Cfa Level 1 - Section 9 Liabilities

CFA Level 1 - Liabilities Email to Friend Comments

9.1 - Introduction Within this section, we will focus on the liability side of the balance sheet, focusing on current and long term liabilities, including capital and operating leases. Pay close attention to the section concerning the classification of leases as capital vs. operating, and how each classification affects other accounts. This concept is tested heavily in the CFA Level 1 exam. 9.2 - Current Liability Basics Liability Definitions Liabilities – These are obligations a company owes to outside parties. Liabilities represent others’ rights to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees. Current liability – These are debts that are due to be paid within one year or the operating cycle, whichever is longer; further, such obligations will typically involve the use of current assets, the creation of another current liability or the provision of some service. Long-term liability – These areobligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Uncertainties Regarding Liability Value In some cases the timing and/or the total liability may be difficult to estimate: 1. Some companies offer clients a warranty period. The company does not know at the time of the sale who the payee will be. Furthermore, the company does not know when this payment will occur. 2. At year-end some companies will estimate some expenses, and recognize some liabilities such as pension benefits. Recording and Reporting Estimated and Contingent Liabilities Liabilities whose timing and amount are known can easily be accounted for. But others – such as warranties, taxes, vacation-pay liability and contingent liabilities, among others - require some estimation. Warranties When a company sells a product, it sometimes offers its customers a warranty of a certain number of years. To be consistent with the matching principle, companies, at the time of the sale, must estimate an amount that must be allocated to the costs associated with the warranties. Most companies will use a historical or industry average to estimate its warranty cost. The estimated warranty cost or liability will be allocated to the estimated warranty liability. For example, say Company ABC sells 100 appliances at $100 and estimates that each appliance will carry a $10 warranty liability. Journal entry:

Taxes Due to timing differences, companies will report deferred income tax liabilities. These are taxes that have not yet been paid but are expected to be paid in the future. For example, say Company ABC estimates its tax bill will total $500. At year-end it has an actual tax bill of $600.

Vacation-pay Liability This liability arises when employees do not take their vacation during an accounting period. Even though they have not taken their vacation, they are still entitled to them, and the result is a future liability. For example, say an executive has three weeks of earned but unfulfilled vacation days, which have a total value to $10,000.

Contingent Liabilities

Contingent liabilities are liabilities that will materialize if some future event occurs. They are contingent on a specific outcome. The most frequent contingent liability is a pending lawsuit. The liability will materialize only if the firm is found guilty. The disclosure and/or inclusion of contingent liabilities in a company’s financial statements will depend on the company’s ability to estimate the amount of the liability and the likelihood that it will occur. Rules: •

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If the liability is probable and can be reasonably estimated, it must be included in the company’s financial statements. The loss will be included in the financial statements, and the liability must be included on the balance sheet. If the liability is probable but cannot be reasonably estimated, then only a footnote disclosure is required. If the liability is not probable and cannot be reasonably estimated, then no disclosure is required.

9.3 - Income Tax Terminology Taxable vs. Financial Income Taxable Income versus Financial Income: 1. Taxable income is calculated in accordance with prescribed tax regulations and rules. 2. Financial income is measured and reported in accordance with generally accepted accounting principles. Differences between taxable income and financial income occur because tax regulations and GAAP are frequently different. This will create a temporary difference between the tax basis of an asset or liability and its reported amount in the financial statements. This difference will result in taxable amounts or deductible amounts in future years when the asset is recovered or the liability is settled. This is known as "deferred income taxes". Tax Terminology Basics • • • •

Taxable income is the amount of income subject to income taxes. Tax payable refers to the tax liability recorded on the balance sheet as a result of taxable income. Tax payable is the amount of taxes that has not been paid but will be in the near term. Income tax paid is the actual taxes paid out of cash. This includes what was paid for this period and other periods during this accounting period. Tax-loss carry-forward occurs when a company has created a net loss within an accounting period that it cannot use to lower previous income taxes paid but can be used in the future to offset future taxable income.

Terminology Found on the Income Statement •

Tax payable includes total taxes to be paid within the accounting period. Said differently, it is equal to the amount of income taxes paid or payable for the period.

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Deferred tax expenses represent the increase in the deferred tax-liability balance from the beginning to the end of the accounting period (noncash expense). Income tax expense includes tax payable and deferred income tax expenses. It is composed of cash and noncash items. Thus it is not the actual tax paid to the government within the accounting period.

Terminology Found on the Balance Sheet • •

Deferred tax asset represents the increase in taxes refundable (saved) in future years as a result of deductible temporary differences at the end of the current year. Deferred tax liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year.

Other terminology: •

Valuation allowance represents that portion of the deferred tax asset that is more likely not to be realized.

Types of Differences • •

Temporary difference is the difference between the book basis and tax basis of an asset or liability that is expected to reverse over time. Permanent difference is the difference between the book basis and tax basis of an asset or liability that is not expected to reverse over time. Look Out! Note: Temporary differences create deferred taxes, while permanent differences cause a firm's effective income tax rate (book income tax expense / pre-tax book income) to differ from the statutory tax rate.

