CFA Level 1 Financial Reporting and Analysis Non-current ... · 1.833 Unamortized discount 4.917 D 1.452 3.465 D 1.632 D 1.833 PV = 95.083 Year 0 Year 1 Year 2 Year 3 1.833 Discount

© 2011, Associate Professor Ole Sørensen, Ph.d. Side 1

CFA Level 1

Financial Reporting and Analysis

Non-current Liabilities


Coupon Bonds

Promises two types of payments: periodic interest payments and a lump-sum payment when the bond matures.

Face Value the lump-sum payment due at maturity

Coupon rate the stated cash interest rate

Periodic payment Coupon Rate x Face Value (actual cashflow)

Initial liability the amount paid to the issuer by the creditor(proceeds)

Effective interest rate the market rate at the time of issuance

Interest expense the market rate at the time of issuance timesthe bond liability

The balance sheet liability over time is a function of initial liability and relationship of periodic interest expense to the actual cash payments

The balance sheet liability at any point in time is equal to the PV of theremaining payments, discounted at market rate in effect at the time of theissuance of the bonds


Comparison of Financial Statement Effects of Coupon Bonds Issuedat Par, Premium, and Discount.

Bond Face Value $100,000

Maturity 3 years

Coupon rate 10% (annual payments)

Premium case: Market rate = 8%Discount case: Market rate = 12%

Interest ExpenseBond Issued at

Balance Sheet LiabilityBond Issued at

Cash flow from(all cases)

Year Par Premium Discount Par Premium Discount Operations Financing

20x1 10,000 8,388 11,452 100,000 103,630 96,535 10,00020x2 10,000 8,256 11,632 100,000 101,886 98,167 10,00020x3 10,000 8,114 11,833 100,000 100,000 100,000 10,000 100,000

Totals 30,000 24,758 34,917 30,000 100,000


Misclassification of Cash Flows

Bonds sold at premium (MR < Coupon rate) part of the coupon payment (10,000) is a reduction ofprincipal and should be treated as financing cash outflow.

Consequence: CFO is understated and CFF is overstated

Bonds sold at discount (MR > Coupon rate) part of the discount amortisation represents additionalinterest expense.

Consequence: CFO is overstated and CFF is understated

In summary, the cash flow classification of debt payments depends on the coupon rate rates, not theeffective interest rates. When these differ, CFO is misstated.


Reclassification of Cash Flows for Coupon Bonds

SFAS 95 Reclassification based on Interest Expense

Cash Flow All Bonds Premium Bond Discount Bond

FunctionalReclassification for

All BondsYear

ActualCashFlow Operations Financing Operations Financing Operations Financing Operations Financing

20x1 10,000 10,000 0 8,388 1,612 11,452 (1,452) 0 10,00020x2 10,000 10,000 0 8,256 1,744 11,632 (1,632) 0 10,00020x3 110,000 10,000 100,000 8,114 101,886 11,833 98,167 0 110,00

Totals 130,000 30,000 100,000 24,758 105,242 34,917 95,083 0 130,000


Premium Bond MR < CP PV = 105.242

5.2423.630

D 1.612 1.886 Unarmortized premiumD 1.744 D 1.886

Year 0 Year 1 Year 2 Year 3

10.0001.612

1.744 Premium amortization1.886

8.388 Interest paid8.256 (CFO)

8.144 Interest expense

Year 1 Year 2 Year 3

FV = 100.000

PV = 105.242


Discount Bond MR < CP PV = 95.083

1.833 Unamortized discount4.917 D 1.452 3.465 D 1.632 D 1.833

PV = 95.083

Year 0 Year 1 Year 2 Year 3

1.833 Discount amortization10.000 1.452

Interest paid Interest expense(CFO)

Year 1 Year 2 Year 3

FV = 100.000

1.632


Amortization Methods

IFRS – the effective interest method (required)

US GAAP - the effective interest method (preferred) or straight line method

Issuance Costs

IFRS – included in the measurement of the liability

US GAAP – Issuance costs are capitalized (prepaid expense) and amortized


Zero-Coupon Bonds

No periodic payments

The lump-sum payment at maturity includes all unpaid interest (equal tohe face value minus the proceeds)

Proceeds at issuance equal the PV of the face amount, discounted at themarket interest rate.

