1. CFA® Level I - Financial Reporting and Analysis
Non-Current (Long-Term) Liabilities
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2. Introduction and Contents
Bonds Payable
Leases
Pensions and Other Post Employment Benefits
Evaluating Solvency

3. 2. Bonds Payable
Bonds are contractual promises made by a company to pay cash in the future to its lenders (bondholders) in exchange for receiving cash in the present. Terms of the bond contract are contained in a document called an indenture.
What is the risk?
Required return?
Bond
market rate of interest at issuance
effective interest rate
$$$

4. Bond Issuance: Coupon Rate = Effective Interest Rate
Face Value (Par Value) = 100
Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually
<Details of issuer’s obligations>
When the bond is issued, investors require are return of 10%. What are the sales proceeds? How is the issuance reflected in the financial statements?
coupon rate = effective interest rate Bond is issued at face value

5. Bond Issuance: Coupon Rate < Effective Interest Rate
Face Value (Par Value) = 100
Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually
<Details of issuer’s obligations>
When the bond is issued, investors require a return of 11%. What are the sales proceeds? How is the issuance reflected in the financial statements?
coupon rate < effective interest rate Bond is issued at a discount

6. Bond Issuance: Coupon Rate > Effective Interest Rate
Face Value (Par Value) = 100
Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually
<Details of issuer’s obligations>
When the bond is issued, investors require a return of 9%. What are the sales proceeds? How is the issuance reflected in the financial statements?
coupon rate > effective interest rate Bond is issued at a premium

7. Carrying Amount (Begin) Amortization of Discount
Accounting for Bond Amortization, Interest Expense and Interest Payments
Once the bond has been issued, the company needs to make coupon payments. How are these payments accounted for?
Amortizing a Bond Discount
Face Value (Par Value) = 100
Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually
Year
Carrying Amount (Begin)
Interest Expense
Interest Payment
Amortization of Discount
Carrying Amount (End)
2011
97.56
10.73
10.00
0.73
98.29
2012
10.81
0.81
99.10
2013
10.90
0.90
100.00
When the bond is issued, investors require a return of 11%. Show the following:
Interest payments
Interest expense
Reported bond value
How are the above numbers reflected in the financial statements?
Balance Sheet
Income Statement
Cash Flow Statement

8. Carrying Amount (Begin) Amortization of Premium
Example
Amortizing a Bond Premium
Face Value (Par Value) = 100
Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually
Year
Carrying Amount (Begin)
Interest Expense
Interest Payment
Amortization of Premium
Carrying Amount (End)
2011
2012
2013
When the bond is issued, investors require a return of 9%. Show the following:
Interest payments
Interest expense
Reported bond value
How are the above numbers reflected in the financial statements?
Balance Sheet
Income Statement
Cash Flow Statement

9. Carrying Amount (Begin) Amortization of Discount
Example
Zero Coupon Bond
Face Value (Par Value) = 100
Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
No coupon payments are made
Year
Carrying Amount (Begin)
Interest Expense
Interest Payment
Amortization of Discount
Carrying Amount (End)
2011
2012
2013
When the bond is issued, investors require a return of 10%. Show the following:
Reported bond value
Interest expense
How are the above numbers reflected in the financial statements?
Balance Sheet
Income Statement
Cash Flow Statement

10. Issuance Costs There are costs associated with issuing a bond
U.S. GAAP: Issuance costs are shown as an asset which is amortized over the life of the bond
IFRS: Issuance costs reduce the carrying value of debt

11. Miscellaneous Points
Effective interest rate does not change during the life of the bond
Book value of bond rises for a discount bond and falls for premium bond
Link between bond amortization and amortization of long-lived assets
Effective interest rate method versus straight-line method

12. Example
A company issued a five-year 8.50% coupon bond two years ago. At the time of issuance the effective interest rate was 8.00%. Today the interest rate is 9.00%. The bond was most likely issued at:
par
a discount
a premium

13. Example
A company issued a five-year 8.50% coupon bond two years ago. At the time of issuance the effective interest rate was 8.00%. Today the interest rate is 9.00%. The book value of the bond today is most likely:
par
above par
below par

