Tag: Practice of Life Insurance Osmania University B.com Notes

A change in reporting entity is a change that results in financial statements that are effectively those of a different reporting entity. This usually involves changing from individual to consolidated reporting, or altering the subsidiaries that make up a group of entities whose results are consolidated.

A change in reporting entity requires retrospective treatment, which means that any prior periods that will be presented in the current year financial statements need to be restated. A change in reporting entity specifically addresses the fact that the comparable financial periods need to include the financial results for the same legal entities or reporting units.

A change in reporting entity occurs when two or more previously separate entities are combined into one entity for reporting purposes, or when there is a change in the mix of entities being reported. When this combination occurs, the resulting entity must restate any prior financial statements that it is including in its reporting package for comparison purposes. By doing so, users of the financial statements can more accurately assess current performance against historical results. The reason for the change in reporting entity must be included in the disclosures that accompany the financial statements of the reporting entity.

A change in reporting entity is:

“A change that results in financial statements that, in effect, are those of a different reporting entity.”

A change in reporting entity is generally limited to the following types of changes:

• Changing specific subsidiaries that make up the group of entities for which consolidated financial statements are presented.
• Presenting consolidated or combined financial statements in place of financial statements of individual entities.
• Changing the entities included in combined financial statements.

Changes in the reporting entity mainly transpire from significant restructuring activities and transactions.  Neither business combinations accounted for by the acquisition method nor the consolidation of a variable interest entity (VIE) are considered changes in the reporting entity.

For financial statements of periods in which there has been a change in reporting entity, an entity should disclose the nature of and reasons for the change.   In addition, the effect of the change on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), other comprehensive income, and any related per-share amounts shall be disclosed for all periods presented.  If the change in reporting entity does not have a material effect in the period of change, but is expected to in future periods, any financial statements that include the period of change should disclose the nature of and reasons for the change in reporting entity.

Step 1: Identify an Error

Accounting changes should be distinguished from error corrections. An error in previously issued financial statements is:

“An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of generally accepted accounting principles (GAAP), or oversight or misuse of facts that existed at the time the financial statements were prepared.”

Accordingly, a change in an accounting policy from one that is not generally accepted by GAAP to one that is generally accepted by GAAP is considered an error correction, not a change in accounting principle. Likewise, if information is misinterpreted or old data is used when more current information is available in developing an estimate, an error exists, not a change in estimate.  Moreover, as it relates to the classification and presentation of account balances on the face of the financial statements, many confuse errors with “reclassifications”. Changing the classification of an account balance from an incorrect presentation to the correct presentation is considered an error correction, not a reclassification (see Section 4 below for more on reclassifications).

Step 2: Assess Materiality of Error

Once an error is identified, the accounting and reporting conclusions will depend on the materiality of the error(s) to the financial statements. In connection with decisions related to the interpretation of federal securities laws, the Supreme Court has concluded that an item is considered material if there is “a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”  While assessing the materiality of an error is not the subject of this publication, companies (particularly SEC registrants) are directed to consider both the quantitative and qualitative considerations outlined in the extensive materiality guidance set forth in SEC Staff Accounting Bulletin (“SAB”) Topics 1.M and 1.N (formerly referred to as SAB Nos. 99 and 108, respectively).  Materiality should be assessed with respect to the misstatement’s impact on prior period financial statements and, in the event prior period financial statements are not restated or adjusted, with respect to the impact of the misstatement’s correction on the current period financial statements.

Step 3: Report Correction of Error

Reporting the correction of the errors depends on the materiality of the errors to both the current period and prior period financial statements.  The error is corrected through one of the following three methods: 

Out-of-period adjustment: An error is corrected within the current period as an out-of-period adjustment when it is considered to be clearly immaterial to both the current and prior period(s).  Disclosures are generally not required for immaterial out-of-period adjustments. However, there may be circumstances in which the out-of-period adjustment stands out (e.g., it appears as a reconciling item in the rollforward of an account balance) that may warrant consideration of disclosure about the item’s nature.     

