Lecture 10: Long-Term Liabilities: Financial Accounting

FINANCIAL ACCOUNTING
Lecture 10: Long-Term Liabilities

(Leases and Bonds)
Dr. Emmanuel De George

Additional Resources
Recommended readings:
Chapter 9 (from pg.464) and Chapter 10 (Bonds) from the textbook.
Pages 466 - 469 discuss present value calculations you MUST be

comfortable with PV concepts and computations!
Lease bad solution article discussing potential new leasing rules -

posted on Portal
Financial Accounting MiM 2016

2
Objectives
In this session our objectives are to:

Discuss valuation of long term liabilities on the Balance Sheet
Classification of Leases (operating vs. capital)
Accounting for Leases
Discuss proposed changes to Lease accounting
Learn how to account for Bond issuances raising debt (likely to run
into next week)

3
How do we value long-term liabilities?
Long-term liabilities are reported in the balance sheet at the present value of
the future cash payments that will be made to pay them off. There are three
basic cash flow patterns for repaying long-term liabilities:
1. Repayment of principal and interest in a single amount at the maturity

date. E.g. a zero-coupon bond
2. Repayment of principal and interest in a series of equal payments.

E.g. a Finance lease, or think about how you pay your credit card
3. payment of interest in a series of equal payments plus repayment of

principal in a single amount at the maturity date. E.g. coupon bond.

4
Brief overview on Present Value calculations
Present Value
Attempts to deal with timing and uncertainty/risk of future cash flows
Basic idea is time value of money: an amount of money in the future is

not equivalent to the same amount of money today
E.g. a lender who lends 100 today wants to receive more than 100 in
the future, with the additional amount being received representing some
form of interest earned, as compensation.

5
Example Present Value of single future payment
What is the present value (as of Jan 1, 2012) of 120 received on Jan 1,
2014 (assume r = 10%)?
We simply use our formula, PV = X/(1+r)n where n = 2:
PV(120) = 120 / 1.12 = 99.17 (or 120 * 0.8264 = 99.17)
PV as of: Jan 1, 2012 Jan 1, 2013 Jan 1, 2014

99.17 109.09 120
(= 109.09/1.1) (= 120/1.1)
6
Annuity
Instead of single payments (in the future) many business transactions involve
multiple cash payments of the same amount, over a number of periods.
An annuity is:
- a series of payments of equal dollar amount each period
- interest periods of equal length
- an equal interest rate for each period (i.e. interest rate cannot change)
- E.g. Lease payments
7
In these cases we can compute present value of the stream of annuity

payments (pmt) as follows:

s s
payment 1 1 1
payment OR PMT * 1
n
n1
(1 r ) n
n1
(1 r ) n i (1 i )
We can then simply do the above math for each period or just simply
consult our PV annuity table for the discount factor! (Table A.2)
8
Example - PV of an annuity
You win $10 million in the lottery. You can either receive the $10 million in
equal installments over a 20 year period, OR you can choose to receive $6
million lump sum today.
Which do you prefer?
9
Example PV of annuity (continued)
Lets compare the options:

Option 1 (PV of lump-sum): Calculate the PV of $6,000,000 today well
that is simply $6,000,000!
Option 2 (PV of annuity): Calculate the PV of $500,000 ($10,000,000/20)

received at end of each year for 20 years with 5% discount rate:

s
1
payment = 500,000*12.4622 = 6,231,100
n1
(1 r ) n
Table A.2
(n = 20, 5%)
10
Accounting for Leases
11
Leases: Introduction and Background
A lease is a special type of contract called an executory contract
Executory contract a contract to pay defined amounts in the future in

return for future benefits
More specifically, a lease is a contractual agreement between a lessor

and a lessee that gives the lessee the right to use specific property,
owned by the lessor, for a specific period of time in return for stipulated,
and generally periodic, cash payments (known as rents)
Accounting requirements: IAS 17 (IFRS) and ASC 840 (US GAAP)
Currently the IASB and FASB are working on new Leasing accounting
standard, expected finalized new standard in late 2015 or early 2016.
12
Leases: Introduction and Background
Need to assess the economic substance and the implications of the

contractual agreement
Is the lease a simple rental agreement, or is it a disguised purchase

