CHAPTER 11
FINANCIAL INSTRUMENTS AS LIABILITIES

CHAPTER OVERVIEW

An astounding variety of financial instruments, derivatives, and nontraditional financing arrangements are now used to fund corporate activities and to manage risk. Statement readers face a daunting task when trying to fully grasp the economic implications of some financial innovations. Off-balance sheet obligations and loss contingencies are difficult to evaluate because the information needed is often not disclosed. Derivatives—whether used for hedging or speculation—are problematic because of both their complexity and the involved details of hedge accounting. For many companies, however, the single most important long-term obligation is still traditional debt financing. GAAP in this area is quite clear. Noncurrent monetary liabilities are initially recorded at the discounted present value of the contractual cash flows—that is, the issue price. The effective interest method is then used to compute interest expense and net carrying value each period. Interest rate changes occurring after the debt has been issued are ignored. GAAP accounting for long-term debt makes it possible to “manage” reported income statement and balance sheet numbers. The opportunity to do so comes from the difference between debt book value and market value when interest rates have changed. The incentives for “managing” income statement and balance sheet numbers may be related to debt covenants, compensation, regulation, or just the desire to paint a favorable picture of a company’s performance and health. Extinguishment gains and losses from early debt retirement and swaps—and those generated by similar transactions—require careful scrutiny. Statement readers need to know whether real economic benefits for the company and its shareholders are produced—or if such gains or losses are just window dressing.