“Little r restatement”: An error is corrected through a “Little r restatement” (also referred to as a revision restatement) when the error is immaterial to the prior period financial statements; however, correcting the error in the current period would materially misstate the current period financial statements (e.g., this often occurs as a result of an immaterial error that has been uncorrected for multiple periods and has aggregated to a material number within the current year). Under this approach, the entity would correct the error in the current year comparative financial statements by adjusting the prior period information and adding disclosure of the error. 

“Big R Restatement”: An error is corrected through a “Big R restatement” (also referred to as re-issuance restatements) when the error is material to the prior period financial statements. A Big R restatement requires the entity to restate and reissue its previously issued financial statements to reflect the correction of the error in those financial statements. Correcting the prior period financial statements through a Big R restatement is referred to as a “restatement” of prior period financial statements.

Contingencies

When estimating the cost for a project, product or other item or investment, there is always uncertainty as to the precise content of all items in the estimate, how work will be performed, what work conditions will be like when the project is executed and so on. These uncertainties are risks to the project. Some refer to these risks as “known-unknowns” because the estimator is aware of them, and based on past experience, can even estimate their probable costs. The estimated costs of the known-unknowns is referred to by cost estimators as cost contingency.

Contingency “refers to costs that will probably occur based on past experience, but with some uncertainty regarding the amount. The term is not used as a catchall to cover ignorance. It is poor engineering and poor philosophy to make second-rate estimates and then try to satisfy them by using a large contingency account. The contingency allowance is designed to cover items of cost which are not known exactly at the time of the estimate but which will occur on a statistical basis.”

The cost contingency which is included in a cost estimate, bid, or budget may be classified as to its general purpose, that is what it is intended to provide for. For a class 1 construction cost estimate, usually needed for a bid estimate, the contingency may be classified as an estimating and contracting contingency. This is intended to provide compensation for “estimating accuracy based on quantities assumed or measured, unanticipated market conditions, scheduling delays and acceleration issues, lack of bidding competition, subcontractor defaults, and interfacing omissions between various work categories.” Additional classifications of contingency may be included at various stages of a project’s life, including design contingency, or design definition contingency, or design growth contingency, and change order contingency (although these may be more properly called allowances).

AACE International has defined contingency as “An amount added to an estimate to allow for items, conditions, or events for which the state, occurrence, or effect is uncertain and that experience shows will likely result, in aggregate, in additional costs. Typically estimated using statistical analysis or judgment based on past asset or project experience. Contingency usually excludes:

• Major scope changes such as changes in end product specification, capacities, building sizes, and location of the asset or project
• Extraordinary events such as major strikes and natural disasters
• Management reserves
• Escalation and currency effects

Some of the items, conditions, or events for which the state, occurrence, and/or effect is uncertain include, but are not limited to, planning and estimating errors and omissions, minor price fluctuations (other than general escalation), design developments and changes within the scope, and variations in market and environmental conditions. Contingency is generally included in most estimates, and is expected to be expended”.

A key phrase above is that it is “expected to be expended”. In other words, it is an item in an estimate like any other, and should be estimated and included in every estimate and every budget. Because management often thinks contingency money is “fat” that is not needed if a project team does its job well, it is a controversial topic.

In general, there are four classes of methods used to estimate contingency. .” These include the following:

• Expert judgment
• Predetermined guidelines (with varying degrees of judgment and empiricism used)
• Simulation analysis (primarily risk analysis judgment incorporated in a simulation such as Monte-Carlo)
• Parametric Modeling (empirically-based algorithm, usually derived through regression analysis, with varying degrees of judgment used).

Assume a company has issued fixed-rate debt, but the majority of their interest-earning assets earn interest based on variable interest rates. The company is exposed to interest rate risk because if interest rates decline substantially, the income earned on their interest earning assets will be less, while the interest payable on their debt remains constant at the fixed rate.

To mitigate this risk, a pay-variable, receive-fixed interest rate swap could be used to “free” themselves from this fixed position. If the hedge qualifies for fair value hedge accounting, then the derivative unlocks the fixed-rate debt, protecting against exposure to changes in fair value of the debt.

Under fair value hedge accounting, the derivative must be recorded at fair value with changes in fair value presented in the same income statement line item as the earnings effect of the hedged item.

Additionally, the change in fair value of the hedged item due to the risk being hedged is recorded as an adjustment to the hedged item through the income statement in the same account line item that normally would be used for that underlying asset or liability.

