week 9 - analysis of financing liabilities & off-balance sheet debt

7/31/2019 Week 9 - Analysis of Financing Liabilities & Off-Balance Sheet Debt

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WEEK 9

ANALYSIS OF FINANCING LIABILITIES, LEASES AND OFF-BALANCE SHEET DEBT

Introduction How do firms incur debt? Operating activities exchange of goods or services for later payment

o Accounts Payable - Amounts owed for goods, supplies or services purchased on open account, generally recorded when title has

passed and recorded at amount payableo Other operating and trade liabilities other credit granted to the company by its suppliers and liabilities

o Advances from customers from customers who pay in advance for goods and services. Customers may pay deposits that

guarantee the payment of expected future obligations or the performance of a future service. They are classified as either current or

non-current liabilities depending on specific conditionsOperating liabilities should be distinguished from other liabilities on the balance sheet as one will require a future cash outflow while the

another will require future delivery of good or services. Operating liabilities are undiscounted.

Financing activities current receipt of cash in exchange of future payments of casho Short-term debt from banks and credit markets expected to be repaid within one year

o Current portion of long-term debt

Off-balance sheet contracts rather than immediate cash exchanges / promise to purchase goods or serviceso Leases

o Through put agreements

Employee-Related Liabilities

o Salaries or wages owed to employees at end of the accounting period, Payroll deductions owed, Short-term compensatedabsences, profit sharing and bonuses. Usually reported as current liabilitieso Post-retirement obligations - resulting from the relationship between the firm and its employees

Recognition and Measurement

A liability is present economic obligation for which the entity is the obligor.Thus: Obligation of an enterprise. There is little or no discretion to avoid the obligation. Arising from past transactions or events. Obligation arises from a transaction or event which has already occurred The settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future

Based on this definition, liability would have three essential characteristics: Exists at present time (i.e. at balance sheet date) Represents economic burdens or obligations - Always includes unconditional obligations (including stand-ready obligations) These burdens / obligations are enforceable - Includes constructive obligations (obligations based on entitys present/past practices)

Measurement rules are significantly different based on whether the liability is considered financial or non-financial. Financial liability is any

liability that is a contractual obligation to either: Deliver cash or other financial asset to another party, or To exchange financial instruments with another party under conditions that are potentially unfavorable

Financial liabilities Non-financial liabilities

Initial Measurement At fair value. Measured at best estimate of payment that would berequired to settle the obligation at balance sheet date

Subsequent Measurement Generally at amortized cost (except those held for

trading, such as derivatives, where fair value is used)

Best estimate of payment that would be required to settle the

obligation at balance sheet date

Financing liabilities are classified on the balance sheet as either;Current Liabilities - Current liabilities are due within one year or one operating cycle and result from both operating and financing activities

of a firm.

Under IFRS, liabilities are classified as current when they meet any one of the following conditions: Expected to be settled within normal operating cycle Held primarily for trading Due within 12 months from balance sheet date No unconditional right to defer settlement for at least 12 months after balance sheet date

Current maturities of long-term debt The portion of long-term debt maturing within 12 months from the balance sheet date is reported as a current liability

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Portions of long-term debts should not be reported as current liabilities if, by contract, they are retired by assets not classified as currentassets

Any liability due on demand, or due on demand within a year or operating cycle, is reported as a current liability

Short-term debt expected to be refinanced Debt due within 12 months is classified as current, unless at balance sheet date the company has the intent and a right (under existing

contract, and solely in its discretion) to refinance with long-term debt

Dividends Payable Cash Dividend - Becomes legal obligation on declaration date / Classified as current liability Preferred Dividends in Arrears - Cumulative preferred dividends that have not been declared require note disclosure / Not recognized as a

liability Stock Dividends - Not a liability; does not meet the definition of a liability as no future outlays of assets/services / Recorded only through

equity accounts i.e. represents a transfer of equity from retained earnings to contributed capital

OR,

Non-current Liabilities / Long-Term Debt - Current liabilities are due after one year or one operating cycle and also result from bothoperating and financing activities of a firm. Sources include public issuance; private placement; long-term credit agreement with a bank orfinancial institution. These may be secured on a specific asset of the firm (mortgage) or on the general claim of assets of the firm. Projectfinancing is repaid solely from a particular activity.

Common borrowings include: Bank Overdraft - An extension of credit from a lending institution when an account reaches zero. An overdraft allows the company to

continue withdrawing money even if the account has no funds in it. Basically the bank allows people to borrow a set amount of money.

Term Loan /Commercial Loan - A loan from a bank for a specific amount that has a specified repayment schedule and a floatinginterest rate. Term loans almost always mature between one and 10 years. For example many banks have term-loan programs that can offer

small businesses the cash they need to operate from month to month. Often a small business will use the cash from a term loan to purchasefixed assets such as equipment used in its production process.

Mortgage - A debt instrument that is secured by the collateral of specified real estate property and that the borrower is obliged to pay

back with a predetermined set of payments. Individuals and businesses to make large purchases of real estate without paying the entire value ofthe purchase up front use mortgages.

Commercial Paper - An unsecured, short-term debt instrument issued by an entity, typically for the financing of accounts receivable,

inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days (9 moths). The debt isusually issued at a discount, reflecting prevailing market interest rates. Commercial paper is not usually backed by any form of collateral, so

only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.

