Book 3 - FRA - Non-current (long-term) liabilities

Question 1

Determine the initial recognition, initial measurement and subsequent measurement of bonds issued at par.

Answer 1

When a bond is issued at par, the bond’s yield at issuance is equal to the coupon rate. In this case, the present value of the coupon payments plus the present value of the face amount is equal to the par value. The effects on the financial statements are straightforward:

• On the balance sheet, assets and liabilities increase by the bond proceeds (face value). The book value of the bond liability will not change over the term of the bond.
• On the income statement, interest expense for the period is equal to the coupon payment because the yield at issuance and the coupon rate are the same.
• On the cash flow statement, the issue proceeds are reported as a cash inflow from financing activities and the coupon payments are reported as cash outflows from operating activities (under U.S. GAAP; they may be reported as CPO or CFF outflows under IFRS). At maturity, repayment of the face value is reported as a cash outflow from financing activities.

Question 2

Determine the initial recognition, initial measurement and subsequent measurement of bonds issued at a discount or premium.

Answer 2

If the coupon rate is less than the bond’s yield, the proceeds received will be less than the face value. The difference is known as a discount. The coupon rate is lower than the coupon rate that would make the market price of the bond equal to its par value. Investors will pay less than face value because of the lower coupon rate. Such bonds are known as discount bonds.

If the coupon rate is greater than the bond’s yield, the bond price and the proceeds received will be greater than face value. We refer to such bonds as premium bonds. In this case, investors will pay more for the above-market coupon payments.

Balance Sheet Measurement.

When a company issues a bond, assets and liabilities both initially increase by the bond proceeds. At any point in time, the book value of the bond liability will equal the present value of the remaining future cash flows (coupon payments and face value) discounted at the bond’s yield at issuance.

A premium bond is reported on the balance sheet at more than its face value. As the premium is amortized (reduced), the book value of the bond liability will decrease until it reaches the face value of the bond at maturity.

A discount bond is reported on the balance sheet at less than its face value. As the discount is amortized, the book value of the bond liability will increase until it reaches face value at maturity.

Question 3

Discuss the effective interest method and calculate interest expense.

Answer 3

For a bond issued at a premium or discount, interest expense and coupon interest payments are not equal. Interest expense includes amortization of any discount or premium. Using the effective interest rate method, interest expense is equal to the book value of the bond liability at the beginning of the period, multiplied by the bond’s yield at issuance.

• For a premium bond, interest expense is less than the coupon payment (yield < coupon rate). The difference between interest expense and the coupon payment is the amortization of the premium. The premium amortization is subtracted each period from the bond liability on the balance sheet. Thus, interest expense will decrease over time as the bond liability decreases.
• For a discount bond, interest expense is greater than the coupon payment (yield > coupon rate). The difference between interest expense and the coupon payment is the amortization of the discount. The amortization of the discount each period is added to the bond liability on the balance sheet. Therefore, interest expense will increase over time as the bond liability increases.

The effective interest rate method of amortizing a discount or premium is required under IFRS. Under U.S. GAAP, the effective interest rate method is preferred, but the straight-line method is allowed if the results are not materially different.

Question 4

Disscus impact on FS issuance of Zero cupon bond.

Answer 4

Zero-coupon bonds make no periodic interest payments. A zero-coupon bond, also known as a pure-discount bond, is issued at a discount from its par value and its annual interest expense is implied, but not explicitly paid. The actual interest payment is included in the face value that is paid at maturity. The effects of zero-coupon bonds on the financial statements are qualitatively the same as any discount bond, but the impact is larger because the discount is larger.

Question 5

Discuss Issuance Costs.

Answer 5

Issuing a bond involves legal and accounting fees, printing costs, sales commissions, and other fees. Under U.S. GAAP, issuance costs are capitalized as an asset (deferred charge) and allocated to the income statement as an expense over the term of the bond.

Under IFRS, the initial bond liability on the balance sheet is reduced by the amount of issuance costs, increasing the bond’s effective interest rate. In effect, issuance costs are treated as unamortized discount.

Question 6

Fair Value Reporting Option.

Answer 6

Recall that the book value of a bond liability is based on its market yield at issuance. So, as long as the bond’s yield does not change, the bond liability represents fair (market) value. However, ifthe yield changes, the balance sheet liability is no longer equal to fair value.