Fair value hedge

Fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability or unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.

Cash flow hedges are used when hedging the variability of cash flows. For example, assume a company issues variable rate debt while the majority of their interest-earning assets are in the form of fixed interest receivables. They are at risk of changes in interest rates because if interest rates increase substantially, the income being earned on their interest earning assets will be constant or fixed, while the interest payable on their debt will fluctuate with the changes in rates.

To mitigate this risk, a receive-variable, pay-fixed interest rate swap could be used to protect against future cash flow uncertainty. If the hedge qualifies for cash flow hedge accounting, then the derivative fixes or locks-in the debt interest payments, protecting against changes in cash flows due to changes in interest rates.

Steps:

Step 1:

Determine the fair value of both your hedged item and hedging instrument at the reporting date;

Step 2:

Recognize any change in fair value (gain or loss) on the hedging instrument in profit or loss (in most cases).

You need to do the same in most cases even if you don’t apply the hedge accounting, because you need to measure all derivatives (your hedging instruments) at fair value anyway.

Step 3:

Recognize the hedging gain or loss on the hedged item in its carrying amount.

Accounting treatment:

Cash flow hedge

Cash flow hedges can help to mitigate the risks that are associated with sudden changes in cash flows of assets or liabilities, rather than the asset or liability itself. There are many different factors that can bring about these sorts of changes, such as increases/decreases in foreign exchange rates, changes in interest rates, changes in asset prices, and so on.

Cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or a component of a recognized asset or liability or a highly probable forecast transaction, and could affect profit or loss.

Again, that’s the definition in IAS 39 and IFRS 9.

Here, you have some “variable item” and you’re worried that you might get less money or have to pay more money in the future than now.

Steps:

Assuming your cash flow hedge meets all hedge accounting criteria, you’ll need to make the following steps:

Step 1:

Determine the gain or loss on your hedging instrument and hedge item at the reporting date;

Step 2:

Calculate the effective and ineffective portions of the gain or loss on the hedging instrument;

Step 3:

Recognize the effective portion of the gain or loss on the hedging instrument in other comprehensive income (OCI). This item in OCI will be called “Cash flow hedge reserve” in OCI.

Step 4:

Recognize the ineffective portion of the gain or loss on the hedging instrument in profit or loss.

Step 5:

Deal with a cash flow hedge reserve when necessary. You would do this step basically when the hedged expected future cash flows affect profit or loss, or when a hedged forecast transaction occurs

Accounting entries for a cash flow hedge:

Fair Value Hedge vs Cash Flow Hedge

• Fair value hedge is hedging against the risk on the fair value of an asset which is expected to impact the financial statement whereas as a cash flow hedge aims at mitigating the risk associated with the cash flows.
• The cash flow hedge mitigates the vulnerability of a cash flow related to an asset, liability or a transaction that is related to a particular risk. A cash flow hedge is formulated in a way that it minimizes the risk that a company might end up paying more for a raw material than what it expects.

IFRS 13 seeks to increase consistency and comparability in fair value measurements and related disclosures through a ‘fair value hierarchy’. The hierarchy categorises the inputs used in valuation techniques into three levels. The hierarchy gives the highest priority to (unadjusted) quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

If the inputs used to measure fair value are categorised into different levels of the fair value hierarchy, the fair value measurement is categorised in its entirety in the level of the lowest level input that is significant to the entire measurement (based on the application of judgement).

Level 1 inputs

Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.

A quoted market price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available, with limited exceptions.

If an entity holds a position in a single asset or liability and the asset or liability is traded in an active market, the fair value of the asset or liability is measured within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the entity, even if the market’s normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price.

Level 2 inputs

Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 2 inputs include:

quoted prices for similar assets or liabilities in active markets quoted prices for identical or similar assets or liabilities in markets that are not active inputs other than quoted prices that are observable for the asset or liability, for example

interest rates and yield curves observable at commonly quoted intervals implied volatilities credit spreads

inputs that are derived principally from or corroborated by observable market data by correlation or other means (‘market-corroborated inputs’).

Level 3 inputs

Level 3 inputs inputs are unobservable inputs for the asset or liability.

Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. An entity develops unobservable inputs using the best information available in the circumstances, which might include the entity’s own data, taking into account all information about market participant assumptions that is reasonably available.

The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants and the measurement date under current market conditions. Three widely used valuation techniques are:

Market approach: Uses prices and other relevant information generated by market transactions involving identical or comparable (similar) assets, liabilities, or a group of assets and liabilities (e.g. a business)

Cost approach: Reflects the amount that would be required currently to replace the service capacity of an asset (current replacement cost)

Income approach: Converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts.

Fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market for the asset or liability. The principal market is the one with the greatest volume and level of activity for the asset or liability that can be accessed by the entity.

The most advantageous market is the one, which maximises the amount that would be received for the asset or paid to extinguish the liability after transport and transaction costs. Often these markets would be the same.

Sensibly an entity does not have to carry out an exhaustive search to identify either market but should take into account all available information. Although transaction costs are taken into account when identifying the most advantageous market, the fair value is calculated before adjustment for transaction costs because these costs are characteristics of the transaction and not the asset or liability. However, if location is a factor, then the market price is adjusted for the costs incurred to transport the asset to that market. Market participants must be independent of each other and knowledgeable, and able and willing to enter into transactions.

This is a complex process and so IFRS 13 sets out a valuation approach, which refers to a broad range of techniques, which can be used. There are three approaches based on the market, income and cost. When measuring fair value, the entity is required to maximise the use of observable inputs and minimise the use of unobservable inputs. To this end, the standard introduces a fair value hierarchy, which prioritises the inputs into the fair value measurement process

Fair value measurements are categorised into a three-level hierarchy, based on the type of inputs to the valuation techniques used, as follows:

Level 1 inputs are unadjusted quoted prices in active markets for items identical to the asset or liability being measured. As with current IFRS standards, if there is a quoted price in an active market, an entity uses that price without adjustment when measuring fair value. An example of this would be prices quoted on a stock exchange. The entity needs to be able to access the market at the measurement date. Active markets are ones where transactions take place with sufficient frequency and volume for pricing information to be provided. An alternative method may be used where it is expedient. The standard sets out certain criteria where this may be applicable. For example where the price quoted in an active market does not represent fair value at the measurement date. An example of this may be where a significant event takes place after the close of the market such as a business reorganisation or combination.

The determination of whether a fair value measurement is based on level 2 or level 3 inputs depends on:

• Whether the inputs are observable inputs or unobservable
• Their significance.

Level 2 inputs are inputs other than the quoted prices in determined in level 1 that are directly or indirectly observable for that asset or liability. They are likely to be quoted assets or liabilities for similar items in active markets or supported by market data. For example, interest rates, credit spreads or yields curves. Adjustments may be needed to level 2 inputs and, if this adjustment is significant, then it may require the fair value to be classified as level 3.

Finally, level 3 inputs are unobservable inputs. These inputs should be used only when it is not possible to use Level 1 or 2 inputs. The entity should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. However, situations may occur where relevant inputs are not observable and therefore these inputs must be developed to reflect the assumptions that market participants would use when determining an appropriate price for the asset or liability. The general principle of using an exit price remains and IFRS 13 does not preclude an entity from using its own data. For example cash flow forecasts may be used to value an entity that is not listed. Each fair value measurement is categorised based on the lowest level input that is significant to it.

IFRS 13 also sets out certain valuation concepts to assist in the determination of fair value. For non-financial assets only, fair value is determined based on the highest and best use of the asset as determined by a market participant. Highest and best use is a valuation concept that considers how market participants would use a non-financial asset to maximise its benefit or value. The maximum value of a non-financial asset to market participants may come from its use in combination with other assets and liabilities or on a standalone basis. In determining the highest and best use of a non-financial asset, IFRS 13 indicates that all uses that are physically possible, legally permissible and financially feasible should be considered. As such, when assessing alternative uses, entities should consider the physical characteristics of the asset, any legal restrictions on its use and whether the value generated provides an adequate investment return for market participants.

