CFA® Level I - Financial Reporting and Analysis Non-Current (Long-Term) Liabilities 1 You can...

CFA® Level I - Financial Reporting and Analysis

Non-Current (Long-Term) Liabilities

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Introduction and Contents

1. Introduction

2. Bonds Payable

3. Leases

4. Pensions and Other Post Employment Benefits

5. Evaluating Solvency

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2. Bonds PayableBonds are contractual promises made by a company to pay cash in the future to its lenders (bondholders) in exchange for receiving cash in the present. Terms of the bond contract are contained in a document called an indenture.

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Bond

$$$

market rate of interest at issuance

effective interest rate

What is the risk?Required return?

Bond Issuance: Coupon Rate = Effective Interest Rate

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Face Value (Par Value) = 100Issue Date = 1 January, 2011Maturity Date = 31 December, 2013Coupon Rate = 10% paid annually

<Details of issuer’s obligations>

When the bond is issued, investors require are return of 10%. What are the sales proceeds? How is the issuance reflected in the financial statements?

coupon rate = effective interest rate Bond is issued at face value

Bond Issuance: Coupon Rate < Effective Interest Rate

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When the bond is issued, investors require a return of 11%. What are the sales proceeds? How is the issuance reflected in the financial statements?

coupon rate < effective interest rate Bond is issued at a discount

Bond Issuance: Coupon Rate > Effective Interest Rate

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When the bond is issued, investors require a return of 9%. What are the sales proceeds? How is the issuance reflected in the financial statements?

coupon rate > effective interest rate Bond is issued at a premium

Accounting for Bond Amortization, Interest Expense and Interest Payments

Once the bond has been issued, the company needs to make coupon payments. How are these payments accounted for?

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When the bond is issued, investors require a return of 11%. Show the following:1. Interest payments2. Interest expense3. Reported bond value

How are the above numbers reflected in the financial statements?

Year

Carrying Amount (Begin)

Interest Expense

Interest Payment

Amortization of Discount

Carrying Amount

(End)

2011 97.56 10.73 10.00 0.73 98.29

2012 98.29 10.81 10.00 0.81 99.10

2013 99.10 10.90 10.00 0.90 100.00

Amortizing a Bond Discount

Balance Sheet

Income Statement

Cash Flow Statement

Example

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When the bond is issued, investors require a return of 9%. Show the following:1. Interest payments2. Interest expense3. Reported bond value


Year


Interest Expense

Interest Payment

Amortization of Premium

Carrying Amount

(End)

2011

2012

2013

Amortizing a Bond Premium

Balance Sheet

Income Statement

Cash Flow Statement

Example

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Face Value (Par Value) = 100Issue Date = 1 January, 2011Maturity Date = 31 December, 2013No coupon payments are made

When the bond is issued, investors require a return of 10%. Show the following:1. Reported bond value2. Interest expense


Year


Interest Expense

Interest Payment

Amortization of Discount

Carrying Amount

(End)

2011

2012

2013

Zero Coupon Bond

Balance Sheet

Income Statement

Cash Flow Statement

Issuance Costs• There are costs associated with issuing a bond

• U.S. GAAP: Issuance costs are shown as an asset which is amortized over the life of the bond

• IFRS: Issuance costs reduce the carrying value of debt

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Miscellaneous Points

• Effective interest rate does not change during the life of the bond

• Book value of bond rises for a discount bond and falls for premium bond

• Link between bond amortization and amortization of long-lived assets

• Effective interest rate method versus straight-line method


ExampleA company issued a five-year 8.50% coupon bond two years ago. At the time of issuance the effective interest rate was 8.00%. Today the interest rate is 9.00%. The bond was most likely issued at:A.parB.a discountC.a premium


ExampleA company issued a five-year 8.50% coupon bond two years ago. At the time of issuance the effective interest rate was 8.00%. Today the interest rate is 9.00%. The book value of the bond today is most likely:A.parB.above parC.below par


Current Market Rates and Fair Value Reporting Option

Discussion so far has focused on reporting bonds at amortized historical costs; this method reflects the market rate at the time the bonds were issued

When market rates change, the bonds’ fair value diverges from reported value

Companies have been given the option to report financial liabilities at fair value