An increase in the bond’s yield will result in a decrease in the fair value of the bond liability. Conversely, a decrease in the bond’s yield increases its fair value. Changes in yield result in a divergence between the book value of the bond liability and the fair value of the bond. The fair value of the bond is the economic liability at a point in time.

IFRS and U.S. GAAP give firms the irrevocable option to report debt at fair value. Under this option, gains (decreases in bond liability) and losses (increases in bond liability) that result from changes in bonds’ market yields are reported in the income statement.

Question 7

Cash Flow Impact of lssuing a Bond.

Answer 7

Question 8

Income Statment inpact of issuing a bond.

Answer 8

Question 9

Balance Sheet Impact of Issuing a Bond.

Answer 9

Question 10

Discuss the derecognition of debt.

Answer 10

A firm may choose to redeem bonds before maturity because interest rates have fallen, because the firm has generated surplus cash through operations, or because funds from the issuance ofequity make it possible (and desirable).

When bonds are redeemed before maturity, a gain or loss is recognized by subtracting the redemption price from the book value of the bond liability at the reacquisition date.

Under U.S. GAAP, any remaining unamortized bond issuance costs must be written off and included in the gain or loss calculation. Writing off the cost of issuing the bond will reduce a gain or increase a loss. No write-off is necessary under IFRS because the issuance costs are already accounted for in the book value of the bond liability.

Any gain or loss from redeeming debt is reported in the income statement, usually as
a part of continuing operations, and additional information is disclosed separately.

Question 11

Explain the role of debt covenants in protecting creditors.

Answer 11

Debt covenants are restrictions imposed by the lender on the borrower to protect the lender’s position. Debt covenants can reduce default risk and thus reduce borrowing costs. The restrictions can be in the form of affirmative covenants or negative covenants.

With affirmative covenants, the borrower promises to do certain things, such as:

• Make timely payments of principal and interest.
• Maintain certain ratios (such as the current, debt-to-equity, and interest coverage ratios) in accordance with specified levels.
• Maintain collateral, if any, in working order.

With negative covenants, the borrower promises to refrain from certain activities that might adversely affect its ability to repay the outstanding debt, such as:

• Increasing dividends or repurchasing shares.
• Issuing more debt.
• Engaging in mergers and acquisitions.

Question 12

Discuss the financial statement presentation ofand disclosures relating to debt.

Answer 12

Firms will often report all of their outstanding long-term debt on a single line on the balance sheet. The portion that is due within the next year is reported as a current liability. The firm separately discloses more detail about its long-term debt in the footnotes. These disclosures are useful in determining the timing and amounts offuture cash outflows.

The footnote disclosure usually includes a discussion of:

• 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.
• The amount of debt maturing in each of the next five years

Question 13

Discuss the motivations for leasing assets instead of purchasing them.

Answer 13

A finance lease is, in substance, a purchase of an asset that is financed with debt.

An operating lease is essentially a rental arrangement.

Leasing can have certain benefits:

• Less costly financing. Typically, a lease requires no initial down payment. Thus, the lessee conserves cash.
• Reduced risk of obsolescence. At the end of the lease, the asset can be returned to the lessor.
• Less restrictive provisions. Leases can provide more flexibility than other forms of financing because the lease agreement can be negotiated to better suit the needs of each party.
• Off-balance-sheet financing. Entering into an operating lease does not result in a balance sheet liability, so reported leverage ratios are lower compared to borrowing the funds to purchase assets.
• Tax reporting advantages. In the United States, firms can create a synthetic lease whereby the lease is treated as an ownership position for tax reporting. This allows the lessee to deduct depreciation expense and interest expense for tax purposes. For financial reporting, the lease is treated as a rental agreement and the lessee does not report the lease liability on the balance sheet.

Question 14

Distinguish between a finance lease and an operating lease from the perspectives of the lessee.

Answer 14

Under IFRS, the classification of a lease is determined by the economic substance of the transaction. If substantially all the rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease. Circumstances that require a lease to be treated as a finance lease include:

• Title to the leased asset is transferred to the lessee at the end of the lease.
• The lessee can purchase the leased asset for a price that is significantly lower than the fair value of the asset at some future date.
• The lease term covers a major portion of the asset’s economic life.
• The present value of the lease payments is substantially equal to the fair value of the leased asset.
• The leased asset is so specialized that only the lessee can use the asset without significant modifications.