9.4 - Tax Deferred Liabilities A deferred tax liability occurs when taxable income is smaller than the income reported on the income statements. This is a result of the accounting difference of certain income and expense accounts. This is only a temporary difference. The most common reason behind deferred tax liability is the use of different depreciation methods for financial reporting and the IRS. A deferred tax asset is the opposite of a deferred tax liability. Deferred tax assets are reductions in future taxes payable, because the company has already paid the taxes on book income to be recognized in the future (like a prepaid tax). Calculation:

Deferred tax liability 1. Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary differences x enacted tax rate). 2. Scheduling of future taxable amounts. Deferred tax asset 1. Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary difference x enacted tax rate). 2. Scheduling of deductible amounts. The Liability Method of Accounting for Deferred Taxes. There are several different tax-allocation methods: Deferred Method The amount of deferred income tax is based on tax rates in effect when temporary differences originate. It is an income-statement-oriented approach. It emphasizes proper matching of expenses with revenues in the period when a temporary difference originates. Finally, it is not acceptable under GAAP. Asset-liability Method The amount of deferred income tax is based on the tax rates expected to be in effect during the periods in which the temporary differences reverse. It is a balance-sheet-oriented approach. It emphasizes the usefulness of financial statements in evaluating financial position and predicting future cash flows. Most importantly, it is the only method accepted by GAAP. Implications of Valuation Allocation A deferred tax asset is a reduction in future cash outflow (taxes to be paid). But, the asset has value only if the firm expects to pay taxes in the future. For example, an Net Operating Loss (NOL) carry-forward is worthless if the firm does not expect to have positive taxable income for the next 20 years. Since accounting is conservative, firms must reduce the value of their deferred tax assets by a deferred tax-asset valuation allowance. This is a contra-asset account CR (credit) balance on the balance sheet - just like accumulated depreciation or the allowance for uncollectible accounts) that reduces the deferred tax asset to its expected realizable value. Increasing the valuation allowance increases deferred income tax expense; decreasing the allowance does the opposite. Changes in the allowance affect income tax expense. Although the need for an allowance is subjective, its existence and magnitude reveals management's expectation of future earnings. Management can use changes in the allowance to “manipulate” NI by affecting income tax expense. Analysts should scrutinize these types of changes. Deferred Tax Liability Treatment If a tax asset or liability is simply the result of a timing difference that is expected to reverse in the future, it is best classified as an asset or liability. But if it is not expected to reverse in the future, it is best qualified as equity. Deferred tax liabilities that should be treated as equity in the following circumstances:

1. A company has created a deferred tax liability because it used accelerated depreciation for tax purposes and not for financial-reporting purposes. If the company expects to continue purchasing equipment indefinitely, it is unlikely that the reversal will take place, and, as such it should be considered as equity. But if the company stops growing its operations, then we can expect this deferred liability to materialize, and it should be considered a true liability. 2. An analyst determines that the deferred tax liability is unlikely to be realized for other reasons; the liability should then be reclassified as stockholders' equity. Look Out! In some cases the deferred tax liability should not be added to stockholders' equity, but should be ignored as a liability. 9.5 - Permanent Vs. Temporary Items Temporary (or timing) differences between book income versus taxable income are due to items of revenue or expense that are recognized in one period for taxes, but in a different period for the books. Book recognition can come before or after tax recognition. These revenue and expense items cause a timing difference between the two incomes, but over the "long run", they cause no difference between the two incomes. This is why they are temporary. When the difference first arises, it is called "an originating timing difference". When it later reverses it is called "a reversing timing difference". Here are two examples of temporary differences: (1) the calculation of depreciation expense by means of the straight-line method for books and by means of an accelerated method for taxes, and (2) the calculation of bad-debts expense by means of the allowance method for books and by means of the direct write-off method for taxes. Over the life of the firm, total depreciation expense and bad debts expense are unaffected by the method. What is affected is how much expense is recognized in any given period. Temporary differences are said to "reverse" because if they cause book income to be higher (or lower) than taxable income in one period, they must cause taxable income to be higher (or lower) than book income in another period. Permanent differences are differences that never reverse. That is, they are items of book (or tax) revenue or expense in one period, but they are never items of tax (or book) revenue or expense. They are either nontaxable revenues (book revenues that are nontaxable) or nondeductible expenses (book expenses that are nondeductible). Examples of permanent differences are (nontaxable) interest revenue on municipal bonds and (nondeductible) goodwill (GW) amortization expense under the purchase method for acquisitions. Calculating Income Tax Expense, Income Taxes Payable, Deferred Tax Assets, and Deferred Tax Liabilities We'll explain this concept by example: Company ABC purchased a machine for $2m with a salvage value of $200,000. It used the accelerated depreciation method for tax purposes and straight-line depreciation for reporting purposes. Tax rate is 40%.