Project Finance / Project Debt - The financing of long-term infrastructure, industrial projects and public services (factory,

building, pipeline, real estate, etc) based upon a non-recourse (i.e. dependent of the project cash flows and if non-successful, the lender may

not claim payment from any other source) or limited recourse financial structure where project debt and equity used to finance the project arepaid back from the cash flow generated by the project. In other words, project financing is a loan structure that relies primarily on the project'scash flow for repayment, with the project's assets, rights, and interests held as secondary security or collateral.

Debt Denominated in Foreign Currency These are motivated by either more favorable terms in foreign markets, or assets denominated inthe foreign currency and debt denominated in the same currency can hedge against exchange rate movements The carrying value of foreigncurrency debt is adjusted for exchange rates. This adjustment for exchange rate is separate from adjustment to current market value. Marketvalue adjustments are based on changes in market interest rates.

Convertible Bonds and Warrants - Convertible bonds are accounted for as if they were unconvertible and they only lower interestexpense. When they are converted, the entire proceeds are reclassified from debt to equity. However, in financial analysis, the equity featureshould be considered. When the bond price is significantly greater than the conversion price, it is likely that the debt will not have to be repaid,

and convertible bond should be treated as equity rather than debt when calculating solvency ratios, such as debt-to-equity. When the bond priceis significantly below the share price, the bond should be treated as debt. At bond price levels close to conversion price, the instrument has bothdebt and equity features. When warrants and bonds are issued together, the accounting treatment differs from that of convertible bonds. The

proceeds must be allocated between the two financial instruments. The fair value of the bond portion is the recorded liability. The fair value of

the warrant is included in equity capital and has no income statement impact. When the warrants are exercised, the additional cash increasesequity capital.

Commodity Bonds - This occurs where interest and principle payments on bond issues are tied to the price of a commodity such as oil, gold,

silver, etc. Producers of these commodities commonly issue such bonds as a strategy. A higher commodity price increases payment tobondholders but is offset by higher profitability. These bonds, therefore, convert interest from fixed to variable cost.

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Perpetual Debt - This is a debt with no stated maturity. When debt does not have a maturity date, for analytical purposes, it may beconsidered preferred equity rather than a liability. An exception would be cases where debt covenants are likely to force repayment orrefinancing of debt.

Notes payable - Notes payable are written promises to pay a sum of money on a specified future date. They rises from

purchases, financing or other transactions. Notes payable may be classified as either short-term or long-term.Notes payable maybe interest bearing or zero-interest-bearing (non-interest-bearing). For zero-interest-bearing notes, the difference between the present value ofthe note and the face value of the note represents the discount on the note payable and the related interest. The discount is the interest expenserecorded over the life of the note. In both cases, interest expense is determined whenever financial statements are prepared.

BONDS

A bond is a contract or written agreement that obligates the borrower (bond issuer) to make certain payments to the lender (bondholder) over thelife of the bond. Payments include interest (usually semi-annual) and lump sum when the bond matures.

Basic Principles: Debt equals the present value of the remaining future stream of payments interest and principle. Interest expense is the amount paid by the borrower to the lender in excess of the amount borrowed.

The amount borrowed (proceeds from an issue) depends on the market rate of interest for bonds of a similar maturity and risk as well as paymentstream. It is the current market rate that allocates payments between interest and principle. The market rate may be less than, equal to, or greaterthan the coupon rate. It is the current market interest that allocates payments between interest and principle.

Face Value = the lump sum due at maturityCoupon rate = stated cash interest rate (but not necessarily the actual rate of return)

Periodic Payment = Coupon Rate X Face Value

Points to be noted:1. The initial liability amount is the amount paid to the issuer by the bondholder (present value of the stream of payments discounted at the

market rate), not necessarily the face value of the debt.2. The effective interest rate on the bond is the market (not the coupon) rate at the time of issuance, and interest expense is that market times the

bond liability.3. The coupon rate and face value determine the actual cash flows (stream of payments from the issuer).4. Total interest expense is equal to the payments by the issuer to the creditor in excess of the amount received.5. The balance sheet liability over time is a function of the initial liability and the relationship of interest expense to actual cash payments.

6. The balance sheet liability at any point in time is equal to the PV of the remaining payments, discounted at the market rate in effect at the timeof issuance of the bonds.

Bonds can be issued at par, at a premium, or at a discount.

Issue at par - when the market rate is equal to coupon rate Issue at premium when the market rate is less than the coupon rate Issue at a discount when the market rate is greater than the coupon rate

Issuance at par when the market rate is equal to the coupon rate; proceeds equal to the face value.

Introduction to Discounting / Present Value Tables:

Table Calculation Example

Amount of 1 Future Value of 1 to be received after n years; a = (1 +

I)nIf the interest rate is 10 percent per year, the

investment of Shs. 1 today will be worth Shs. 1.6105 atyear 5

Present Value of 1 Present Value of 1 to be received after n years; pn = 1/

(1 + I)nIf the interest rate is 10 percent per year, the present

value of Shs. 1 received at year 5 is Shs. 0.6209

Future amount of Ordinary Annuity Future value of 1 invested at a continuouslycompounded rate n for t years; An,i = [(1 + i)

n - 1]/iThe future value of an ordinary annuity of Shs. 1 infive years at 10 % is Shs. 6.1051

PV of an Ordinary Annuity Present value of 1 per year for each of n years; Pn,i ={[1- 1/(1 + i)n]/i} - {(1-Pn)/i}

