Chapter 12: Noncurrent (Long-Term) Liabilities

Chapter 12NONCURRENT (LONG-TERM) LIABILITIESPresenters namePresenters titledd Month yyyyLEARNING OUTCOMESDetermine the initial recognition and measurement and subsequent measurement of bonds.Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Discuss the derecognition of debt.Explain the role of debt covenants in protecting creditors.Discuss the financial statement presentation of and disclosures relating to debt.Discuss the motivations for leasing assets instead of purchasing them.Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.Determine the initial recognition and measurement and subsequent measurement of finance leases.Compare and contrast the disclosures relating to finance and operating leases. Describe defined contribution and defined benefit pension plans. Compare and contrast the presentation and disclosure of defined contribution and defined benefit pension plans. Calculate and interpret leverage and coverage ratios.1Bonds: contentsPricing of debt based on present value of future cash payments.How an issuer accounts for debt:Issued at par Issued at a price other than parIssuance, periodic interest payments, repaymentRole of debt covenants in protecting creditors.Copyright 2013 CFA Institute2LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.Pages 6066102Bonds: borrowers cash flowsCopyright 2013 CFA Institute3At issuance (Time 0), borrower receives cash in exchange for bonds.

Issue price equals present value of future cash flows.12345Pays periodic interest at the coupon rate.At maturity, pays principal amount.0LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.Pages 606610

The slide illustrates the timing of the borrowers bond-related cash flows. At Time 0 (at issuance), the bond issuer receives cash in exchange for issuing the bond. Subsequently, the issuer pays periodic interest at the coupon rate. At maturity, the issuer pays the principal owed.Bonds are contractual promises made by a company (or other borrowing entity) to pay cash in the future to its lenders (bondholders) in exchange for receiving cash in the present. The terms of a bond contract are contained in a document called an indenture. The cash or sales proceeds received by a company when it issues bonds is based on the value (price) of the bonds at the time of issue; the price at the time of issue is determined as the present value of the future cash payments promised by the company in the bond agreement.Ordinarily, bonds contain promises of two types of future cash payments: 1) the face value of the bonds, and 2) periodic interest payments. The face value of the bonds is the amount of cash payable by the company to the bondholders when the bonds mature. The face value is also referred to as the principal, par value, stated value, or maturity value. The date of maturity of the bonds (the date on which the face value is paid to bondholders) is stated in the bond contract and typically is a number of years in the future. Periodic interest payments are made based on the interest rate promised in the bond contract applied to the bonds face value. The interest rate promised in the contract, which is the rate used to calculate the periodic interest payments, is referred to as the coupon rate, nominal rate, or stated rate. Similarly, the periodic interest payment is referred to as the coupon payment or simply the coupon. For fixed rate bonds (the primary focus of our discussion here), the coupon rate remains unchanged throughout the life of the bonds. The frequency with which interest payments are made is also stated in the bond contract. For example, bonds paying interest semiannually will make two interest payments per year.3Determining the value of a bond: exampleAssumptions about the debt instrument (the bond):Principal = $1,000; Coupon interest rate = 10%; Maturity = 5 years Future cash flows for a five-year, 10% bond, $1,000 principal.Payments include periodic interest payments and principal payment.The market value of a bond is equal to the present value of its future cash flows.

Copyright 2013 CFA InstituteDiscount each payment at the appropriate discount ratePV = ?4LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.Pages 606618

Terminology :Usually bond refers to a debt instrument with original maturity greater than 10 years; note is a debt instrument with original maturity greater than 1 year, less than or equal to 10 years; and bill is a debt instrument with original maturity less than 1 year.Here, we use the term bond because the accounting treatment is similar for bonds and notes.4Accounting for debt by the issuer: example Assumptions about the bond:Principal = $1,000.Coupon interest rate: Stated or contractual rate of interest to be paid to the bondholders = 10%, annual.Maturity = 5 years.

Assumption about the debt market on the day of valuing:Market rate (yield or effective rate): Return the market demands on that bond on day we are valuing it = 10%.For simplicity, assume a flat interest rate yield curve.Copyright 2013 CFA Institute5LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.Pages 606618

The market rate is the rate at which the future cash flows are discounted.For simplicity, these examples assume a flat interest rate yield curve (i.e., that the market rate of interest is the same for each period). More-precise bond valuations use the interest rate applicable to each time period in which a payment of interest or principal occurs.5TimeInterest PaymentPrincipal PaymentTotal PaymentPresent Value of Total Payment01 100 - 100 91 2 100 - 100 83 3 100 - 100 75 4 100 - 100 68 5 100 1,000 1,100 683 Total 500 1,000 1,500 1,000 Accounting for debt: examplePrincipal = $1,000; Coupon interest rate = 10%; Maturity = 5 years.Market rate on the day we are valuing the bond = 10%. Bond will be issued at par (i.e., 100% of face value). PV = FV/[(1+i)n]Copyright 2013 CFA Institute6LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.Pages 606618

