L1R32 - Financial Reporting and Analysis - I

8/19/2019 L1R32 - Financial Reporting and Analysis - I

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Reading 32: Non-Current(Long-Term) Liabilities


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Reading 32 - LOSs

• LOSs Covered• 32a, 32b, 32c, 32d, 32e, 32f, 32g, 32h,32j

• LOSs Not Covered• 32i, 32k


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Bond Terminology – I• Par value: amount payable to the bondholders at maturity; also

called face value, principal , stated value, maturity value• Coupon rate: interest rate used to calculate periodic interest

payments; also called nominal rate, stated rate• Coupon payment: coupon rate times par value• Market rate of interest: interest rate demanded by investors given

the risks of an investment• Effective interest rate: the market rate of interest when bonds areissued; used to compute interest expense

• If the effective interest rate > coupon rate, bonds are issued at a discount(price < par)

• If the effective interest rate = coupon rate, bonds are issued at par (price =

par)• If the effective interest rate < coupon rate, bonds are issued at a premium(price > par)

• Interest expense: coupon payments plus amortization of anypremium/discount; there are two methods of amortization – effectiveinterest method and straight-line


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Bond Terminology – IIExample: Lynx Industries issues one thousand $1,000 par, 6% coupon,

5-year, annual pay bonds for a total of $958,998.

• The par value of a single bond is $1,000• The coupon rate is 6%• The (annual) coupon payment for a single bond is 6%× $1,000 =

$60, for the entire issue is $60,000• The maturity is 5 years• The effective interest rate is 7% (covered in quant, fixed income)• The initial (net) liability – book value – is $958,998• The initial discount is $1,000,000 − $958,998 = $41,002• First year’s interest expense

• Effective interest rate method: $958,998× 7% = $67,130• $60,000 is the coupon payment• $7,130 is the amortization of the discount

• Straight-line amortization: $68,200• $60,000 is the coupon payment• $8,200 is the amortization of the discount


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Effects on Financial Statements – I• Issuance

• Balance sheet• Liability equal to proceeds

• IFRS subtracts issuance costs from liability

• US GAAP records issuance costs as an asset• Cash increase equal to proceeds

• Income statement• No effect

• Cash flow statement• CFF inflow equal to proceeds


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Effects on Financial Statements – II• Life of the bonds

• Issued at a discount• Balance sheet

• Liability increases by amount of amortization

• Cash decrease equal to coupon payments

• Income statement

• Interest expense = coupon payment + amortization of discount• Cash flow statement

• CFF outflow equal to coupon payments

• Issued at par• Balance sheet

• Liability unchanged• Cash decrease equal to coupon payments

• Income statement• Interest expense = coupon payment

• Cash flow statement• CFF outflow equal to coupon payments


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Effects on Financial Statements – III• Life of the bonds (cont.)

• Issued at a premium• Balance sheet

• Liability decreases by amount of amortization

• Cash decrease equal to coupon payments

• Income statement

• Interest expense = coupon payment − amortization of premium• Cash flow statement

• CFO outflow equal to coupon payments

• Maturity• Balance sheet

• Liability eliminated• Cash decrease equal to par value• Income statement

• No effect• Cash flow statement

• CFF inflow equal to par value


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Amortization of Premium/Discount – I• Effective interest rate method

• Interest expense = beginning book value timeseffective interest rate

• Amortization of premium/discount = interestexpense − coupon payment

• Required by IFRS, preferred by US GAAP• Straight-line method

• Amortization of premium/discount = initialpremium/discount÷ original years to maturity

• Interest expense = coupon payment + amortizationof premium/discount

• Allowed by US GAAP


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Amortization of Premium/Discount – IIExample (cont.): Lynx Industries issues one thousand $1,000 par, 6%

coupon, 5-year, annual pay bonds for a total of $958,998. Theeffective rate is 7%.

The following amortization table illustrates the effective rate method.Interest expense = Beginning book value× 7%, amortization =

interest expense − coupon payment, and ending book value =beginning book value + amortization.

Year Beg. BV Int. Exp. Coupon Amort. End. BV

1 $958,998 $67,130 $60,000 $7,130 $966,128

2 966,128 67,629 60,000 7,629 973,7573 973,757 68,163 60,000 8,163 981,920

4 981,920 68,734 60,000 8,734 990,654

5 990,654 69,346 60,000 9,346 1,000,000


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Amortization of Premium/Discount – IIIExample (cont.): Lynx Industries issues one thousand $1,000 par, 6%

coupon, 5-year, annual pay bonds for a total of $958,998. Theeffective rate is 7%.

