FASB Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements," defines liabilities as:

Probable is used with its usual general meaning and refers to that which can reasonably be expected on the basis of available evidence but is not certain. Obligation is broader than "legal obligation," referring to duties imposed legally or socially and to that which one is bound to do by contract, promise, or moral responsibility. Concepts Statement No. 6 (par. 36) elaborates that a liability has three essential characteristics:

APB Opinion No. 10, "Omnibus Opinion—1966," states in paragraph 7 that "It is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff exists." FASB Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts," clarifies that a right of setoff is a debtor's legal right, by contract or otherwise, to discharge all or a portion of the debt owed to another party by applying against the debt an amount that the other party owes to the debtor. The Interpretation states in paragraph 5 that a right of setoff exists when all of the following conditions are met:

A debtor having a valid right of setoff may offset the related asset and liability and report the net amount.

For purposes of the Interpretation, cash on deposit at a financial institution is to be considered by the depositor as cash rather than as an amount owed to the depositor. Thus, for example, an overdraft in a bank account at a particular bank may not be offset against a cash balance at the same institution because the cash balance is not considered an amount owed to the depositor.

The Interpretation addresses offsetting of amounts recognized for forward, interest-rate swap, currency swap, option, and other conditional or exchange contracts. The fair value of those contracts or an accrued receivable or payable arising from those contracts, rather than the notional amounts or the amounts to be exchanged, is recognized in the statement of financial position. The fair value of contracts in a loss position should not be offset against the fair value of contracts in a gain position unless a right of setoff exists. Similarly, amounts recognized as accrued receivables should not be offset against amounts recognized as accrued payables unless a right of setoff exists. An exception is made to permit offsetting of fair value amounts recognized for forward, swap, and other conditional or exchange contracts executed with the same counterparty under a master netting arrangement, without regard to whether the reporting party intends to set them off. A master netting arrangement exists if the reporting entity has multiple contracts, whether for the same type of conditional or exchange contract or for different types of contracts, with a single counterparty that are subject to a contractual agreement that provides for net settlement of all contracts through a single payment in a single currency in the event of default on or termination of any one contract. Offsetting the fair values recognized for forward, interest rate swap, currency swap, option, and other conditional or exchange contracts outstanding with a single counterparty results in the net fair value of the position between the two counterparties being reported as an asset or a liability in the statement of financial position.

Various accounting pronouncements specify accounting treatments in circumstances that result in offsetting or in a presentation in a statement of financial position that is similar to the effect of offsetting, for example, the accounting for pension plan assets and liabilities under FASB Statement No. 87, "Employers' Accounting for Pensions," and the accounting for advances received on construction contracts under the American Institute of Certified Public Accountants (AICPA) Audit and Accounting Guides Construction Contractors and Audits of Federal Government Contractors. Interpretation No. 39 does not modify the accounting treatment prescribed by other pronouncements.

FASB Interpretation No. 41, "Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements," modified Interpretation No. 39 to permit offsetting in the statement of financial position of payables and receivables that represent repurchase agreements, without regard to whether the reporting party intends to set them off, if conditions specified in the Interpretation are met.

FASB Concepts Statement No. 5 (par. 67) recognized that items currently reported in financial statements are measured by different attributes, depending on the nature of the item. Liabilities that involve obligations to provide goods or services to customers are generally reported as historical proceeds, which is the amount of cash, or its equivalent, received when the obligations were incurred and may be adjusted after acquisition for amortization or other allocations. Liabilities that involve known or estimated amounts of money payable at unknown future dates, for example, trade payable or warranty obligations, generally are reported at their net settlement value, which is an undiscounted amount. Long-term payables are reported at their present value, discounted at the implicit or historical rate, which is the present value of future outflows required to settle the liability. (See Section 4 for a discussion of how the use of present value and discounting concepts in measuring long-term payables contributes to earnings management by the faulty design of generally accepted accounting principles (GAAP).)

Many liabilities result from financial instruments, for example, bonds and notes payable. (See "Disclosures about Fair Value of Financial Instruments" below for the definition of a financial instrument.) The FASB concluded in Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," issued in June 1998, that fair value is the most relevant measure for financial instruments and that fair value measurement is practical for most financial assets and liabilities. Paragraph 334 of Statement No. 133 states:

Only certain liabilities resulting from financial instruments, such as liabilities resulting from derivative financial instruments and guarantees, are currently reported at fair value.

The fair value of a liability is commonly said to be the amount at which that liability could be settled in a current transaction between willing parties, that is, other than in a forced or liquidation transaction. (The ambiguity of that definition is discussed in Section 1.) Quoted market prices in active markets are the best evidence of fair value. Thus, if a quoted market price is available for an instrument, its fair value is the product of the number of trading units of the instrument times that market price. If an instrument trades in more than one market, the price in the most active market for that instrument should be used. If quoted market prices are not available, the estimate of fair value may be based on the best information available in the circumstances, including prices for similar liabilities and the results of using other valuation techniques such as the present value technique.

In February 2000, the FASB issued Concepts Statement No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements". The Board introduced in that Concepts Statement the expected cash flow approach, which focuses on explicit assumptions about the range of possible estimated cash flows and their respective probabilities. That approach differs from the traditional approach to present value applications, which have typically used a single set of estimated cash flows and treated uncertainties implicitly in the selection of a single interest rate.

The Board also concluded in that Concepts Statement that, when using present value techniques to estimate the fair value of a liability, the objective is to estimate the value of the assets required currently to (1) settle the liability with the holder or (2) transfer the liability to an entity of comparable credit standing. In either case, the measurement should reflect the credit standing of the entity obligated to pay. Thus, an improvement in a debtor's credit standing would result in the debtor's reporting a greater liability in its statement of financial position, and deterioration in the debtor's credit standing would result in the debtor reporting a smaller liability. The income statement results of that treatment have been challenged.

FASB Concepts Statements do not establish standards prescribing accounting procedures or disclosure practices for particular items or events. They do, however, guide the Board in developing accounting and reporting standards and may provide some guidance in analyzing new or emerging problems of financial accounting and reporting in the absence of applicable authoritative pronouncements.

At the time of this writing, the FASB has on its agenda a project to provide guidance for measuring and reporting essentially all financial assets and liabilities at fair value in the financial statements.

FASB Statement No. 107, "Disclosures about Fair Values of Financial Instruments" (par. 3), defines a financial instrument as—

Cash, evidence of an ownership interest in an entity, or a contract that both:

Contractual obligations encompasses both those that are conditioned on the occurrence of a specified event and those that are not. All contractual obligations that are financial instruments meet the definition of a liability set forth in FASB Concepts Statement No. 6, "Elements of Financial Statements," although some may not be recognized as liabilities in financial statements, that is, they may be "off-balance sheet," because they fail to meet some other criterion for recognition. For some financial instruments, the obligation is owed to or by a group of entities rather than a single entity.

Examples of contractual obligations that are financial instruments include loans; bonds; notes payable; trade payables; deposit liabilities of banks; interest rate swaps; foreign currency contracts; put and call options on stock, foreign currency, or interest rate contracts; commitments to extend credit; and guarantees of the indebtedness of others, regardless of whether explicit consideration was received for the guarantees.

FASB Statement No. 107 requires disclosure, either in the body of the financial statements or in the accompanying notes, of (1) the fair value of financial instruments, regardless of whether recognized in the statement of financial position, for which it is practicable to estimate that value; and (2) the method(s) and significant assumptions used to estimate the fair value of financial instruments.

Practicable, in this context, means that an estimate of fair value can be made without incurring excessive costs.^[364]

If it is not practicable to estimate the fair value of a financial instrument or a class of financial instrument, Statement No. 107 requires disclosure of the following:

Quoted market prices, if available, should be used to measure fair value. If quoted market prices are not available, management's best estimate of fair value may be based on the quoted market price of a financial instrument with similar characteristics or on valuation techniques (e.g., the present value of estimated cash flows using a discount rate commensurate with the risks involved, option pricing models, or matrix pricing models). In estimating the fair value of deposit liabilities, a financial entity should not take into account the value of core deposit intangibles. For deposit liabilities without defined maturities, the fair value to be disclosed is the amount payable on demand at the date of the financial statements.

The disclosures about fair value are not required for:

In addition, no disclosure is required for trade payables when their carrying amount approximates fair value.