Derecognition of Debt• Once bonds are issued, a company may leave the bonds outstanding until maturity or redeem the

bonds before maturity

• Gains and losses are recognized for bonds redeemed before maturity Loss = Redemption price – book value of the bond liability at the reacquisition date Example: Redemption Price = 1,020,000, Book value = 990,000, Loss = 30,000

• Gain or loss from extinguishing debt is reported in the income statement in a separate line item where amount is material

• Dealing with bond issuance costs U.S. GAAP: Unamortized bond issuance costs must be written off and included in gain/loss calculations IFRS: No write-off because issuance cost is included in book value of bond liability


Debt Covenants• Restrictions on the issuer that protects the bond holder’s interest

• Reduce default risk and decrease interest cost

• Affirmative covenants (certain requirements to be fulfilled e.g. interest payments on time)

• Negative covenants (restrictions on an entity’s actions e.g. no additional borrowing)

• Technical default


Presentation and Disclosure of Long-Term Debt• Firms usually combine their long term debt outstanding into a single line item• The portion of liability due within one year is shown as a current liability • Footnotes disclose more information about long term debt:

The nature of the liabilities Maturity dates Stated and effective interest rates Call provisions and conversion privileges Restrictions imposed by creditors Assets pledged as security Amount of debt maturing in next five years

• MD&A provides other information about a company’s capital resources, including debt financing and off-balance sheet financing


3. Leases


Lessor(Asset Owner)

Payments over lease term

Lessee(Asset User)

A lease can be classified as an operating or finance (capital) leaseThe accounting treatment is different depending on how the lease is categorized

Advantages of (Operating) LeasesLessee Perspective

• Less costly financing: lease requires no initial payment

• Lessee typically pays less financing cost relative to purchasing on credit

• Reduced risk of obsolescence• Improves the leverage ratios

compared to borrowing the funds to purchase the asset

• Tax reporting advantages: in the U.S., firms can create a synthetic lease. Asset shown on balance sheet for tax purposes.

Lessor Perspective

• Lessor might have a tax advantage by keeping asset on its balance sheet

• Possibly more efficient for lessor to maintain asset


Finance Lease vs. Operating Lease

• Economic substance of the transaction defines the lease categorization: if the risk/reward associated with the asset are transferred to the lessee, the lease should be categorized as a finance (capital) lease

• U.S. GAAP: A lease must classified by lessee as finance (capital) lease if any one of these four criteria are met: Ownership transfer Bargain purchase option Lease term 75% or more of useful life Present value of lease payments is 90% or more of fair value of leased asset


Lessor generally prefers finance leasesLessee generally prefers operating leases

Reporting by Lessee (Operating Lease)

• Balance Sheet: No entry Off-balance sheet transaction

• Income Statement: Rent expense equal to the lease payment

• Cash Flow Statement: Cash flow from operations


Reporting by Lessee (Finance Lease)• Balance Sheet

At inception, present value of future lease payments is recognized as an asset and as a liability

Asset is depreciated and lease payable is amortized

• Income Statement Interest expense = liability at the beginning of period x interest rate

• Cash Flow Statement Interest expense reduces CFO Rest of the lease payments reduces CFF


ExampleYou lease a machine on 1 January 2011 for 4 years and pay 100 at the start of every year. The fair value is 340. Relevant internet rate is 10%. How should this lease be categorized? What is the impact on the financial statements? Assume straight line depreciation.


ExampleYou lease a machine on 1 January 2011 for for 4 years and pay 100 at the start of every year. The fair value is 340. Relevant internet rate is 10%. How should this lease be categorized? What is the impact on the financial statements? Assume straight line depreciation.


Year

Carrying Amount (1 Jan)

Depreciaton Expense

Accumulated Depreciation

Carrying Amount (31 Dec)

Lease Liability (1 Jan)

Lease Payment (1 Jan)

Interest Expense for

Year

Redection of Lease Liability

Lease Liability (31 Dec)

2011 348.69 87.17 87.17 261.52 348.69 100.00 24.87 75.13 273.56

2012 261.52 87.17 174.34 174.35 273.56 100.00 17.36 82.64 190.91

2013 174.35 87.17 261.51 87.18 190.91 100.00 9.09 90.91 100.01

2014 87.18 87.17 348.68 0.01 100.01 100.00 0.00 100.00 0.01

Asset Lease Liability

CFO CFFSpreadsheets will be shared on our Google Group

ExampleYou lease a machine for 4 years and pay 100 at the start of every year. The fair value is 340. Relevant internet rate is 10%. Show the total expense under the two different categorizations.


