alues of debt. Increases (decreases) in the market rate of interest decreases (increases) the market value of debt. These gains (from the decrease in market value of debt) or losses (from the increase in market value of debt) are not reflected in the financial statements. Hence the book value of debt will not equal the market value. However, for purposes of analysis, market values may be more appropriate than book values. For example, firms that issue debt when interest rates are low are relatively better off when interest rates increase and this increase should be reflected in a higher value of equity and a lower value of debt. Adjusting the firm’s debt down to market value will result in the measurement of debt to what would have to be paid to retire the debt and will decrease the debt-equity ratio. If interest rates decrease, the opposite effects will occur from adjusting debt to its market value.
e: Explain why the gain or loss resulting from retirement of debt prior to maturity is treated as an extraordinary item.
A company may choose to retire debt prior to maturity because of declining interest rates, increased cash flows (e.g., from the sale of assets), or a decision to change the company's financial leverage. When a firm retires debt prior to maturity there may be a difference between book value and market value. This difference is treated as an extraordinary gain or loss in the income statement. When a firm replaces a high coupon issue with another issue when interest rates are lower, the firm is no better off as a result of refinancing. In this case, the firm will recognize an immediate extraordinary loss, but will record lower future interest expense. The point is that the amount and timing of the accounting gain and the economic gain may be quite different.
1.C: Leases and Off-Balance Sheet Debt --and-- Financial Reporting by Lessors and for Sale Leasebacks
a: Classify a lease as capital or operating.
A lease is a capital lease if just one of the following criteria hold:
·         The title is transferred to the lessee at the end of lease period.
·         A bargain purchase option exists.
·         The lease period is at least 75% of the asset’s life.
·         The present value of the lease payments is at least 90% of the fair value of the asset using the minimum of the lessee's incremental borrowing rate or the rate implicit in the lease.
Note: The