Accounting Research Bulletin (ARB) No. 43, "Restatement and Revision of Accounting Research Bulletins," Chapter 3, paragraph 7, as amended by FASB Statement No. 78, "Classification of Obligations That Are Callable by the Creditor," states, in part:

Under FASB Statement No. 109, "Accounting for Income Taxes," deferred tax liabilities (i.e., the deferred tax consequences attributable to taxable temporary differences) are classified as current or noncurrent based on the classification of the related asset or liability for financial reporting. A deferred tax liability that is not related to an asset or liability, including deferred tax assets related to carryforwards, is classified according to the expected reversal date of the temporary difference.

A suggestion has been made to eliminate the classification of current liabilities (and current assets). See Loyd Heath, Accounting Research Monograph No. 3, "Financial Reporting and the Evaluation of Solvency," AICPA, 1978.

Common kinds of current liability include:

Accounts payable includes all trade payable arising from purchases of merchandise or services. In published balance sheets this classification normally also includes the liability related to nonfinancial expenses that are incurred continuously, that is, estimated amounts payable for wages and salaries, rent, and royalties. Accrued interest and taxes are also normally included under this caption. Federal income taxes payable are frequently shown separately. The traditional distinction between accounts payable and accrued expenses has tended to disappear, and the common practice today is to include the two items in one heading.

In most cases, notes payable, if shown as a separate category, refers to a definite borrowing of funds, as distinguished from goods purchased through the use of trade acceptances. In this latter case, relatively rare today, notes payable may be presented as part of accounts payable. Dividends payable, the liability to shareholders representing dividend declarations, has traditionally been viewed as a distinct kind of obligation. Deferred revenues appear when collection is made in whole or part prior to the actual furnishing of goods or services. A common example is found in the insurance industry, where premiums are regularly collected in advance. Tickets, service contracts, and subscriptions are other deferred revenue items.

Advances and deposits required to guarantee performance and returnable to the depositor are current liabilities. The returnable containers used in many industries are sometimes included in this category. Withheld amounts, also referred to as agency obligations, result from the collection or acceptance of cash or other assets for the account of a third party. By far the most common items today are federal, state, and local income taxes and payroll taxes withheld from wages.

Estimated liabilities refer to obligations whose amount may be uncertain but the existence of which is unquestioned. Examples include product and service guarantees and warranties.

In some cases, the term accounts payable is restricted to trade creditors' accounts, represented by unpaid invoices for the purchase of merchandise or supplies. In other cases, "accounts payable" includes all unpaid invoices, regardless of their nature. In the accounting system, of course, accounts payable will normally be limited to those transactions for which the company has received an invoice. As stated previously, for financial statement presentation purposes, it is common to include "accrued expenses" in the same balance sheet caption.

Accounts payable may be recorded at gross invoice price (i.e., without deducting discounts offered for prompt payment), or they may be shown net. Although it has been argued that the latter treatment is conceptually superior regardless of the circumstances, in practice receivables tend to be recorded gross. Accounts payable should be recorded net, however, if it is customary in an industry to permit customers to take the discount regardless of when the invoice is paid. If the discount is always allowed, it amounts to a purchase price reduction and should be accounted for as such. If it is allowed only within the discount period, it appears to be more in the nature of a financial item.

The practical difficulties of apportioning small discounts to a series of items on one invoice lead most companies to account for discounts separately from the purchase price of merchandise. Inventory is recorded at the gross price, and the credit balances resulting from the discount are normally netted against the total year's purchases. In principle, year-end adjustments should be made for that portion of the purchases that remains in inventory, but in practice that is rarely done.

Some companies consider that the rate of interest implicit in the usual trade discount is so large that substantial efforts should be devoted to assuring that it is not lost. If conditions preclude the taking of the discount, the difference between the gross price actually paid and the net price that would have been paid may be accounted for as "discount lost." The balance of this account may be interpreted as a financial expense or as evidence of inefficiency in the accounts payable operation.

Bank loans evidenced by secured or unsecured notes payable to commercial banks are a common method of short-term financing. Ordinarily the notes are interest bearing, and in such cases the amount borrowed and the liability to be recorded is the face amount of the note.

In some instances, however, non-interest-bearing or "discount" paper is issued. In such transactions, the bank deducts the interest in advance from the amount given to the borrower, who subsequently repays the full amount of the note.

Assume, for example, that the X Company gives the bank a $1,000 non-interest-bearing 2-month note on a 12 percent basis. The customary entry to record the borrowing is as follows:

Reporting of the discount as "prepaid interest" has been objected to on the ground that the company has borrowed only $980 and that, therefore, the $20 asset is in no way a prepaid item. Essentially the same problem arises on a long-term basis when bonds are issued at a discount. This matter is discussed in Subsection 25.4(f).

In some cases bank loans or notes are taken for short periods, but with the intent on the part of both borrower and lender that the note will be continuously refinanced. See "Current and Long-Term Liabilities" for a discussion of short-term obligations expected to be refinanced.

Short-term notes payable often arise directly or indirectly from purchases of merchandise, materials, or equipment. If such notes arise directly from purchases, they may be classified in the financial statements with accounts payable. If, however, the notes arise indirectly, or have substantially different payment dates from the usual trade payables, they should be shown separately.

An accounts payable figure can be determined at the balance sheet date from the control account, even though it is normally necessary to review all invoices paid for a reasonable period subsequent to the balance sheet date (search for unrecorded liabilities) to assure that all amounts actually payable at the balance sheet date are properly recorded. In contrast, although some part of the balance of accrued expenses may be determined from recurring expense accruals, in general it is necessary to make a thorough review of all the company's relevant expense accounts—rent, salaries, and so on—to determine the appropriate amount at year end. Thus accrued liabilities (expenses) arise principally only when financial statements are prepared. When preparing the accruals for the different expenses, it is well to keep in mind a sense of balance between the possibility of producing financial statements with every conceivable accrual determined precisely and the added economic value of that precision. In many cases the amount of extra work necessary to estimate certain accruals with extreme accuracy may not be justified by their value to a user of the financial statements. For such immaterial items, relatively rough estimates may suffice.

Advances from officers and employees are related-party transactions that may require disclosure in accordance with FASB Statement No. 57, "Related Party Disclosures," and, for Securities and Exchange Commission (SEC) registrants, Regulations S-X and S-K. Related-party disclosures are not required, however, for compensation arrangements, expense allowances, and other similar items in the ordinary course of business. The requirements for disclosure of related-party transactions are discussed in Subsection 25.8(a).

The amount of cash dividends declared, but unpaid, is commonly treated as a current liability in balance sheets. See Chapter 27 for a discussion of the nature and treatment of dividends.

Stock dividends declared, constituting only a rearrangement of the equity accounts, are not recorded as a liability.

In Statement No. 5, "Accounting for Contingencies" (par. 1), the FASB defines a contingency as:

Not all the uncertainties inherent in the accounting process result in the type of contingencies foreseen by Statement No. 5. Estimates, such as those required in the determination of useful lives, do not make depreciation a contingency. Similarly, a requirement that the amount of a liability be estimated does not produce a contingency as long as there is no uncertainty that the obligation has been incurred. Thus amounts owed for services received, such as advertising and utilities, are not contingencies, although the amounts actually owed may have to be estimated at the time financial statements must be prepared.

An entity's commitment to a plan to exit an activity, by itself, does not create a present obligation to others that meets the definition of a liability. FASB Statement No. 146, "Accounting for Exit or Disposal Activities," requires recognition of a liability for costs associated with an exit or disposal activity when a liability has been incurred, and points out that a liability is not incurred until a transaction or event occurs that leaves an entity with little or no discretion to avoid the future transfer or use of assets to settle the liability.

When a domestic corporation consolidates a foreign branch or subsidiary or when an importer purchases goods or incurs liabilities expressed in foreign currencies, the problem arises of translating the liabilities into U.S. dollar amounts. Accounting principles in this area have undergone considerable change in recent years and are discussed in Chapter 13.

As indicated previously, obligations expected to be liquidated within the next operating cycle by the use of current assets or the creation of other current obligations should be classified as current liabilities.

(ii) Other Current Liabilities.

Regulation S-X, Rule 5.02(20), requires the separate statement in the balance sheet or in a note thereto of any item in excess of five percent of total current liabilities. Such items may include, but are not limited to, accrued payrolls, accrued interest, taxes, indicating the current portion of deferred income taxes, and the current portion of long-term debt. Remaining items may be shown in one amount.

Figure 25.1. Sample presentation of short-term liabilities as required by the SEC. (Source: Oklahoma Gas & Electric Co., 1988 Annual 10K Report.)