If the interest rate is 10 percent per year, theinvestment of Shs. 1 received in each of the next 5

years is Shs. 3.7907

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Example:

Face Value: Shs. 1,000,000Coupon: 10%

Interest Payment: SemiannualTerm: 3 yearsThe purchaser expects 6 payments of interest (each payment is Shs. 50,000) and a final payment of Shs. 1M. (For simplicity ignore underwritingcosts and expenses associated with bond issuance. The costs are normally capitalized and amortized over the life of the bond issue)

(a) Issue at par = when the market rate (10%) is equal to coupon rate (10%)

(a) (b) (c) (d) (e) (f)

=5% X (a) FC X CR =(b) - (c) =(a) + (d) FV

Period Ending

Liability

(Opening)

Interest

Expense

Coupon

Payment

Change in

Liability

Liability

(Closing)

Face Value of the

Bond

1,000,000 1,000,000

Year 1, 30th Jun. 1,000,000 50,000 50,000 0 1,000,000 1,000,000

Year 1, 30th Dec. 1,000,000 50,000 50,000 0 1,000,000 1,000,000

Year 2, 30th Jun. 1,000,000 50,000 50,000 0 1,000,000 1,000,000

Year 2, 30th Dec. 1,000,000 50,000 50,000 0 1,000,000 1,000,000

Year 3, 30th Jun. 1,000,000 50,000 50,000 0 1,000,000 1,000,000

Year 3, 30th Dec. 1,000,000 50,000 50,000 0 1,000,000 1,000,000

300,000 300,000

Calculations of proceeds

PVA of Shs 50,000 for 6 periods, discounted at 5% 50,000 X 5.07569 = 253,785

PV of Shs 1,000,000 for 6 periods, discounted at 5% 1,000,000 X 0.74622 = 746,215

Total 1,000,000

The investor in the bond is willing to pay Shs. 1m., being the present value of the stream of payments and face value of the bond. Since the debt has been issued at the market rate of 10%, periodic interest expense equals periodic cash payments. The liability remains at Shs.

1m throughout the life of the bond.

(b) Issue at premium = when the market rate (8%) is less than the coupon rate (10%)

(a) (b) (c) (d) (e) (f) (g)

=4% X (a) FC X CR =(b) - (c) =(a) + (d) FV FV

Period Ending

Liability

(Opening)

Interest

Expense

Coupon

Payment

Change in

Liability

Liability

(Closing)

Face Value of

the Bond

Closing

Premium

1,052,421 1,000,000 52,421Year 1, 30th Jun. 1,052,421 42,097 50,000 (7,903) 1,044,518 1,000,000 44,518

Year 1, 30th Dec. 1,044,518 41,781 50,000 (8,219) 1,036,299 1,000,000 36,299

Year 2, 30th Jun. 1,036,299 41,452 50,000 (8,548) 1,027,751 1,000,000 27,751

Year 2, 30th Dec. 1,027,751 41,110 50,000 (8,890) 1,018,861 1,000,000 18,861

Year 3, 30th Jun. 1,018,861 40,754 50,000 (9,246) 1,009,615 1,000,000 9,615

Year 3, 30th Dec. 1,009,615 40,385 50,000 (9,615) 1,000,000 1,000,000 0

247,579 300,000 (52,421)



Total 1,052,421

The investor is willing to pay Shs. 1,052,421 for the bond. After the first six months, the bondholder earns Shs. 42,097 (4% of Shs. 1,052,421) but receives Shs. 50,000 (coupon rate times the face value).

This Shs. 50,000 is made up of interest expense of Shs. 42,097 and principal repayment of Shs. 7,903, reducing the liability to Shs. 1,044,518.

At the time of maturity the bond value will have reduced to Shs. 1,000,000. The process whereby the bond premium or discount is amortizedover the life of the bond is known as the effective interest method.

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(c) Issue at a discount = when the market rate (12%) if greater than the coupon rate (10%)

(a) (b) (c) (d) (e) (f) (g)


Period EndingLiability

(Opening)InterestExpense

CouponPayment

Change inLiability

Liability(Closing)

Face Value ofthe Bond

ClosingDiscount

950,827 1,000,000 (49,173)

Year 1, 30th Jun. 950,827 57,050 50,000 7,050 957,876 1,000,000 (42,124)

Year 1, 30th Dec. 957,876 57,473 50,000 7,473 965,349 1,000,000 (34,651)

Year 2, 30th Jun. 965,349 57,921 50,000 7,921 973,270 1,000,000 (26,730)

Year 2, 30th Dec. 973,270 58,396 50,000 8,396 981,666 1,000,000 (18,334)

Year 3, 30th Jun. 981,666 58,900 50,000 8,900 990,566 1,000,000 (9,434)

Year 3, 30th Dec. 990,566 59,434 50,000 9,434 1,000,000 1,000,000 -

349,173 300,000 49,173



Total 950,827

When the market rate exceeds the coupon rate, the bondholder is unwilling to pay the full face value of the bond. The bondholder can purchasea 12% bond and receive periodic payments of Shs. 60,000. The periodic payments form this bond are Shs. 50,000. Thus an investor will only

purchase this bond at a discount. At a 12% market rate, this bond will be issued at a discount of Shs. 49,173, and the proceeds and initialliability will be Shs. 950,827. Interest expense for the first six month will be Shs. 57,050, but cash interest paid will only be Shs. 50,000. The shortfall is added to the balance

sheet liability. This continues until the bond matures. At that point the initial principle of Shs. 950,827 plus the accumulated unpaid interest ofShs. 49,173 equals the face value payment that retires the debt.