The following amortization table illustrates the straight-line method. Amortization = $41,002÷ 5 = $8,200, interest expense = coupon

payment + amortization, and ending book value = beginning bookvalue + amortization.


1 $958,998 $68,200 $60,000 $8,200 $967,198

2 967,198 $68,200 60,000 $8,200 975,3993 975,399 $68,200 60,000 $8,200 983,599

4 983,599 $68,200 60,000 $8,200 991,800

5 991,800 $68,200 60,000 $8,200 1,000,000


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Amortization of Premium/Discount – IVExample (cont.): Lynx Industries issues one thousand $1,000 par, 6%

coupon, 5-year, annual pay bonds for a total of $1,043,295. Theeffective rate is 5%.


interest expense − coupon payment, and ending book value =beginning book value + amortization.


1 $1,043,295 $52,165 $60,000 ($7,835) $1,035,460

2 1,035,460 $51,773 60,000 (8,227) 1,027,2333 1,027,233 $51,362 60,000 (8,638) 1,018,594

4 1,018,594 $50,930 60,000 (9,070) 1,009,524

5 1,009,524 $50,476 60,000 (9,524) 1,000,000


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Amortization of Premium/Discount – VExample (cont.): Lynx Industries issues one thousand $1,000 par,

zero-coupon, 5-year, annual pay bonds for a total of $712,986. Theeffective rate is 7%.


interest expense, and ending book value = beginning book value +amortization.


1 $712,986 $49,909 $0 $49,909 $762,895

2 762,895 $53,403 0 53,403 816,2983 816,298 $57,141 0 57,141 873,439

4 873,439 $61,141 0 61,141 934,579

5 934,579 $65,421 0 65,421 1,000,000


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Practice Question 32-1DeMarco-Robbins (DR) issues $5,000,000 of 5% coupon, 10-year

bonds at a time when market rates are at 4.8%. In year 2, DR’sinterest expense using the effective rate method, compared to interestexpense using the straight-line method, should be:

A. Lower than it would be using straight-lineB. The same as it would be using straight-line

C. Higher than it would be using straight-line


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Practice Question 32-1DeMarco-Robbins (DR) issues $5,000,000 of 5% coupon, 10-year

bonds at a time when market rates are at 4.8%. In year 2, DR’sinterest expense using the effective rate method, compared to interestexpense using the straight-line method, should be:

A. Lower than it would be using straight-lineB. The same as it would be using straight-line

C. Higher than it would be using straight-line

Correct answer: A. Lower that it would be using straight-line

For a premium, the amortization under the effective rate method ishigher in the early years and lower in the later years; in year 2 of 10,

the amortization would be higher than the straight-line amortization.

The amortization of a premium reduces interest expense, so reducingit by a higher amount of amortization will result in a lower interestexpense.


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Issuance Costs• Printing costs, legal fees, commissions, etc.

• Reduces the net proceeds from the bond issuance• Reduces cash on balance sheet• Reduces CFF inflow

• IFRS

• Deducted from liability• Increases effective interest rate

• US GAAP• Reported as an asset (deferred expense)• Amortized straight-line over the life of the bonds


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• As market rates change, fair market value of fixed-rate

bonds changes• Increase in interest rates, decrease in fair market value• Decrease in interest rates, increase in fair market value

• Bonds are generally reported at amortized historical cost• Based on market rate at time of issuance

• Overstates economic liability, leverage when interest rates rise• Understates economic liability, leverage when interest rates fall

• Companies must disclose fair market value of financingliabilities

• Option to report financial liabilities at fair value• Gains/losses reported on income statement

Changing Market Rates – I


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Changing Market Rates – II


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• Retirement at maturity

• No gain/loss to recognize• CFF outflow: par value

• Retirement before maturity• Purchase on open market

• Exercise call option• Early retirement (e.g., sinking fund) provision• Bondholder exercises a put option• Possible gain/loss

• Gain if repurchase price < carrying value

• Loss if repurchase price > carrying value• Carrying value includes unamortized issuance costs (US

GAAP)

• Gain/loss is classified as unusual or infrequent• CFF outflow: repurchase price

Derecognition of Debt – I


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Example: Five years ago, Smokey’s Restaurants issued $1,000,000

par of 6% coupon, semiannual pay, 10-year bonds for $950,000. Theissuance costs were $50,000, which Smokey’s is amortizing over 10years. The current carrying value of the bonds is $970,922.

Smokey’s purchases half of the bonds on the open market at 98.25.

Compute the gain/loss (if any) that Smokey’s will report on theirincome statement.