14. Current Market Rates and Fair Value Reporting Option
Discussion so far has focused on reporting bonds at amortized historical costs; this method reflects the market rate at the time the bonds were issued When market rates change, the bonds’ fair value diverges from reported value Companies have been given the option to report financial liabilities at fair value

15. Derecognition of Debt
Once bonds are issued, a company may leave the bonds outstanding until maturity or redeem the bonds before maturity
Gains and losses are recognized for bonds redeemed before maturity
Loss = Redemption price – book value of the bond liability at the reacquisition date
Example: Redemption Price = 1,020,000, Book value = 990,000, Loss = 30,000
Gain or loss from extinguishing debt is reported in the income statement in a separate line item where amount is material
Dealing with bond issuance costs
U.S. GAAP: Unamortized bond issuance costs must be written off and included in gain/loss calculations
IFRS: No write-off because issuance cost is included in book value of bond liability

16. Debt Covenants
Restrictions on the issuer that protects the bond holder’s interest
Reduce default risk and decrease interest cost
Affirmative covenants (certain requirements to be fulfilled e.g. interest payments on time)
Negative covenants (restrictions on an entity’s actions e.g. no additional borrowing)
Technical default

17. Presentation and Disclosure of Long-Term Debt
Firms usually combine their long term debt outstanding into a single line item
The portion of liability due within one year is shown as a current liability
Footnotes disclose more information about long term debt:
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
Amount of debt maturing in next five years
MD&A provides other information about a company’s capital resources, including debt financing and off-balance sheet financing

18. Payments over lease term
3. Leases
Lessor
(Asset Owner)
Lessee
(Asset User)
Payments over lease term
A lease can be classified as an operating or finance (capital) lease The accounting treatment is different depending on how the lease is categorized

19. Advantages of (Operating) Leases
Lessee Perspective
Lessor Perspective
Lessor might have a tax advantage by keeping asset on its balance sheet
Possibly more efficient for lessor to maintain asset
Less costly financing: lease requires no initial payment
Lessee typically pays less financing cost relative to purchasing on credit
Reduced risk of obsolescence
Improves the leverage ratios compared to borrowing the funds to purchase the asset
Tax reporting advantages: in the U.S., firms can create a synthetic lease. Asset shown on balance sheet for tax purposes.

20. Finance Lease vs. Operating Lease
Economic substance of the transaction defines the lease categorization: if the risk/reward associated with the asset are transferred to the lessee, the lease should be categorized as a finance (capital) lease
U.S. GAAP: A lease must classified by lessee as finance (capital) lease if any one of these four criteria are met:
Ownership transfer
Bargain purchase option
Lease term 75% or more of useful life
Present value of lease payments is 90% or more of fair value of leased asset
Lessor generally prefers finance leases
Lessee generally prefers operating leases

21. Reporting by Lessee (Operating Lease)
Balance Sheet: No entry
Off-balance sheet transaction
Income Statement: Rent expense equal to the lease payment
Cash Flow Statement: Cash flow from operations

22. Reporting by Lessee (Finance Lease)
Balance Sheet
At inception, present value of future lease payments is recognized as an asset and as a liability
Asset is depreciated and lease payable is amortized
Income Statement
Interest expense = liability at the beginning of period x interest rate
Cash Flow Statement
Interest expense reduces CFO
Rest of the lease payments reduces CFF

23. Example
You lease a machine on 1 January 2011 for 4 years and pay 100 at the start of every year. The fair value is Relevant internet rate is 10%. How should this lease be categorized? What is the impact on the financial statements? Assume straight line depreciation.

24. Example Lease Liability Asset
You lease a machine on 1 January 2011 for for 4 years and pay 100 at the start of every year. The fair value is Relevant internet rate is 10%. How should this lease be categorized? What is the impact on the financial statements? Assume straight line depreciation.
Lease Liability
Asset
Year
Carrying Amount (1 Jan)
Depreciaton Expense
Accumulated Depreciation
Carrying Amount (31 Dec)
Lease Liability (1 Jan)
Lease Payment (1 Jan)
Interest Expense for Year
Redection of Lease Liability
Lease Liability (31 Dec)
2011
348.69
87.17
261.52
100.00
24.87
75.13
273.56
2012
174.34
174.35
17.36
82.64
190.91
2013
261.51
87.18
9.09
90.91
100.01
2014
348.68
0.01
0.00
CFO
CFF
Spreadsheets will be shared on our Google Group