(d) Effects on the Income Statement, Balance Sheet and Cash Flows

(If interest is classified under CFO)

Income Statement

(Interest Expense)

Balance Sheet

(Bond / Long-Term Debt)

Cash Flows

(For ALL Cases)

Par Premium Discount Par Premium Discount CFO CFF

Year 1 100,000 83,878 114,522 1,000,000 1,036,299 965,349 100,000

Year 2 100,000 82,562 116,317 1,000,000 1,018,861 981,666 100,000

Year 3 100,000 81,139 118,334 1,000,000 1,000,000 1,000,000 100,000 1,000,000

300,000 247,579 349,173 For bonds issued at a premium, interest expense decreases over time. For bonds issued at a discount, interest expense increases over time. The increases/decreases are a direct function of the increasing/decreasing balance sheet liability At any point in time, the balance sheet liability is equal to the PV of the remaining payments discounted at the effective interest rate at issuance Cash flow classifications of debt payments depend on the coupon rates, not the effective interest rate. When these differ CFO is misstated. Not

that amortization of premium or discount is non-cash flow and is included in the income statement.

Analytical Reclassifications (If interest is classified under CFO)

(i) Reclassification Based on Interest Expense(ii) Functional

Reclassification for ALL

Bonds

Cash Flows - IFRS (For

ALL Cases) Premium Bond Discount Bond

CFO CFF CFO CFF CFO CFF CFO CFF

Year 1 100,000 83,878 16,122 114,522 (14,522) 100,000

Year 2 100,000 82,562 17,438 116,317 (16,317) 100,000

Year 3 100,000 1,000,000 81,139 1,018,861 1,118,334 (18,334) 100,000

300,000 1,000,000 247,579 1,052,421 1,349,173 (49,173) 0 300,000

Zero-Coupon Debt

A zero-coupon bond has no periodic payments (coupon rate = 0). For that reason, it must be issued at a deep discount to face value. The lump sumpayment at maturity includes all unpaid interest (equal to face value less the proceeds)The proceeds at issuance equal to the PV of the face amount, discounted at the market interest rate.

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Using the class example;

(a) (b) (c) (d) (e) (f) (g)


Period EndingLiability

(Opening)InterestExpense

CouponPayment

Change inLiability

Liability(Closing)

Face Value ofthe Bond

ClosingDiscount

746,215 1,000,000 (253,785)

Year 1, 30th Jun. 746,215 37,311 0 37,311 783,526 1,000,000 (216,474)

Year 1, 30th Dec. 783,526 39,176 0 39,176 822,702 1,000,000 (177,298)

Year 2, 30th Jun. 822,702 41,135 0 41,135 863,838 1,000,000 (136,162)

Year 2, 30th Dec. 863,838 43,192 0 43,192 907,029 1,000,000 (92,971)

Year 3, 30th Jun. 907,029 45,351 0 45,351 952,381 1,000,000 (47,619)

Year 3, 30th Dec. 952,381 47,619 0 47,619 1,000,000 1,000,000 0

253,785 0 253,785

The interest on the zero-coupon bond never reduces operating cash flows. This has significant analytic consequences. Reported CFO issystematically overstated when zero-coupon (or deep discount) bond is issued. Moreover, solvency ratios, such as cash-basis interestcoverage, are improved relative to issuance of bonds at par. It should also be notable that cash required to repay the obligation may become asignificant burden (interest expense increases cash flow by generating income tax deductions).

Effects of Changes in Interest Rates

Debt reported on the balance sheet is equal to the present value of future cash payments discounted at the market rate on the date of issuance.

Changes in the current market rates affect the market value of the debt. Increases in the rate decrease the market value of the debt. For financialanalysis the market value of the debt may be more relevant than its book value. An analysis of a firms relative debt and borrowing capacity are

based on market conditions.

Variable-Rate Debt

Some debt issues do not have a fixed coupon payment. The periodic interest payment varies with the level of interest rates.Such debt instruments are generally designed to trade at their face value.

Fixed- Versus Variable-Rate debt and Interest and Rate Swaps

Borrowers can issue either fixed-rate or variable-rate debt directly. Alternatively, they can enter into interest rate swap agreements that convertfixed-rate obligation to floating-rate or vice versa. Reasons - To match variability of its earnings When management beliefs that interest will fall

Swaps are contractual obligations that supplement existing debt agreements. Each firm remain liable for its original debt, makes all payments on the

debt, and carries that debt on its books.

Estimating Market Value of Debt

Readily available for traded debt, else: Publicly traded debt of a company having same maturity, using the market rate to discount the debt Publicly traded debt of equivalent companies in the same industry Estimate of risk premium over government debt/bonds of the same maturity

Retirement of Debt Prior to Maturity

When firma retire debt prior to maturity, the difference between the book value of the liability and the amount paid at the retirement of that debt istreated as an extraordinary gain or loss in the income statement.

Bond Covenants Nature

Creditors use debt covenants to protect their interests by restricting activities of the borrower that could jeopardize the creditors position. Auditorsand management must certify that the firm has not violated the debt covenants.

An analyst must take into account the nature of debt covenants and the risk that the firm may violate them. Given that most of the covenants areaccounting-based, they may affect managements choice of accounting policies.