Many companies disclose arrangements for compensating balances in the note covering short-term debt, although these are covered in Regulation S-X under requirements related to cash.

An example of a note that presents the required SEC information is given in Exhibit 25.1.

In the less detailed form used in published reports to shareholders, it is common to present current liabilities as follows:

• Payable to banks

• Accounts payable and accrued expenses

• Federal income taxes payable

• Current portion of long-term debt

As a general rule, current liabilities should not be offset against related assets. For example, an overdraft at one bank should not be canceled against a debit balance at another bank; such offsetting distorts the current ratio. An exception to the general rule is indicated by APB Opinion No. 10, Omnibus Opinion—1966, in the instance of short-term government securities "when it is clear that a purchase of securities (acceptable for the payment of taxes) is in substance an advance payment of taxes that will be payable in the relatively near future...."

Supplemental disclosure should be used to indicate partially and fully secured current claims, overdue payments, and special conditions of future payment [see Subsection 25.1(b)].

Bonds are essentially long-term notes issued under a formal legal procedure and secured either by the pledge of specific properties or revenues or by the general credit of the issuer. In the last case, the bonds are considered "unsecured." The most common bonds are those issued by corporations, governments, and governmental agencies. A significant difference, from the viewpoint of the holder although not the issuer, is that most obligations of state and local governmental units are free of federal income taxes on interest and sometimes of state taxes, as well. Both state and local government bonds are usually called municipals. Agency bonds are obligations of government agencies and frequently carry a form of guarantee from the government unit. The typical bond contract, known as an indenture, calls for a series of "interest" payments semiannually and payment of principal or face amount at maturity. Bonds differ from individual notes in that they represent fractional shares of participation in a group contract, under which a trustee acts as intermediary between the corporation and holders of the bonds. The terms are set forth in the trust indenture covering the entire issue. Indentures are frequently long and complex documents and normally contain various conditions and restrictions related to the operations of the borrower.

The conditions and restrictions referred to as covenants may include restrictions on dividend payments and an agreement to maintain a minimum amount of working capital. Failure to comply with covenants would lead to default and acceleration of the due date of the debt. This event may trigger default on other obligations of the corporation under cross-covenant provisions.

Bonds, like stocks, are a means of providing the funds required for the long-run operation of the corporation and have been used for this purpose on a large scale, particularly in the utility field. The primary difference between the two broad classes of securities is that bonds represent a contractual liability, whereas stocks represent a residual equity. Failure to pay interest and principal as agreed under the bond indenture usually results in definite legal action to protect the rights of the bondholder. As long as the corporation meets all obligations as prescribed, the bondholder has little or no influence on the administration of the company. However, if the issuer violates one or more of the restrictive covenants in the indenture, the power of the holders may increase substantially.

Bonds are normally long-term securities and are often issued for periods of 10 years or longer. Maturities vary with industry and with general conditions at the time of issue. Intermediate-term securities, with maturities of one to five years, like bonds in every other respect, are normally called notes. Whereas bonds are usually issued in units of $1,000, prices are quoted in multiples of $100. Thus a bond quoted at $85 would actually be priced at $850. Alternatively, bond prices may be quoted in terms of their interest yield.

Bonds may be classified in a number of different ways. The security given in connection with the bond may range from a first or senior lien on specific physical property, such as a first mortgage bond or an equipment obligation, to securities that are a general lien, such as debentures, and finally to conditional promises with no lien, such as income bonds. The analysis of bonds is treated in detail in Chapter 18.

The traditional distinction between bonds and stocks became blurred through the increasing use of hybrid types such as convertible bonds, bonds with stock-purchase warrants attached, and redeemable preferred stocks. Similarly, the popularity of serial bonds, in which a portion of the issue matures each year, has blurred distinctions based on maturities.

For financial statement purposes, clear identification of bonds that are "secured" and similarly clear labeling of the assets involved are absolute requirements.

The general right of a corporation to create a bonded indebtedness is found in the power to borrow funds granted by statute, and specific authorization of such action is usually included in the charter or bylaws. However, the authority of the directors to place a mortgage on corporate assets may be subject to shareholder approval. Securing such approval is often advisable, even if not required, in the event of a heavy borrowing program, in view of the effect of such a program on the shareholders' position. Under some statutes, corporate borrowing is subject to general restrictions (e.g., limitation to a certain percentage of total capital stock).

Following is an outline of 14 procedural steps when bonds are issued through investment bankers:

If the entire issue is "sold" to the underwriters, which is the most frequent procedure, and the corporation has no responsibility with respect to the process of distribution, the entries covering the issue boil down to a charge to the underwriters—or directly to "cash," if payment is made upon delivery—and a credit to "bonds payable." If the corporation disposes of the bonds through the efforts of its own organization, the accounting will be more extended and may include the recording of subscriptions.

Assume, for example, that a company authorizes debenture bonds in the par amount of $1 million and undertakes to dispose of the bonds at par through its own office. Assume, further, that subscriptions are taken at par for 700 bonds of $1,000 each. The following general entries are required:

Assuming cash is received in full for 500 bonds, the entries are:

When the bonds are issued, the account with bonds subscribed is charged and the regular liability account, "bonds payable," is credited.

When bond subscriptions are collected on the installment plan, it may be advisable to set up separate accounts for each installment receivable, as a means of controlling collections and segregating balances past due. In any event, detailed records of each subscription must be maintained.

On the balance sheet, bond subscriptions are preferably shown as a receivable, with bonds subscribed reported as a form of liability.

(ii) Issue of Bonds at Discount and Premium.

Bonds are recorded in the main liability account at par or maturity value. If issued for less than par, the difference is charged to a discount account, illustrated as follows:

An account "discount on bond subscriptions" may be used to reflect the discount until the bond subscriptions are collected in full, at which time the account will be transferred to "discount on bonds payable."

If bonds are issued for cash in excess of the face amount of the bonds, the excess is credited to a premium account as follows:

The entries for bond subscriptions at a premium would correspond with the discount illustration shown above.

The practice of recording the face amount of the bonds and discount (or premium) in separate accounts is thoroughly established, in spite of the fact that on the investors' books it is good practice to record the purchase of the bond at cost without regard to face or maturity value. It is theoretically correct to credit "bonds payable" with the proceeds of the bond issue, but the practice illustrated above is not objectionable, provided it is properly interpreted and reported.

(iii) Segregation of Bond Issue Costs.

Charges connected with the issue of new bonds—such as legal expenses in preparing the bond contract and mortgage, cost of printing certificates, registration costs, and commission to underwriters—are costs of the use of capital obtained for the whole life of the issue and should be capitalized and written off over that period.

It is common practice to lump these costs with actual discount (or net them against premium, as the case may be). Good accounting requires careful distinction between these costs and bond discount, which is properly an offset to the maturity value of the bonds. Issue costs should likewise not be offset against the premium liability.

Occasionally the amount of bond issue costs is difficult to determine. That is particularly true where bonds are sold through underwriters who share expenses. As a general rule, the difference between the amount paid in by the first bona fide bondholders and maturity value represents premium or discount. The difference between this amount paid in and net proceeds to the issuer represents bond issue cost.

For example, if bonds with a face value of $1 million are issued through underwriters to original holders at a price of 1001/2, and if the net proceeds to the issuer are 981/4, out of which bond issue costs amounting to $15,000 are paid, the entries are:

Bond issue costs of $37,500 are classified on the balance sheet as an intangible asset and amortized over the life of the bond issue on a straight-line basis.

(v) Bonds Issued between Interest Dates.

When a bond is sold after the stated issue date, the price paid by the purchaser will include interest accrued at the coupon rate from the issue date on the bond. At the outset this accrued interest represents a liability to the issuer covering the amount of interest advanced by the investor, in view of the date of purchase, and payable at the next interest date.

For example, 10 percent bonds in maturity amount of $100,000 and dated January 1 are marketed at par and accrued interest one month after the stated date. The entries to record the sale and the initial payment of interest are:

When a bond is finally sold after one or more interest coupons have matured, the matured coupons are detached by the issuing company and the buyer is charged only with interest accrued since the last interest payment date.

Cases involving discount and premium are discussed below.

When an investor buys a bond, he acquires two rights: (1) the right to receive periodic interest payments from the date of purchase to maturity and (2) the right to receive face value at maturity date. It follows that the current price of the bond is the sum of (1), the present value of the interest payments, plus (2), the present value of the face amount.