of an asset funded by a loan?
To answer this, we have to look at economic substance versus

legal form, i.e. control of benefits of the economic asset
13
Why is the classification of leases important?
Fundamental Issue of lease accounting: Classification
If the lease agreement is regarded as a capital (a.k.a. finance) lease, an

asset and associated loan (liability) should be recognized, i.e. On-Balance
Sheet. This also implies recognition of depreciation expense and interest
expense.
Otherwise, treat as ordinary rental expenditure (operating leases). That is,

no recognition in the balance sheet, i.e. Off-Balance Sheet. Only effect
is on the Income Statement where rent expense is recognised only.
This has significant impact on financial reporting incentives
14
Operating Leases keep debt off Balance Sheet!
Sample of retail chains that ultimately went into liquidation, and there off-
balance sheet commitments relative to reported debt (based on 5-year
average before liquidation).
source: IASB Lease project update, August 2014
15
Leases: Classification
IFRS and US GAAP both require that leases be classified as finance

(capital) or operating:
- Finance (or Capital) Leases imply ownership

- Operating Leases imply a simple rental
US GAAP is more form-driven (series of tests) while IFRS is more

substance driven (more subjective)
16
Finance (Capital) Leases US GAAP
A lease will be classified as a Finance (capital) lease if it meets any of the

following 4 criteria:
The lease transfers ownership rights to the lessee
Bargain Price, Option to purchase at low price (< Fair Value)
Lease term is more than 75% of the leased assets useful life
Present value of future lease payments is more than 90% of the leased
assets fair value
17
Finance (Capital) Leases IFRS
IFRS (IAS 17) is similar to US GAAP but does not include the 75% and 90%
tests:
The lease transfers ownership rights to the lessee
Lease contains bargain price option, i.e. purchase at low price
Lease term is for the major part of the economic life of the asset if title is
not transferred (no specific 75% rule here)
At the inception of the lease the present value of the minimum lease
payments amounts to at least substantially all of the fair value of the
leased asset (no specific 90% rule)
18
IAS 17 also introduces a fifth condition for a finance lease
The leased assets are of such a specialised nature that only the
lessee can use them without major modifications.
Under all standards, a lease that is not a finance lease is an operating

lease.
Also, only non-cancellable leases may be capitalised.
19
Accounting for Finance (Capital) Leases:
The lease is treated as a financing arrangement for the purchase of

the assets:
Lease liability on Balance Sheet recorded at PV of future cash
payments that will be made for the lease
Lease asset on Balance Sheet recorded at the cash equivalent
price (PV) of the future cash payments plus the down payment.
The cash flow pattern for a capital lease is an annuity and each
lease payment includes both principal and interest (i.e. pattern #2).
20
Leases: Example
Use the following details of a lease contract to determine the type of lease:
1. Lease term is 3 years. The agreement is non-cancellable, requiring equal

payments of 21,709 at the end of each year, however this includes the property
taxes of 2,000 per year
2. The fair value of the equipment is 47,000. Its estimated useful life is 4 years
3. The lease contains no renewal option, and the equipment reverts to the lessor at
the termination of the lease
4. The lessees incremental interest rate is 15% and it is equal to the rate used by
the lessor
5. The equipment is not of a specialized nature
Is this an on-balance sheet or off-balance sheet lease??
21
Leases: Example
Solution
The lease transfers ownership rights to the lessee - NO
Lease contains bargain price option, i.e. purchase at low price - NO
Lease term is for the major part of the economic life of the asset if title is
not transferred Yes (3 yrs / 4 yr life = 75%)
At the inception of the lease the present value of the minimum lease
payments amounts to at least substantially all of the fair value of the
leased asset - Yes
([21,709 2,000] * 2.2832) = 45,000 (PV of lease)
45,000 / 47,000 = 95.7% of fair value
The leased assets are of such a specialised nature that only the lessee
can use them without major modifications - NO
22
Leases: Example
Solution
Given we met two of these criteria - we classify this lease as a Finance

lease.
23
Leases: Accounting Treatment
Operating lease (off-balance sheet)

Under an operating lease the lessee will only record an annual rent
expense. In the previous example this will be 19,709. The lessee will
also record a property tax expense of 2,000
Finance lease (on-balance sheet)