Debt covenants commonly place limits on one or more of the following:(a) Activities:

Payment of dividends including repurchases Production and investment (mergers, acquisitions, leasebacks, and outright disposal of assets) Issuance of new debt and/or incurrence of new liabilities Payoff patterns (including establishment of sinking funds)

(b) Accounting-Based:

Attribute: Measured As: Limits

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Retained Earnings Restricted retained earnings Payment of dividends or stock repurchases below minimum level of

restricted retained earnings

Net Assets Net tangible assets or net assets Investments, dividend payments, and new debt issues if net assets fall acertain level

Working Capital Minimum working capital or currentratio

Mergers and acquisitions, dividend payments, and new debt issues ifworking capital or the current ratio fall below a certain level

Debt-to-Equity Debt-to-equity ratio Issuance of additional debt

Costs and effects of constraint violations Although creditors have a right to demand immediate payment when an accounting based debt covenantis violated, they rarely do so. Creditors ma renegotiate the terms of the debt to demand: Accelerated principle repayments An increase in interest rate Liens on assets (such as debtors) New covenants increasing restrictions on the firms investing, borrowing and dividend paying ability

Presentation and Disclosure of Current Liabilities

Disclose separately: bank loans, trade creditors and accrued liabilities, taxes, dividends, deferred revenue, future income taxes, amounts owingto related parties

Identify secured liabilities and related assets pledged

Analysis of Current Liabilities

Ref Liquidity ratios

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LEASES (IAS 17 LEASES)

Definition

A lease is an agreement in which the lessor (owner of the property) conveys the right to use property, plant, or equipment, for a stated period oftime, to the lessee (user of the property).

Motivation operating lease

(a) Avoid recognition of the asset and liability from the balance sheet (the benefit does not accrue in case of a finance lease)(b) Report lower leverage by not recognizing the liability operating lease(c) Lessors prefer to report all leases as capital and therefore recognize a sale (installment sale)(d) Off-Balance-Sheet Financing - Higher profitability ratios and indicators of operating efficiency

Motivation finance lease

(a) Up to100% Financing at Fixed Rates - No down payment required / Rate charged is fixed for the term of the lease(b) Protection against obsolescence - Property can be upgraded

(c) Flexibility - Lease may be structured to meet different needs (e.g., cash flow)(d) Less costly financing

(e) Tax Advantages

Classification

From both the lessor and lessee points of view, a lease may be classified as EITHER:

(a) Operating or short-term leases allow the lessee to use the asset for only a portion of its economic life. A lease is classified as a financelease if it transfers substantially all the risks and rewards incident to ownership.

OR,

(b) Finance or Capital leases effectively transfer, or substantially all the risks and rewards of leased property to the lessee. All leases otherthan finance leases are classified as operating leases.

No mathematical thresholds are used to determine whether a lease should be classified as a finance or as an operating lease. An overall analysis ofthe transaction needs to be performed, at inception of the contract, to determine whether it is an operating or finance lease. Classification is made at

the inception of the lease. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form.

Lease classification is not intended to be alternatives. However, management actively negotiates the provisions of lease agreements and thepreferred accounting treatment is an important element of contractual negotiations.

When a lease include both land and buildings elements, an entity assesses the classification of each element as a finance or an operating leaseseparately. In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has anindefinite economic life.

Use judgment to evaluate individual circumstances and conditions

Whenever necessary in order to classify and account for a lease of land and buildings, the minimum lease payments (including any lump-sum

upfront payments) are allocated between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in theland element and buildings element of the lease at the inception of the lease.

Special issues when land and building are leased together and title is not transferred: Land lease cannot be a finance lease; building lease can be If value of leased interest in land is immaterial, treat as building If material, allocate payments between land and building based on relative values of leased interests in each

Situations (individually or in combination) that would normally lead to a lease being classified as a finance lease include the following:

Risks and rewards of ownership - The lease transfers ownership (risks and rewards) of the asset to the lessee by the end of the lease term.Risks include; losses from idle capacity, technological obsolescence, changes in value due to changing economic conditions, etc. Rewardsinclude; expectation of service potential or profitable operation over the assets economic life, gain from appreciation in value, realisation of aresidual value, etc.

Title transfer / rights and obligations at end of lease / BPO - The lessee has the option to purchase the asset at a price which is expected tobe sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that theoption will be exercised. (Bargain Price Option - A BPO gives the lessee the option to purchase the leased asset at a price sufficiently less than

the expected fair value of the asset that the exercise of the option appears reasonably assured.)

Renewal options - The lease term is for the major part of the economic life of the asset, even if title is not transferred (The lease term isnormally considered to be the non-cancelable term of the lease plus any periods covered by bargain renewal options.)

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Recovery of investment - At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially allof the fair value of the leased asset

Asset nature -The lease assets are of a specialized nature such that only the lessee can use them without major modifications being made

Other indications that it is a finance lease include:

If the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee

Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments)

The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent

Accounting by Lessees

The following principles should be applied in the financial statements of lessees:

(a) Finance Lease:

A capital lease is treated as the purchase of an asset the lessee records both an asset and liability at inception of the lease. Atcommencement of the lease term, finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the

present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the entity'sincremental borrowing rate).

Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability (the finance charge to

be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability).

The depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there is no reasonable certaintythat the lessee will obtain ownership at the end of the lease - the asset should be depreciated over the shorter of the lease term or the life of the

asset.