Year Expense Depreciation Interest Total

2011 100 87.17 24.87 112.04

2012 100 87.17 17.36 104.53

2013 100 87.17 9.09 96.26

2014 100 87.17 0.00 87.17

Operating Lease Finance Lease

Financial Statement Impact of Lease Accounting for Lessee

Finance Lease Operating LeaseAssets Higher LowerLiabilities (current and long term) Higher LowerNet income (in the early years) Lower HigherNet income (later years) Higher LowerTotal net income Same SameEBIT (operating income) Higher LowerCash flow from operation Higher LowerCash flow from financing Lower HigherTotal cash flow Same Same


Ratio Impact of Lease AccountingFinance Lease Operating Lease

Current ratio Lower HigherWorking capital Lower HigherAsset turnover Lower HigherReturn on assets * Lower HigherReturn on equity * Lower HigherDebt/Assets Higher LowerDebt/Equity Higher Lower


* In early years

Reporting by Lessor

• Operating lease: Record revenue when earned Report leased asset on balance sheet Depreciation expense on income statement

• Finance lease: Any one from the four criteria plus the additional revenue recognition criteria Direct finance lease Sales type lease


Reporting by Lessor


Direct finance lease: present value of lease payments = carrying value of lease asset Lessor earns interest expense At inception record a lease receivable

Sales type lease: present value of lease payments > carrying value of lease asset Lessor “sells” the asset to lessee Provides financing on the sale Reports profit on sale and reports interest revenue on lease receivable

Direct Financing Lease - Lessor PerspectiveYou lease a machine for 4 years and receive 100 at the start of every year. Relevant interest rate is 10%. What are the accounting entries assuming this is a direct financing lease.


Lease Receivable - Lessor Perspective

Lease Receivable

(1 Jan)Lease Payment

(1 Jan)

Interest Income for

Year

Redection of Lease

Receivable

Lease Receivable

(31 Dec)

348.69 100.00 24.87 75.13 273.56273.56 100.00 17.36 82.64 190.91190.91 100.00 9.09 90.91 100.01100.01 100.00 0.00 100.00 0.01

Disclosures for Finance and Operating Leases

• Lease disclosures show payments under both capital and operating leases for the next five years and after that

• Disclosures can help estimate extent of a company’s off-balance-sheet lease financing through operating leases

• See Example 11


4. Pensions and other Post-Employment Benefits

Pensions and other post-employment benefits give rise to non-current liabilities reported by many companies. Pension plans can be divided in two major categories:

1. Defined Contribution: Company contributes an agreed-upon amount to the plan Pension expense on the income statement Operating cash outflow

2. Defined Benefit: Company makes promises of future benefits to be paid to employees Company make a contribution to pension fund (Plan Assets); pension payments are made from

this fund


Disclosures for Defined Benefit Plans• Funded Status = Plan Assets - Defined Benefit Obligation

If positive overfunded or net pension asset If negative underfunded or net pension liability

• Net pension asset or liability is reported on the balance sheet• Each period the change in net pension asset or liability is recognized either in profit

or loss or in other comprehensive income• Under IFRS, the change in the net pension asset or liability has three components

Employee service costs Net interest expense or income Re-measurements

• Under U.S. GAAP, the change in the net pension asset or liability has five components


ExampleOn 31 December 2012 a company has pension obligation of 100 and pension assets are 90. What will the company report on the balance sheet under IFRS? Under U.S. GAAP?


5. Evaluating Solvency


Solvency Ratios Numerator Denominator

Debt to assets ratio Total debt Total assets

Debt to capital ratio Total debt Total debt + Total shareholders equity

Debt to Equity ratios Total debt Total shareholders equity

Financial leverage ratios Average total assets Average total equity

Coverage Ratios Numerator Denominator

Interest coverage EBIT Interest payments

Fixed charge coverage EBIT + lease payments Interest payments + lease payments

Summary• Bonds

Issuance Par, Discount, Premium Amortization

• Leases Lessee, Lessor Advantages of leasing Accounting for operating and finance leases

• Pensions• Evaluating Solvency


Conclusion• Read summary

• Review learning objectives

• Examples

• Practice problems: good but not enough

• Practice questions from other sources


CFA® Level I - Financial Reporting and Analysis Non-Current (Long-Term) Liabilities 1 You can...

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