7.4 Debt, Equity, and Contingencies
Key Takeaways
- The 2026 FAR Blueprint puts notes and bonds payable, covenant compliance, and equity transactions in Area II, while contingencies and commitments fall in Area III, Select Transactions.
- Debt carrying amount changes through discounts, premiums, issuance costs, effective-interest expense, repayments, modifications, and extinguishments.
- Covenant questions require the definitions in the debt agreement (EBITDA, funded debt, permitted add-backs) rather than generic textbook ratio formulas.
- Equity questions focus on issuance, small vs. large stock dividends, stock splits, and treasury stock under the cost method (a contra-equity account).
- A loss contingency is accrued only when loss is probable and reasonably estimable; reasonably possible losses are disclosed, and a range with no best estimate accrues the minimum.
Debt, Equity, and Contingencies
The 2026 AICPA FAR Blueprint places debt (financial liabilities) and equity in Area II, Select Balance Sheet Accounts, and places contingencies and commitments in Area III, Select Transactions. That placement matters: debt and equity questions ask for carrying amount, covenant compliance, or journal entries, while contingency questions ask whether recognition, disclosure, both, or neither is required.
Debt Carrying Amount
Notes and bonds payable are not always reported at face amount. Carrying amount reflects unamortized discounts, premiums, and debt issuance costs (which, under ASU 2015-03, are presented as a direct deduction from the debt). Interest expense is calculated with the effective interest method: interest expense = beginning carrying amount x market (effective) rate; the difference between that and the cash coupon amortizes the discount or premium.
| Debt feature | Carrying amount effect | Income statement effect |
|---|---|---|
| Discount on bonds payable | Reduces liability below face | Interest expense exceeds cash coupon; rises over time |
| Premium on bonds payable | Increases liability above face | Interest expense below cash coupon; falls over time |
| Debt issuance costs | Reduce liability (contra) | Amortized to interest expense |
| Principal repayment | Reduces liability | No interest expense by itself |
Worked example. $100,000 face bonds issued at $96,000 (discount $4,000), stated rate 5% paid annually, market rate 6%. Year 1 cash interest = $5,000; effective interest expense = $96,000 x 6% = $5,760; discount amortized = $760; new carrying amount = $96,760.
Extinguishment and Modification
For an extinguishment, remove the old debt's carrying amount and recognize a gain or loss for the difference between carrying amount and the reacquisition price (including call premiums and fees). Example: carry $96,760, reacquired for $99,000 -> $2,240 loss on extinguishment. For a modification, compare old and new cash flows: a 10%-or-greater change in present value (the 10% test) is accounted for as an extinguishment; otherwise it is a modification with a revised effective rate.
The Blueprint also expects candidates to recognize when a change qualifies as a troubled debt restructuring because of the borrower's financial difficulty and a creditor concession.
Debt Covenants
A covenant problem is a document-reading problem. If the agreement defines EBITDA, current liabilities, funded debt, or permitted add-backs, use those definitions even when they differ from textbook formulas. A ratio may be tested at year-end, quarterly, or after giving effect to a transaction.
Covenant workflow:
- Identify the required threshold and testing date.
- Apply the agreement's definitions, not generic ones.
- Reclassify debt to current if a covenant violation makes it callable within 12 months (unless a waiver of at least one year is obtained by the balance-sheet date).
- Compute the ratio and compare it with the covenant.
- Consider waiver timing and disclosure if noncompliance exists.
Equity Transactions
Equity questions cover ownership transactions, not income-statement gains and losses. Issuing common stock records cash or other consideration received, common stock at par or stated value, and additional paid-in capital (APIC) for the excess. Treasury stock is the corporation's own reacquired shares; under the cost method it is a contra-equity account recorded at repurchase cost, and reissuance above cost credits APIC-treasury (never a gain to income).
- Small stock dividend (under 20-25% of outstanding shares): capitalize at fair value of the shares distributed.
- Large stock dividend (at or above 20-25%): capitalize at par or stated value.
- Stock split: changes share count and par per share but requires no journal entry; total par is unchanged.
Preferred stock adds dividend-preference questions. Cumulative preferred accrues unpaid (in-arrears) dividends that must be satisfied before common dividends; arrears are disclosed, not accrued, until declared. Participating preferred shares share in dividends beyond their stated rate. Book value per common share = (total equity - preferred claim including arrears) / common shares outstanding, a recurring computation. Retained earnings is reduced by declared dividends; a dividend becomes a liability on the declaration date, is fixed by the holders on the record date, and is paid on the payment date.
Contingencies and Commitments
Under ASC 450, a loss contingency is accrued when the loss is probable and reasonably estimable. If a range is estimated and no amount is more likely than another, accrue the minimum and disclose the additional exposure. If loss is reasonably possible, disclose but do not accrue. If remote, neither accrual nor disclosure is generally required, except for certain guarantees.
Gain contingencies are conservative: disclosed only when realization is probable and not recognized until realized. Commitments (purchase obligations, construction contracts, unused credit lines) may not meet liability recognition at the reporting date but can still require disclosure when significant.
Exam Discipline
Read the contract, compute the carrying amount, then decide recognition or disclosure. Do not record an entry for legal exposure just because a lawsuit exists; FAR wants the accounting conclusion supported by probability, measurability, and reporting-date facts.
The probability thresholds drive a quick decision grid:
| Likelihood of loss | Reasonably estimable | Accrue? | Disclose? |
|---|---|---|---|
| Probable | Yes | Yes | Yes |
| Probable | No | No | Yes |
| Reasonably possible | Either | No | Yes |
| Remote | Either | No (except certain guarantees) | Generally no |
Product warranty obligations are the most common accrued loss contingency: when products are sold with a warranty, estimate and accrue the expected warranty cost in the period of sale (matching), then charge actual repair costs against the liability. Subsequent events also matter: a loss contingency that becomes evident before the financial statements are issued may require adjustment if the underlying condition existed at the balance-sheet date, or disclosure only if the condition arose afterward. Always test the lawsuit's filing date and the reporting date together.
A company issued bonds at a discount. Which statement best describes the effect of amortizing the discount using the effective interest method?
A company is sued before year-end. Counsel says an unfavorable outcome is probable and estimates the loss range at $300,000 to $500,000, with no amount in the range more likely than another. What should the company generally do under U.S. GAAP?