Tax differential:

Make sure you know the following for your exam: 1. Total tax bill is the same.

2. Timing differences create a tax liability. Calculation: Income tax expense = reported income before tax * tax rate Income tax payable = IRS reported income * tax rate Deferred tax liability (asset) = income tax expense – income tax payable

Figure 9.1: Cumulative Effect of Total Taxes

9.6 - Adjustments To Financial Statements From Tax Rate Changes If the tax rate changes, then under the asset-liability (or balance sheet) method, all deferred tax assets and liabilities must be revaluated using the new tax rate that is expected to be in place at the time of the reversal. An increase in the expected tax rate at time of reversal will create a larger tax burden than expected for the company once the transaction is reversed. That said, the current tax expense also increases. This will have a negative impact on current net income and decrease stockholders’ equity. A decrease in the tax rate will have the opposite effect. Example: Company ABC has an EBITDA of $50,000 in the first five years of operations. To generate this income it purchases a machine for $40,000, with no salvage value at the beginning of year 5. The equipment has a fiveyear life. For tax purposes the company uses the double-declining depreciation method and uses a straight-line depreciation for financial-reporting purposes. At the time of purchase, the estimated tax rate at time of reversal was 40%.

In year 2 the tax rate at time of reversal is estimated at 20%. Taxes payable = new tax rate * taxable income = 20% * $41,411= $8,222 Deferred taxes = new tax rate * (DDM-SL) = 20% * ($8,889-$13,333) = ($899) Benefit from tax rate in year 1 = [$42,500* (40%-20%)] – [$30,000*(40%-20%)] = $1,250 Tax expense = tax payable in year 2 - decrease in deferred taxes in year 2 – benefits from tax rate on year-1 taxes = $8,889+$899–$2,667= $4,667 9.7 - Long-Term Liability Basics Reporting Debt Issues A company can issue debt securities to finance its operations. These debt securities are bonds. A bond is a promise, in most cases, to pay a predetermined annual or semiannual interest payment and to pay back the principal (face value) when the bond matures. When a company issues a bond with coupon payments that are equal to the current market rate, the bond is said to be issued at par. From an accounting point of view, this means that if a company issues a $1m bond at par, the company will get $1m for the bond. Bonds that are issued with coupon payments that are not equal to the current interest rate are said to be issued at a "premium" or "discount". If Company ABC issues a bond that will pay 9% a year for five years and similar bonds

are paying 10%, why would investors buy Company ABC's bond if they can purchase the other bond that will give them 10%. The only way they will purchase the bond is if the company sells the bond at a discount of it par value to compensate for the lower coupon payments. The company will ultimately get less money for its bond than the stated par value and is said to sell at a discount. If Company ABC issues a bond that will pay 10% a year for five years and similar bonds are paying 9%, why would the company pay more to investors? The only way the company will sell this bond to investors is if the company sells the bond at a premium to its par value (for more money) to compensate the company for the paying a higher coupon. The company will ultimately get more money for its bond than the stated par value, and the bond is said to sell at a premium. From an accounting standpoint, a company that sells a bond at a discount (or premium) will record on a cash basis a smaller interest payment but in reality will have a higher interest expense because it received fewer dollars for its bond. In accordance with the matching principle, premium and discounts must be amortized over the life of the bond. U.S. GAAP allows companies to amortize premiums or discounts by utilizing a straight-line amortization or the effective interest rate method. Discount vs. Premium Pricing If coupon = to market rate, the bond is issued at par. If coupon > market rate, the bond is issued at a premium. The issuing company will get more money at initiation than it will pay to investors at maturity. In exchange it will pay a higher coupon than it would have to if the bond was issued at par. If coupon < market rate, the bond is issued at a discount. The issuing company will get less money at initiation than it will pay to investors at maturity. In exchange it will pay a lower coupon than it would have to if the bond was issued at par. 9.8 - Journal Entries and Accounting Impact We will now discuss the journal entries and accounting impact of bonds issued at par, a premium, or a discount. The market value of a bond is calculated as follows:

Formula 9.1 Market value of a bond = PV of coupon payments + PV of principal

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Par-value bonds Company ABC issues a $1m bond that will pay a 10% semiannual (coupon) for five years and similar bonds are paying 10%. Market value = $1m Face value or principal or book value = $1m

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Bond issued at a Premium Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years and similar bonds are paying 10%. Bond premiums are amortized using straight-line depreciation.

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Bond issued at a Discount Company ABC issues a $1m bond that will pay a 9% semiannual (coupon) for five years and similar bonds are paying 10%. Bond discounts are amortized using staring-line depreciation.