For example, a corporation plans to issue $1 million face value, 20-year bonds. The bonds bear interest (coupon rate) of nine percent, payable semiannually. If the market yield (rate of interest) on securities of this quality is 10 percent at the date of issue, the sale price of the bond is the sum of the following two:

Here both present values are calculated to yield 10 percent per annum (or, more precisely, 5 percent each six months, since interest is compounded semiannually).

The present value of item 1, an annuity of $45,000 for 40 periods at 5 percent, is $772,158.89. The present value of the maturity payment of $1,000,000, payable in 20 years at 10 percent, is $142,045.68. Thus we can compute the value of the bond and the discount as:

The effect of various yield rates on the issue price of this bond issue can be shown by calculating the bond issue price at various yields, as shown in the following table:

As shown in the 4.5 percent line of the table above, when the yield rate is the same as the coupon rate, the investor pays face value for the bonds.

In some cases, the issue price of the bonds is determined first; then the problem arises of estimating the effective rate established by that price. More sophisticated financial calculators are capable of determining the yield under such conditions.

It was standard practice for many years to show bond discount on the balance sheet as a deferred charge and bond premium as a deferred credit, with the bond liability account remaining at face value throughout the life of the bonds.

A debate over this accounting practice raged for decades. However, it was ended by APB Opinion No. 21, which states: "[D]iscount or premium resulting from the determination of present value in cash or non-cash transactions is not an asset or liability separable from the note which gives rise to it."

Also APB Opinion No. 21 calls for the presentation in the balance sheet of discount or premium as direct deduction or addition to the face amount of the note. Such an amount should not be classified as a deferred charge or credit.

Examples in APB Opinion No. 21 show discount presented either in parenthetical form in the caption for a note or as a separate statement amount deducted from the outstanding balance of the note. The Opinion notwithstanding, some companies apparently classify discount or premium in some other account when the amount is inconsequential. As noted earlier, this is frequently the case when coupon values are almost identical to market interest rates.

Interest payment dates may not coincide with accounting period dates. In such circumstances, it is necessary to accrue interest on outstanding bonds. And even when the stated date of payment and the end of the accounting period are the same, systematic accrual of interest expense and liability is good procedure, especially since interest money may be deposited prior to the interest date and payment of all coupons may not be effected on that date. A regular monthly accrual is usually desirable.

For example, if 12 percent bonds in the par amount of $1,000,000 are issued at par on June 1, the issuing company may well make entries at the end of each month throughout the life of the bonds as follows:

Bond interest is ordinarily paid semiannually. Thus the regular cash requirement for interest on an issue of $1,000,000 of 12 percent bonds is 6 percent or $60,000 every six months. Interest may be paid directly by the issuer or through the trustee. In the former case, the issuer mails checks to all registered holders and makes a deposit in some specified bank sufficient to cover all outstanding coupons (or, in some instances, makes payments by check or in actual cash to parties presenting coupons). In the latter case, the issuer deposits the required interest money with the trustee and depends on the trustee to carry out the actual process of paying the individual bondholders. Assuming that deposit with the trustee is tantamount to payment, the entries covering such deposit are, for example:

However, a more complete and satisfactory treatment is to charge the trustee with the money deposit and cancel the liability when payment of coupons has been reported (or coupons have been returned). Thus:

The amount of unredeemed coupons due at any time is represented by the balance of "bond interest payable," and the amount available for payment is the balance of the interest fund. If desired, the amount of past-due coupons may be transferred to a distinct account.

Paid or canceled coupons should be filed systematically either by the issuing company or by the trustee.

(ii) Interest on Bonds Held by Trustee.

Bonds of the company's own issue in the hands of the trustee are not truly outstanding, and any "interest" payments on such bonds required by the trust agreement should not be permitted to affect the interest accounts of the issuer. A requirement that "interest" be deposited on bonds already held by the trustee is simply a means of accelerating the accumulation of the sinking fund.

Assume, for example, that 10 percent of an issue on which the total semiannual interest is $20,000 is in the hands of the trustee and that the agreement calls for deposit of the entire amount. The appropriate entries are:

APB Opinion No. 21 requires that bond discount or premium be charged systematically to income as interest expense or income over the life of the bond issue using the interest method. The effect on the income statement of systematic amortization of premium or discount is to show interest expense at the effective amount.

As an illustration of the interest method, assume a $1 million issue of five-year bonds with 8 percent annual interest (payable semiannually), priced to yield 10 percent to investors, for a market price of $922,782.65.

The interest method is a procedure for absorbing the discount or premium in accord with the ordinary mathematical interpretation of the composition of the issue price; it provides for spreading of the total interest charge in terms of the effective or market rate of interest. Under the interest method, the periodic amortization is the difference between the interest due and effective rates of interest applied to the carrying amount of bonds outstanding at the interest date. For the illustrative issue, the entry to record interest and the amortization of discount for the first period is:

In each subsequent period, bond interest expense will be charged with the effective rate of interest times the carrying amount of the bonds, and the periodic amortization will be the difference between that amount and the bond interest liability. The amortization of premium is given similar treatment.

An accumulation table for the bonds above for the first three years under the interest method is as follows:

In practice, it is common to develop such tables when bonds are first issued, to provide a basis for subsequent accounting. As interest dates are not likely to coincide with financial reporting dates, tables are frequently developed on a monthly or daily basis to permit correct entries whenever financial statements are prepared. Similar entries and tables result for the amortization of bond premium.

Bonds that may eventually be converted into a certain number of shares of common stock and bonds that have warrants attached, permitting the purchase of common stock at a fixed price, have achieved considerable popularity. The attraction to the buyer of such issues is obvious—they provide the fixed income of bonds along with the opportunity to participate in an equity increase. An attraction of such issues to the issuing corporation is that they are typically sold at interest rates below those that would be required for similar securities in the absence of the equity privileges. In some cases, the corporation's credit may be such that debt could not be issued at all without the conversion privilege or warrants.

APB Opinion No. 14, "Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants," states that no portion of the proceeds from the issuance of convertible debt or debt with nondetachable stock purchase warrants should be accounted for as attributable to the conversion feature. Such securities include debt securities that are convertible into common stock of the issuer or an affiliated company at a specified price at the option of the holder and that are sold at a price or have a value at issuance not significantly in excess of face amount. The terms of such securities generally include:

If convertible debt is issued at a substantial premium, there is a presumption that the premium represents paid-in capital.

Opinion No. 14 requires that the proceeds of debt securities with detachable stock purchase warrants be allocated between the debt and paid in capital, based on the relative fair values of the two securities at the time of issuance. Any resulting discount or premium on the debt securities should be accounted for as such. The same accounting treatment applies to issues of debt securities (issued with detachable warrants) that may be surrendered in settlement of the exercise price of the warrant.

EITF Issue No. 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," addressed the accounting for a convertible security with a nondetachable conversion feature that is in-the-money at the commitment date. That issue also addressed certain convertible securities that have a conversion price that is variable based on future events. A number of practical issues regarding the application of the guidance in Issue No. 98-5 were raised subsequent to the final consensus. The EITF addressed those issues in Issue No. 00-27, "Application of Issue No. 98-5 to Certain Convertible Instruments." At the date of this writing, EITF Issue No. 00-27 continues to be on the Task Force's agenda.

In some cases bonds of a particular class and series are marketed at different times and at different prices. Assume, for example, that of an issue with a maturity amount of $1 million, the first $600,000 is sold at 102 and the second $400,000 at 105. Under such conditions two alternative procedures are available. The two blocks of the issue may be accounted for separately, and the premium on each block may be amortized at the effective rate involved. The alternative is to combine both blocks in the accounts and to apply an overall approximate rate, determined in the light of the conditions under which the two blocks were issued. Separate computations are generally advisable where considerable time elapses between issue dates and there is a substantial difference between the effective rates involved.

In the rare case of various maturities of serial bonds being issued at the same yield rate, that rate can be applied to the net book value of the entire issue to determine amortization as in the interest method illustrations above.

In the much more common case of serial bonds that are issued with different yields on each maturity, the interest method of amortization of discount or premium should be applied to each maturity, treating it as if it were a separate issue. Formerly, such treatment was considered "too complex," but the development of sophisticated financial calculators obviates that argument.

No special accounting problems arise when bonds are paid as agreed at maturity, assuming that items of bond issue cost and of discount or premium have been disposed of systematically.

The amount of any matured bonds not presented for redemption by the holder at maturity date should be segregated in a special account. That balance should be carried as a current liability except where a special fund—not reported in current assets—is maintained to redeem the bonds when they are presented. No interest accrues on matured bonds not in default.