Under U.S. GAAP, the criteria are conceptually similar, but are more specific than under IFRS. A lessee must treat a lease as a capital (finance) lease ifany of the following criteria are met:

• Tide to the leased asset is transferred to the lessee at the end of the lease period.
• A bargain purchase option permits the lessee to purchase the leased asset for a price that is significantly lower than the fair market value of the asset at some future date.
• The lease period is 75% or more ofthe asset’s economic life.
• The present value of the lease payments is 90% or more of the fair value of the leased asset.

Question 15

Distinguish between a finance lease and an operating lease from the perspectives of the lessor.

Answer 15

Under IFRS, classification by the lessor is the same as the lessee’s; that is, if substantially all the rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease. Otherwise, the lease is treated as an operating lease.

Under U.S. GAAP, ifany one ofthe capital (finance) lease criteria for lessees is met, and the collectability of lease payments is reasonably certain, and the lessor has substantially completed performance, the lessor must treat the lease as a capital (finance) lease. Otherwise, the lessor will treat the lease as an operating lease.

With an operating lease, the lessor recognizes rental income and continues to report and depreciate the leased asset on irs balance sheet. With a capital (finance) lease, the lessor removes the leased asset from the balance sheet and replaces it with a lease investment account (lease receivable).

Question 16

Determine the initial recognition, initial measurement, and subsequent measurement offinance leases by lessee.

Answer 16

Operating lease. At the inception of the lease, the balance sheet is unaffected. No asset or liability is reported by the lessee. During the term of the lease, rent expense equal to the lease payment is recognized in the lessee’s income statement. In the cash flow statement, the lease payment is reported as an outflow from operating activities.

Finance lease. At the inception of the lease, the lower of the present value of future minimum lease payments or the fair value of the leased asset is recognized as both an asset and as a liability on the lessee’s balance sheet. Over the term of the lease, the asset is depreciated in the income statement and interest expense is recognized. Interest expense is equal to the lease liability at the beginning of the period multiplied by the lease interest rate.

In the cash flow statement, the lease payment is separated into its interest and principal components.

Balance sheet. A finance lease results in a reported asset and a liability. Consequently, turnover ratios that use total or fixed assets in their denominators will be lower when a lease is treated as a finance lease as compared to an operating lease. For the same reason, return on assets will also be lower for finance leases. Most importantly, leverage ratios, such as the debt-to-assets ratio and the debt-to-equity ratio, will be higher with finance leases than with operating leases because of the reported liability. The principal payment due within the next year is reported as a current liability on the lessee’s balance sheet.

Income statement. Operating income (EBIT) will be higher for companies that use finance leases relative to companies that use operating leases. With an operating lease, the entire lease payment is an operating expense, while for a finance lease, only the depreciation of the leased asset (not the interest portion of the lease payment) is treated as an operating expense.

Cash flow statement. Total cash flow is unaffected by the accounting treatment of a lease. If the lease is treated as a finance lease, then only the portion of the lease payment that is considered interest expense reduces cash flow from operations. The part of the lease payment considered repayment of principal reduces cash flow from financing activities.

*There are two points that candidates often find confusing. First, interest payments are an operating cashflow but are not considered an operating expenditure. That is, they are not subtracted in calculating operating income (EBIT). Second, adding equal amounts to assets and liabilities will typically increase the debt-to-assets ratio. Because assets are typically larger than debt (liabilities), the numerator of the debt-to-assets ratio increases by a greater proportion than the denominator when equal amounts are added to each, so the ratio increases. With respect to the current ratio and working capital, the current year principal amortization for a finance lease is added to current liabilities, but there is no increase in current assets because the asset is long-lived. *

Question 17

Determine the initial recognition, initial measurement, and subsequent measurement offinance leases by lessor.

Answer 17

From the lessor’s perspective, a capital lease under U.S. GAAP is treated as either a sales­ type lease or a direct-financing lease. If the present value of the lease payments exceeds the carrying value of the asset, the lease is treated as a sales-rype lease. If the present value of the lease payments is equal to the carrying value, the lease is treated as a direct financing lease.