The slide illustrates the initial measurement of the bonds value based on the assumptions given.The sum of the present value of the total payments is $1,000. Calculating the value of the bonds at issuance and thus the sales proceeds involves three steps: (1) identifying key features of the bonds and the market interest rate, (2) determining future cash outflows, and (3) discounting the future cash flows to the present (sum of the present value of the future payments of interest and principal). As shown, because the market rate is equal to the coupon interest rate, the bonds will be issued at par (i.e. at 100% of face value). Ignoring issuance costs, the issuing company will receive sales proceeds (cash) equal to the face value of the bonds.6Issuers Accounting for debt at issuance: examplePrincipal = $1,000; Coupon interest rate = 10%, annual payments; Maturity = 5 years.Market rate on issuance date = 10%. Issued at par. Recorded in the long-term liability section of the balance sheet because maturity date is > one year awayIssuers balance sheet: Increase cash for $1,000 and increase bond payable for $1,000.Issuers journal entry: Debit cash and credit bonds payable.

ASSETS = LIABILITIES +OWNERS EQUITY+ $1000Cash+ $1000Bond payableCopyright 2013 CFA Institute7LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.Pages 606618

At issuance, the issuers balance sheet shows an increase cash for $1,000 and increase bond payable for $1,000.The issuers journal entry is debit cash and credit bonds payable.

7Issuers Accounting for debt at interest payment: examplePrincipal = $1,000; Coupon interest rate = 10%, annual payments; Maturity = 5 years.Issued at par.For simplification, assume each interest payment occurs on the last day of the fiscal year.Issuers balance sheet when interest paid: Decrease cash and increase interest expense (which reduces owners equity). Issuers journal entry: Debit interest expense, credit cash.

ASSETS = LIABILITIES +OWNERS EQUITY $100Cash $100Interest expenseCopyright 2013 CFA Institute8LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

The issuers balance sheet when interest paid: Decrease cash and record an interest expense (an interest expense appears as a negative because it reduces owners equity; expenses reduce net income, which, in turn, reduce retained earnings).The issuers journal entry: Debit interest expense, credit cash.

8Issuers Accounting for debt repaymentPrincipal = $1,000; Coupon interest rate = 10%, annual payments; Maturity = 5 years.Issued at par. For simplification, assume principal repayment occurs on the last day of the fiscal year.Issuers balance sheet when principal repaid: Decrease cash and decrease bonds payable.Issuers journal entry: Debit bonds payable and credit cash.

ASSETS = LIABILITIES +OWNERS EQUITY $1000Cash $1000Bonds payableCopyright 2013 CFA Institute9LOS. Discuss the derecognition of debt.Pages 618620

The issuers balance sheet when principal repaid: Decrease cash and decrease bonds payable.The issuers journal entry: Debit bonds payable and credit cash.

9Issuers Accounting for debt over its life: examplePrincipal = $1,000; Coupon = 10%; Maturity = 5 years; Issued at par.Bonds Premium orCommonRetainedTransactionYearCashPayable (Discount) StockEarningsInitial borrowBegin 1$1,000 $1,000 0 Pay interest 1 1000 100Pay interest 2 1000 100Pay interest 3 1000 100Pay interest 4 1000 100Pay interest 5 1000 100Pay principal 5 1,0001,000Copyright 2013 CFA Institute10LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.LOS. Discuss the derecognition of debt.Pages 606620

The slide shows the year-by-year effect on the issuers balance sheet, summarizing the previous slides.In the first year, cash (an asset) increases and bonds (a liability) increase.In the following years, at each interest payment, cash (an asset) decreases and an interest expense is recorded. (An interest expense appears as a negative in this spreadsheet because it reduces owners equity; expenses reduce net income, which, in turn, reduce retained earnings.)

