CFA® Level I - Financial Reporting and Analysis Non-Current (Long-Term) Liabilities www.irfanullah.co You can discuss questions and receive updates by joining our Google Group: https://groups.google.com/forum/#!forum/december-2013-cfa-level-1

Introduction and Contents Bonds Payable Leases Pensions and Other Post Employment Benefits Evaluating Solvency www.irfanullah.co

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 $$$ www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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. www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 340. Relevant internet rate is 10%. How should this lease be categorized? What is the impact on the financial statements? Assume straight line depreciation. www.irfanullah.co

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 340. 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 www.irfanullah.co

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 340. 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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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? www.irfanullah.co

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 www.irfanullah.co

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 www.irfanullah.co

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