The lessee will record an asset and a liability at the inception of the
lease. The asset will be depreciated and the liability will be treated as any
other loan. This implies that the I/S will include depreciation expense
affecting operating profit. It will also include the imputed interest cost as
part of the interest expense
24
Leases: Accounting Treatment Example
Refer to the previous example. Determine the annual depreciation

expense (straight line) and the interest expense in years 1-3.
25
Solution:
The annual depreciation expense will be 15,000 (45,000/3). Interest
expense will be as indicated in the following table. Recall i=15%
A B = A*i C D=C-B E = A-D

Lease liability Interest Annual Reduction in Lease
at begin. of expense payment lease liability liability at
Year the year for the year end of year
1 45,000 6,750 19,709 12,959 32,041
2 32,041 4,806 19,709 14,903 17,138
3 17,138 2,571 19,709 17,138 0
26
The transaction worksheet is (first year only):
Transact./date Assets Liabilities Shareholders

Equity
Fixed Assets Cash Long-term Income

debt Statement
PPE Acc. Depr.
Inception 45,000 45,000

Depreciation (15,000) (15,000)
Property tax (2,000) (2,000)
Lease payment (19,709) (12,959) (6,750)
Closing Bal. 45,000 (15,000) (21,709) 32,041 -
Income Statement
27
Financial Accounting MiM 2016 impact: 23,750
Implications for Net Income
Expenses: Capital vs. Operating Lease
24000
23000
Pounds
22000 Capital Lease

21000 Operating Lease
20000
19000
1 2 3
Year
28
Implications for Cash Flows
(Year 1 of our previous example)
Operating lease:
Cash Flow from Operations will include the full payment of 21,709
Capital lease
No cash impact at inception (unless we have a down-payment)
The payment of 21,709 will be split between:
- property tax element (2,000) in operating cash flow
- interest element (6,750) in either operating cash flows or
financing cash flows; and
- A reduction of 12,959 in lease debt will be reported under
financing cash flows
29
Lease disclosures in Financial Statements
Finance Leases: You will see the asset and liabilities recognized in Balance
Sheet, and depreciation and interest expense
included in Income Statement
Operating Leases: You will only see annual rental expense (i.e. lease
payment). But what about all your future lease
payment obligations?
These are required disclosure in Notes.
Lufthansa Annual Report
KLM Royal Dutch Airlines Annual Report
30
Lufthansa Lease disclosure (from 2011)
1.8+ Billion of future

lease payments not
recognized! i.e. not part
of leverage ratio!
31
Further Example Finance vs Operating
Now we will go through the following example
32
EXAMPLE On January 1, 2009, equipment was acquired on a 5-year lease.
The lease calls for a $100,000 down payment and four year-end payments of
$100,000 each, starting on December 31, 2009. The year-end is December 31.
1) Assume the lease is an operating lease. Show the entry to record the
first lease payment and the year end adjusting entry.
ASSETS S/H EQUITY
Prepaid Cash I/S

Rent
Opening Bal. - XX -
1.1.09 Initial 100,000 (100,000) -

payment
31.12.09 rent (100,000) - (100,000)

expense 33
2) Show the entry to record the second lease payment on December

31, 2009
ASSETS S/H EQUITY
Prepaid Cash I/S

Rent
Opening Bal. - XX -
1.1.09 First lease pmt 100,000 (100,000) -
31.12.09 Year 1 rental (100,000) - (100,000)
31.12.09 Second lease pmt 100,000 (100,000)
34
NOW ASSUME: the lease is a capital lease. The equipment is expected to
last 5 years. Straight-line depreciation with zero salvage value is used. The
current interest rate is 7%. (Note: The present value factor is 3.3872. why?)
3) What amounts are recognized in regards to the first lease payment

on January 1, 2009.
Lease Asset = PV of Lease = $100,000 + $100,000 * 3.3872 = $438,720
Lease Liability = PV of future payments = $100,000 * 3.3872 = $338,720
ASSETS LIAB S/H EQUITY
Equipment Cash Lease I/S

Liability
Opening Bal. - XX - -
1.1.09 Initial payment 438,720 (100,000) 338,720 -