The fair value measurement of a liability, or the entity’s own equity, assumes that it is transferred to a market participant at the measurement date. In many cases there is no observable market to provide pricing information and the highest and best use is not applicable. In this case, the fair value is based on the perspective of a market participant who holds the identical instrument as an asset. If there is no corresponding asset, then a corresponding valuation technique may be used. This would be the case with a decommissioning activity. The fair value of a liability reflects the non performance risk based on the entity’s own credit standing plus any compensation for risk and profit margin that a market participant might require to undertake the activity. Transaction price is not always the best indicator of fair value at recognition because entry and exit prices are conceptually different.

The guidance includes enhanced disclosure requirements that include:

• Information about the hierarchy level into which fair value measurements fall
• Transfers between levels 1 and 2
• Methods and inputs to the fair value measurements and changes in valuation techniques, and
• Additional disclosures for level 3 measurements that include a reconciliation of opening and closing balances, and quantitative information about unobservable inputs and assumptions used.

Fair value of liabilities and equity

IFRS 13 requires that the fair value of a liability or equity instrument of the entity be determined under the assumption that the instrument would be transferred on the measurement date, but would remain outstanding (i.e., it is a transfer value not an extinguishment or settlement cost.).  Accordingly, the fair value of a liability must take account of non-performance risk, including the entity’s own credit risk

Offsetting positions

The new Standard allows a limited exception to the basic fair value measurement principles for a reporting entity that holds a group of financial assets and financial liabilities with offsetting positions in particular market risks as defined in IFRS 7, Financial Instruments: Disclosures, or counterparty credit risk (also as defined in IFRS 7) and manages those holdings on the basis of the entity’s net exposure to either risk. The exception allows the reporting entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position.

Valuation techniques

When transactions are directly observable in a market, the determination of fair value can be relatively straightforward, but when they are not, a valuation technique is used. IFRS 13 describes three valuation techniques that an entity might use to determiner fair value, as follows:

• The market approaches. An entity uses “prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities”.
• The income approaches. An entity converts future amounts (e.g., cash flows or income and expenses) to a single current (i.e., discounted) amount.
• The cost approach.

Premiums and discounts

IFRS 13 permits a premium or discount to be included in a fair value measurement only when it is consistent with the unit of account for the item. This means that premiums or discounts that reflect size as a characteristic of the entity’s holding (e.g. a blockage factor reducing the price which could be achieved on disposal of an entire large equity holding) rather than as a characteristic of the asset or liability (e.g. a control premium when measuring the fair value of a controlling interest) are not included.

Disclosures

IFRS 13 requires a number of quantitative and qualitative disclosures about fair value measurements. Many of these are related to the following three-level fair value hierarchy on the basis of the inputs to the valuation technique: Level 1 inputs are fully observable (e.g. unadjusted quoted prices in an active market for identical assets and liabilities that the entity can access at the measurement date); Level 2 inputs are those other than quoted prices within Level 1 that are directly or indirectly observable; and Level 3 inputs are unobservable.

A nonmonetary exchange is the transfer of assets and/or liabilities with another entity. The most common situation is when two organizations exchange assets, such as a real estate swap or the exchange of one fixed asset for another. The accounting for a nonmonetary exchange is based on the fair values of the assets transferred. This results in the following set of alternatives for determining the recorded cost of a nonmonetary asset acquired in an exchange, in declining order of preference:

• At the fair value of the asset received, if the fair value of this asset is more evident than the fair value of the asset transferred in exchange for it.
• At the fair value of the asset transferred in exchange for it. Record a gain or loss on the exchange.
• At the recorded amount of the surrendered asset, if no fair values are determinable or the transaction has no commercial substance.

Types of Non-Monetary transactions

The following are the types of non-monetary transactions.

• Non-reciprocal transfers with nonowners such as charitable donation of property by an entity, land contribution by state or local governments to a private enterprise for the purpose of setting up a structure.
• Non-reciprocal transfer to owners such as stock split, exchange of non-monetary assets for common stock.
• Non-monetary exchanges such as inventory exchange for a similar product or any productive asset. Or exchange of productive assets.

Accounting for an Exchange of Nonmonetary Assets

There can be any number of variations on the nonmonetary exchange concept, including ones where some cash is exchanged, along with other nonmonetary assets. If there is a significant amount of monetary consideration paid (known as boot), the entire transaction is considered to be a monetary transaction. In GAAP, a significant amount of boot is considered to be 25% of the fair value of an exchange. Conversely, if the amount of boot is less than 25%, the following accounting applies:

Payer. The party paying boot is not allowed to recognize a gain on the transaction.