10Discount or premium on bondsCopyright 2013 CFA InstituteOften, the contractual interest rate and the market rate differ. Therefore, bonds sell above or below face value.Coupon RateMarket Rate (examples)Bonds Sell At a10%8%Premium10%Par12%Discount11LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

When a bond is issued at a price equal to its face value, as in this example, the bond is said to have been issued at par.If the coupon rate on the bonds is higher than the market rate when the bonds are issued, the market value of the bonds and thus the amount of cash the company receives will be higher than the face value of the bonds. In other words, the bonds will sell at a premium to face value because they are offering an attractive coupon rate compared with current market rates. If the coupon rate is lower than the market rate, the market value and thus the sale proceeds from the bonds will be less than the face value of the bonds; the bond will sell at a discount to face value. 11Issuers Accounting for bonds issued at a discount Principal = $1,000; Coupon interest rate = 10%, paid annually; Maturity = 5 years.Return the market demands on the bond on the day we are valuing it = 12%. Issued at 92.8 (i.e., 92.8% of face value).At issuance, cash increases by $928 and bonds payable increases by $1,000. What do we do with the difference?We show it as a discount to bonds payable.ASSETS = LIABILITIES +OWNERS EQUITY+ $928Cash+ $1,000 $72Bond payableBond discountCopyright 2013 CFA Institute12LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

Assume that the market rate on the bond on day we are valuing it = 12%.The present value of the future cash flows discounted at 12% is $927.904, rounded to $928.On a financial calculator, FV = $100, n = 5 years, I = 12%, PMT = $10. Solve for present value (PV), which equals $92.7904. Multiply 92.7904% by face value.Or, FV = $1,000, n = 5 years, I = 12%, PMT = $100. Solve for PV, which equals $927.9045.The sales proceeds of the bonds when issued are $928. The bonds sell at a discount of $72 ($1,000 $928) because the market rate when the bonds are issued (12%) is greater than the bonds coupon rate (10%). At issuance, reflected on the balance sheet as an increase of cash and an increase in a long-term liability, bonds payable, of $928. The bonds payable is composed of the face value of $1,000 minus a discount of $72. The bond discount is shown with a negative sign because it is a contra-liability.Issuers journal entry: Debit cash ($928), debit discount on bonds payable ($72), credit bonds payable ($1,000).12Bonds issued at a discountCopyright 2013 CFA InstituteIssuers Balance Sheet Presentation

Book value (also known as carrying value)13LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

The book value (also known as carrying value) equals the face value minus the discount.13Issuers accounting for Bond issued at a discountPrincipal = $1,000; Coupon rate = 10%; Maturity = 5 years.Issue price 92.8% of par to yield 12% (effective rate).Each year:Cash interest payment = Principal x Coupon rate x Time = $1,000 10% 1 year = $100Interest expense = Carrying value Effective rate TimeAmortization of discount = Interest expense Cash interest payment

TransactionYearCashBonds Payable Discount CommonStockNet Inc. to Ret. EarningsInitial borrowingBegin 1$928 $1,000 72Pay interest 1 10011 111Interest expense$928 12% 1Copyright 2013 CFA Institute14LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

The market rate at the time of issuance is the effective interest rate or borrowing rate that the company incurs on the debt. The effective interest rate is the discount rate that equates the present value of the two types of promised future cash payments to their selling price. For the issuer, interest expense reported for the bonds in the financial statements is based on the effective interest rate.Each year, the cash interest payment is calculated as Principal Coupon rate Time.For every year, the calculation is $1,000 10% 1 year = $100. Each year, the interest expense is calculated as the Carrying value Effective rate Time.For the first year, the calculation is $928 12% 1 year = $111.Each year, the amortization of the discount is calculated as Interest expense Cash interest payment.For the first year, the amount of discount amortized is $111 $100 = $11. 14Issuers accounting for Bond issued at a discountPrincipal = $1,000; Coupon rate = 10%; Maturity = 5 years.Issue price = 92.8% of par to yield 12% (effective rate).Year 2, Cash interest payment = $100.Interest expense = Carrying value Effective rate Time.Amortization of discount = Interest expense Cash interest payment.TransactionYearCashBonds Payable DiscountCommonStockNet Inc. to Ret. EarningsInitial borrowingBegin 1928 1,000 72Pay interest 1 10011 111Interest expensePay interest 2 10013 113Interest expense($928 + $11) 12% 1Copyright 2013 CFA Institute15LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

In Year 2, the cash interest payment is still $100.In Year 2, the carrying value is now $928 plus $11 = $939.Each year, the interest expense is calculated as the Carrying value Effective rate Time, so the interest expense equals $939 12% = $112.68, or $113.Each year, the amortization of the discount is calculated as Interest expense cash interest payment.For Year 2, the amount of discount amortized is $113 $100 = $13.