35
NOW ASSUME: the lease is a capital lease. The equipment is expected to
last 5 years. Straight-line depreciation with zero salvage value is used. The
current interest rate is 7%. (Note: The present value factor is 3.3872.)
4) What amounts are recognized in regards to the second lease

payment
Interest expense = $338,720 x 7% = $23,710
ASSETS LIAB S/H EQUITY
Equipment Cash Lease I/S

Liability
Opening Bal. - XX - -
1.1.09 Initial payment 438,720 (100,000) 338,720 -
31.12.09 Lease Pmt (100,000) (76,290) (23,710)

36
Opening Bal.
of Lease Value In 7% Change in Balance Owed
Date Liab (Cash Out) Interest Expense Balance Owed on Liability
1/1/09 - $438,720
- ($100,000) $338,720 $338,720
12/31/09 $338,720 ($100,000) $23,710 ($ 76,290) $262,430
12/31/10 $262,430 ($100,000) $18,370 ($ 81,630) $180,800
12/31/11 $180,800 ($100,000) $12,656 ($ 87,344) $ 93,456
12/31/12 $ 93,456 ($100,000) $ 6,544 ($ 93,456) $ 0
Total ($ 61,280) $61,280 0
5) What is total impact on the Profit and Loss account (I/S) for 2009?
Depreciation expense = $438,720 5 years = $87,744 per year

Interest expense = 23,710 (see above)
Therefore, total expense recognized in the Income Statement in 2009
is: 87,444 + 23,710 = 111,454 37
Financial Statement Effects Over the five years the total cash payments
and the total expenses will be the same no matter which method of accounting
is used. For the operating lease this will be: 5 x $100,000 = $500,000 of rent
expense. For the capital lease this will be: $438,720 of depreciation expense +
$61,280 of interest expense = $500,000 of total expense.
Effect of the operating lease on the December 31, 2009 balance sheet
Assets: Liabilities:
Cash $200,000 Lease liability -0-

Prepaid Rent + 100,000
rent
Equipment -0- SH Equity: $100,000 expense
Total $100,000 Total $100,000
38
Effect of the Finance (Capital) lease on the December 31, 2009 balance sheet
Assets: Liabilities:
Cash $200,000 Lease liability $262,430
Equipment + 438,720 SH Equity: $ 23,710 Interest

Acc. Depr. ( 87,744) 87,744 Depreciation
$350,976 $111,454
Total + $150,976 Total + $150,976
39
Future of Lease Accounting
Current convergence project between IASB and FASB to release a
new accounting standard covering Leases (replacing IAS 17)
The IASB is of the view that all leases result in a lessee obtaining the
right to use an asset and the provision of financing, regardless of the
nature or remaining life of the underlying asset. Accordingly, the IASB
concluded that all leases should be accounted for in the same
way
Key Change: All leases with terms greater than 12 months brought
onto Balance Sheet (effectively ending off-balance sheet leases)
40
Why remove Off-Balance Sheet financing
Sample of retail chains that ultimately went into liquidation, and there off-
balance sheet commitments relative to reported debt (based on 5-year
average before liquidation).
41
Future of Lease Accounting
All leases would be required to be recognized on balance sheets,

with some exceptions (i.e. leases of 12 months or less, and other
exceptions being discussed such as small assets, e.g. laptops and
office furniture).
IFRS (single model for accounting) for all leases, companies will
simply recognize interest and amortization separately. Note that this
was a new development in October 2014.
Expected implementation in 2019
42
Future of Lease Accounting: Is it a Lease or a
Service agreement?
43
Additional Practice Questions/Exercises
From Libby, Libby and Short (8th ed.)
Chapter 9: Multiple Choice questions; E9-9; E9-10; E9-14.
44
Accounting for Bonds (debt funding)
45
How do firms finance growth?
Pecking Order theory (Myers and Majluf, 1984,JFE) found that the cost
of capital is positively related to extent of information asymmetry. By
implication, firms prefer the following ordering of capital raising:
1. Internal capital (i.e. cash flow from operations)

2. Issue debt (e.g. Bonds or convertible debt)
3. Issue equity
46
Bonds: Introduction and Background
A Bond is a debt security, in which the issuer owes the holders