Recipient. The receiver of the boot recognizes a gain to the extent that the monetary consideration is greater than a proportionate share of the carrying amount of the surrendered asset. This calculation is based on the percentage of monetary consideration received to either:

• The fair value of the nonmonetary asset received.
• Total consideration received
• Nonmonetary exchanges of inventory should be recognized at the carrying amount of the inventory transferred.

Exchanges with commercial substance

A business transaction is said to have commercial substance when it is expected that the future cash flows of a business will change as a result of the transaction. A change in cash flows is considered to be when there is a significant change in any one of the following:

• Such as a change in the timing of cash inflows received as the result of a transaction; for example, a business agrees to a delayed payment in exchange for a larger amount.
• Such as experiencing an increase in the risk that inbound cash flows will not occur as the result of a transaction; for example, a business accepts junior secured status on a debt in exchange for a larger repayment amount.
• Such as a change in the amount paid as the result of a transaction; for example, a business receives cash sooner in exchange for receiving a smaller amount.

A contract is said to have the commercial substance if because of that contract there is a change in timing of cash flow, there is an increment in the cash flow, there is a change in the risk, or more benefits occur due to contract.

For example, A Ltd entered into a contract with ABX and Co. who is a major supplier of raw material required by A Ltd. for production of goods for supplying materials to A ltd.at a cost lower than the cost at which A Ltd. was buying from other suppliers, and because of it, the cost of production is decreased as a result the benefits will also be transferred to the customers by decreasing the selling price which thereby results in the increase in revenue. In this whole scenario, since there is a change in cash flow, it is said to have existed in the contract.

The concept of commercial substance is also applied to exchanges of assets between businesses. When there is commercial substance (which is when there is a change in cash flow resulting from the transaction), the parties should recognize a gain or loss on the exchange. If there is no commercial substance, record the acquired asset at the book value of the asset given up in the exchange. There are additional issues related to the recognition of a gain or loss when a transaction has no commercial substance.

Exchanges without commercial substance

situations where there is no commercial substance include:

• The swapping of bandwidth capacity by different Internet and phone service providers. By doing so, both entities recognize revenue, when in fact no real revenue generation occurs that would result in a change in profits.
• Sale of assets to the owner of a sole proprietorship, who immediately leases it back to the business. There is little distinction between a proprietorship and its owner, so it is likely that no real change of ownership occurred.

The retirement of bonds refers to the repurchase of bonds from investors that had been previously issued. The issuer retires bonds at the scheduled maturity date of the instruments. Or, if the bonds are callable, the issuer has the option to repurchase the bonds earlier; this is another form of retirement. Once bonds are retired, the issuer eliminates the bonds payable liability on its books.

Retirement of securities refers to the cancellation of stocks or bonds because their issuer has bought them back, or (in the case of bonds) because their maturity date has been reached.

Many securities are routinely bought back by their issuing company such as preferred stocks and corporate bonds. In the case of stock, this reduces the number of shares outstanding. In the case of bonds, it means that the company is essentially paying the investors who bought loaned them money their principal back and getting rid of its debt obligations.

Bond Retirement before Maturity

In some circumstances, the corporation or company wishes to retire all or some of its bonds before the maturity date. This is also called the early retirement of bonds. The main reason for the early retirement is the decreasing of interest significantly in the market. Thus, the issuers wish to replace its high-interest paying bonds with the new low-interest paying bonds.

There are two common ways that the issuers can retire their bonds before the maturity date. These are through the exercise a call option or purchase them through the open market.

Purchase on the open market: In this way, the issuers can retire the bonds early by repurchasing them on the open market. When the issuers repurchase bonds on the open market, they need to pay the bonds at the current price or current market value of the bonds.

Through exercise a call option: In this way, the issuers will need to issue a callable bond that allows them to exercise their right in order to retire the bonds early. In these callable bonds, the issuers reserve the right to exercise the option before the maturity by paying the par value bonds plus a call premium to the bondholders.

