Changes in Accounting for Debt - Essay Example

Under the exposure draft or ED, the liability and the equity components of a convertible bond should be separated and classified accordingly. However, under the ED, only those conversion options that “establish an ownership relationship will be classified as equity” (ED-FI, p. 4). How does SFAS 145 change accounting for early extinguishment of debt? Do the changes take into account different economic reasons for early payment of debt?

Before the issuance of SFAS 145, the standard used to account for the early extinguishment of debt was FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt. Under Statement No. 4, the gains or losses realized from the early settlement of debt should be shown as part of the company’s extraordinary items in its income statement. This classification is required regardless of the reason behind the early settlement.

Under SFAS 145, gains or losses from early extinguishment of debt can now be classified as part of the income or loss from continuing operations in the income statement; provided that early extinguishments of debts are part of the recurring transactions for the issuer. However, if such early extinguishments of debts are unusual or are infrequent transactions, the gains or losses realized from such early extinguishments should still be classified as extraordinary items in the income statement. The change was made because FASB recognized that early payments of debt have become part of the risk management strategy of certain companies. Such transactions are now also viewed as recurring financing activities that an entity can utilize to manage its interest rate risk. FASB also thinks that this change is consistent with the definition of unusual or extraordinary transactions under APB Opinion No. 30 and will reduce the frequency of using the caption “extraordinary items” in the income statement.

3. What effect does SFAS 145 have on the income statement and balance sheet?
The requirement of SFAS 145 related to the classification of gains or losses from early extinguishment of debt affects the income statement classification of the entity. If the entity’s early extinguishment of debt is a normal occurrence then the gain or loss will be reclassified from extraordinary items to income from continuing operations. This will affect the calculation of the earnings per share of the entity for continuing operations and extraordinary items. Such a requirement, however, will not affect the entity’s balance sheet.

The second major change made by SFAS 145 is the accounting for the changes in the lease terms (both for capital and operating leases), which should be the same as the accounting for sale-leaseback transactions. This requirement affects the balance sheet of the original lessee if this lessee becomes a guarantor. The original lessee, who becomes the guarantor under the revised lease agreement, is required to recognize a guarantee obligation in the liabilities section of its balance sheet. Thus, the amount of the total liabilities of the original lessee will change with the removal of the original obligation and the recognition of the guarantee obligation. However, with the modification in the lease terms, the related asset is removed from the balance sheet, resulting in a decrease in total assets.

4. Do you believe that SFAS 145 will lead to more relevant and useful information regarding early payment of debt? Explain your answer.

Yes, the requirement under SFAS 145 for the early payment of debt will lead to more relevant and useful information. For one, it is consistent with the definition of extraordinary items under APB Opinion No. 30 (i.e., unusual and infrequent), thus, there is no more confusion on how the term “extraordinary” will be applied to this type of transaction and the frequency of using this type of classification will be reduced. For another, SFAS 145 also shows recognition of the fact that early extinguishment of debt is now a normal occurrence, a part of a company’s interest risk management, and should therefore be shown as part of the normal operations of the company.

SFAS 145’s change in the classification of the gains or losses from the early payment of a debt can also help financial statement users to “better distinguish transactions that are part of an entity's recurring operations from those that are unusual or infrequent” (Reinstein, par. 4). It will also enable the creditor - banks to determine if the companies are following or violating their debt covenants, which are usually focused on normal operations because gains or losses from early payments of debts that are frequently done by the entity are now seen as part of the continuing operations of the entity. Read More