Note:

The interest on a zero-coupon bond never reduces CFO (as no interest ispaid)

Consequence: reported CFO is systematically “overstated”

Adjustments:

Reported CFOLess Zero-Coupon Interest (amortisation of discount)Adjusted CFO


Analysis of Financing Liabilities

Effects of Changes in Interest Rates

- Estimating the market value of debt

Retirement of Debt Prior to Maturity

Motives:

Declining interest rates permit the reduction of interest costs Increasing CFO permits debt retirement earlier than expected Sale of assets or additional equity generates funds and the firm

decides to reduce financial leverage

Accounting for Debt Retirement

The difference between the book value of the liability and the amount paidat retirement (gain or loss) is reported as a part of continuing operations


Accounting for Leases

Classifying Leases as Capital or Operating

Under US GAAP a lease is a capital lease of any of the following is true:

1. The lease transfers ownership of the property to the lessee at theend of the lease term

2. The lease contains a bargain purchase option

3. The lease term is equal to 75% or more of the estimatedeconomic life of the leased property (not applicable to land orwhen the lease terms begins within the final 25% or theeconomic life of the asset)

4. The PV of the minimum lease payments (MLPs) equals orexceeds 90% of the fair value of leased property to lessor.

Otherwise the lease is classified as an operating lease.

Under IFRS the classification is determined by examining theeconomic substance of the transaction


Reporting and disclosure considerations for lessees

For operating leases, lease payments are reported as rent expenses whenthey become due and no assets or liability is shown on the balance sheetfor future amounts to be paid. Future minimum lease payments (MPL’s)are disclosed.

For capital leases, present value of future lease payments is shown as anasset and liability on the balance sheet and payments are shown as interestexpense and principal repayment. The leased asset is depreciated.


Financial reporting by Lessee

ExampleLease beginning December 31, 20X0Annual MLPs of $ 10,000 made at the end of each year for four yearsDiscount rate 10%

Operating lease

No entry is made at the inception of the lease Over the life of the lease, only the annual rental expense of

$ 10,000 will be charged to income and CFO

Capital Lease

At the inception of the lease, an assets and liability equal to thePV of the lease payments, $31,700, is recognised

Over the life of the lease:

1. The annual rental expense of $ 10,000 will be allocated between interestand principal payments on the $31,700 leasehold liability according to thefollowing amortisation schedule:

Allocation of Paymentof $ 10,000

Year OpeningLiability

Interest Principal ClosingLiability

20X0 31,70020X1 31,700 3,170 6,830 24,87020X2 24,870 2,487 7,513 17,35720X3 17,357 1,735 8,265 9,09220X4 9,092 909 9,092 02. The costs of the leasehold assets of $31,700 is charged to operations(annual depreciation is $7,925) using the straight-line method over theterm of the lease.


Comparative analysis of Capitalized and Operating Leases

Balance Sheet Effect of Lease Capitalization20X0 20X1 20X2 20X3 20X4

AssetsLeased Assets 31,700 31,700 31,700 31,700 31,700Accumulated Depreciation 0 7,925 15,850 23,775 31,700Leased Assets, net 31,700 23,775 15,850 7,925 0

LiabilitiesCurrent portion of lease obligation 6,830 7,513 8,265 9,092 0Long-term debt: lease obligation 24,870 17,357 9,092 0

31,700 24,870 17,357 9,092 0

Note: No assets or liabilities are recognised if the lease is treated as anoperating lease.

Lease capitalization increases assets balances, resulting in lower assetturnover and ROA.

Leverage ratios: As lease obligations are not recognised for operatingleases, leverage ratios are understated. Lease capitalization adds bothcurrent and non-current liabilities to debt, resulting in a correspondingdecrease in working capital and increase in the debt-to-equity ratio.