(investors) a debt and is obliged to repay the principal and interest (the
coupon) at a later date, termed maturity.
Bonds are generally issued for a fixed term (the maturity) longer than one
year
A bond is mostly just a loan, but in the form of a security, although

terminology used is rather different.
The issuer is equivalent to the borrower, the bond holder is simply a

lender, and the coupon rate is simply like stated interest
47
Bonds: Introduction and Background
Bond purchasers lend cash to the company today for the promise of
receiving cash payments from the company in the future.
Cash Payments Most bonds require the company to make two types of
cash payments to the bondholders (i.e. repayment pattern #3):
1. Periodic payment of interest an annuity
2. Repayment of the principal at maturity a single amount
(Zero-coupon bonds are an exception; they only require repayment of

the principal and interest at the endrepayment pattern #1.)
48
Bonds: Terminology
ON THE FACE OF THE BOND (i.e. issuance)
Face Value (Principal): amount to be paid at maturity
Coupon rate (r): rate used to compute the cash payments each
period (usually semi-annually).
Maturity date/Term: date on which (period until) principal is repaid.
IN THE MARKET (the bond market)
Price: actual cash received
Market Rate (m) or Yield: The rate of return being earned on the original
price.
49
Pricing of Bonds: Example
A bond can be priced by adding the present values of two different streams
of cash flows:
(1) The present value of the face amount that will be paid.
(2) The present value of the annuity of coupon payments
What is the present value of a 10 year bond (face value 1,000) that
has a coupon rate of 12% paid semi-annually, issued on 01/01/2011
when the current market rate is 10%?
50
Pricing of Bonds: Example
Step 1: Compute the present value of the face amount at the time it will be
paid.
20
PV = 1000/1.05 = 1000 * 0.3769
= 376.90
Step 2: Compute the present value of the annuity of coupon payments

PV = 60 * 12.4622 (We use n=20, i=0.05 - always use market rate
when using PV tables!)
coupon payments
of 1,000*6% = 747.73
every 6 months
Issue price of bond = (1) + (2) = 1,124.63 (Why greater that face value?)
51
Examples of alternative Issues of Bonds
Basic Information for alternative issues of a 10 year bond, with face value of $1,000:
Premium Par Discount
Coupon Rate (r) 12% 12% 12%
Market Rate (m) 10% 12% 14%
Present Value $1,125 $1,000 $894
Bonds are issued either:

At par (price=face value; when r = m)
At a discount (price < face value; r < m)
At a premium (price > face value; r > m) prior example
52
Accounting at issuance
Recall our prior example of a 10yr Bond issued on 01/01/2011, when we issue the
Bond we record the following:
Assets = Liabilities + SE
Cash Bonds Payable Retained
(Net) Earnings
Premium amount on
If issued at Par +1000 +1000
Bond for paying More
than what investors are
If issued at a +1,125 +1000 + 125
willing to lend
premium
If issued at a +894 +1,000 106 Discount amount on

discount Bond for paying Less
than what investors are
willing to lend
53
Accounting at issuance (cont.)
Alternatively, we could show the discount and premium amounts distinctly under
separate liability accounts (as per your textbook). Either way, it makes no difference to
Net Bond Payable amount included in Balance Sheet.
Assets = Liabilities + SE
Cash Bonds + Premium on - Discount Retained
Payable Bonds on Bonds Earnings
(at Par)
If issued at Par +1000 +1000
If issued at a +1,125 +1000 +125

premium Net Bond Payable = 1,125
If issued at a +894 +1,000 (106)
discount
Net Bond Payable = 894
54
How do we account for Bonds after issuance
Cash flows are often at a different rate than the Economic flows
Accounting Expense is based on economic flows; so:
Coupon Paid (Payable) = (Coupon Rate)*(Face Value)
Interest Expense = (Market Rate at Issuance)*(Current Book Value of Bond)
The difference between the coupon paid and the expense is a:

reduction in the premium (decrease in debt payable)
reduction in the discount (increase in debt payable)
The Book Value of Debt is always the PV of future cash flows based on the
market rate at the date of issue
55
Amortization of Premium or Discount
Amortization of Premium and Discount