25. Example Operating Lease Finance Lease Year Expense Depreciation
You lease a machine for 4 years and pay 100 at the start of every year. The fair value is Relevant internet rate is 10%. Show the total expense under the two different categorizations.
Operating Lease
Finance Lease
Year
Expense
Depreciation
Interest
Total
2011
100
87.17
24.87
112.04
2012
17.36
104.53
2013
9.09
96.26
2014
0.00

26. Financial Statement Impact of Lease Accounting for Lessee
Finance Lease
Operating Lease
Assets
Higher
Lower
Liabilities (current and long term)
Net income (in the early years)
Net income (later years)
Total net income
Same
EBIT (operating income)
Cash flow from operation
Cash flow from financing
Total cash flow

27. Ratio Impact of Lease Accounting
Finance Lease
Operating Lease
Current ratio
Lower
Higher
Working capital
Asset turnover
Return on assets *
Return on equity *
Debt/Assets
Debt/Equity
* In early years

28. Reporting by Lessor Operating lease: Record revenue when earned
Report leased asset on balance sheet
Depreciation expense on income statement
Finance lease:
Any one from the four criteria plus the additional revenue recognition criteria
Direct finance lease
Sales type lease

29. Reporting by Lessor
Direct finance lease: present value of lease payments = carrying value of lease asset
Lessor earns interest expense
At inception record a lease receivable
Sales type lease: present value of lease payments > carrying value of lease asset
Lessor “sells” the asset to lessee
Provides financing on the sale
Reports profit on sale and reports interest revenue on lease receivable

30. Direct Financing Lease - Lessor Perspective
You lease a machine for 4 years and receive 100 at the start of every year. Relevant interest rate is 10%. What are the accounting entries assuming this is a direct financing lease.
Lease Receivable - Lessor Perspective
Lease Receivable (1 Jan)
Lease Payment (1 Jan)
Interest Income for Year
Redection of Lease Receivable
Lease Receivable (31 Dec)
348.69
100.00
24.87
75.13
273.56
17.36
82.64
190.91
9.09
90.91
100.01
0.00
0.01

31. Disclosures for Finance and Operating Leases
Lease disclosures show payments under both capital and operating leases for the next five years and after that
Disclosures can help estimate extent of a company’s off-balance-sheet lease financing through operating leases
See Example 11

32. 4. Pensions and other Post-Employment Benefits
Pensions and other post-employment benefits give rise to non-current liabilities reported by many companies. Pension plans can be divided in two major categories:
Defined Contribution: Company contributes an agreed-upon amount to the plan
Pension expense on the income statement
Operating cash outflow
Defined Benefit: Company makes promises of future benefits to be paid to employees
Company make a contribution to pension fund (Plan Assets); pension payments are made from this fund

33. Disclosures for Defined Benefit Plans
Funded Status = Plan Assets - Defined Benefit Obligation
If positive  overfunded or net pension asset
If negative  underfunded or net pension liability
Net pension asset or liability is reported on the balance sheet
Each period the change in 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 has three components
Employee service costs
Net interest expense or income
Re-measurements
Under U.S. GAAP, the change in the net pension asset or liability has five components

34. Example
On 31 December 2012 a company has pension obligation of 100 and pension assets are 90. What will the company report on the balance sheet under IFRS? Under U.S. GAAP?

35. 5. Evaluating Solvency Solvency Ratios Numerator Denominator
Debt to assets ratio
Total debt
Total assets
Debt to capital ratio
Total debt + Total shareholders equity
Debt to Equity ratios
Total shareholders equity
Financial leverage ratios
Average total assets
Average total equity
Coverage Ratios
Numerator
Denominator
Interest coverage
EBIT
Interest payments
Fixed charge coverage
EBIT + lease payments
Interest payments + lease payments

36. Summary Bonds Leases Pensions Evaluating Solvency Issuance
Par, Discount, Premium
Amortization
Leases
Lessee, Lessor
Advantages of leasing
Accounting for operating and finance leases
Pensions
Evaluating Solvency

37. Conclusion Read summary Review learning objectives Examples
Practice problems: good but not enough
Practice questions from other sources