Executory costs include cost of ownership like maintenance, insurance, taxes, and other costs. If the lease agreement makes the lesseeresponsible for the executory costs, the lessee treats them as expenses. In some cases, the lessor pay executory costs, and the lessee will

reimburse the lessor through higher periodic lease payments. These costs are excluded in determining the minimum lease payment.

(b) Operating Lease Foroperating leases, the lease payments should be recognized as an expense in the income statement over the lease term on a straight-line

basis, unless another systematic basis is more representative of the time pattern of the user's benefit. Therefore we simply record the rentpayments.

Advance payments are considered prepayments of rent. They are deferred and allocated to rent over the lease term.

Leasehold improvements - Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the

lease. If a lessee constructs a new building on or makes modifications to existing structures, that cost represents an asset just like any othercapital expenditure. Like other assets, its cost is allocated as depreciation expense over its useful life to the lessee, which will be the shorter ofthe physical life of the asset or the lease term.

In Summary:

Balance Sheet Economic Outturn Account

Finance Lease

AssetLease Obligation

Accumulated DepreciationReduction in Lease Obligation

Finance ChargeDepreciation Expense

Operating Lease N/A Rental Expense

Sale and Leaseback Transactions

Entity owns asset Sells it and leases it back Decision by seller-lessee: finance lease or operating lease? Sale and leaseback are interdependent transactions

For a sale and leaseback transaction that results in a finance lease, any excess of proceeds over the carrying amount is deferred and amortized overthe lease term.

Leaseback is an operating lease

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Sale made at FV - recognize gain or loss in current income Sale < FV and lease payments are at FV recognize loss in current income Sale < FV and lease payments are lower to compensate defer loss & amortize on same basis as lease payments Sale > FV excess over FV is deferred and amortized over period of expected use If FV < carrying amount, impairment; recognize loss currently

Financial Reporting by Lessees: Capital Versus Operating Leases

Example;Non-cancelable lease beginning 1 January 2010, with annual MLPs of Shs. 10,000 made at the end of each year for four years. Discount rate of 10%

Operating lease: No entry is made at the inception of the lease Over the life of the lease, only the lease payments (expense) of Shs. 10,000 will be charged to income and CFO.

Finance Lease: At the inception of the lease, an asset (lease asset) and liability (leased liability) equal to the present value of lease payments, Shs. 31,699 is

recognized. Over the life of the lease:

o The annual lease payment of Shs. 10,000 will be allocated between interest and principle payments on the Shs. 31,699 leased

liability. (Lease amortization schedule)

Opening

Liability Interest Principle

Closing

Liability

Year 0 31,699

Year 1 31,699 3,170 6,830 24,869

Year 2 24,869 2,487 7,513 17,355

Year 3 17,355 1,736 8,264 9,091

Year 4 9,091 909 9,091 0

o The Cost of the leasehold asset of Shs 31,699 is depreciated using a policy consistent with other company assets or if there is no

certainty that the asset will be acquired at the expiry of the lease, on straight-line method over the lease term.Comparative Analysis of Capitalized and Operating Leases

Balance Sheet / Income Statement

Lease transactions impact several financial ratios: Debt to equity ratio Lease liabilities are recorded Rate of return on assets Lease assets are recorded

Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the

balance sheet.Statement of Cash FlowsSales-type leases The lessor recognizes the interest revenue in the operating activities section of the statement and the principalreduction in the investing section. In addition, the lessor has sales revenue and cost of goods sold recognized in the operating activities

section.

Year 0 Year 1 Year 2 Year 3 Year 4

Assets

Lease Asset 31,699 31,699 31,699 31,699 31,699

Accumulated Depreciation 0 7,925 15,850 23,775 31,699

31,699 23,774 15,849 7,924 0

Liabilities

Current portion of lease obligation 6,830 7,513 8,264 9,091 0

Long-term portion of lease obligation 24,869 17,355 9,091 0 031,699 24,869 17,355 9,091 0

Financial ratios Lease capitalization increases asset balances resulting in lower assets turnover and return on assets Income statement capitalization results in higher operating income (EBIT)

Operating Lease Finance Lease

Operating = Total

Expense

Operating

Expense

Non -Operating

Expense Total Expense

Year 1 10,000 3,170 7,925 11,095

Year 2 10,000 2,487 7,925 10,412

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Year 3 10,000 1,736 7,925 9,660

Year 4 10,000 909 7,925 8,834

Disclosure: Lessees - Finance and Operating Leases

Separately for finance and operating leases, disclosure is required for: Carrying amount of asset Reconciliation between total minimum lease payments and their present value Amounts of minimum lease payments at balance sheet date and the present value thereof, for:

o The next year

o Years 2 through 5 combinedo Beyond 5 years

Contingent rent recognized as an expense Total future minimum sublease income under non-cancelable subleases General description of significant leasing arrangements, including contingent rent provisions, renewal or purchase options, and restrictions

imposed on dividends, borrowings, or further leasing

NON-FINANCIAL LIABILITIES

Decommissioning and restoration obligations (asset retirement obligation, ARO or site restoration obligation) - Obligation associatedwith retirement of a long-lived asset must be recognized when incurred. Existing legal obligations include those related to dismantling,restoring, and reclamation of oil and gas properties, certain closure, reclamation, and removal costs of mining facilities, closure and post-

closure costs of landfills, decommissioning nuclear facilities, etcInitial measurement at is at best estimate of the expenditure required to settle the present obligation at balance sheet date. Future costs arediscounted (i.e. present value). Capitalized costs are not recorded in separate account but are added to the carrying amount of the underlying

asset and amortized over underlying assets useful life.

