2015, Study Session # 9, Reading # 32

NON-CURRENT (LONG-TERM) LIABILITIES

MRI
CR
IE
FV
PV
A&L
CV
BS

CFS
O.L
F.L
GP
BV
IS
CFO
CFF

= Market Rate of Interest

= Coupon Rate
= Interest Expense
= Fair Value
= Present Value
= Assets & Liabilities
= Carrying Value
= Balance Sheet

32. a

=
=
=
=
=
=
=
=

Cash Flow Statement

Operating Lease
Finance Lease
Gross Profit
Book Value
Income Statement
Cash Flow From Operation
Cash Flow from Financing

Debt Issuance

Bond Issued at Par

Bond Issued at Discount

MRI (return required by bondholders) = CR.

PV of coupon + PV of face amount = par value.
 A&L by face value on B.S.
Interest expense = coupon paid (I.S).
Issuance proceeds as CFF inflow, coupon payment in
CFO & repayment of face value, outflow from CFF.
Under U.S. GAAP or as CFO or CFF under IFRS.

CR < MRI = discount.

Investors pay less than
face value because of
low coupon.

Bond Issued at Premium

CR > MRI= Premium.

Investor will pay more for
attractive coupon rate.

B/S Impact

A & L by bond sale proceeds.

Price of the bond at issuance = PV of future cash payments.

Interest exp & Value of bond at issuance is calculated using market rate of interest at
issuance.

31. b

I.E includes amortization of discount or premium at issuance if not issued at par.

I.E (effective I.R method) = BV of bond liability t1 MRI at issuance.

Premium bonds I.E < coupon payment, difference is amortization of premium.
I.E
as bond liability
& reduces periodic premium amortization & vice versa in
case of a discount bond.

Zero Coupon Bonds

No periodic payments of interest & interest expense is implied.

Actual interest payments are included in face value.

F.S impact is qualitatively same as any other discount debt.

Issuance Cost

Bond issuance costs usually netted against bond proceeds & reported as CFF.

IFRS
Initial bond liability on B/S is reduced by
amount of issuance cost,  effective I.R.

U.S.GAAP
Capitalize as an asset & allocate over term of
bond.

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2015, Study Session # 9, Reading # 32

32. c

Extinguishing Debt

At maturity BV & face value of liability is same so no G/L.

Firm may choose to redeem bonds before maturity due to various
reasons.

When redeemed before maturity G/L is calculated by subtracting
redemption price from BV of liability.

Unamortized issuance cost must be written off & included in G/L
calculation (U.S.GAAP). No write-off is necessary under IFRS (already
included in BV of liability).

In CFS, G/L is eliminated from N.I in arriving at CFO & cash paid to
redeem bonds is shown as an outflow from financing activities.

FV Reporting Option

If yield, bonds carrying amount no longer equal to its market value.

 Yield,
FV of liability & vice versa.
Option to report debt at FV (IFRS & U.S.GAAP) & G/L in I.S.
MV of debt is more appropriate then B.V.
When I.R were low at issuance, firm is better off when I.R rise (low MV
of debt,
debt,  equity,
debt to assets & debt to equity) & vice
versa.

32. d

Restriction imposed by lender on

borrower to protect lenders
position & to reduce default risk.

Debt Covenants

Affirmative Covenants
Borrower promises to do certain
things e.g. timely interest &
principal payment, maintain
ratios etc.

Negative Covenants
Refrain certain activities that
adversely affect ability to repay
e.g. Limit paying  dividends &
issuing more debt etc.

If technical default (covenant violated), bondholder can demand immediate repayment of principal.

32. e

Firms provide disclosure about long term debt in footnotes & MD&A.

Disclosure usually includes maturity dates, stated & effective I.R, restrictions by creditors & the
amount of scheduled debt repayments for the next five years.

Discussion in MD&A can be both quantitative & qualitative.

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2015, Study Session # 9, Reading # 32

32. f

Lease contractual arrangement whereby the owner (lessor) grants lessee the right to use the asset for a particular period &
payment.

Leasing can have less costly financing, reduce obsolescence risk, less restrictive provisions, off B.S financing & tax reporting advantages.

Lease Classification

Finance lease

Operating lease

In substance, purchase of asset with debt.

Equal amounts to both A&L.

Dep. expense on assets & interest exp. to liab.

32. g

Rental arrangement.

No A or L.

Periodic payments as rental expense.

Lessees Perspective

IFRS

U.S.GAAP

If all rights & risks of ownership are transferred to

lessee, finance lease.

Circumstances for a finance lease include:

Title transferred at end of lease.

Lessee can purchase assets at significant
lower price in future.

Lease term covers major portion of assets
economic life.

The PV of lease payments is substantially
equal to FV of leased asset.

Specialized asset, that only lessee can use
without modifications.

Capital lease if any of following occur:

Title transferred at lease end.

Bargain purchase option.

Lease period is 75% or more of assets life.

PV of lease payment is 90% or more of FV
leased asset

Lease not meeting any of above criteria is operating lease & preferred by lessee (no Liability).