Income Statement Effects of Lease ClassificationOperatingLease

Capital Lease

Operating =Total Expense

OperatingExpense

NonoperatingExpense

Rent Depreciation Interest Total Expense20X1 10,000 7,925 3,170 11,09520X2 10,000 7,925 2,487 10,41220X3 10,000 7,925 1,735 9,66020X4 10,000 7,925 909 8,834Totals 40,000 31,700 8,300 40,000

Note: Capitalization results in higher EBIT

In general, firms with operating leases report higher ROE, ROA andinterest coverage ratio


Cash flow effect of lease ClassificationOperating Lease Capital Lease

Year OperationsCFO

OperationsCFO

FinancingCFF

20X020X1 10,000 3,170 6,83020X2 10,000 2,487 7,51320X3 10,000 1,735 8,26520X4 10,000 909 9,091

Note: That at the inception of the lease (year 20X0), no cash flows arereported.

Capital lease reports higher CFO compared to those reported using theoperating method.


Ratios Capital Lease Operating Lease

Current ratio Lower HigherNet Working Capital Lower HigherAsset Turnover Lower HigherROA Lower HigherROE Lower HigherDE/E Higher Lower

Statements TotalsAssets Higher LowerLiabilities Higher LowerNet Income(yearly years)

Lower Higher

CFO Higher LowerCFF Lower HigherTotal cash flows Same Same


Financial Reporting by Lessors

Lease classification: Lessor

Sale-Type Leases versus Direct Financing

Balance sheet effects Income statement effects Cash flow effects

Capital Lease if any of the four criteria holds plus

The collectability of lease payment is predictableAll costs are incurred

Sales type-lease: Lessor is a dealer and seller and the leasedequipment

Direct financing lease: Lessor is not a dealer in the leased asset(e.g. a financing company)


Sales-Type-Lease

Three year lease End-of-year lease payments $1,000 Implicit interest rate 10% Cost price $2,283

Accounting recognition (lessor)

At inception:

Sales revenue 2,487COGS 2,283

Gross Profit 204

Gross investment in lease 3,000Unearned income (513)

Net investment in lease 2,487

Lessor amortisation Schedule Sales–Type Lease

AnnualPaymentReceived

InterestIncome

ReductionIn

investment

NetInvestment

Year0 2,4871 1,000 248 751 1,7362 1,000 174 826 9103 1,000 91 910 0

Total 3,000 513 2,487


Balance sheet effect

Sales-Type Lease Direct Financing LeaseNet investment in Leases

Year Current Long-term Total Current Long-term Total0 751 1,736 2,487 658 1,625 2,2831 826 910 1,736 756 870 1,6252 910 0 910 870 0 8703

Income Statement Effects

Sales-Type Lease Direct Financing LeaseYear Income Income0 Gain on

sale204 Gain on

sale0

1 Interest 248 Interest 3422 Interest 174 Interest 2443 Interest 91 Interest 130

Total 717 717

Cash Flow Statement Effects

Sales-Type Lease Direct Financing LeaseYear CFO CFI Total CFO CFI Total0 204 (204) 0 0 0 01 248 751 1,000 342 658 1,0002 174 826 1,000 244 756 1,0003 91 910 1,000 130 870 1,000

Total 717 2,283 3,000 3,000


At Inception Sales-Type Direct FinancingProfit Yes (Selling price –cost) NoneAssets Increase No Change

During Lease Term:Interest Revenue Less MoreTotal Cash Flow Same SameCFO Less MoreCFI More LessTotal gross profitAnd interest income

Same Same


Lessor – Operating Lease

Balance SheetAssets under lease Depreciation Net

Year 0 2.283 0 2.283Year 1 2.283 761 1.522Year 2 2.283 761 761Year 3 2.283 761 0

Income StatementRental revenue Depreciation Income

Year 0 0Year 1 1.000 761 239Year 2 1.000 761 239Year 3 1.000 761 239Sum 3.000 2.283 717

Cash flow StatementCFO

Year 0Year 1 1.000Year 2 1.000Year 3 1.000Sum 3.000

Documents

CFA Level 1 Financial Reporting and Analysis Non-current ... · 1.833 Unamortized discount 4.917 D 1.452 3.465 D 1.632 D 1.833 PV = 95.083 Year 0 Year 1 Year 2 Year 3 1.833 Discount