Question

Transit Airlines provides regional jet service in the Mid-South. The following is information on liabilities of Transit at December 31, 2018. Transit’s fiscal year ends on December 31. Its annual financial statements are issued in April. Transit has outstanding 6.4% bonds with a face amount of $85 million. The bonds mature on July 31, 2027. Bondholders have the option of calling (demanding payment on) the bonds on July 31, 2019, at a redemption price of $85 million. Market conditions are such that the call option is not expected to be exercised. A $34 million 7% bank loan is payable on October 31, 2024. The bank has the right to demand payment after any fiscal year-end in which Transit’s ratio of current assets to current liabilities falls below a contractual minimum of 1.9 to 1 and remains so for 6 months. That ratio was 1.75 on December 31, 2018, due primarily to an intentional temporary decline in parts inventories. Normal inventory levels will be reestablished during the sixth week of 2019. Transit management intended to refinance $41 million of 5% notes that mature in May of 2019. In late February 2019, prior to the issuance of the 2018 financial statements, Transit negotiated a line of credit with a commercial bank for up to $36 million any time during 2019. Any borrowings will mature two years from the date of borrowing. Transit is involved in a lawsuit resulting from a dispute with a food caterer. On February 13, 2019, judgment was rendered against Transit in the amount of $52 million plus interest, a total of $53 million. Transit plans to appeal the judgment and is unable to predict its outcome though it is not expected to have a material adverse effect on the company. Required: 1. How should the 6.4% bonds be classified by Transit among liabilities in its balance sheet? 2. How should the 7% bank loan be classified by Transit among liabilities in its balance sheet? 3. How should the 5% notes be classified by Transit among liabilities in its balance sheet? 4. How should the lawsuit be reported by Transit? 5. Calculate the total current liabilities, total long-term liabilities, and total liabilities of a classified balance sheet for Transit Airlines at December 31, 2018. Transit's accounts payable and accruals were $41 million.

Answer 1

1 The requirement to classify currently maturing debt as a current liability includes debt that is callable by the creditor in the upcoming year – even if the debt is not expected to be called. So, the entire $85 million debt is a current liability.

2. The entire $34 million loan should be reported as a long-term liability because amount is payable in 2024. The current liability classification includes a. Situations in which creditor has the right to demand payment because existing violation of a provision of debt agreement makes it callable and (b) situations in which debt is not callable but will be callable within the year if an existing violation is not corrected within specific period. Here, the existing violation is expected to be corrected within 6 months (actually 6 weeks in this case).

3. The managment's intent is to refinance all $41,000,000 of the 5% notes, but the refinancing agreement explains the ability only for $41,000,000. $41 million can be reported as long term but $5 million should be reported as current liability. Short term obligations are expected to refinanced with long-term obligations that can be reported as noncurrent liabilities only if the firm (a) intends to refinance on a long-term basis and (b) demonstrated the ability to do so. To refinance on long term basis can be demonstrated either by an existing refinance agreement or actual financing before the issue of financial statements. The refinancing agreement limits the ability to refinance the $41 million of the notes. In the absence of other evidence of ability to refinance, remaining $6 million cannot be reported as long-term.

4. The lawsuit resulting from a dispute with a food caterer should not be accrued. The suit is in appeal and it is not deemed probable that that transit will lose the appeal. Footnote disclosure is required.

5. Current Liabilities

Accounts payable and accruals $41

6.4% bonds maturing on July 31, 2027, callable July 31, 2019 85

Current portion of 5% notes payable due May 2018 6

Total Current Liabilities 132

Long-Term Debt

7% bank loan payable on October 31, 2024 34

Currently maturing debt classified as long-term:

5% notes payable due May 2018 40

Total Long-Term Liabilities   74

Total Liabilities $206