9.9 - Total Interest Cost Components Total interest expense, which is reported on the income statement, includes the total coupon payment plus a portion of the underappreciated discount or premium for the specified accounting period. U.S. GAAP allows companies to amortize premiums or discounts by utilizing a straight-line amortization or the effective interest rate method. •

Straight-line Depreciation Formula 9.2 Depreciation amount = premium or discount at issue payment periods

Example Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years and similar bonds are paying 10%. Bond premiums are amortized using straight-line depreciation. The company issues at $1,038,609 and face value is $1m. Interest expense = coupon payments – unamortized portion of bond premium for the period The carry value = total market value at time of issue – cumulative amortized premium or discount Unamortized portion of bond premium for every period (six months in this example) = $38,609 / (10 payment periods) = $3,860.9

Result Under this method the issuing company will recognize an equal amount of unamortized depreciation for every period. •

Effective Interest Rate Method Effective interest rate method results in an interest expense that is a constant percentage of the carrying value of the bonds; thus interest expense varies from period to period. In contrast, the straight-line method results in a constant interest expense from period to period. Formula 9.3 Interest expense = current interest rate at time of issue * carry value

The carry value = total market value at time of issue – cumulative amortized premium or discount Formula 9.4 Amortized premium (discount) = coupon payment – interest expense

Example Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years, and similar bonds are paying 10%. Bond premiums are amortized using the effective interest rate depreciation method. The company issues at $1,038,609 and face value is $1m.

9.10 - Reporting The Retirement Or Conversion of Bonds A company that retires its bond at maturity will issue to bondholders the last interest payments, if any, and the face value of the bond. At that time the book value of the bond will equal the face value.

Journal entry

Retiring Bonds Prior to Maturity Sometimes bonds can be retired before they mature. They can be retired, or if they are convertible bonds, they can be converted to another form of securities such as common stock. If a company retires a bond prior to maturity, the stated book value (or carry value for a discount or premium bond) will most likely be the same as market value for which the company repurchased the bond. This difference creates an extraordinary gain or loss for the repurchasing company. This gain or loss is classified as extraordinary because it is non-recurring in nature. Extraordinary gains and losses are reported on the income statement below the operating line net of taxes. Remember: carrying value is computed as:

Formula 9.5 Bonds Payable at par - Unamortized Discount Carrying Value

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Bonds Payable at par Unamortized Premium Carrying Value

To compute the gain or loss, compare the carrying value of the bonds with the amount we pay to redeem the bonds.

Formula 9.6 Carrying Value - cash paid to retire bonds = gain or loss on bond retirement Look Out! If the carrying value is greater than the cash paid, there is a gain on the bond retirement. If the carrying value is less than the cash paid, there is a loss on the bond retirement. Journal entry: A company retires a bond with a $1m face value early for $1.2m and creates a loss of $200,000.

Converting Bonds Into Common Stock Some bonds can be converted or exchanged into common stock. Under SFAS 14 the convertible feature of a bond is completely ignored when the bond is issued, and it is considered only when it is converted into equity. The effect of a conversion of a bond into common stock is a decrease in liabilities for the carrying value of the bond and an increase in stockholders' equity for an amount equal to the bond carrying value. Gains or losses on bond conversion are not recognized. Any difference between the carrying value of the bond converted and the par value of the new shares issued is recorded in the account called "contributed capital in excess of par value". The market value of the common stock is ignored. Example: Bondholders converted $20,000 worth of convertible bonds into the issuer's $5-par common stock. Each $1,000 bond is can be converted into 10 shares of common stock. The carrying value of the bonds at the time of conversion is $21,500. 1. First we need to compute the carrying value of the bonds converted Carrying value = bonds payable + bond premium = $20,000 + $1,500 = $21,500 2. Then we calculate the number of bonds converted Number of bonds converted = $20,000/$1000 = 20 bonds 3. Then we calculate the number common shares to be issued? Number of common shares = 20 bonds * 10 shares = 200 common shares 4. Then we calculate the contributed capital in excess of par value Contributed capital in excess of par value = carrying value of the bond – par value of the new shares = 21,500 – (200*$5) = $20,500 Journal entry

9.11 - Accounting For Long-Term Liabilities Mortgages payable A mortgage is a long-term debt secured by a real estate property such as a building or land. The mortgage is usually paid back in equal installments. These installments include a portion that is attributable to interest expense and the other to capital repayment. Long-term leases Companies generally acquire the right to use an asset by purchasing it outright. But in some cases companies can lease an asset as opposed to an outright purchase. Leases can be classified as operating leases or capital leases. Operating leases are defined as short-term leases by which the company enters into an agreement with the lessor to use the asset for a portion of the asset’s economic life. The lessee (the company leasing the equipment) will have no obligation to purchase the asset

in the future. Capital leases, on the other hand, are long-term leases that create a long-term obligation for the lessee. If the asset qualifies as a capital lease, the asset is recorded on the balance sheet and the present value of the lease obligations are also recorded on the balance sheet. The asset is amortized over the life of the lease by using a straight-line depreciation method. Each rental payment includes a portion that is allocated to interest expenses and repayment of principal. Pensions A pension plan is a qualified retirement plan set up by a corporation, labor union, government or other organization for its employees. A pension plan is an agreement under which the employer agrees to pay monetary benefits to employees once their period of active service has come to an end. A third party frequently manages the pension plan. Look Out! The CFA institute concentrates on two types of pension plans: defined-benefit plans and defined-contribution plans.