Carrying value ($970,922× 50%) $485,461Unamortized issuance costs

($50,000× 5/10× 50%) (12,500)

Purchase price ($1,000,000× 50%× 0.9825) (491,250)Loss on repurchase ($18,289)

Derecognition of Debt – II


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Practice Question 32-2Canfield & Miller has a $10 million bond issue maturing this year.

They’ve been sufficiently profitable that they can pay off the issue withcash on hand. When they do, their debt-to-asset ratio will most likely :

A. DecreaseB. Remain unchangedC. Increase


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Practice Question 32-2Canfield & Miller has a $10 million bond issue maturing this year.

They’ve been sufficiently profitable that they can pay off the issue withcash on hand. When they do, their debt-to-asset ratio will most likely :

A. DecreaseB. Remain unchangedC. Increase

Correct answer: A. Decrease

Canfield & Miller’s profitability suggests positive equity, so theirliabilities are less than their assets; furthermore, their debt is likely lessthan their liabilities, so their debt is less than their assets, and their

existing debt-to-asset ratio is less than one. When the same amount issubtracted from the numerator and the denominator, the ratio willdecrease.


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• Long-term liabilities are aggregated as a single amount

• Liabilities due within one year: current liabilities• Footnotes

• Stated and effective interest rates• Maturity dates

• Pledged collateral• Scheduled repayments over the next 5 years• Covenants

• Timely principal and interest payments• Maintenance of pledged collateral

• Dividend restrictions• Minimum working capital levels• Maximum leverage levels• Minimum liquidity ratios

Presentation / Disclosures


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• Fixed interest rates

• No down payment

• Less risk of obsolescence

• No concern about disposal

• Fewer restrictions (covenants)

• Tax benefits of ownership (e.g., depreciation, interest)

• Synthetic leases: benefits of ownership without balancesheet disclosure

Motivations for Leasing


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• Lessee must treat a lease as a finance (capital) lease if

any of these conditions apply:• Lease term is ≥ 75% of the asset’s economic life• Present value of minimum lease payments ≥ 90% of

the fair value of the asset•

Discount rate is lower of:• Rate inherent in lease

• Lessee’s incremental borrowing rate

• Ownership transfers at the end of the lease term• Bargain purchase option exists

• Lessor must treat a lease as a finance lease if lesseemust, and

• Collectability of lease payments is reasonablyassured

• Lessor has performed substantially under the lease

Finance vs. Operating Leases, US GAAP


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• IFRS requires lessee and lessor to treat a lease as a

finance lease if substantially all risks, rewards ofownership are transferred to lessee

• Situations that normally result in a finance lease• Lease term is majority of asset’s economic life

• Present value of minimum lease payments issubstantially all of the fair value of the asset• Ownership transfers at the end of the lease term• Lessee has the option to purchase the asset at

sufficiently below fair market value when the option

is exercisable that it is likely to exercise the option• Leased asset is sufficiently specialized that only the

lessee can use it without modification

Finance vs. Operating Leases, IFRS


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Example: Castle Enterprises leases equipment for five annual

payments of $80,000, payable in advance. The equipment has asalvage value of $50,000, and the present value of the lease payments(at the 9% rate implicit in the lease) is 95% of the fair market value ofthe equipment, so Castle treats it as a finance lease. Castle usesstraight-line depreciation over the life of the lease.

The present value of the lease payments is $371,674. Castle recordsan asset (Investment in Equipment) for $371,674, and a liability(Leases Payable) for $371,674.

The annual depreciation expense is ($371,674 − $50,000) / 5 =

$64,335

Lessee Finance Lease Accounting – I


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Example (cont.):

Lessee Finance Lease Accounting – II

Year Beg. BV Payment Interest Principal End. BV

1 $371,674 $80,000 $26,251 $53,749 $317,925

2 317,925 80,000 21,413 58,587 259,338

3 259,338 80,000 16,140 63,860 195,478

4 195,478 80,000 10,393 69,607 125,8725 125,872 80,000 4,128 75,872 50,000

Year Beg. BV Dep'n Accum. Dep'n End. BV

1 $371,674 $64,335 $64,335 $307,339

2 307,339 64,335 128,670 243,004

3 243,004 64,335 193,004 178,670

4 178,670 64,335 257,339 114,335

5 114,335 64,335 321,674 50,000

Theamortizationtable for thelease liability

is:

The depreciation

schedule for thelease asset is:


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Example (cont.):

Operating expenses (depreciation), non-operating expenses (interest),CFO (interest) and CFF (principal):

Lessee Finance Lease Accounting – III

Year Op. Exp. Non-Op. Exp. CFO CFF

1 $64,335 $26,251 ($26,251) ($53,749)

2 64,335 21,413 (21,413) (58,587)

3 64,335 16,140 (16,140) (63,860)

4 64,335 10,393 (10,393) (69,607)

5 64,335 4,128 (4,128) (75,872)Total $321,674 $78,326 ($78,326) ($321,674)


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Example: Moat Industries leases equipment for five annual payments

of $80,000, payable in advance. The equipment has a salvage valueof $50,000, and the present value of the lease payments (at the 9%rate implicit in the lease) is 85% of the fair market value of theequipment, so Moat treats it as an operating lease.

