanding for 5 1/2 years as of that date. Therefore, the book value of the bonds on July 1, 2005 equals the face value of the bonds ($1,000,000) plus the unamortized bond premium of $18,000 = (4.5/10)$40,000, for a total of $1,018,000.
The gain on the bond extinguishment is the difference between the book value and the amount paid to extinguish the bonds: $1,018,000 - 1.01($1,000,000) = $8,000. The gain results because it cost Fox less to retire the bonds than the book value of the bonds.
On March 1, 1997, Somar Co. issued 20-year bonds at a discount. By September 1, 2002, the bonds were quoted at 106 when Somar exercised its right to retire the bonds at 105.
How should Somar report the bond retirement on its 2002 income statement?
A. A gain in continuing operations.
B. A loss in continuing operations
C. An extraordinary gain
D. An extraordinary loss
B. This is a loss in continuing operations explanation. Such gains and losses are ordinary, not extraordinary. This means they are included in income from continuing operations.
A 15-year bond was issued in 1995 at a discount. During 2005, a 10-year bond was issued at face amount with the proceeds used to retire the 15-year bond at its face amount.
The net effect of the 2005 bond transactions was to increase long-term liabilities by the excess of the 10-year bond's face amount over that of the 15-year bond's:
A. Face amount.
B. Carrying amount
C. Face amount less the deferred loss on bond retirement
D. Carrying amount less the deferred loss on bond retirement
B. The proceeds of the second bond issue, which equal the second issue's carrying value and face value, were used to retire the first issue at that same amount.
However, the first issue has a lower carrying value than the face value because of the unamortized discount. Therefore, the net increase in long-term debt is the amount of the unamortized discount, which also equals the difference between the carrying values of the two issues.
T/F: Interest rates have increased since a bond was issued. If the bond is retired early, we would expect a loss.
We would expect a gain.
T/F: The bond term is 144 months. The firm retired the bonds after they were outstanding 44 months. The fraction of the original discount to credit in the entry to record the retirement is 44/100.
T/F: In substance defeasance does not meet the definition of debt extinguishment.
Defeasance = the action or process of rendering something null and void.
A debtor and a creditor have negotiated new terms on a note. How can you determine whether the restructuring is a troubled debt restructure?
A. If the interest rate as stated in the restructuring agreement has been reduced relative to the original loan agreement
B. If the present value of the restructured flows using the original interest rate is less than the book value of the debt at the date of the restructure.
C. If the interest rate that equates (1) the book value of the debt at the date of the restructure and (2) the present value of restructured cash flows, exceeds the original interest rate
D. If the present value of the restructured flows using the original interest rate is less than the market value of the original debt at the date of the restructure
B. This is one of the ways to determine if a restructuring is troubled. Under the terms of this answer, the creditor is receiving a stream of cash flows with a present value less than what is currently owed and is making a concession.
Choose the correct statement regarding the accounting treatment of troubled debt restructures (TDRs) under international accounting standards (IAS).
A. Settlements are treated the same way as under U.S. standards.
B. Modification of terms TDRs are treated the same way as under U.S. standards.
C. A significant modification of terms for IAS is treated as a modification of terms type II under U.S. standards.
D. A non-significant modification of terms for IAS is treated as a modification of terms type I under U.S. standards.
A. Both sets of standards treat settlements as extinguishments with a gain to the debtor for the difference between debt book value and fair value of consideration paid.
For a troubled debt restructuring involving only a modification of terms, which of the following items specified by the new terms would be compared to the carrying amount of the debt to determine if the debtor should report a gain on restructuring?
A. The total future cash payments.
B. The present value of the debt at the original interest rate.
C. The present value of the debt at the modified interest rate
D. The amount of future cash payments designated as principal repayments
A. In a troubled debt restructuring involving only a modification of terms, the debtor will recognize a gain only if the total undiscounted future cash payments for principal and interest under the new terms are less than the current amount payable for principal and accrued interest.
When the future payments under the new terms are less than the current obligation, the debtor writes down the carrying amount of the liability by the amount of the difference and thus recognizes a gain.
On December 30, 2004, Hale Corp. paid $400,000 cash and issued 80,000 shares of its $1 par value common stock to its unsecured creditors on a pro rata basis pursuant to a reorganization plan under Chapter 11 of the bankruptcy statutes. Hale owed these unsecured creditors a total of $1,200,000. Hale's common stock was trading at $1.25 per share on December 30, 2004.
As a result of this transaction, Hale's total stockholders' equity had a net increase of
The market value of the stock issued to the creditors is $100,000 (80,000 x $1.25). The fair value of consideration paid to settle the debt therefore is $500,000 ($400,000 cash + $100,000 of stock). The gain on settling the debt therefore is $700,000 ($1,200,000 - $500,000 total consideration).
The gain increases owners' equity by way of net income. The issuance of stock is recorded at market value, $100,000. Thus, the total owners' equity increase is $800,000 ($700,000 + $100,000). Note that this amount is also the difference between the amount of debt retired ($1,200,000) and cash paid ($400,000).