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A defined-benefit pension plan promises a specific benefit at retirement to its employees. Since the benefits are defined, the employer is responsible for accumulating sufficient funds. Such plans insulate employees from investments that perform poorly, but it also prevents them from enjoying the entire upside potential of the pension if it does well. That said, pension funds are governed by the Employee Retirement Income Security Act of 1974 (ERISA), a more conservative investment approach, and large gains are unlikely to occur. Corporations refrain from setting up these types of plans because they can create enormous pension liabilities for a company if the pension’s portfolio does not perform well. Defined pension plans need to be revalued periodically by an actuary. Under SFAS 87, companies are required to use the same actuarial cost method and are required to disclose assumptions about the pension obligation and pension cost. The major issue with SFAS 87 is that a company may make pension contributions using different assumptions.

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A defined-contribution pension plan, by contrast, specifies how much the employer will contribute annually. The actual amount the employee will receive at retirement will depend on the overall performance of the pension fund. With such a plan, investments that perform poorly mean lower income in retirement, and vice versa. Under this plan the company does not carry any risk and does not create any pension liabilities if it pays its annual contribution amount. Contributions made are simply expenses on an annual basis.

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Accounting for pension funds. To be able to pay their pension obligations, companies must accumulate funds known as the “plan assets”. Plan assets are not formally recognized on the balance sheet, but are actively monitored in the employer’s informal records. The plan assets can change due to returns on plan assets – such as dividends, interest, market-price appreciation and cash contributions - employer contributions and retiree benefits paid, which are benefits actually paid to retired employees. The composition of pension expenses is beyond this problem set.

Look Out! Candidates should know that pension expenses are deducted from the income statement. Though the pension plan assets and liabilities are not included in the financial statement, companies are required to include the following information in the footnotes:

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The components of the annual pension expense The projected benefit obligation (as well as the accumulated benefit obligation and vested benefit obligation) Other information that makes it possible for interested analysts to reconstruct the financial statements with pension assets and liabilities included.

<< Back Next >> 9.12 - Post-Retirement Obligations Post-retirement benefits include all retiree health and welfare benefits other than pensions and can include:

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Medical Coverage Dental coverage Life insurance Group legal services

These benefits are much more difficult to estimate than pension obligations. Under SFAS 106, employers have some latitude in making these estimates. The expected post-retirement benefit obligation is computed by taking the present value of expected post-retirement benefits. Accounting for post-retirement benefits 1. Accounting for post-retirement benefits is, to the extent it is possible, the same as for pension benefits. 2. Any differences are due to fundamental differences between pensions and other post-retirement benefits. 3. The main difference from an accounting perspective is that post-retirement healthcare benefits usually are “all-or-nothing” plans in which a certain level of coverage is promised upon retirement, and the coverage is independent of the length of service beyond the eligibility date. Cost is unrelated to service and is attributed to the years from the employee’s date of hire to the full-eligibility date. Elements of post-retirement benefit cost:

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Service cost Interest cost Return on plan assets Amortization and deferral Amortization of unrecognized prior service cost Amortization of transition asset and liability

SFAS 106 permits the amortization of the transition liability over 20 years, versus the average remaining service period of active employment found under pension plans. 9.13 - Effects Of Debt Issuance Bonds Issued at Par - Effects On: •

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Income statement - The income statement will include an interest expense equal to the bond’s coupon payment attributable to the specified accounting period. Balance sheet - The balance sheet will include at all times a long-term liability equal to the face value of the bond. Cash flow statement - Going forward, cash flow from operations will include the interest expense recorded on the income statement. As of the issuing date, the company will account in cash flow from financing the total amount received for the bond.

Bonds Issued at a Premium – Effect On: • •

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Income statement - The income statement will include an interest expense equal to the bond’s coupon payment minus the amortized portion of the premium received during the specified accounting period. Balance sheet - The balance sheet will include at all times a long-term liability equal to its carrying value. At initiation the carrying value will be equal to the face value of the bond plus the total unamortized premium. Every year the bond value recorded on the balance sheet will be reduced until the bond comes to maturity and the bond value displayed on the balance is equal to the bond’s face value. Cash flow statement - Going forward, cash flow from operations will include the actual coupon paid to the debt holder during the specified accounting period. Since this is a bond that was sold at a premium, it is paying out a larger coupon than is currently stated as an interest expense on the income statement. As a result, CFO will be understated relative to that of a company that sold its bond at par. The amortized portion of the bond premium will be included in cash flow from financing. This will cause the reported cash flow from financing to be overstated relative to that of a company that sold its bond at par.