If default occurs at maturity, no special entries are required prior to the settlement made through reorganization procedure, although the fact that the liability has matured but remains unpaid should be indicated in the balance sheet. Occasionally, creditors consent to a postponement of payment provided the corporation continues to pay interest at a specified rate. Where a special settlement following default at maturity provides for issue of new securities to replace the defaulted bonds, the book value assigned to such securities will presumably equal the maturity amount of the bonds (plus any unpaid interest accruing since maturity), except as conditions clearly warrant some other treatment.

Default of bonds prior to maturity creates a situation similar to that of default at maturity. Generally, no entries are called for, but the condition of default should be clearly described in the statements. Interest continues to accrue on defaulted bonds under conditions prescribed in the contract and should be recorded.

In Issue No. 86-30 the EITF considered whether the waiver of a lender's rights resulting from the violation of a covenant with retention of the periodic covenant test represents, in substance, a grace period. If viewed as a grace period, the borrower must classify the debt as current under FASB Statement No. 78, unless it is probable that the borrower can cure the violation (comply with the covenant) within the grace period. The Task Force's consensus was that unless the facts and circumstances would indicate otherwise, the borrower should classify the obligation as noncurrent unless (1) a covenant violation has occurred at the balance sheet date or would have occurred absent a loan modification and (2) it is probable that the borrower will not be able to cure the default at measurement dates that are within the next 12 months.

Compositions with creditors in the event of financial weakness often involve a scaling down of acknowledged liabilities, either through actual cancellation of the claims or through issue of stock to cover some element of the total debt. Chapter 11 of the Bankruptcy Act is designed to facilitate such agreements, to eliminate losses due to forced sale of property, and to prevent cash payments to dissenting minorities when a revision in the debt structure is agreed to by a substantial majority of claimants of the same class. These procedures tend to encourage continued operations under the same management when this seems desirable (see Chapter 45).

Many bond contracts provide for the calling of any portion, usually selected by random draw, or all of the issue at the option of the company at a stated price, usually above par, to allow the corporation to reduce its debt before maturity as the occasion arises. When interest rates decline, debtors may consider transactions that would use the leverage of an existing call provision to reduce the higher interest rate on an older debt issue. For example, the debtor may exchange new noncallable debt with a lower interest rate for old callable debt or have the creditor pay a fee in return for an agreement not to exercise the call provision for the life of the debt or for a shorter period. In periods of high interest rates, buyers of new bonds prefer indentures that restrict the call privilege. Also, bonds are often retired piecemeal through sinking fund operations, or acquired by the issuer on the open market.

FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, provides guidance as to when debt should be considered to be extinguished for financial reporting. See Subsection 25.9(b) for a discussion of Statement of Financial Accounting Standards (SFAS) No. 140.

As interest rates rose in the 1970s, some corporations retired older, low-interest bonds (and, in some cases, low-yielding convertible bonds), to increase earnings by passing the gain on retirement through income. In many cases, these retirements appeared to be uneconomic, suggesting that earnings creation was the principal reason. See below, under "Gains and Losses from Extinguishment of Debt," for a more complete discussion.

Outstanding bonds acquired by the issuer may be permanently retired or—if the conditions of acquisition permit—they may be held in the corporate treasury for reissue at some later date. If the bonds were issued at par and are redeemed at par, the only special problem is the absorption of any bond issue costs remaining on the books. Additional problems arise when there is unabsorbed discount or premium on the books at the time of redemption, or where the redemption price differs from the maturity value.

Assuming outright redemption, all balances relating to the bonds redeemed should be eliminated.

The M Co., for example, has outstanding a bond issue of $100,000 maturity amount. On the books related to this issue are unamortized bond issue costs of $2,000 and unamortized discount of $3,000. At this point the entire issue is called at 105, and costs are incurred in the carrying out of this transaction of $1,500. The summarized entries are:

When bonds are redeemed by purchase on the market, a book profit may result.

Assume conditions as in the preceding example except that instead of calling the entire issue, the M Co. bought bonds in par amount of $20,000 on the market at a total expenditure, including all charges, of $15,000. The summarized entries are:

In this case, with 20 percent of the issue retired, the write-off of issue costs and discount is restricted to 20 percent.

Bonds acquired by the corporation as a result of call or purchase may be canceled by formal action, or they may be held in substantially the same category as authorized bonds that have never been issued. The most common modern form of presentation is to show only the net amount of bonds outstanding on the balance sheet and to indicate the existence of treasury bonds in a note to the statements.

It follows from this that the acquisition by a corporation of its own bonds amounts to redemption of those bonds, and disposition of any balances of unamortized premium or discount, or bond issue costs, should follow the recommendations presented above under "Gains and Losses from Extinguishment of Debt," permitting recognition of book gain or loss.

Where the recommendations above for accounting for acquisition of treasury bonds have been followed, accounting for reissue is essentially the same as for bonds that have never before been outstanding. If the par amount of the treasury bonds is carried in a special account, that account is credited at par when the bonds are issued.

Retirement of bonds through the operation of a special fund is familiar financial practice. The fund procedure may be a plan adopted by the issuing corporation and entirely within its control, or it may be an arrangement provided by contract, involving a trustee.

Most commonly, the sinking fund is an arrangement rather than an actual fund. That is, the bond indenture requires the borrowing corporation to make specific, periodic payments to the trustee, who then acquires the necessary bonds. Whether the sinking fund actually holds the bonds or arranges for their retirement is actually a moot question, since when held by the sinking fund, the bonds are effectively retired. In the past, sinking funds might actually consist of a fund, holding assets other than the debt in question. Because the purpose of the sinking fund arrangement is to provide gradual retirement of the debt, there is no reason for the fund to undertake the risk of holding securities of another issuer. In another common arrangement the company may acquire bonds in the open market or through calls, hold them as treasury bonds, then deposit them in satisfaction of sinking fund requirements at appropriate dates. In the case of some convertible debt, the conversion of enough bonds may satisfy the sinking fund requirements.

When the trustee has used the funds to acquire the corporation's bonds, either at or before maturity, the bonds so acquired are in effect retired and should be reported as such on the balance sheet of the corporation. Accounting for corporation bonds acquired by a sinking fund trustee should follow the same procedures described in Subsection 25.6(f). This treatment is proper even when the bonds are kept "alive" by the trustee for the purpose of accumulating "interest" from the corporation issuer. "Interest" payments by the corporation to the trustee on the corporation's own bonds held in the fund should be treated simply as additional deposits.

Ignoring effect on taxes and other special factors, there is no object in refunding prior to maturity except when more favorable terms can be secured, particularly with respect to interest rate. However, the bare fact that the market rate has fallen does not justify refunding. To retire a complete issue of outstanding bonds prior to maturity ordinarily necessitates exercise of right of call, and this means payment of a redemption premium, usually substantial. Moreover, the costs of refunding must be considered. When the old issue is called before maturity, the trustee will require a fee for additional services. There will be legal and accounting fees, taxes, and printing costs. More serious are the added costs of registration and marketing the issue. Another factor that may be important is the additional interest charge required by the overlapping of the two issues.

There has been considerable discussion in financial circles as to the proper method of computing the saving—if any—to be realized by refunding under a specified set of conditions. Probably the most significant approach is that which compares the present values at the prevailing effective rate of the cash requirements of the two programs, considering the new issue to run for only the remaining life of the old. (It is pure speculation to make the comparison for a longer term.)

For example, the M Co. has outstanding $1 million, maturity amount, of six percent bonds, with 10 years yet to run. These bonds are callable at any interest date at 105. Assume that the effective market rate of interest for this class of security is currently only four percent, for loans of 10 years or longer. The service costs of various kinds required to call the old bonds and float the new loan are estimated at $30,000. The present cash value of the obligations under the old contract is found as follows:

The amount of cash required to meet these claims through the medium of a new loan is $1,080,000 (including redemption premium of $50,000 and costs of $30,000). By comparison, it appears that an advantage is realized by refunding.

It is important to note that the question of book loss realized on redemption has no bearing on the determination of the financial advantage of a refunding program over continuation of the existing contract.

However, as noted above in connection with early retirement of bonds and notes, some companies have undertaken early retirement to produce reported earnings, even though the transactions are inherently uneconomical.

The desire to realize a book loss for tax purposes in the form of unamortized discount and expense may be an important or even a decisive factor in bringing about a decision to refund. It is even possible for a situation to develop in which a refunding might seem to be advantageous, in view of the tax angle, although no saving in interest charges results.

