Intent and Ability to Refinance on a Long-Term Basis

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> Intent and Ability to Refinance on a Long-Term Basis

45-14     A short-term obligation shall be excluded from current liabilities if the entity intends to refinance the obligation on a long-term basis and the intent to refinance the short-term obligation on a long-term basis is supported by an ability to consummate the refinancing demonstrated in either of the following ways:

a.  Post-balance-sheet-date issuance of a long-term obligation or equity securities. After the date of an entity's balance sheet but before that balance sheet is issued or is available to be issued (as discussed in Section 855-10-25), a long-term obligation or equity securities have been issued for the purpose of refinancing the short-term obligation on a long-term basis. If equity securities have been issued, the short-term obligation, although excluded from current liabilities, shall not be included in owners' equity.

Case 14-10 (concluded)

b.  Financing agreement. Before the balance sheet is issued or is available to be issued (as discussed in Section 855-10-25), the entity has entered into a financing agreement that clearly permits the entity to refinance the short-term obligation on a long-term basis on terms that are readily determinable.

1.  The agreement does not expire within one year (or operating cycle from the date of the entity's balance sheet and during that period the agreement is not cancelable by the lender or the prospective lender or investor (and obligations incurred under the agreement are not callable during that period) except for violation of a provision with which compliance is objectively determinable or measurable. For purposes of this Subtopic, violation of a provision means failure to meet a condition set forth in the agreement or breach or violation of a provision such as a restrictive covenant, representation, or warranty, whether or not a grace period is allowed or the lender is required to give notice. Financing agreements cancelable for violation of a provision that can be evaluated differently by the parties to the agreement (such as a material adverse change or failure to maintain satisfactory operations) do not comply with this condition.

2.  No violation of any provision in the financing agreement exists at the balance sheet date and no available information indicates that a violation has occurred thereafter but before the balance sheet is issued or is available to be issued or, if one exists at the balance sheet date or has occurred thereafter, a waiver has been obtained.

3.  The lender or the prospective lender or investor with which the entity has entered into the financing agreement is expected to be financially capable of honoring the agreement.

Analysis Case 14-11

Requirement 1

Earnings are not affected by conversion under the book value method. On the other hand, a gain or loss is recorded and thus earnings are affected by conversion if the market value method is used and the market value differs from the book value of the convertible bonds. In this case, the $6 million fair value of the common stock is higher than the book value of the bonds because the book value would be some amount less than the face amount of 20% x $25 million. A loss would be recorded for the difference, reducing earnings.

Requirement 2

The 7% bonds were issued at a discount (less than face amount). We know this because the stated rate was less than the prevailing or market rate for bonds of similar risk and maturity at the time the bonds were issued. Thus, the bonds would have to be sold at a discount for them to yield 8%.

Requirement 3

The amount of interest expense would be less in the first year of the term to maturity than in the second year of the life of the bond issue. That’s because the 8% effective interest rate is applied to an increasing bond carrying amount, and results in higher interest expense in each successive year.

Requirement 4

We determine gain or loss on early extinguishment of debt by comparing the book value of the bonds at the date of extinguishment with the purchase price. If more is paid than the book value, a loss results. If less is paid than the book value, a gain results. In this case, a loss results. The bonds were issued at a discount so the book value of the bonds at the date of extinguishment must be less than the face amount. Thus, the reacquisition price is more than the book value.

British Airways Case

Requirement 1

Using IFRS, as British Airways does, companies use the “net method” to record notes and other borrowings. A discount on notes would be recorded only using the “gross method,” in which a borrowing sold for less than face value is recorded with a contra-liability account – Discount. The discount is then amortized over the life of the debt. Under IFRS, the discount also is amortized over the life of the debt, but credited directly to the note account rather than to a separate discount account. Thus, “Amortization of discount” in Sealy’s statement of cash flows does not and would not appear in the corresponding note of British Airways.

Under U.S. GAAP, debt issue costs are recorded separately as an asset and then amortized as reported by Sealy. A conceptually more appealing treatment, and the one prescribed by IFRS, is to reduce the recorded amount of the debt by the debt issue costs (called transaction costs under IFRS).

British Airways Case (continued)

Requirement 2

BA does not report any convertible securities.

Under IFRS, convertible debt is divided into its liability and equity elements. We achieve separation by measuring the fair value of a similar liability that does not have an associated equity component. In the exercise, we know that bonds similar in all respects, except that they are nonconvertible, currently are selling at 99 (99% of face amount), so the liability-first separation gives us the following entry:

Cash(101% x $300M) 303

Convertible bonds payable (99% x£300 million)*297

Equity – conversion option (to balance) 6

* Note that the discount on the bonds (£300 million – [99% x $300 million] = £3 million) is combined with the face amount, and the net amount is recorded as Convertible bonds payable. This is the “net method” which is the preferred approach under IFRS.

Under U.S. GAAP, the entire issue price of convertible debt is recorded as debt:

Cash(given) 303

Convertible bonds payable (face amount) 300

Premium on bonds payable (to balance) 3

Requirement 3

If the BA had elected the FVO for all of its fixed rate borrowings, the Fair value adjustment account would have a March 31, 2009 debit balance of £56 million, the difference between the £442 million carrying value and the £386 million fair value.

British Airways Case (concluded)

Requirement 4

International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option for financial assets and liabilities. Under IFRS No. 39, companies can elect the fair value option only in specific circumstances.

To avoid misuse, the fair value option is limited to only those financial instruments falling into one of the following categories.

• a group of financial assets, financial liabilities, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, or

• the fair value option designation eliminates or significantly reduces an “accounting mismatch” that would otherwise arise if we measured the assets or liabilities or recognized gains and losses on them on different measurement bases.

Although U.S. GAAP guidance indicates that the intent of the fair value option under U.S. GAAP is to address these sorts of circumstances, it does not require that those circumstances exist.

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