Bonds Issued at a Discount – Effect On: • •

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Income statement - The income statement will include an interest expense equal to the bond’s coupon payment plus the amortized portion of the discount received during the specified accounting period. Balance sheet - The balance sheet will include at all times a long-term liability equal to its carrying value. At initiation the carrying value will be equal to the face value of the bond minus the total unamortized discount. Every year the bond value recorded on the balance sheet will be increased until the bond comes to maturity and the bond value displayed on the balance is equal to the bond’s face value. Cash flow statement - Going forward, cash flow from operations will include the actual coupon paid to the debt holder during the specified accounting period. Since this is a bond that was sold at a discount, it is paying out a smaller coupon than is currently stated as an interest expense on the income statement. As a result CFO will be overstated relative to that of a company that sold its bond at par. The amortized portion of the bond discount will be included in cash flow from financing. This will cause the reported cash flow from financing to be understated relative to that of a company that sold its bond at par.

Computation Company ABC issues a $1m bond that will pay a 10% semiannual (coupon) for three years; the company will generate $500,000 EBITDA over the next three years. Contract the effect if market rate at the time of issuance was 10%, 11% and 9%. (Straight-line depreciation is used for premiums and discounts). Taxes are not considered. Opening balance sheet:

9.14 - Implications Of Debt Issuance 1) Income Statement

2) Cash Flow Statement

3) Balance Sheet

Effect on Reported Cash Flows from Zero-Coupon Debt Issuance Zero-coupon bonds are also referred to as "deep-discount bonds" or "pure-discount instruments". These bonds do not provide any periodic interest payments to the bondholders and are sold at deep discount to the stated par value. These bonds will have the same type of effect on a company's balance sheet, income statement and cash flow statements as that of discount bonds; the only difference is that the effect will be more pronounced. 9.15 - Effect Of Changing Interest Rate On Debt Market Value A company that issued debt prior to an increase (or decrease) in market rates experiences an economic gain (or loss) when the rates change. This economic gain or loss is not reflected in a company's financial statement. Market-value changes will not appear on the income statement or balance sheet. As a result, the book value of a company's debt will not be equal to its market value. From a company valuation point of view, the book value of equity (total assets - liability) will not reflect the current economic reality. Furthermore, if an analyst compared two companies - one that issues $1m in debt at 10% and another that issues the same debt amount at 8% three months later - the debt-to-equity ratio of both companies will be the same. However, the company that issued the debt at a lower rate will be in a much better financial position. Times interest earned and other ratios will enable an analyst to uncover these differences. 9.16 - Capital And Operating Leases Lease Classification A lessee (the company leasing equipment) should classify a lease transaction as a capital lease if it is non-cancelable and if one or more of the four classification criteria are met: •

The agreement specifies that ownership of the asset transfers to the lessee.

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The agreement contains a bargain purchase option. The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.

If none of these criteria are met, the lease can be classified as an operating lease. Choosing Capital and Operating Leases Most companies will want to classify their leases as operating leases because they can provide a company with the following: •

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Tax incentive o The tax benefit of owning an asset (depreciation expense) can be exploited best by transferring it to a party that has a higher tax bracket. o A firm with a lower tax bracket will have incentives to classify a lease as an operating lease. o A firm with a higher tax bracket will be more likely to classify a lease as a capital lease. Non-tax incentives o o If a lease is classified as an operating lease, no asset and liability are recorded on the balance sheet. This will allow a company to display a higher return on assets than it would display had it classified the lease as a capital lease. It will also allow a company to display better solvency ratios such as debt-to-equity. o o Off-balance sheet financing because the operating lease classification keeps the liability off the balance sheet. Since no liability is recognized, the company would display to its debt lenders better debt covenant ratios. o o Some companies link management bonuses to specific ratios, such as return on capital, since return on capital will be higher if a lease is classified as an operating lease. o o If the leased asset is going to be used for a short period of time and/or the lessee feels that the equipment may experience a large decrease in value over time, the lessee will want to structure it as an operating lease.

There are limited benefits to classifying leases as capital leases. The only benefits are: • •

Since the total lease expense is higher in the first years of a capital lease, a company will may benefit from a tax saving. Operating cash flow will be higher under a capital lease.

9.17 - Effects Of Capital Vs. Operating Leases Capital Leases - Effects On: •

Balance sheet - At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments.

The discount rate used will be the lower of the following two rates: The lessor's (the rental company's) implied rate The lessee incremental borrowing rate

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Going forward, the leased asset is depreciated in a manner consistent with the lessee's usual policy for depreciating its operational assets. It can be over the term of the lease (most common) or over the asset's useful life, if ownership transfers or a bargain purchase option is present. Income statement - A capital-lease payment includes two components: one is the interest expense which is included in the income statement but is not part of operating income (earnings before taxes from continuing operations) - and the second component is the principal payment, which is included in the income statement and operating income. The interest portion will be higher in the first few years of the lease, and is consistent with the interest expense of an amortized loan. Total income over the life of the leased assets will be the same for operating and capital leases. Cash flow statement - Total cash flow statements remain unaffected by operating and capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease expense. The principal payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO and understate CFF.

