CFA 32: Non-Current (Long-Term) Liabilities Flashcards
accounting for bond amortisation, interest expense, and interest payments
Bonds Payable
Companies initially report bonds as a liability on their balance sheet at the amount of the sales proceeds net of issuance costs under IFRS and at the amount of the sales proceeds under US GAAP, ignoring any bond issuance costs. The amount at which bonds are reported on the company’s balance sheet is referred to as the carrying amount, carrying value, book value, or net book value.
If the bonds are issued at par, the initial carrying amount will be identical to the face value, and usually the carrying amount will not change over the life of the bonds. For bonds issued at face value, the amount of periodic interest expense will be the same as the amount of periodic interest payment to bondholders.
If, however, the market rate differs from the bonds’ coupon rate at issuance such that the bonds are issued at a premium or discount, the premium or discount is amortized systematically over the life of the bonds as a component of interest expense.
For bonds issued at a premium to face value, the carrying amount of the bonds is initially greater than the face value. As the premium is amortized, the carrying amount (amortized cost) of the bonds will decrease to the face value. The reported interest expense will be less than the coupon payment.
The accounting treatment for bonds issued at a discount reflects the fact that the company essentially paid some of its borrowing costs at issuance by selling its bonds at a discount. Rather than there being an actual cash transfer in the future, this “payment” was made in the form of accepting less than the face value of the bonds at the date of issuance. The remaining borrowing cost occurs as a cash interest payment to investors each period. The total interest expense reflects both components of the borrowing cost: the periodic interest payments plus the amortization of the discount.
The accounting treatment for bonds issued at a premium reflects the fact that the company essentially received a reduction on its borrowing costs at issuance by selling its bonds at a premium. Rather than there being an actual reduced cash transfer in the future, this “reduction” was made in the form of receiving more than face value for the bonds at the date of issuance. The total interest expense reflects both components of the borrowing cost: the periodic interest payments less the atomization of the premium. When bonds mature, the carrying amount will be equal to the face value regardless of whether the bonds were issued at face value, a discount, or a premium.
Two methods for amortizing the premium or discount of bonds that were issued at a price other than par are the effective interest rate method and the straight-line method. The effective interest rate method is required under IFRS and preferred under US GAAP because it better reflects the economic substance of the transaction.
The effective interest rate method applies the market rate in effect when the bonds were issued (historical market rate or effective interest rate) to the current amortized cost (carrying amount) of the bonds to obtain interest expense for the period. The difference between the interest expense (based on the effective interest rate and the amortized cost) and the interest payment (based on the coupon rate and face value) is the amortization of the discount or premium. The straight-line method of amortization evenly amortizes the premium or discount over the life of the bond, similar to straight-line depreciation on long-lived assets. Under either method, as the bond approaches maturity, the amortized cost approaches face value.
accounting for current market rates and fair value reporting option
Bonds Payable
As market interest rates change, the bonds’ carrying amount diverges from the bonds’ fair market value. When market interest rates decline, the fair value of a bond with a fixed coupon rate increases. As a result, a company’s economic liabilities may be higher than its reported debt based on amortized historical cost.
Conversely, when market interest rates increase, the fair value of a bond with a fixed coupon rate decreases and the company’s economic liability may be lower than its reported debt. Using financial statement amounts based on amortized cost may underestimate (or overestimate a company’s debt-to-total-capital ratio and similar leverage ratios.
IFRS and US GAAP require fair value disclosures in the financial statements unless the carrying amount approximates fair value or the fair value cannot be reliably measured.
A company selecting the fair value option for a liability with a fixed coupon rate will report gains (losses) when market interest rates increase (decrease). When market interest rates increase or other factors cause the fair value of a company’s bonds to decline the company reports a decrease in the fair value of its liability and a corresponding gain. When interest rates decrease or other factors cause the fair value of a company’s bonds to increase, the company reports and increase in the fair value of its liability and a corresponding loss. The gains or losses resulting from changes in fair values are recognized in profit or loss.
accounting for derecognition of debt
Bonds Payable
If a company decides to redeem bonds before maturity and thus extinguish the liability early, bonds payable is reduced by the carrying amount of the redeemed bonds. The difference between the cash required to redeem the bonds and the carrying amount of the bonds is a gain or loss on the extinguishment of debt.
Under IFRS, debt issuance costs are included in the measurement of the liability and are thus part of its carrying amount.
Under US GAAP, debt issuance costs are accounted for separately from bonds payable and are amortized over the life of the bonds. Any unamortized debt issuance costs must be written off at the time of redemption and included in the gain or loss on debt extinguishment.
A gain or loss on the extinguishment of debt is disclosed on the income statement, in a separate line item, when the amount is material.
In a statement of cash flows prepared using the indirect method, net income is adjusted to remove any gain or loss on the extinguishment of debt from operating cash flows and the cash paid to redeem the bonds is classified as cash used for financing activities.