IFRS does not distinguish between a sales-type lease and a direct financing lease. However, similar treatment to a sales-rype lease is allowed under IFRS for finance leases originated by manufacturers or dealers. In this case, the present value of the lease payments likely exceeds the carrying value of the asset.

A sales-type lease is treated as if the lessor sold the asset for the present value of the lease payments and provided a loan to the buyer in the same amount. Sales-type leases are typical when the lessor is a manufacturer or dealer because the cost (balance sheet value) of the leased asset is usually less than its fair value.

At the inception of the lease, the lessor recognizes a sale equal to the present value of the lease payments, and cost of goods sold equal to the carrying value of the asset. Just as with a normal sales transaction, the difference between the sales price and cost of goods sold is gross profit. The asset is removed from the balance sheet and a lease receivable is created, equal to the present value of the lease payments. As the lease payments are received, the principal portion of the payment reduces the lease receivable and the interest portion of the lease payment is recognized as interest income. The interest portion of each lease payment is equal to the lease receivable at the beginning of the period multiplied by the lease interest rate.

In the cash flow statement, the interest portion of the lease payment is reported as an inflow from operating activities, and the principal reduction is reported as an inflow from investing activities, just as with an amortizing loan.

In a direct financing lease, no gross profit is recognized by the lessor at the inception of the lease. Because the present value of the lease payments is equal to the carrying value of the leased asset, the lessor is simply providing a financing function to the lessee. In this case, the lessor is not usually a manufacturer or dealer, but has purchased the asset from a third party.

At the inception of the lease, the lessor removes the asset from its balance sheet and creates a lease receivable in the same amount. As the lease payments are received, the principal portion of each payment reduces the lease receivable.

In the income statement, the lessor recognizes interest income over the term of the lease. The interest portion of each lease payment is equal to the lease receivable at the beginning of the period multiplied by the interest rate.

In the cash flow statement, the interest portion of the lease payment is reported as an inflow from operating activities and the principal reduction is reported as an inflow from investing activities.

**Operating Lease. **If the lease is treated as an operating lease, the lessor simply recognizes the lease payment as rental income. In addition, the lessor will keep the leased asset on its balance sheet and depreciate it over its useful life.

Question 18

Compare the disclosures relating to finance and operating leases.

Answer 18

Both lessees and lessors are required to disclose useful information about finance leases and operating leases in the financial statements or in the footnotes, including:

• General description of the leasing arrangement.
• The nature, timing, and amount of payments to be paid or received in each of the next five years. Lease payments after five years can be aggregated.
• Amount of lease revenue and expense reported in the income statement for each period presented.
• Amounts receivable and unearned revenues from lease arrangements.
• Restrictions imposed by lease agreements.

For lessees, analysts often use the disclosures to estimate the off-balance-sheet liabilities of operating leases.

Question 19

Describe defined contribution and defined benefit pension plans.

Answer 19

A pension is a form of deferred compensation earned over time through employee service. The most common pension arrangements are defined contribution plans and defined benefit plans.

A defined contribution plan is a retirement plan in which the firm contributes a sum each period to the employee’s retirement account. The firm’s contribution can be based on any number of factors, including years of service, the employee’s age, compensation, profitability, or even a percentage of the employee’s contribution. In any event, the firm makes no promise to the employee regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk.

In a defined benefit plan, the firm promises to make periodic payments to employees after retirement. The benefit is usually based on the employee’s years of service and the employee’s compensation at, or near, retirement.

Question 20

Compare the presentation and disclosure of defined contribution and defined benefit pension plans.

Answer 20

The financial reporting requirements for defined contribution plans are straightforward. Pension expense is simply equal to the employer’s contribution. There is no future obligation to report on the balance sheet as a liability.

Financial reporting for a defined benefit plan is much more complicated than for a defined contribution plan because the employer must estimate the value of the future obligation to its employees. The obligation involves forecasting a number of variables, such as future compensation levels, employee turnover, average retirement age, mortality rates, and an appropriate discount rate.

The change in the net pension asset or liability is recognized on the firm’s financial statements each year.