When convertible bonds issued at par are converted into stock at par, dollar for dollar, the conversion is ordinarily assumed to be the equivalent of the payment of the liability and the issue of additional stock at par. The entries necessary to recognize conversion under these conditions, accordingly, consist essentially of a charge to bonds outstanding and a corresponding credit to capital stock. In the case of the conversion of bonds issued at a premium into stock on a par-for-par basis, the unamortized premium on the date of conversion is preferably treated as a form of stock premium. Similarly, an unaccumulated discount attaching to bonds converted into stock on a par-for-par basis should be set up as a type of stock discount, although that discount would presumably not represent an amount that might be collected from shareholders by assessment. The schedule of accumulation of discount or amortization of premium set up for convertible bonds should disregard the possibility of conversion and should be adhered to until conversion takes place.

When bonds are convertible into stock at some specified price other than par or stated value, the book value of the bonds converted is generally made the basis of the credit to capital stock.

Assume, for example, that a company has outstanding an issue of debenture bonds in the par amount of $1 million, with applicable unamortized discount of $50,000, and that those bonds are convertible into the common stock of the company on any interest date at a price of $25 per share, or on the basis of 40 shares of stock for each bond in the maturity amount of $1,000. The shares of this class of stock have a stated value of $10 each. At this point 10 percent of the bond issue is presented for conversion, and shares are issued in accordance with the exchange ratio. The summarized entries are:

In some cases the specified conversion price of the stock increases in terms of stated periods. The contract may also provide for termination of the conversion privilege at a specified date. A minor complication arises when the exchange ratio is such that conversion calls for issue of fractional shares. In that situation the converting bondholder may pay—in sufficient cash to entitle him to a whole number of shares, the corporation may make an appropriate cash payment, or the corporation may actually issue the fractional shares.

The treatment of unamortized bond issue cost on conversion date is something of a problem. As a matter of convenience, such cost may be absorbed in the conversion entries in the same manner as bond discount. However, a better treatment would be to retain the balance of issue cost as in effect a cost of stock financing. A convertible bond is potential capital stock and may become actual stock at any time the bondholder elects. As long as the bonds are outstanding, the schedule of amortization of issue costs based on the total life of the bonds should be maintained, as conversion is not assured and is beyond the control of the issuer. Upon conversion, nevertheless, the contingency becomes controlling, and the balance of bond issue cost becomes a cost of issuing stock.

FASB Statement No. 84, "Induced Conversions of Convertible Debt," which amends APB Opinion No. 26, "Early Extinguishment of Debt," specifies that when a convertible debt is converted to equity securities of the debtor pursuant to an inducement offer, the debtor should recognize an expense (not extraordinary) equal to the fair value of all securities and other consideration transferred in excess of the fair value of securities issuable pursuant to the original conversion terms.

Measurement of the fair value of the securities should be as of the date the inducement is accepted. Usually that is when conversion takes place or a binding agreement is signed.

Inducement includes changes made by the debtor to the conversion privileges for purposes of inducing conversion. The Statement applies only to conversions occurring pursuant to changed conversion privileges that are exercisable for a limited period and include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted. Inducements include reducing the original conversion price, issuing warrants or other securities not included in the original terms, or payment of cash.

In Issue No. 85-17, the EITF concluded that when accrued but unpaid interest is forfeited at the date of conversion of convertible debt, either because the conversion date falls between interest payment dates or because there are no interest payment dates (a zero coupon convertible instrument), interest should be accrued or imputed to the date of conversion of the debt instrument. Accrued interest from the last interest payment date, if applicable, to the date of conversion, net of unrelated income tax effects, if any, should be charged to expense and credited to capital as part of the cost of the securities issued. Thus, accrued interest is accounted for in the same way as the principal amount of the debt and any unamortized issue or premium discount.

Bonds are sometimes sold with warrants or subscription rights attached. The rights or warrants permit their holder to purchase other securities, normally common shares, at some fixed or determinable price in a future period or at a certain future date. The warrants are essentially calls or options on the common stock. The theory, of course, is that the combination of the warrant and the bond enables the company to market the bond at a lower interest rate.

As mentioned previously, Opinion No. 14 requires that the proceeds of debt securities with detachable stock purchase warrants be allocated between the debt and paid-in capital, based on the relative fair values of the two securities at the time of issuance. Any resulting discount or premium on the debt securities should be accounted for as such. The same accounting treatment applies to issues of debt securities (issued with detachable warrants) that may be surrendered in settlement of the exercise price of the warrant.

As an illustration of the accounting for a bond with warrants, consider the following example. A company issues a bond at par with an 8.75 percent yield. Each bond has a warrant attached that permits the holder of the warrant to purchase a share of the company's stock for $20, within five years. The common shares are currently selling for $50. It is determined that the company's bond, without the warrant attached (a straight bond), could have been sold for 95, that is, $950 per bond.

The underwriter handling the issue estimates that the warrant will be worth about $75 when issued. Note that APB Opinion No. 14 calls for this valuation (and that of the comparable straight bond) to be made "at the time of issuance," which it defines as "the date when agreement as to terms has been reached and announced." That is not the actual date of issue of the securities, when relative market values for the two securities could be determined. The date given in APB Opinion No. 14 is earlier. Thus the fair value will be approximated or estimated by someone, probably the underwriter.

The allocation required under APB Opinion No. 14 is as follows:

The entries, for the issuance assuming one bond, would be:

This accounting applies to warrants that are "separable" from the bonds, which is the most common situation. If the warrants were required to trade with the bond, the issue would be almost identical to a convertible bond and should be accounted for as a convertible.

A mortgage is essentially a pledge of title to physical property as security for repayment of a loan. A mortgage refers to the security for a debt, not the debt itself. A promissory note usually accompanies the granting of a mortgage. On the balance sheet the liability should appear as "Mortgage Notes Payable" or "Notes Payable—Secured" with brief reference to the property pledged. The term mortgage payable as a liability caption is, nevertheless, occasionally found in financial statements.

Figure 25.2. Sample presentation of long-term debt. (Source: Crown Cork & Seal, 2001 Annual Report.)

If mortgages are payable on the installment plan, the liability account is charged each payment date with the amount of principal paid. When the periodic installments are fixed amounts covering both payment on principal and accrued interest, the payments must be apportioned between principal and interest (see "Installment Purchase Contracts").

With respect to individual mortgages and accompanying notes, the borrower usually receives cash in the face amount of the note, in which case the face amount is the true liability and discount or premium is not involved. However, when the consideration for the note is in the form of property, as is the case when a mortgage is given on the property purchased or when "points" are given, the liability may be more or less than the face of the note. Points are the analogue, in mortgage financing, of original issue discount for bonds. They raise the effective interest rate above that specified in the note. A point is one percent of the face of the note. For example, if a 20-year mortgage note for $100,000 face were signed, but the banker demanded four points, the borrower would receive four percent less than $100,000, or $96,000. If the note carried an interest rate of 10.75 percent, for example, the borrower would still be obligated to make the monthly payments on $100,000, that is, $1,015 per month. Since he received only $96,000, the borrower's effective interest rate is increased to about 12.3 percent on the money he received. Accounting for this transaction would follow the reasoning outlined in Subsection 25.4(d).

In some mortgage loan arrangements, the lender is entitled to participate in appreciation in the market value of the mortgaged real estate project or the results of operations of the mortgaged real estate project, or in both. Accounting for such arrangements is discussed in Chapter 13.

Installment purchase contracts are a popular means of financing asset acquisitions. In the typical case, the buyer secures possession upon making a down payment and agrees to pay the balance in a series of installments, usually with interest, over an extended period. In some cases, buyers with excellent credit ratings are not required to provide down payments. Transfer of title is often deferred until payment of the final installment. Proper accounting requires showing the asset at full cost and the balance of the contract payable as a liability.

Purchase contracts are commonly payable in equal periodic installments. The regular installment may include both interest on the contract balance and a payment on the principal, or it may apply entirely to principal, with interest paid separately.

To illustrate the first plan, assume a contract covering the purchase of equipment for $5,000, with interest at 12 percent, which provides for semiannual payments of $500 each until the entire obligation has been discharged. The division of these payments between interest and retirement of principal, at an interest rate of 12 percent, compounded semiannually, is shown in the accompanying table.

The entries in this case for the first semiannual payment (assuming no interim accrual of interest) are:

In this example, the fair value of the property is assumed to be the full contract price of $5,000, because interest is provided at a presumably adequate rate. If no interest were provided, the provisions of APB Opinion No. 21 would apply.