Amortization of discount or premium makes up the difference
between the cash interest payment and the interest expense.
Therefore, the balance in the Bonds Payable account will approach
the face amount as the bonds approach the maturity date.
Amortization of premium reduces the balance in the
bonds payable account at each interest payment and
$1,125 interest expense decreases over time.
Premium
$1,000
Discount Amortization of discount increases the balance in the

$894 bonds payable account at each interest payment and
interest expense increases over time.
56
Accounting after Bond issuance (e.g. Discount)
Assets Liabilities + Shareholders Equity

Cash Bonds Payable + P/L Account Retained
(Net) Earnings
(Interest
Expense)
1/1/2011 Issuance 894.06 894.06
31/6/2011 (60) 2.58 (62.58)
interest payment
31/12/2011 (60) 2.77 (62.76)
interest payment
(125.34)X
Closing Balance 774.06 899.41 -
57
Amortization table of Bond Liability (@ Discount)
Net Book Value Market Rate/Pmts Per Yr
Beg Interest Coupon Amortization Discount Ending
Period NBV Expense Payment of Discount Balance NBV
1 894.06 62.58 60.00 2.58 103.36 896.64
2 896.64 62.77 60.00 2.77 100.59 899.41
3 899.41 62.96 60.00 2.96 97.63 902.37
4 902.37 63.17 60.00 3.17 94.47 905.53
...
...
...
...
...
...
...
...
...
...
...
...
...
...
18 973.76 68.16 60.00 8.16 18.08 981.92
19 981.92 68.73 60.00 8.73 9.35 990.65
20 990.65 69.35 60.00 9.35 0.00 1,000.00
58
Accounting after Bond issuance (e.g. Premium)
Assets Liabilities + Shareholders Equity

Cash Bonds Payable + P/L Account Retained
(Net) Earnings
(Interest
Expense)
1/1/2011 Issuance 1,124.62 1,124.62
31/6/2011 (60) (3.77) (56.23)
interest payment
31/12/2011 (60) (3.96) (56.04)
interest payment
(112.27)X
Closing Balance 1,004.62 1,116.89 -
59
Amortization table of Bond Liability (@ Premium)
Net Book Value Market Rate/Pmts Per Yr
Beg Interest Coupon Amortization Premium Ending

Period NBV Expense Payment of Premium Balance NBV
1 1,124.62 56.23 60.00 3.77 120.85 1,120.85
2 1,120.85 56.04 60.00 3.96 116.90 1,116.90
3 1,116.90 55.84 60.00 4.16 112.74 1,112.74
4 1,112.74 55.64 60.00 4.36 108.38 1,108.38
...
...
...
...
...
...
...
...
...
...
...
...
...
...
18 1,027.23 51.36 60.00 8.64 18.59 1,018.59
19 1,018.59 50.93 60.00 9.07 9.52 1,009.52
20 1,009.52 50.48 60.00 9.52 0.00 1,000.00
60
Convertible Debt
Hybrid Security (i.e. has elements of Debt and Equity). Type of Bond
that allows the bondholder the option to convert into specified number of
equity shares (usually at a specified date).
Typically carry a reduced interest rate, but in return bondholders received

option to become owners by converting to equity.
How do we account for these? IFRS requires we split out the equity
option component (recognize as equity) and then recognize the debt
component just as we do with Bonds (i.e. liability at present value). i.e.
issuing convertible debt will increase your cash, and then give rise to a
liability (PV of bond payments) and equity (option value of conversion).
61
Convertible Debt (continued)
How do we compute the liability and equity components?

The liability component is calculated by discounting the future cash flows of
the bonds (interest and principle) at the rate of a similar debt instrument
without the conversion option. i.e. compare to price of normal bond
The equity component is then difference between the present value of the
liability component of the convertible bond (above) and the total proceeds
we received from the issue.
E.g. We issue 1,000, 12% convertible bond, receiving 1,000. The market
rate of a similar bond is 14%.
DR Cash 1,000 (proceeds received)
CR Bond Liability 894 (PV of non-convertible similar bond)
CR Share Option (Equity) 106 (difference)
62
Additional Practice Questions/Exercises
From Libby, Libby and Short (8th ed.)
Chapter 10: Multiple Choice questions; E10-3; E10-7; E10-11; E10-13
63
Summary
After this lecture you should be now be able to:
Understand how long-term liabilities are valued on Balance Sheet