Bond Retirement at Maturity

For the retirement at maturity, the corporation issued the bond will need to repay the bondholders the carrying value of the bond. In this case, the carrying value of the bond is always equal to the par value of the bonds regardless of the bond issued at par, at a premium, or a discount.

Therefore, at the maturity date, the principal or par value of the bond will need to remove from the liability account.

Bond Retirement by Conversion

This retirement can be done through conversion. This occurs when a corporation issues convertible bonds that allow the bondholders to convert the bonds into common stock equity.

When the conversion occurs, the carrying value of the bonds is transferred to the equity account and there is no gain or loss recorded in the income statement. For a detailed calculation of the convertible bond, you can read another article on the convertible bond.

The journal entry for this retirement is as follow:

Bonds payable is a liability account that contains the amount owed to bond holders by the issuer. This account typically appears within the long-term liabilities section of the balance sheet, since bonds typically mature in more than one year. If they mature within one year, then the line item instead appears within the current liabilities section of the balance sheet.

Bonds payable are recorded when a company issues bonds to generate cash. As a bond issuer, the company is a borrower. As such, the act of issuing the bond creates a liability. Thus, bonds payable appear on the liability side of the company’s balance sheet. Generally, bonds payable fall in the non-current class of liabilities.

Terms of bonds payable are contained within a bond indenture agreement, which states the face amount of the bonds, the interest rate to be paid to bond holders, special repayment terms, and any covenants imposed on the issuing entity.

The carrying value is found through the following formula:

Carrying Value = Bonds Payable + Unamortized Premium/Discount

An entity is more likely to incur a bonds payable obligation when long-term interest rates are low, so that it can lock in a low cost of funds for a prolonged period of time. Conversely, this form of financing is less commonly used when interest rates spike. Bonds are typically issued by larger corporations and governments.

Important Terms

Coupon: Coupon payments represent the periodic interest payments from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the bond’s face value. As we note from above, Nike’s bond pays interest semiannually; generally, one half of the annual coupon is paid to the bondholders every six months.

Par value: The amount of money that is paid to the bondholders at maturity. It generally represents the amount of money borrowed by the bond issuer.

Maturity: Maturity represents the date on which the bond matures, i.e., the date on which the face value is repaid. The last coupon payment is also paid on the maturity date.

Coupon rate: The coupon rate, which is generally fixed, determines the periodic coupon or interest payments. It is expressed as a percentage of the bond’s face value. It also represents the interest cost of the bond to the issuer.

Convertible Bonds

A convertible bond is the same as the bond with warrants. The major difference between convertible bonds and warrants is that warrants can be separated into distinct securities but convertible bonds are not. Convertible bonds are the fixed income securities that would be converted into common stocks after a certain period of time. Therefore, the convertible bond gives the holder the right to exchange for its a given number of shares of common stock any time on or before the expiration date.

Convertible securities also give investors the right to exchange their bond or shares for common stock of the company. Each convertible security will give specifics on the number of shares you’ll receive upon conversion, as well as the expiration date by which the security must be converted. In some cases, conversion is mandatory, while other convertible securities leave the conversion decision at the discretion of the owner.

Warrants

Warrants are financial assets giving the holder the right but not obligation to buy shares of common stocks directly from the issuing authority at a fixed price for a given period of time. Each warrant specifies the number of shares of common stock a holder can purchase at the exercise price at the expiration date. Some features of warrants are the same as those of call options. From the viewpoint of the holders call options and warrants like the same. But still there exists a significant difference in contractual features of them. Say warrants have a long maturity period. Some warrants are the same as the perpetual having no expiration date at all. The basic difference between call options and warrants is that call options are issued by individuals and warrants are issued by the firms. When a warrant is exercised, a firm must issue new shares of stock. Each time a warrant is exercised, the number of shares outstanding increases. In case of a call, options are not necessary i.e., when a call option is exercised, there is no change in the number of shares outstanding. Warrants vs Convertible Bonds.

Warrants, on the other hand, typically don’t have any intrinsic value of their own. Unlike convertible securities, there’s no underlying bond or preferred shares that give the warrant owner any additional rights. The only value that the warrant has comes from its conversion feature.