Leasing, as a means of financing the acquisition of long-term assets, has seen a rapid expansion in the United States and other countries since World War II. It was not until the 1960s, however, that authoritative accounting pronouncements began to significantly affect lease accounting. There now exist several major pronouncements and many interpretations. The related accounting is complex. Chapter 23 is devoted entirely to lease accounting, from both the lessee and lessor points of view.

Deferred revenue is the term often applied to liabilities that arise from the receipt of payment in advance of furnishing the service for which the funds are received. Usually deferred revenues are current, in that the service will be rendered in the next accounting period and the obligation discharged. A more complete discussion of accounting for deferred revenue is given above in connection with current liabilities. In some cases, however, payments are received covering a period of years, and here it is necessary to reduce the obligation each period by an appropriate amount, with a concurrent credit to revenue. Such long-term collections in advance should be shown as long-term liabilities in the balance sheet, under an appropriate title. The amount to be discharged in the following accounting period should be classed as current, with only the balance shown as a long-term liability.

Casualty insurance premiums are frequently collected three to five years in advance, and the long-term portions of such premiums represent long-term liabilities on the books of the insurer.

Although most accruals of expenses are properly classified as current liabilities, there are some commitments such as three-to-five-year product and service warranties, self-insurance programs, and pension plans that deserve classification as long-term obligations. The amount of the obligation is estimated in the light of a company's past experience and is established by an expense charge. That the amount is estimated and the identity of the specific obligee may be unknown at the time the obligation is recognized do not affect the propriety of the entry. Subsequently, when payment or service is made, the long-term liability account is eliminated.

The extent to which inflation should be recognized in long-term expense accruals is unclear. If, for example, a company gives a five-year repair warranty on a product, it is reasonable to assume that the labor cost of repair work performed in five years will be considerably higher than it is today. It is not clear whether the accrual of the liability for the warranty work should be made at current prices or at estimated future prices.

SOP 96-1, "Environmental Remediation Liabilities" (par. 6.12), states:

That guidance may be applicable to other kinds of liabilities by analogy.

In the past it was common to refer to such long-term expense accruals as operating or liability reserves, which, on occasion, were located ambiguously between the liability and equity sections of the balance sheets. These amounts are clearly liabilities and should be presented as such. The use of the term reserve in this context is not good practice.

Long-term borrowings on open account from affiliated corporations or other parties are a kind of long-term liability and should normally be shown separately. Long-term advances received for future use of property or merchandise, or for service to be rendered, represent a liability on the books of the party obligated to furnish property or render the service. Classification of this type of item as a "deferred credit" is not recommended.

FASB Statement No. 143, "Accounting for Assets Retirement Obligations," sets forth accounting and disclosure requirements for legal obligations associated with the retirement of a tangible long-lived asset that result from the acquisition, construction, or development and (or) the normal operation of a long-lived asset. Accounting for asset retirement obligations is discussed in Chapter 21.

Plans for payment of employee pensions and other retirement allowances involve assumption of obligations that are deferred until employee retirement dates. Accounting for retirement plans is the subject of Chapter 38. Deferred compensation is covered in Chapter 39.

The objectives of accounting for income taxes, as set forth in FASB Statement No. 109, Accounting for Income Taxes, are:

The following four basic principles are applied in accounting for income taxes at the date of the financial statements:

A complete discussion of this subject is in Chapter 24 of this Handbook.

FASB Statement No. 47, Disclosure of Long-Term Obligations, requires that an enterprise disclose its commitments under unconditional purchase obligations, such as take-or-pay contracts or through-put contracts that are associated with suppliers' financing arrangements. Such arrangements result in obligations to transfer funds in the future for fixed or minimum amounts or quantities of goods or services at fixed or minimum prices.

Disclosure is required of an unconditional purchase obligation that (par. 6):

If the obligation is not recognized on the purchaser's balance sheet, the required disclosures, which may be combined for similar or related obligations, include (par. 7):

Disclosure of the amount of imputed interest necessary to reduce the unconditional purchase obligation(s) to present value is encouraged but not required. The discount rate to determine the present value of the obligation(s) should be the interest rate of the borrowings that financed the facilities that will provide the goods or services, if known by the purchaser. If not, the rate should be the purchasers' incremental borrowing rate at the date the obligation is entered into.

For obligations that are recognized on the balance sheet, Statement No. 47 requires as the following disclosures for each of the five years following the latest balance sheet date (par. 10):

FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, issued in November 2002, changed dramatically the accounting for guarantees within its scope by creating the concept of a noncontingent obligation to "stand ready" to perform over the term of the guarantee in the event that specified triggering events or conditions occur.

Guarantors are now required to recognize, at the inception of a guarantee, a liability for the fair value of the obligations they have undertaken in issuing the guarantee. The liability consists of two elements:

The dividing line between equity and liabilities seems clear in concept. FASB Concepts Statement No. 6, Elements of Financial Statements, defines equity as net assets, that is, the residual interest that remains in the assets of an entity after deducting its liabilities. In practice, however, the difference may be obscured. Certain securities issued by business enterprises seem to have characteristics of both liabilities and equity in varying degrees, or the name given to some securities may not accurately describe their essential characteristics.

FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, provides guidance on accounting for freestanding financial instruments that have both liability and residual-interest characteristics, including those that comprise more than one option or forward contract. Financial instruments are freestanding if they are entered into separately from other interests or transactions or are legally detachable and separately exercisable. At the time of this writing, the FASB has on its agenda a project to develop a comprehensive standard on financial instruments with characteristics of equity, liabilities, or both. That project is also expected to produce amendments to the definition of a liability in Concepts Statement No. 6, aspects of which are already reflected in Statement No. 150.

Three classes of freestanding financial instruments are required to be classified as a liability (or an asset in some cases):

With one exception, all instruments within the scope of Statement No. 150 are initially measured at their fair value. The exception is that, for freestanding "physically settled" forward purchase contracts that obligate the issuer to purchase a fixed number of its own shares for cash, fair value is adjusted for any consideration or unstated rights or privileges that may have affected the terms of the transaction. For example, if the underlying shares are expected to pay dividends before the repurchase date, the dividends should be reflected in the implicit interest rate used in determining the fair value of the instrument. For another example, if a physically settled forward purchase contract on the issuer's own shares is issued to a customer to whom the issuer simultaneously sold a product at a discount, that discount would be taken into account in arriving at an appropriate implied discount rate.

With two exceptions, all instruments within the scope of Statement No. 150 are subsequently measured at fair value, with changes in fair value recognized in earnings. The two exceptions are the physically settled forward purchase contracts discussed above and mandatorily redeemable instruments. If both the amount to be paid under a physically settled forward purchase contract or a mandatorily redeemable instrument and the settlement date are fixed, the liability is measured subsequently at the present value of the amount to be paid at settlement, accruing interest cost at the rate implicit at inception. If either the amount to be paid or the settlement date varies based on specified conditions, the liability is measured subsequently at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, and the difference between the amount so determined and the amount reported for the liability at the previous reporting date would be reflected in interest cost.

Entities that have only one class of "equity" instruments, all of which are mandatorily redeemable financial instruments required to be classified as liabilities, must describe those instruments in the balance sheet as "shares subject to mandatory redemption" to distinguish them from other liabilities. Similarly, payments to holders of such instruments and related accruals must be presented separately from payments to and interest due to other creditors in the statement of cash flows and in the income statement. In addition, such entities must disclose the related par value and paid-in capital amounts separately from retained earnings or accumulated deficit.

FASB Statement No. 150 requires disclosure of detailed information about each financial instrument within its scope. In addition, FASB Statement No. 129, Disclosure of Information about Capital Structure, requires entities that issue redeemable stock to disclose the amount of redemption requirements, separately by issue or combined, for all issues of capital stock that are redeemable at fixed or determinable prices on fixed or determinable dates in each of the five years following the date of the latest statement of financial position presented.

If a debtor has difficulty making scheduled payments on a debt, a restructuring of the debt may be arranged. That is, the creditor may agree to alter the payments of principal, interest, or both in such a manner as to make it more likely that the debtor can make the payments. For example, the creditor may agree to a reduction in the original interest rate, deferral of interest payments, extension of the time for payment of principal, a reduction in the absolute value of the principal amount, or some combination thereof. Creditors may also accept cash, other assets, or an equity interest in the debtor in satisfaction of the debt even though the value received is less than the amount of the debt.