Recall that the indirect method of the statement of cash flows begins with net income and makes necessary adjustments to arrive at cash from operations including removal of gains or losses from non-operating activities.
direct financing leases
Leases
A type of finance lease, from a lessor perspective, where the present value of the lease payments (less receivable) equals the carrying value of the leased asset. The revenues earned by the lessor are financing in nature.
sales-type leases
Leases
A type of finance lease, from a lessor perspective, where the present value of the lease payments (less receivable) exceeds the carrying value of the leased asset. The revenues earned by the lessor are operating (the profit on sale) and financing (interest) in nature.
accounting and reporting by the lessee
Leases
Because a finance lease is economically similar to borrowing money and buying an asset, a company that enters into a finance lease as the lessee reports an asset (leased asset) and related debt (lease payable) on its balance sheet. The initial value of both the leased asset and lease payable is the lower of the present value of future lease payments and the fair value of the leased asset; in many cases these will be equal.
On the income statement, the company reports interest expense on the debt, and if the asset acquired is depreciable, the company reports depreciation expense.
Because an operating lease is economically similar to renting an asset, a company that enters into an operating lease as the lessee records a lease expense on its income statement during the period it uses the asset. No asset or liability is recorded on its balance sheet.
The main accounting differences for a lessee between a finance lease and an operating lease, then, are that reported assets and debt are higher and expenses are generally higher in the early years under a finance lease. Because of the higher reported debt and expenses under a finance lease, lessees often prefer operating leases to finance leases.
On the lessee’s statement of cash flows, for an operating lease, the full lease payment is shown as an operating cash outflow. For a finance lease, only the portion of the lease payment relating to interest expense potentially reduces operating cash flow; the portion of the lease payment that reduces the lease liability appears as a cash outflow in the financing section.
A company reporting a lease as an OPERATING LEASE Will typically show higher profits in early years, higher return measures in early years, and a stronger solvency position than an identical company reporting an identical lease as a finance lease.
However, the company reporting the lease as a FINANCE lease will show higher operating cash flows because the portion of the lease payment that reduces the carrying amount of the lease liability will be reflected as a financing cash outflow rather than an operating cash outflow. The interest expense portion of the lease payment on the statement of cash flows can be treated as operating or financing cash outflow under IFRS and is treated as operating cash outflow under US GAAP.
finance lease (capital lease)
Leases
An agreement allowing the lessee to use some asset for a period of time; essentially a rental.
operating lease
Leases
An agreement allowing the lessee to use some asset for a period of time; essentially a rental.
accounting and reporting by the lessor
Leases
Similar to accounting and reporting on the lessee side, the lessor also must determine whether a lease is classified as operating or finacne.
Under IFRS, the determination off a finacne lease on the lessor’s side mirrors that of the lessee’s. That is, in a finacne lease the lessor transfers substantially all the reisks and rewards incidental to legal ownership.
Under US GAAP, the lessor determines whether a lease is a captial or operating lease using the same four identifying criteria as a lessee, plus the additional revenue recognition criteria. That is, the lessor msut be reasonably assured of cash collection and has performed substantially under the lease. From the lessor’s perspective, US GAAP distinguishes beween types of capital leases. There are tow main types of capital leases from a lessor’s perspective:
1) direct financing leases
2) sales-type leases
Under IFRS and US GAAAP, if a lessor enters into an operating lease, the lessor records any lease revenue when earned. The lessor also continues to report the leased asset on the balance sheet and the asset’s associated depreciation expense on the income statement.
Under IFRS, if a lessor enters into a finance lease, the lessor reports a receivable at an amount equal to the net investment in the lease (the present value of the minum lease payments receivable and ay estimated unguaranteed residual avlue accruing to the lessor). The leased asset is derecognised; assets are redused by the carrying amount of the leased asset. Initial direct costs incurred by a lessor, other than a manufacturer or dealer lessor, are added to the receivable and reduce the amount of income recognised over the lease term. The lease payment is treated principal (reduces lease receivable) and finacnce income. The recognition of fincance income should reflect a constant periodic rate of retun on the lessor’s net investment in the lease.
For lessors taht are MANUFACTURERS or DEALERS, theinitla direct costs are treated as an expense when the selling profit is recognized; typically, selling profit is recognised at the beginning of the lease term. Sales revenue equals the lower of the fair value of the asset or the present value of the minium lease payments. The cost of sale is the carrying amount of the leased asset less the present value of the estimated unguaranteed residual value.
Under US GAAP, a direct financing lease results when the rpresent value of lease payments (and thus the amount recorded as a lease receivable) equals the carrying calue of the leased asset. Because there is no “profit” on the asset itself, the lessor is essentially providing financing to the lessee and the revenues earned by the lessor are financing in nature (i.e. interst revenue). If, however, the present value of lease payments (and thus the amount recorded as a lease receivable) exceeds the carrying camount of the leased asset, the lease is treated as a sales-type lease.