Warrants resemble options in that they typically require investors to make an additional payment within a specified time frame in order to exercise the warrant and receive common stock in exchange. Warrants tend to have longer lifespans than ordinary options, with expiration dates as much as 10 years into the future being relatively common. Investors aren’t required to exercise warrants, but they’re worthless after they expire unexercised.

Both warrants and convertible securities have their place within the capital structure of a company. The investments have some things in common, but their differences also have maximum value to different sets of investors. Those who want maximum reward will prefer warrants, but those who want some protection from worst-case scenarios will gravitate toward convertible securities.

The major difference is that the equity option embedded in a convertible bond is not detachable from the convert, so that you have to value the bond and the embedded option together. If you want to make a direct comparison with a detachable warrant, you can think of the embedded option in a convertible bond as having a strike price equal to the value of the remaining cash flows of the convertible bond, so that the strike prices change over time as coupon payments are made, and changes with the level of both interest rates and the credit quality of the bond issuer.

Debt restructuring is a process that allows a private or public company or a sovereign entity facing cash flow problems and financial distress to reduce and renegotiate its delinquent debts to improve or restore liquidity so that it can continue its operations.

Replacement of old debt by new debt when not under financial distress is called “refinancing”. Out-of-court restructurings, also known as workouts, are increasingly becoming a global reality.

Debt restructuring involves a reduction of debt and an extension of payment terms and is usually less expensive than bankruptcy. The main costs associated with debt restructuring are the time and effort spent negotiating with bankers, creditors, vendors, and tax authorities.

Creditors of corporates are generally banks and non-banking financial companies (NBFCs). The corporate debt restructuring is done by lowering the amount of payable towards the debt. Also, the interest rate is lowered. However, the repayment tenure is enhanced, which would help the company in paying the outstanding dues.

At times, a part of the company’s debt would be waived off by the creditors. But, that would be in exchange for equities of the company. Nevertheless, this kind of arrangement is more favourable for the distressed company as compared to declaring themselves to be bankrupt and undergo tedious procedures.

Methods

Debt-for-equity swap

In a debt-for-equity swap, a company’s creditors generally agree to cancel some or all of the debt in exchange for equity in the company.

Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors. This is because both the debt and the remaining assets in these companies are so large that there is no advantage for the creditors to drive the company into bankruptcy. Instead, the creditors prefer to take control of the business as a going concern. As a consequence, the original shareholders’ stake in the company is generally significantly diluted in these deals and may be entirely eliminated.

Bondholder haircuts

A debt-for-equity swap may also be called a “bondholder haircut”. Bondholder haircuts at large banks were advocated as a potential solution for the subprime mortgage crisis by prominent economists:

Economist Joseph Stiglitz testified that bank bailouts “are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this”. He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.

Economist Jeffrey Sachs has also argued in favor of such haircuts: “The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices.”

If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute dollars and the government may be able to just provide guarantees in the short term to buttress confidence in the recapitalized institution. For example, Wells Fargo owed its bondholders $267 billion, according to its 2008 annual report. A 20% haircut would reduce this debt by about $54 billion, creating an equal amount of equity in the process, thereby recapitalizing the bank significantly.

Informal Debt Repayment Agreements

Companies that are restructuring debt can ask for lenient repayment terms and even ask to be allowed to write off some portions of their debt. This can be done by reaching out to the creditors directly and negotiating new terms of repayment. This is a more affordable method than involving a third-party mediator and can be achieved if both parties involved are keen to reach a feasible agreement.

Debt Restructuring vs. Debt Refinancing

Debt restructuring is distinct from debt refinancing. The former requires debt reduction and an extension to the repayment plan. On the other hand, debt refinancing is merely the replacement of an old debt with a newer debt, usually with slightly different terms, such as a lower interest rate.

Debt Restructuring vs. Bankruptcy

Debt restructuring usually involves direct negotiations between a company and its creditors. The restructuring can be initiated by the company or, in some cases, be enforced by its creditors.

On the other hand, bankruptcy is essentially a process through which a company that is facing financial difficulty is able to defer payments to creditors through a legally enforced pause. After declaring bankruptcy, the company in question will work with its creditors and the court to come up with a repayment plan.

In case the company is not able to honor the terms of the repayment plan, it must liquidate itself in order to repay its creditors. The repayment terms are then decided by the court.