FASB Statement No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings," governs the accounting for the restructuring of a "contractual ... obligation to pay money on demand or on fixed or determinable dates that is already included as ... [a] liability in the ... debtor's balance sheet at the time of the restructuring." Examples of such obligations are accounts payable, debentures and bonds, and related accrued interest. Statement No. 15 does not apply, however, to lease agreements; employment-related agreements; or debtors' failure to pay trade payables according to their terms, or creditors' delays in taking legal action to collect overdue amounts of interest and principal, unless they involve an agreement between the debtor and creditor to restructure.

Under FASB Statement No. 15, if the debtor transfers its receivables from third parties, real estate, or other assets to a creditor to settle fully a debt, the debtor should recognize a gain on "restructuring" of the debt equal to the excess of (1) the carrying amount of the debt settled (including accrued interest and unamortized premium or discount, finance charges, and issue costs, as applicable) over (2) the fair value of the assets transferred. Fair value of assets is measured by (in order of preference): (1) their market value in an active market, (2) the selling prices of similar assets for which there is an active market, or (3) a forecast of expected cash flows, discounted at a rate commensurate with the risk involved.

If only the terms of the debt are modified (i.e., no assets or equity interest are transferred), the carrying amount of the payable at the time of the restructuring is not changed unless it exceeds the total future cash payments (undiscounted) specified by the new terms. If the total future cash payments specified by the new terms are less than the carrying amount of the payable:

If the debtor may be required to pay additional amounts based on a contingency such as its financial condition improving, the debtor must assume that the contingent future payments will have to be paid and include them in the "total future cash payments specified by the new terms" to the extent necessary to prevent recognition of a gain on restructuring that may be offset in future periods. The same principle applies if the amount of future payments is uncertain, for example, if the number of future interest payments is uncertain because the principal and accrued interest are payable on demand.

If a troubled debt restructuring involves a partial settlement by transferring assets or granting an equity interest and a modification of terms of the remaining payable, the carrying amount of the payable should first be reduced by the fair value of the assets transferred or equity interest granted. The difference between the carrying amount and the fair value of the assets transferred is recognized as a gain or loss. The reduced carrying amount of the debt is then compared with the total future cash payments specified by the new terms in accounting for the portion of the restructuring that is a modification of terms of the remaining debt.

Interest expense is recorded by the debtor subsequent to the restructuring so that a constant effective interest rate is applied to the carrying amount of the payable at the beginning of the period between the restructuring and the maturity. That is, in substance, the interest method prescribed by APB Opinion No. 21 and described elsewhere in this chapter (Sections 25.2 and 25.5). If a gain is recognized on a troubled debt restructuring, no interest expense is recognized on the debt going forward, other than for any contingent interest payments.

Also, Statement No. 15 requires disclosure of the principal features of a restructuring, of any gain or loss, and of the per share effects.

FASB Technical Bulletin No. 81-6, "Applicability of FASB Statement 15 to Debtors in Bankruptcy Situations," indicates that the principles of troubled debt restructuring of Statement No. 15 do not apply if a company is involved in a Chapter 11 bankruptcy proceeding that will result in a restatement of all of its indebtedness, say at 50 cents on the dollar. However, Statement No. 15 would apply to an isolated troubled debt restructuring by a debtor involved in a bankruptcy proceeding as long as it did not result in a general restatement of the debtor's liabilities.

The following conditions would indicate that a debt restructuring may not be a troubled debt restructuring for purposes of Statement No. 15:

Statement No. 15 notes that, in general, a debtor that can obtain funds from sources other than the existing creditor at market interest rates at or near those for nontroubled debt is not involved in a troubled debt restructuring.

EITF Issue No. 02-4, "Determining Whether a Debtor's Modification or Exchange of Debt Instruments Is within the Scope of FASB Statement No. 15," provides further guidance for determining whether an event is a troubled debt restructuring for purposes of Statement No. 15. If a modification or exchange of debt instruments is not within the scope of Statement No. 15, the provisions of EITF No. 96-19, "Debtor's Accounting for a Modification or Exchange of Debt Instruments" (see below), should be applied.

FASB Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," provides guidance to debtors as to when debt should be considered to be extinguished for financial reporting purposes:

Previously under FASB Statement No. 76, "Extinguishment of Debt," a debtor considered debt to be extinguished if it irrevocably placed cash or other assets in a trust to be used solely for satisfying scheduled payments of both interest and principal of a specific obligation and the possibility that the debtor would be required to make future payments with respect to the debt was remote. An in-substance defeasance transaction does not meet Statement No. 140's criteria for derecognizing a liability. For debt that was considered defeased under the provisions of FASB Statement No. 76, there should continue to be a general description of the defeasance transaction and the amount of the debt that is considered extinguished at the end of the period so long as that debt remains outstanding.

If a creditor releases a debtor from primary obligation on the condition that a third party assumes the obligation and the original debtor becomes secondarily liable as guarantor, the original debtor treats the release as an extinguishment. However, as a guarantor, the original debtor must recognize a guarantee obligation in the same manner as had he never been primarily liable to that creditor, with due regard for the likelihood that the third party will perform on its obligation. The guarantee obligation is initially measured at its fair value and that amount reduces the gain or increases the loss recognized on extinguishment.

In EITF Issue No. 96-19, the Task Force reached a consensus that an exchange of debt instruments with substantially different terms is debt extinguishment and should be accounted for in accordance with paragraph 16 of Statement 125 (par. 16 of Statement No. 125 is now included in FASB Statement No. 140). Thus, a substantial modification of terms should be accounted for like, and reported in the same manner as, an extinguishment.

EITF No. 96-19 concluded that, from the debtor's perspective, an exchange of debt instruments between or a modification of a debt instrument by a debtor and a creditor in a nontroubled debt situation is deemed to have been accomplished with debt instruments that are substantially different if present value of the cash flows under the terms of the new debt instrument is at least 10 percent different from the present value of the remaining cash flows under the terms of the original instrument.

Cash flows can be affected by changes in principal amounts, interest rates, or maturity. They can also affected by fees exchanged between the debtor and creditor to change:

If the terms of a debt instrument are changed or modified in any of the ways described above and the cash flow effect on a present value basis is less than 10 percent, the debt instruments are not considered to be substantially different.

The following guidelines are to be used to calculate the present value of the cash flows for purposes of applying the 10 percent test:

If it is determined that the original and new debt instruments are substantially different, the calculation of the cash flows related to the new debt instrument at the effective interest rate of the original debt instrument is not used to determine the initial amount recorded for the new debt instrument or to determine the debt extinguishment gain or loss to be recognized. The new debt instrument should be initially recorded at fair value, and that amount should be used to determine the debt extinguishment gain or loss to be recognized and the effective rate of the new instrument

If it is determined that the original and new debt instruments are not substantially different, a new effective rate must be determined based on the carrying amount of the original debt instrument and the revised cash flows.

Fees paid by the debtor to the creditor or received by the debtor from the creditor (fees may be received by the debtor from the creditor to cancel a call option held by the debtor or to extend a no-call period) as part of the exchange or modification are to be accounted for as follows:

Costs incurred with third parties directly related to the exchange or modification (such as legal fees) are to be accounted for as follows:

EITF Issue No. 96-19 also carried over the consensus from EITF Issue No. 86-18, which it superseded, that a borrower should not account for the original debt securities as extinguished and that those securities should not be offset against the receivable from the third party in the borrower's financial statements in the following situation:

In recent years numerous modifications to traditional debt instruments have required the EITF to address the accompanying accounting issues. In one instance, a traditional convertible debt instrument was modified by giving the buyer the option to put (sell) the issue back to the issuer at a premium. Other modifications to traditional debt have included debt issuances that have altered the traditional way in which interest rates are set. There have been issuances of debt with increasing interest rates and deferral of the setting of interest rates as well as issuances of debt instruments that provide not only for principal repayment, but also contingent payments. Companies have also sold their marketable securities granting the buyer the right to sell those assets back to the issuer. Those modifications have led to such fundamental questions as whether the transaction is a sale or a borrowing, the amount of liability to be accrued, the amount of interest expense and pattern of interest recognition, and the method of accounting for possible impairments. The following section summarizes both the accounting issues that have arisen from these financial instrument modifications and the EITF consensus agreements on acceptable accounting.

Under FASB Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," a transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets is accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met:

If a transfer of financial assets does not meet criteria for sales recognition, the transferor accounts for the transaction as a secured borrowing with a pledge of collateral.