In a modification of the terms, troubled debt restructure of type II (sum of new flows > book value of debt), what amount of gain is recognized by the debtor?
A. The difference between the book value of the debt and the sum of new cash flows.
B. The difference between the present value of the new flows using the original rate of interest and the book value of the debt.
C. No gain is recognized.
D. The difference between the present value of the new flows using the new rate of interest (based on the restructured flows) and the book value of the debt
C. Although the debtor has an economic gain (the creditor is making a concession), GAAP requires that the debtor compute the new rate of interest based on the restructured cash flows and recognize interest expense over the note term. No gain is recognized by the debtor.
On October 15, 2004, Kam Corp. informed Finn Co. that Kam would be unable to repay its $100,000 note due on October 31 to Finn. Finn agreed to accept title to Kam's computer equipment in full settlement of the note.
The equipment's carrying value was $80,000 and its fair value was $75,000. Kam's tax rate is 30%.
What amounts should Kam report as disposal gain (loss) and restructuring gain for the year ended September 30, 2005?
Disposal gain (loss)
Disposal gain (loss) = $(5,000)
Restructuring gain =$25,000
Kam recognizes an ordinary loss of $5,000 on disposal of the equipment. This is the difference between the equipment's $80,000 carrying value, and its $75,000 fair value. If Kam had sold the equipment before using it to settle the debt, this amount of gain would have resulted. Being an ordinary gain, it is reported on a pre-tax basis.
The $25,000 recognized restructuring gain is the difference between the book value of the note ($100,000) and the fair value of the equipment ($75,000). The fair value is used because it represents the current sacrifice to retire the debt.
Again, had the equipment been sold first, Kim would have had $75,000 to pay off the debt. When debt is retired for less than its book value, a gain results.
T/F: The debtor and creditor accounting for troubled debt restructuring is essentially the same for all types of restructures.
T/F: A debtor records interest after a modification of terms troubled debt restructuring when the sum of nominal restructured flows is less than the book value of the debt.
In situation, the debtor: Records no further interest; all future cash payments are returns of principal.
T/F: A creditor cannot have a gain on a settlement troubled debt restructuring.
The creditor in a modification of terms troubled debt restructuring has a loan impairment, regardless of the relationship between the sum of the restructured cash flows and the book value of the receivable.
A firm is required by its creditors to maintain a 2.00 (or greater) current ratio in order to maintain compliance with a debt covenant. The current ratio of the firm is currently at the minimum before any of the transactions are listed. Which of the following actions would cause the firm to fall out of compliance?
A. Sell a used plant asset at book value.
B. Pay an account payable.
C. Declare cash dividends.
D. Pay cash dividends previously declared.
C. This transaction increases current liabilities, thus reducing the current ratio. The current ratio is current assets divided by current liabilities. There is no effect on current assets.
A firm's debt to equity ratio (total debt to total owners' equity) cannot exceed 3.0 without allowing a major creditor to call a loan to the firm. The ratio is currently at the maximum before any of the transactions are listed. Which of the following transactions would not subject the firm to an immediate call by the creditor?
A. Recognize an increase in the current deferred income tax liability.
B. Purchase treasury stock for less than its original issue price.
C. Purchase treasury stock for more than its original issue price.
D. Retire a different loan by issuing common stock.
D. This transaction reduces total liabilities and increases OE by the same amount. The numerator of the ratio is reduced and the denominator is increased. Both factors cause the ratio to decrease below the maximum.
Choose the correct statement concerning the classification of a liability when a firm is subject to a debt covenant.
A. All liabilities callable on demand are classified as current in all circumstances.
B. If the liability is callable on demand, the covenant is violated, and the covenant is violated, then the liability is classified as current if the violation is waived by the creditor.
C. If the covenant includes a subjective acceleration clause and there is only a remote chance that debt will be called, then the liability is classified as noncurrent.
D. If a covenant grants a grace period during which it is possible that the violation will be cured, then the liability is classified as noncurrent.
C. It must be at least possible that the liability will be called in order for the classification to downgraded to current.
Which of the following actions helps a firm to maintain compliance with a debt covenant that includes a minimum current ratio and a minimum retained earnings balance: (1) refinancing current debt on a long-term basis, (2) appropriating retained earnings, (3) purchasing treasury stock, (4) declaring cash dividends.
1 and 2. Both actions are appropriate. Refinancing current debt on a long-term basis reduces current liabilities (increases noncurrent debt) and increases the current ratio. Appropriating retained earnings is an action that typically signals a future reduction in dividends, albeit on a temporary basis. As a result, total retained earnings is maintained at a higher level.
T/F: When a firm is subject to a debt covenant requiring a minimum quick (acid-test) ratio, it should avoid any transactions that increase current liabilities.
should avoid any transactions that decrease current liabilities
T/F: A violation of a debt covenant requires the creditor to call the debt or otherwise force the debtor to take an action that it would not otherwise take.
One option is calling the debt immediately, along with a variety of other responses to a violation.
The debtor is forced to make operational changes to its advantage.