Product guarantees and customer programs - Continuing obligation results when an entity provides customer programs requiring that

goods or services be provided after the initial product or service is delivered. There are two approaches to accounting for the outstandingliability

o Expense approach - Liability is measured at cost of meeting the obligation, and expense is matched against period revenues (current)

o Revenue approach - Liability is measured at value of the service to be provided (not cost) and recognized in revenue as earned

(future)

Warranty obligations Warranty (product guarantee) is a promise made by a seller to correct problems experienced with a productsquantity, quality, or performance. These are stand-ready obligations at reporting date that result in future post-sale costs

o Use of Cash Basis - Acceptable for accounting purposes when warranty costs are immaterial, or warranty period is relatively short.

Warranty costs charged to the period in which the costs are paid. No estimated liability recorded or reported.o Warranty Sold Separately - Applies to extended product warranties; or warranties sold as separate product (or having stand-alone

value). Accounted for using revenue approach whereby revenue from warranty sale deferred and recognized over life of the warrantygenerally using straight-line method

Customer loyalty programs - Many companies offer customer loyalty programs (such as supermarket points, frequent flyer miles, discounts,etc). Revenues from original sales that give rise to loyalty points (or other award credits) should be allocated. Fair value of award credits

should be deferred as unearned revenue and recognized when exchanged for promised rewards.

Premiums and rebates - Premiums, coupons, contests, and other benefits have generally been accounted for under the expense approach. Inthe future, standards may focus on measuring such obligations at their value (not estimated cost).

Contingencies and uncertain commitments - A contingency is an existing condition or situation involving uncertainty as to possible gain or

loss that will ultimately be resolved when one or more future events occur or fail to occur. Loss contingencies involve situations of possibleloss at the balance sheet date. A liability incurred as a result of a loss contingency is a contingent liability. Estimated losses from losscontingencies are accrued as liabilities (called provisions) if the occurrence of the confirming future event is probable (less strict thanlikely), and amounts are reliably measurable. Measurement of liability is made using the expected value method (takes into account

probabilities of possible outcomes). Term contingent liabilities is used only for possible obligations that are not recognized. Disclosurerequired unless likelihood is remote

Litigation, claims, and assessments - To determine whether a liability should be recorded, evaluate the time period in which the underlying

cause of action occurred, the probability of an unfavorable outcome, the ability to make a reasonable estimate of loss. To evaluate thelikelihood of an unfavorable outcome, consider nature of litigation and progress of case, opinion of legal counsel, experience in similar cases,company response to the lawsuit

Financial guarantees (example: standby letter of credit guaranteeing anothers payment of a loan) - recognize guarantee at fair value.Key focus is to give users information about risks assumed by being a guarantor

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Commitments - Executory contracts are agreements where neither party has yet performed. These commitments are not considered liabilitiesas at balance sheet date, but they do represent a contractual obligation of future funds. Disclosure is required for abnormal commitments orones that carry significant risks

Unearned revenues - When cash is received before the product is delivered or service is rendered. Examples include gift certificates,prepayment for subscription

OFF-BALANCE SHEET FINANCING ACTIVITIES

Many economic transactions and events are not recognized in the financial statements because they do not qualify as accounting assets ortransactions under IFRS. But these unreported assets and liabilities have real cash flow consequences. They are used as a financing, liquidity orrisk-sharing technique. They are the means through which companies typically incur risks of loss that may not fully transparent to investors.

The impact of off-balance sheet financing activities is the reduction of assets and liabilities. This boosts leverage (debt/equity), profitability

(ROA), and activity (sales/assets) ratios.

Operating lease Classifying a lease as an operating lease provides a company with the opportunity to utilize the leased asset and assume acontractual obligation to pay the lessor during a specific period of time without having to report the asset and the liability.

Take-or-pay (TOP) Firms use take-or-pay contracts to ensure the long-term availability of raw materials and other inputs necessary foroperations. Under these arrangements, the purchasing firm commits to buy a minimum quantity of an input for a specified period. Input pricesmay be fixed or determinable from market. These contracts are often used as collateral for financing the supplier. TOP arrangements are

common in oil and gas, pulp and paper, metals, minerals. Buyer effectively receives the use of a productive asset without reporting it on itsbalance sheet. Disclosure rules require firms to report the minimum future payments. To reflect economic reality of TOP contracts an analystshould add the PV of the minimum payments to both the assets and liabilities. This increases leverage and reduces asset turnover.

Throughput arrangements - Natural-gas companies use throughput arrangements with pipelines or processors to ensure distribution orprocessing. The effects are the same as take-or-pay contracts.

Sale of receivables securitization of debts can be used to raise capital or in borrowing. That is a firm sells its debtors to a buyer (normally a

financial institution). The seller uses the proceeds from the sale for operations or to reduce existing debt. Most sales of receivables provide thebuyer with a limited recourse to the seller. However, the recourse provision is generally well above the expected loss ratio on the receivables(allowance for doubtful accounts). The potential liability associated with the buyer-recourse provision is not displayed on the balance sheet.

Sale of receivables no-recourse basis - Truly removed from balance sheet. Sale of receivables limited recourse basis - Firms recorded them by reducing accounts receivables and increasing CFO. Theseller is exposed to the collecting risk and so economically they are just collateralized loans.