Understand differences and financial statement implications of operating
versus finance leases, and be able to find relevant information in
Financial Statements.
Be able to account for finance or operating leases
Understand the major changes in new lease accounting rules
Understand the accounting for Bonds and Convertible Debt
64
Appendix A: Early Redemption of Bonds
A gain (loss) arises on early extinguishment of debt if and only if the net book value
exceeds (is less than) the purchase price (the price the firm needs to pay to retire the
bonds). The process is:
(1) Estimate the current market value of the bond using the current market rate of
interest. (Note: In real life, you can generally just look up the current market price
of the bond.) You must include both the principal amount and any unpaid interest in
this calculation.
(2) Recognize a gain or loss as:

Net Book Value of the Bond Purchase Price (or current market value)
65
Appendix A: Early Redemption of Bonds
Assume that the bonds issued at a Premium on Jan 1 2007 (from earlier
exercise) were repurchased on December 31st, 2007, after the coupon interest
payment has been made (recall: coupon was 12%, market was 10%). The
prevailing market rate on Dec 31st is 14%.
What is the value of the bond?
Value of principal = 1,000 * 0.296 (n=18, i=7%) = 296
Value of interest payments = 60 * 10.06 (n=18, i=7%) = 603.60
Therefore, Bond Value (repurchase price) = 899.60
Do we have a Gain or Loss?
Net Book Value Repurchase Price = 1,116.90 899.60 = 217.30 gain
66
Appendix B: Brief overview on Present Value
calculations
Single Payment
Suppose we are offered a lump sum amount X at some date in the future -
the present value of X (denoted PV(X)) is the amount of money we would
have to be offered today in order to make us indifferent between having X in
the future or PV(X) today
Present value of a cash flow, X, received n periods from now is:
PV (X) = X / (1+r)n
= X * 1/(1+r)n
Where n = # of periods; r is called the discount rate for the period (e.g.
interest rate or WACC); and1/(1+r)n is called the discount factor
Financial Accounting MiM 2016 67

Appendix B: Present Value of annuity
In these cases we can compute present value of the stream of annuity

payments (pmt) as follows:

s s
payment 1
payment OR PMT * 1 1 1 n
n1
(1 r ) n
n1
(1 r ) n i (1 i )
We can then simply do the above math for each period or just simply
consult our PV annuity table for the discount factor! (Table A.2)
68
Appendix B: Present Value Calculations
Example 1 Present Value of single future payment
Suppose that today is Jan 1, 2012 and we want to calculate the present
value of 110 to be received one year from today (assume r = 10%)
Use the PV tables:

Then PV(110) = 110 / (1+r)n Table A.1
= 110 / (1+0.10)1 (n=1, r=10%)
= 110 / 1.1 OR = 110 * 0.9091
= 100 = 100
69
Example 2 PV of several future payments (unequal amounts)
To find the total present value of a stream of cash flows, we need to

determine the present value of each of the cash flows and then add them
together. I.e. PV of receiving 100 today, 110 in one year, and 145 in two
years, assuming annual discount rate of 8%:
PV of stream = 100 + 110 / (1.08)1 + 145 / (1.08)2

= 100 + 110* 0.9259 + 145* 0.8573
= 100 + 101.85 + 124.31
= 326.16
70
Example 3
Sean is saving to buy tickets to the Coldplay concert that he plans to go to in a

year. If the bank is currently paying 10% interest (simple annual), how much
does Sean need to deposit at the bank now in order to receive 50 year from
now to buy the tickets?
PV = 50/1.11 = 50 * 0.9091 = 45.45
What if the interest is compounded semiannually?
PV = 50/1.052 = 50 * 0.9070 = 45.35
71
Example 4
Cameron decides to drop out of business school to start a car wash. She
estimates the following stream of cash flows for the business (in thousands):
t = 0: initial investment of 500 t = 3: 200 inflow

t = 1: 100 inflow t = 4: 300 inflow
t = 2: 0 t = 5: 100 inflow
Assuming the prevailing rate of interest on projects of similar risk is 12%,