Moat doesn’t record an asset and doesn’t record a liability. Moat willhave no depreciation expense. Their only expense each year will be$80,000 in rental expense, an operating expense. The cash outflowswill all be CFO.

Lessee Operating Lease Accounting


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Practice Question 32-3Operating expenses and total expenses under a finance lease,

compared to those under an operating lease, are most likely :Operating TotalExpenses Expenses

A. Lower LowerB. Lower The same

C. Higher Higher


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Practice Question 32-3Operating expenses and total expenses under a finance lease,

compared to those under an operating lease, are most likely :Operating TotalExpenses Expenses

A. Lower LowerB. Lower The same

C. Higher Higher

Correct answer: B. Lower The same

Expenses under a finance lease are split between operating expenses(depreciation) and interest (non-operating); expenses under an

operating lease are all operating expenses (rent). Total expenses arethe same – and equal to the total lease payments – so operatingexpenses under a finance lease must be lower than those under anoperating lease.


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• Operating lease

• Lessor retains asset on balance sheet• Lessor records rental income

• Finance lease• Lessor removes asset from balance sheet• Lessor records lease receivable

• Sales-type lease• Dealer, manufacturer leasing their own products• Profit recorded on sale

• Revenue is lower of fair value of asset or PV of minimumlease payments

• Cost is carrying value less PV of residual• Interest income recognized during lease period• Direct financing lease

• Finance company• No profit recorded on sale• Interest income recognized during lease period

Lessor Lease Accounting – I


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Example: Gauntlet Products leases to equipment to Castle Enterprises

for five annual payments of $80,000, payable in advance. Theequipment has a salvage value of $50,000, and the present value ofthe lease payments (at the 9% rate implicit in the lease) is 95% of thefair market value of the equipment, so Castle treats it as a financelease. The carrying value of the equipment on Gauntlet’s balancesheet is $260,000. Gauntlet treats the lease as a sales-type lease.

The present value of the lease payments is $371,674, and the presentvalue of the residual is $32,496. Gauntlet records revenue of$339,178 (= $371,674 − $32,496) and expenses of $260,000, for agross profit of $79,178. Gauntlet also records a lease receivable of

$339,178.

Lessor Lease Accounting – II


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Example (cont.):

The amortization table for the lease receivable is:

Year Beg. BV Payment Interest Principal End. BV1 $339,178 $80,000 23,326 $56,674 282,504

2 282,504 80,000 18,225 61,775 220,729

3 220,729 80,000 12,666 67,334 153,394

4 153,394 80,000 6,606 73,394 80,000

5 80,000 80,000 0 80,000 0

Lessor Lease Accounting – II


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• Company contributes money to the plan, has no further

obligation• Accounting

• Income statement• Pension expense equals required contribution

• Balance sheet• Decrease in cash equal to actual contribution• Liability if actual contribution < required contribution• Asset if actual contribution > required contribution

• Cash flow statement• CFO outflow equal to actual contribution

Defined Contribution Plans


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• Company contributes money to the plan, promises to

pay future pension benefits• Company must estimate future obligation

• Wage/salary growth rate• Average retirement age

• Average longevity after retirement• Discount rate• Accounting

• Balance sheet• Net pension asset if plan assets > PV of benefit obligation

• Net pension liability if plan assets < PV of benefit obligation

Defined Benefit Plans – I


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• Accounting (cont.)

• Change in net pension asset/liability during period• IFRS

• Employee service cost• Net interest expense or income• Actuarial gains/losses

• Actual return − expected return• US GAAP

• Employee service cost• Interest expense• Expected return on plan assets

• Past service costs• Actuarial gains/losses

Defined Benefit Plans – II


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• Accounting (cont.)

• Balance sheet• IFRS – not amortized

• Actuarial gains/losses• Actual return − expected return

• US GAAP – amortized

• Past service costs• Actuarial gains/losses

• Income statement• IFRS

• Employee service cost

• Net interest expense or income• US GAAP

• Employee service cost• Interest expense• Expected return on plan assets

Defined Benefit Plans – III

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L1R32 - Financial Reporting and Analysis - I

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