To reflect economic reality of sale of receivables limited recourse basis, an analyst should; add backsold receivables to receivables and create

a current liability equal to the proceeds of sale; subtract sold receivables from CFO and CFF; and increase revenues and interest expense byeffective interest paid on the transaction. These adjustments reduce the current ratio, increase the leverage and reduce the interest coverage.

Finance subsidiaries Financial obligations of unconsolidated subsidiaries (because they are not wholly owned by the parent) may also beoff-balance sheet. These involve use of legally separate but wholly owned finance subsidiaries to borrow funds to finance the parent company.Finance subsidiaries enable the parent company to generate sales by granting credit to dealers and customers for the purchase of its goods or

services.

Firms often manipulate accounts by shifting their assets and liabilities out to subsidiaries. Some types of off-balance-sheet accountingmove debt to a newly created company specifically for that purpose. These are called special purpose entities (SPEs). Analyst should add

backproportionate share of the asset or liability for debt-to-equity ratio, receivable turnover, interest coverage ratio.

Joint ventures and investment affiliates facilitate sharing of economies of scale, technological and operating risks. Enables firms to alsoshare production and distribution capacities. These may create obligations for parent firms if any direct or indirect guarantees are given to

secure financing. Analyst should add guaranteed debt or proportionate non-guaranteed share of debt

Consignment inventory - Consignment inventory is an arrangement where inventory is held by one party (says a distributor) but is owned byanother party (for example a manufacturer or a finance company).

Sale and repurchase agreements - These are arrangements under which the company sells an asset to another person on terms that allow thecompany to repurchase the asset in certain circumstances. If the seller has the right to the benefits of the use of the asset, and the purchaseterms are such that the purchase is likely to take place, the transaction should be accounted for as a loan.

Sale and leaseback transaction - involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are

usually negotiated as a package. The accounting treatment depends on the types of lease involved. If it is a financial lease, then it is insubstance a loan from the lessor to the lessee. If it is operating lease and the transaction has been conducted at fair value, then it can be

regarded as normal sale transaction.

Other Off-Balance Sheet Activities other executory contracts, employment agreements, consulting agreements, licenses, royalty contracts,guarantees under customer contracts, and employee pension plan and postretirement benefit arrangements

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Accounting for Long Term Liabilities

IFRS versus GAAP

Listed below are some of the major differences between International Financial Reporting Standards (IFRS) and U.S. GAAP in accounting for long-term liabilities. This material is excerpted from Wiley IFRS 2010: Interpretation and Application of International Financial Reporting Standards.

U.S. GAAP: Long Term Liabilities IFRS: Long Term Liabilities

Convertible debt classified as liability Convertible debt assigned to both debt and equity based on relative fair values

Entities should reassess at the end of each reporting period whether an

embedded derivative should be separated

Entities should reassess at the end of each reporting period whether an

embedded derivative should be separated only if there is a change in theterms that significantly modifies the cash flows

Non-current presentation of defaulted debt if waiver granted before

statement issuance date

Non-current presentation of defaulted debt if waiver granted before

balance sheet date only

Equity-like instruments giving holder right to demand cash settlement, or

with defined cash settlement terms, must be classed as liabilities

Similar to U.S. GAAP

Joint project with IASB to address instruments with attributes of both

liabilities and equity is ongoing.

Joint project with FASB to address instruments with attributes of both

liabilities and equity is ongoing.

Accounting for Leases

IFRS versus GAAP

Listed below are some of the major differences between International Financial Reporting Standards (IFRS) and U.S. GAAP in accounting forleases. This material is excerpted from Wiley IFRS 2010: Interpretation and Application of International Financial Reporting Standards.

U.S. GAAP: Accounting for Leases IFRS: Accounting for Leases

Capital lease accounting is required if one of four defined conditions aremet; otherwise, operating lease

Similar to U.S. GAAP; finance lease treatment if risks and rewards aretransferred to lessee; also if property is special purpose for lessee use

No additional factors that parallel those under IFRS for determination offinancing (capital) treatment by lessor

If lessee to bear lessors loss upon lease cancellation, or lessee willshoulder gain or loss from change in residual value of leased asset, or

lessee has bargain renewal right, then lease may be deemed financingtransaction for lessor

Third-party guarantees cannot be included in minimum lease payments todetermine whether capital lease criteria are met

Third-party guarantees must be included in minimum lease payments todetermine whether capital lease criteria are met

Lessors must use implicit rate and lessees generally would use

incremental borrowing rate to calculate the present value of minimumlease payments

Present value of lease payments computed using implicit rate (if

unknown, incremental rate can be used)

More guidance provided on specialized topics; deferral of profit on sale-leasebacks is required

Only general guidance; profit recognition on sale-leasebacks permitted iffair value priced

Separate accounting for land and building in combined lease depends on

terms and materiality of land

Separation of land and building components of lease is mandatory under

recent provisions

Output contracts are leases Output contracts are not leases

Leasehold interest in land accounted for as prepayment Leasehold interest in land can be accounted for as investment property,valued at fair value with changes in current earnings; or else as

prepayment

Gain on sale/leaseback not recognized in current earnings, but deferred

and amortized, unless seller retains use of much of asset, in which casegain is recognized (immediate recognition of loss also commonlyrequired)

Gain on sale/leaseback amortized over term of financing lease, but

recognized at once if operating leaseback

Lease obligations disclosures more extensive than under IFRS Lease obligations disclosures less than under U.S. GAAP

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week 9 - analysis of financing liabilities & off-balance sheet debt

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