Both types of capital leases have smimilar effects on the balance sheet: The lessor reports a leas receivable based on the present value of future lease payments and derecognizes the leased asset. The carrying value of the leased asset relative to the presnet value of lease payments distinguishes a direct financing lease from a sales-type lease. A direct financing lease is reportedwhen the present value of lease payment is equal to the value of the leased asset to the lessor. When the present value of lease payaments is greater than the value of theleased asset, the lease is a sales-ype lease. The income statement effect will thus differ based on the type of lease.
In a direct financing lease, the lessor excahanges a lease receivable for the leased asset, no longer reporting the leased asset on its books. The lessor’s revenue is dereived from interest on the lease receivable. In a sales-type lease, the lessor “sells” the asset to the lessee and also provides finaicng on the sale. Therefore, in a sales-type lease, a lessor reports revenue form the sale, cost of goods sold (i.e. the carrying amount of the asset leased), profit on the sale, and interest renvue earned from financing the sale. The lessor will show a profit on the transaction in the year of inception and interest revenue over the life of the lease.
When a lessor enters into a sales-type lease ( a lease agreement where the present value of the future elase payments is greater than the value of the leased asset to the lessor) it will show a profit on the transaction in the year of lease inception and interest renveue over the life of the lease.
accounting for pensions and other post-employment benefits
The accounting and reporting for pension plans depends on the type of pension plan offered. Two common types of pension plans are defined-contribution plans and defined-benefit plans.
Under a defined-contribution plan, a company contributes an agreed-upon (defined) amount into the plan. The agreed-upon amount is the pension expense.
*The amount the company contributes to the plan is treated as an operating cash outflow. The only impact on assets and liabilities is a decrease in cash, although if some portion of the agreed-upon amount has not been paid by fiscal year-end, a liability would be recognized on the balance sheet.
Accounting for a defined-benefit plan is more complicated. Under a defined-benefit plan, a company makes promises of future benefits to be paid to the employee during retirement. For example, a company could promise an employee annual pension payments equal to 70 percent of his final salary at retirement until death. Estimating the eventual amount of the obligation arising from that promise requires the company to make many assumptions, such as the employee’s expected salary at retirement and the number of years the employee is expected to live beyond retirement.
The company estimates the future amounts to be paid and discounts the future estimated amounts to a present value (using a rate reflective of a high-quality corporate bond yield) to determine the pension obligation. The discount rate used to determine the pension obligation significantly affects the amount of the pension obligation. The pension obligation is allocated over the employee’s employment as part of pension expense.
If the fair value of the fund’s assets is higher than the present value of the estimated pension obligation, the plan has a surplus and the company’s balance sheet will reflect a net pension asset. Conversely, if the present value of the estimated pension obligation exceeds the fund’s assets, the plan has a deficit and the company’s balance sheet will reflect a net pension liability.
Thus, a company reports either a net pension asset or a net pension liability. Each period, the change in the 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 each period is viewed as having three general components. Two of the components of this change are recognized as pension expense in profit and loss:
1) Employee’s service costs
2) The net interest expense or income accrued on the beginning net pension asset or liability.
The service cost during the period for an employee is the present value of the increase in the pension benefit earned by the employee as a result of providing one more year of service. Their service cost also includes past service costs, which are changes in the present value of the estimated pension obligation related to employees’ service in prior periods, such as might arise from changes in the plan.
The net interest expense or income is calculated as the net pension asset or liability during a period - “remeasurements” - is recognized in other comprehensive income. Remeasurements are not amortized into profit or loss over time.
Remeasurements include (a) actuarial gains and losses and (b) the actual return on plan assets less any return included in the net interest expense or income. Actuarial gains and losses can occur when changes are made to the assumptions on which a company bases its estimated pension obligation (e.g. employee turnover, mortality rates, retirement ages, compensation increases).
The actual return on plan assets would likely differ from the amount included in the net interest expense or income, which is calculated using a rate reflective of a high-quality corporate bond yield; plan assets are typically allocated across various asset classes, including equity as well as bonds.
Under US GAAP, the change in net pension asset or liability each period is viewed as having five components, some of which are recognized in profit and loss in the period incurred and some of which are recognized in other comprehensive income and amortized into profit and loss over time.
The three components recognized in profit and loss in the period incurred are
1) Employees’ service costs for the period;
2) Interest expense accrued on the beginning pension obligation
3) Expected return on plan assets, which reduces the amount of expense recognized;
4) Past service costs
5) Actuarial gains and losses
Past service costs are recognized in other comprehensive income in the period in which they arise and then subsequently amortized into pension expense over the future service period of the employees covered by the plan. Actuarial gains and losses are also recognized in other comprehensive income in the period in which they occur and then amortized into pension expense over time. In effect, US GAAP allows companies to “smooth” the effects on pension expense over time for these latter two components.
Similar to other forms of employee compensation for a manufacturing company, the pension expense related to production employees is added to inventory and expensed through cost of sales (cost of goods sold). For employees not involved directly in the production process, the pension expense is included with salaries and other administrative expenses. Therefore, pension expense is not directly reported on the income statement. Rather, extensive disclosures are included in the notes to the financial statements.