Operating Leases - Effects On: • • •

Balance sheet - No assets or liabilities are recorded. Income statement - The operating-lease payment will be treated as an operating expense. Cash flow statement - Cash flow from operations will include the total lease payment for the specified accounting period.

Comparison of Capital vs. Operating Leases Let's compare the differences between both lease options through example. Option 1 Company Leasing has approached Company ABC to lease equipment from it for five years (non-cancelable lease). The annual payment would be $20,000. The discount rate implied in the lessor's implied rate is 6%. Company ABC has an incremental borrowing rate of 7%. After the five-year period, the asset will be transferred to the lessor, which it will sell for scrap. Option 2 Company L&R has also approached Company ABC to rent equipment from it. Under the term of the rental agreement, Company ABC will rent the equipment from Company L&R for an annual fee of $20,000. This equipment has an estimated useful life of 10 years. Classification If Company ABC accepts Company Leasing's offer, the lease agreement has to be classified as a capital lease because the non-cancelable lease term is equal to 75% or more of the expected economic life of the asset. (At the end the five years, the equipment is sold for scrap). The second option can be classified as an operating lease. 9.18 - Determining The Value Of The Lease And The Lease Asset

The discount rate used will be 6% because it is the lesser of the lessor’s implied rate and the lessee’s incremental borrowing rate. 1) Balance Sheet Effect:

Book Ending Interest Value Beginning Princiapl Lease Lease Expense Of The Year Lease (3) Payment value Depreciation (2) Asset Value (1) =(4)-(1) (4) (liability) = (fixed =(1)-(3) (1)*6% assest) 0

-

-

-

-

84,247

-

84,247

1

84,247

5,055

14,945

20,000

69,302

16,849

67,398

2

69,302

4,158

15,842

20,000

53,460

16,849

50,548

3

53,460

3,208

16,792

20,000

36,668

16,849

33,699

4

36,668

2,200

17,800

20,000

18,868

16,849

16,849

5

18,868

1,132

18,868

20,000

0

16,849

0

Under the capital-lease method the asset will only equal the lease liability at initiation and at the end of the lease. In this example, the asset was depreciated using the straight-line depreciation method, or $16,849 ($84,247/5). • • • • •

On the other hand, the lease obligation is reduced by the principal-repayment amount during each specified accounting period. This interest component is determined by multiplying the beginning-period lease value with the discount rate used in the determination of the PV of the lease obligation. Since the lease obligation decreases with time, it is highest in the first year and declines over time. That said, the principal repayment on the lease liability is determined by subtracting the interest component for the specified period with the actual lease payment to the lessor. As a result, the principal-repayment amount increases with time and is lowest in the first year.

Look Out! At the end of the lease, both the lease obligation will be eliminated and so will the asset value. 2) Income Statement Effect:

Under a capital lease, operating expenses include the depreciable portion of the leased asset, and the interest portion is classified as a non-operating expense and is included in earnings before tax. • • • •

As noted earlier, the interest expense that emerges from capital leases is highest in the first years and decreases over time (unlike depreciation expense, which is constant). This creates a variation in a company’s reported total expenses. In the earlier years, a company using a capital lease will report a lower net income than a company using an operating lease. This will also create a tax benefit for the company that uses a capital lease in the first years. This tax benefit will cancel out because in the later years, the interest component will decrease and reported income will increase.

3) Cash Flow Statement Impact:

Cash flow statements remain unaffected by the choice of classifying leases as operating or capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease obligation. The principal repayment on the lease obligation payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO by the amount included in CFF and understate CFF.

Summary of Financial Effects:

Impacts on Key Financial Ratios:

9.19 - Sale And Leaseback An arrangement where the seller of an asset leases back the same asset from the purchaser. The lease arrangement is made immediately after the sale of the asset with the amount of the payments and the time period specified. Essentially, the seller of the asset becomes the lessee and the purchaser becomes the lessor in this arrangement. A leaseback arrangement is useful when companies need to untie the cash invested in an asset for other investments, but the asset is still needed in order to operate. Leaseback deals can also provide the seller with additional tax deductions. The lessor benefits in that they will receive stable payments for a specified period of time. •

•

•

Under both U.S. and IASB GAAP: When the lease is capitalized, SFAS 13 (US GAAP) and IAS 17 (IASB GAAP) require the lessee to defer any gain on the sale of the asset. The gain would then be recognized over the life of the lease. Under IAS 17 only: Gains on sale and leasebacks of assets are recognized immediately should the lease be classified as operating. Under SFAS 13 only: Gains on sale and leaseback of assets must by amortized over the life of the lease.