Lessors perspective

IFRS

U.S. GAAP

If all rights & risks of ownership are transferred,

finance lease, otherwise operating.

If any one of lease criteria is met, & reasonably

assured cash collectability, & lesser has
substantially performed under the lease, capital
lease, otherwise operating.

Operating lease rental income & depreciation on asset.

Capital lease replace asset with lease investment account.

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2015, Study Session # 9, Reading # 32

32. h

Reporting by the lessee

Operating lease

Finance Lease

B.S is unaffected.

Rent expense (lease payment) in I.S.

CFS, lease payment as CFO outflow.

A&L (lower of PV of future minimum lease

payment & FV of leased asset).

Asset is dep. in I.S & interest expense (lease
liability t1 lease rate) is recognized.

CFS, principal (outflow from financing), interest:
outflow from CFO (U.S.GAAP), CFO or CFF (IFRS).

Ratios & F.S effects of leases

B.S

I.S

CFS

 EBIT for capital lease.

Total expense over life of lease is same.

N.I in early years will be lower under
finance lease (sum of dep. & interest is >
lease payment) & higher in later years.

Turnover ratios will be lower under

finance lease.


ROA,  leverage ratios,
current
ratio & working capital under capital
lease.

 CFO &
CFF under finance lease &

vice versa in case of O.L.

Total CFs are unaffected.

Reporting by the lessor

U.S.GAAP

Sale-Type Lease

PV of lease payment >
CV of asset

IFRS

Direct Financing Lease

PV of lease payment =
CV of asset

No distinguish b/w sales-type &

direct financing.

Similar treatments for sales-type
leases originated by dealers or
manufacturers.

Sales-type lease

Lessor (normally manufacturer or dealer) sells asset for PV of lease payment &
provides loan of same amount to buyer.

Sale = PV of lease payment, cost = CV of asset & difference is GP.

Principal portion reduces lease receivable & interest portion is recognized as
interest income.

In CFS, interest is inflow from CFO & Principal as inflow from CFI.

Direct Financing Lease

No GP is recognized, simply providing a financing function.

Remove asset from B.S & create lease receivable by same amount.

CFS treatment is similar as under sales-type.

Operating Lease

Rental income by lessor.

Keep asset on B.S & depreciate it.

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2015, Study Session # 9, Reading # 32

32. i

Both lessee & lessor are required to disclose useful information about leases, including ;

General description of leasing arrangement.

Timing, nature & amount to be paid or received in each of next five years & payments
after 5 years are aggregated.

Lease revenue & expense in I.S & amount receivable & unearned revenues.

Restrictions imposed by lease agreements.

I.R used in lease calculations is not always disclosed.

Types of Pension Plans

32. j, k

Defined Contribution Plans (DCP)

Defined-Benefit Plans (DBP)

Company contributes a defined amount into the plan

(treated as pension expense).

Cash flows contributed to the plan are treated as an
operating cash outflows.

Impact on assets & liabilities
in cash & a liability is
recognized if some portion of agreed upon amount has
not yet been paid.

More complicated than DCP.

Company promises future benefits to be paid to
employees during retirement.

Assumptions are made to determine future obligation.

The pension obligation is allocated over the employees
employment as part of pension expense.

Recognition of DBP

Most DBPs are funded through pension trust fund.

If the fair value of plan assets > (<) the PV of pension
obligation, the plan has a surplus (deficit) & the companys
balance sheet will reflect a net pension asset (liability).

Defined Benefit Plan

IFRS

U.S.GAAP

in net pension asset or liability have three components.

 
  
  

 
 / 
&  


 

    &

 


Employees service costs PV of in the pension benefit

earned by the employee by providing one more year of service.

Net interest expense or income net pension asset or liability
discount rate (reflective of high quality corporate bond yield).

in net pension asset or liability each period is viewed as having

five components.

Three components are recognized in P&L in the period
incurred.

Service costs.

Interest exp.

Expected return on assets (
amount of expense
recognized).

Past service costs & actuarial G/L are recognized in OCI &
subsequently amortized over time (smooth pension
expenses).

Remeasurements:

Actuarial G/L resulting from made to assumptions.

Actual return on plan asset any return included in net
interest exp or income

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2015, Study Session # 9, Reading # 32

32. l

In evaluating solvency (ability to satisfy long-term obligations), analysts look at leverage &
coverage ratios

Ratios

Leverage ratios

Coverage ratios

Measure amount of debt (interest bearing obligation) in capital

structure.

Debt-to-assets ratio = total debt / total assets (% of total assets
financed with debt).

Debt-to-capital ratio = total debt / (total debt + total equity)
(total capital excludes non-interest bearing liabilities).

Debt-to-equity ratio = total debt / total equity (amount of debt
financing relative to equity base).

Financial leverage ratio = Avg. total assets / Avg total equity
(leverage used in DuPont)

Higher these ratios, higher the leverage.

Sufficiency of earnings to repay interest & other fixed charges.

Interest coverage = EBIT / interest payment.

Fixed charges coverage = EBIT + lease payment / interest + lease
payments.

Lower the ratios, the greater difficulty to make payments.

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