Chapter+11-bankrupcy - 342 The importance of short-term...

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342 The importance of short-term liabilities as an element of working capital was discussed in Chapter 8. In this chapter, we examine the nature of long-term liabilities. The emphasis is on recognition and measurement of transactions and events as liabilities, with specific attention to some of the more troublesome aspects, and analysis of the risk associated with a company’s use of long-term debt. Investors, creditors, and other users view the separation of liabilities into their current and noncurrent elements as important because their decision models use the working capital concept, current ratios, and projections of expected future cash flows to analyze and compare the performance of firms. The amount of long-term debt relative to equity is also relevant because the debt-to-equity ratio is directly related to the risk associated with investing in the firm’s stock.1 As the debt-to-equity ratio of a firm increases, the market’s perception of the riskiness of investing in the firm’s stock also rises. Thus, it is important that accountants have criteria to appropriately classify liabilities as short-term or long-term so that decision makers can reliably evaluate the firm’s ability to meet current needs and to determine the level of riskiness inherent in projections of future cash flows over time. CHAPTER 11 Long-Term Liabilities 1. See Robert S. Hamada, “The Effect of the Firm’s Capital Structure on the Systematic Risk of Common Stocks,” The Journal of Finance (March 1969), pp. 13–31; and Mark E. Rubinstein, “A Mean-Variance Synthesis of Corporate Financial Theory,” The Journal of Finance (May 1973), pp. 167–181. The Definition of Liabilities 343 The Definition of Liabilities Statement of Financial Accounting Concepts ( SFAC ) No. 6 describes the elements comprising the balance sheet as assets, liabilities, and equity. Assets have future economic benefit. Liabilities and equity provide resources (capital) for the acquisition of assets. The amount of liabilities a firm has relative to equity is termed the firm’s capital structure. In current accounting practice, liabilities and equity are treated as separate and distinct elements of the firm’s capital structure. This distinction is apparent in the fundamental accounting equation assets = liabilities + equity Accordingly, liabilities and equity are both claimants to enterprise assets; but equity represents an ownership interest, whereas liabilities are creditor claims. These interests are different and their separate disclosure is relevant to decision makers who rely on published financial information.2 Theories of equity postulate how the balance sheet elements are related and have implications for the definitions of both liabilities and equity. The two prominent theories of equity—entity theory and proprietary theory— imply unique relationships between assets, liabilities, and equity.
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The entity theory depicts the accounting equation as assets = equities According to the entity theory, there is no fundamental difference between liabilities and owners’ equity.3 Both provide capital to the business
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