9.20 - Types Of Off-Balance-Sheet Financing Types of Off-Balance-Sheet Financing

Many economic transactions and events are not recognized in the financial statements because they do not qualify as accounting assets or transactions under GAAP standards. That said, these unreported assets and liabilities have real cash flow consequences. As a result, it is important to be able to identify and qualify these assets and liabilities. •

•

• •

•

Operating lease - Classifying a lease as an operating lease provides a company with the opportunity to utilize the leased asset and assume a contractual obligation to pay the lessor during a specific period of time without having to report the asset and, more importantly, the liability. Take-or-pay contract – This is an agreement between a buyer and seller in which the buyer will still pay some amount even if the product or service is not provided. Companies use take-or-pay contracts to ensure that their vendor makes the materials, such as raw materials, that they need to sustain operations available to them. In the event that a company does not purchase the material from the vendor, the company will have to pay some amount to the vendor. This provides a company with the ability to acquire the use of an asset without having to record it as an asset and a liability. These arrangements are common in the natural-gas, chemical, paper and metal industry. Throughput arrangements – Natural-gas companies use throughput arrangements with pipelines or processors to ensure distribution or processing. The effects are the same as take-or-pay contracts. Commodity-linked bonds – Natural-resource companies may also finance inventory purchases through commodity-indexed debt where interest and/or principal repayments are a function of the price of the underling commodity. The sale of accounts receivables – A company may sell its receivables to an unrelated third party to reduce its debt and improve its financial position. Most sales of receivables provide the buyer 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.

A more elaborate sale of account receivables is a parent company selling its receivables to a finance subsidiary where the parent owns less than 50% of the subsidiary. If the parent owns less than 50%, the financial asset and liability of the subsidiary are not included in the parent balance sheet; only the investment in the subsidiary is recorded as an asset. (If less than 50%, the equity method is used). Furthermore, the parent generally supports the subsidiary borrowings through extensive income-maintenance agreements and direct and indirect guarantees of debt. •

•

Joint ventures – Companies may enter into a joint venture with a supplier or other company. To obtain financing for such a venture, companies often enter into a take-or-pay or throughput contract with minimum payments designed to meet the venture’s debt-service requirements. Furthermore, direct or indirect guarantees may be present. Generally, companies account their investments in joint ventures using the equity method since no single company holds a controlling interest. As a result, the balance sheet reports on the net investment in the venture. Investments – Some companies issue long-term debt that is exchangeable for common shares of another publicly-traded company. Since the debt is secured by another liquid asset, the interest expense on the loan is usually smaller. This issuance is also used by companies with a large capital-gain liability on stock held. The company’s biggest concern in this case would be the large capital-gains tax liability they would have to pay should they default on the loan and have to exchange the debt for the securities it holds.

9.21 - Effects Of Off-Balance Sheet Financing Transactions On Financial Ratios • •

•

Take-or-pay contracts and throughput agreements These types of agreements effectively allow companies to keep some operation assets and liabilities off the balance sheet. As a result, in the analysis of a company’s financial statement, the balance sheet should be restated and include the present value of the minimum future payments to both the assets and liabilities section of the balance sheet. If this is not done, the debt-toequity and asset-turnover ratio will be overstated. Sales of receivables Sales of receivables artificially reduce the receivables and short-term borrowing needs. Furthermore, they distort the pattern of cash flow from operations as the firm receives cash earlier than it would if the receivables had been collected in due course. In addition, the potential liability associated with the buyer-recourse provision is not displayed on the balance sheet. From an analytical point of view, the current-asset ratio, working capital and receivable turnover will be overstated. On the other hand, the leverage ratios such as debt-to-equity will be too high. The reported income will also be too high because if it did not sell its receivables, the company would have had to borrow the funds it acquired from the sale of the receivables to finance its current operations. Analysts should adjust the balance sheet by adding back the amount of accounts receivables sold and increase short-term borrowing by an equal amount. Furthermore, the income statement needs to be restated and include the interest expense that would have been incurred by the firm had it not sold its receivables and borrowed the money instead.

9.22 - Accounting For Leases A lessor (the leasing company) can account for a lease in three ways: • • •

Operating lease Direct-financing lease Sales-type lease

Lease capitalization, which includes the directfinancing lease and the sales-type lease, needs to be recognized when a lease meets any one of the four criteria

specified for capitalization of leases and both of the following revenues-recognition criteria: • •

Collection of the monthly lease payments is reasonably predictable. Lessor's performance is substantially complete, or future costs are reasonably predictable.

If the lease is accounted for as a capital lease, the lessor must determine if it classifies as a direct-finance lease or as a sales-type lease. To classify as a sales-type lease, the fair value of the asset must be greater than the lessor's book value. If not, it is accounted for as a direct-financing lease. Direct-Financing Lease As its name implies, a direct-financing lease is basically the coupling of a sale and financing transaction. In this case, the lessor removes the leased asset from its books and replaces it with a receivable from the lessee. The only income recognized by the lessor is the interest received. The implied rate is taken by calculating IRR of the asset; cash inflow is equal to lease payments and cash outflow is equal to the book value of the lease asset. Sales-Type Lease A sales-type lease is accounted for like a direct-financing lease, except that profit on a sale is recognized upon inception of the lease, in addition to the interest income recognized during the lease term. The gross profit recognized at the inception of the lease is the PV of all lease payments minus the cost of the leased asset.