what is the present value of the above stream of cash flows?
72
Example 4 (continued)
Beg of period 1 P1 P2 P3 P4 P5
100 $0 200 300 100
(500.00) t=0
Bad 100 * 0.8929 = 89.29 1 period

investment! 0 2 periods
(Best to
stay at 200 * 0.7118 = 142.36 3 periods
LBS) 300 * 0.6355 = 190.65 4 periods
100 * 0.5674 = 56.74 5 periods
(20.96)
73
Example 5
Eric has been buying a lottery ticket every week for the past 10 years in the
hopes that he wins big and can retire immediately to pursue his main goal in
life: becoming a chef! In his last week before graduating from LBS he wins!
His winnings will pay him 1.5 million a year for 10 years.
What is the present value of his winnings if the current market rate of
interest is 12%?
i.e. the present value of an annuity of 1.5 million a year for 10 years
PV = 1.5m * 5.6502 = 8.48 mm
PV/A Table A.2 (n=10, 12%)

74

Lecture 10: Long-Term Liabilities: Financial Accounting

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FINANCIAL ACCOUNTING

Lecture 10: Long-Term Liabilities

Dr. Emmanuel De George

Chapter 9 (from pg.464) and Chapter 10 (Bonds) from the textbook.

Pages 466 - 469 discuss present value calculations you MUST be

Lease bad solution article discussing potential new leasing rules -

Financial Accounting MiM 2016

In this session our objectives are to:

Financial Accounting MiM 2016

1. Repayment of principal and interest in a single amount at the maturity

2. Repayment of principal and interest in a series of equal payments.

3. payment of interest in a series of equal payments plus repayment of

Financial Accounting MiM 2016

Attempts to deal with timing and uncertainty/risk of future cash flows

Basic idea is time value of money: an amount of money in the future is

Financial Accounting MiM 2016

Example Present Value of single future payment

We simply use our formula, PV = X/(1+r)n where n = 2:

PV(120) = 120 / 1.12 = 99.17 (or 120 * 0.8264 = 99.17)

PV as of: Jan 1, 2012 Jan 1, 2013 Jan 1, 2014

In these cases we can compute present value of the stream of annuity

Which do you prefer?

Example PV of annuity (continued)

Lets compare the options:

Option 2 (PV of annuity): Calculate the PV of $500,000 ($10,000,000/20)

A lease is a special type of contract called an executory contract

Executory contract a contract to pay defined amounts in the future in

More specifically, a lease is a contractual agreement between a lessor

Accounting requirements: IAS 17 (IFRS) and ASC 840 (US GAAP)

Need to assess the economic substance and the implications of the

Is the lease a simple rental agreement, or is it a disguised purchase

To answer this, we have to look at economic substance versus

Fundamental Issue of lease accounting: Classification

If the lease agreement is regarded as a capital (a.k.a. finance) lease, an

Otherwise, treat as ordinary rental expenditure (operating leases). That is,

This has significant impact on financial reporting incentives

source: IASB Lease project update, August 2014

IFRS and US GAAP both require that leases be classified as finance

- Finance (or Capital) Leases imply ownership

US GAAP is more form-driven (series of tests) while IFRS is more

A lease will be classified as a Finance (capital) lease if it meets any of the

IAS 17 also introduces a fifth condition for a finance lease

Under all standards, a lease that is not a finance lease is an operating

Also, only non-cancellable leases may be capitalised.

Accounting for Finance (Capital) Leases:

The lease is treated as a financing arrangement for the purchase of

1. Lease term is 3 years. The agreement is non-cancellable, requiring equal

Given we met two of these criteria - we classify this lease as a Finance

Operating lease (off-balance sheet)

Finance lease (on-balance sheet)

Refer to the previous example. Determine the annual depreciation

A B = A*i C D=C-B E = A-D

The transaction worksheet is (first year only):

Transact./date Assets Liabilities Shareholders

Fixed Assets Cash Long-term Income

Inception 45,000 45,000

Closing Bal. 45,000 (15,000) (21,709) 32,041 -

Expenses: Capital vs. Operating Lease

22000 Capital Lease

(Year 1 of our previous example)

Lufthansa Annual Report

KLM Royal Dutch Airlines Annual Report