15Issuers accounting for Bond issued at a discountPrincipal = $1,000; Coupon = 10%; Maturity = 5 years.Issued at 92.8 to yield 12%.TransactionYearCashBonds Payable DiscountCommonStockNet Inc. to Ret. EarningsInitial borrowingBegin 1928 1,000 72Pay interest 1 100 11 111Interest exp.Pay interest 2 100 13 113Interest expPay interest 3 100 14 114Interest expPay interest 4 100 16 116Interest expPay interest 5 100 18 118Interest expPay principal 5 1,0001,000Copyright 2013 CFA Institute16LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

The table shows cash, discount, and interest expense over all five years.By maturity, the amount of discount amortized = $72, so the carrying amount of the discount is zero and the carrying value of the bonds equals the principal amount in bonds payable.16Issuers Accounting for bond issued at a premiumPrincipal = $1,000; Coupon interest rate = 10%, paid annually; Maturity = 5 years.Return the market demands on the bond on the day we are valuing it = 8%. Issued at 108 (i.e., 108% of face value).At issuance, cash increases by $1080 and bonds payable increases by $1,000. What do we do with the difference?We show it as a premium to bonds payable.ASSETS = LIABILITIES +OWNERS EQUITY+ $1080Cash+ $1000+ $80Bond payableBond premium17Copyright 2013 CFA InstituteLOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

Assumption about the debt market on the day of valuing: Market rate for the bond on the day we are valuing it = 8%. The present value of the future cash flows discounted at 8% are $1,080 (rounded). On financial calculator, FV = $1,000, PMT = $100, i = 8%, n = 5 years. Solve for PV, which equals $1079.8542.Or FV = $100, n = 5 years, i = 8%, PMT = $10. Solve for PV, which equals $107.9854. Multiply face value by 107.9854%.

The sales proceeds of the bonds when issued are $1,080. The bonds sell at a premium of $80 because the market rate when the bonds are issued (8%) is less than the bonds coupon rate (10%). At issuance, reflected on the balance sheet as an increase of cash and an increase in a long-term liability, bonds payable of $1,080. The bonds payable is composed of the face value of $1,000 plus a premium of $80. The bond premium account is an adjunct account. It increases the carrying value of the bonds payable.Issuers journal entry: Debit cash ($1080), credit bonds payable ($1,000), and credit premium on bonds payable ($80).17Accounting for bond issued at a premiumPrincipal = $1,000; Coupon interest rate = 10%; Maturity = 5 years. Issue price = 108% of par to yield 8%. Assets =Liabilities + Owners EquityTransactionYearCashBonds PayablePremium

CommonStock Net Inc.to Ret. EarningsInitial borrowingBegin 11,080 1,000 80 Pay interest 1 1001486Interest expensePay interest 2 1001585Interest expensePay interest 3 1001684Interest expensePay interest 4 1001783Interest expensePay interest 5 1001981Interest expensePay principal 5 1,0001,000Copyright 2013 CFA Institute18LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.LOS. Discuss the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.Pages 606618

The table shows cash, discount, and interest expense over all five years.The bond premium is an adjunct account.Each year, the cash interest payment is calculated as Principal Coupon rate Time.For every year, the calculation is $1,000 10% 1 year = $100. Each year, the interest expense is calculated as the Carrying value Effective rate Time.For the first year, the calculation is $1,080 times 8% 1 year = $86.Each year, the amortization of the premium is calculated as Cash interest payment Interest expense.For the first year, the amount of premium amortized is $100 $86 = $14.By end of five years, the balance in the premium account is $0, so the carrying value of the bonds payable equals the face value.18Bond Prices Subsequent to IssuanceBonds may be issued:At face value.Below face value: discount.Above face value: premium.Subsequent to issuance, bonds may trade at face value, at a discount, or at a premium depending on the market rates at that time. Changes in value subsequent to issuance do not affect the value of the bond on the issuers statement unless the issuer has chosen the fair value option (much less common).

Copyright 2013 CFA Institute19LOS. Determine the initial recognition and measurement and subsequent measurement of bonds.Pages 60661819Payment of bondsMay be redeemed at maturity or before maturityA firm may decide to retire bonds earlyTo reduce interest costs or to remove debt from balance sheetBut only if it has sufficient cashTo account for retiring bonds earlyEliminate carrying value of bonds at redemption dateRecord cash paidRecognize gain or loss on redemptionGain or loss on bond repurchase = Net bonds payable Repurchase payment Amount of repurchase payment will depend on market rates at the time of repurchaseCopyright 2013 CFA Institute20LOS. Discuss the derecognition of debt.Pages 618620

Once bonds are issued, a company may leave the bonds outstanding until maturity or redeem the bonds before maturity either by calling the bonds (if the bond issue includes a call provision) or by purchasing the bonds in the open market. If the bonds remain outstanding until the maturity date, the company pays bondholders the face value of the bonds at maturity. The discount or premium on the bonds would be fully amortized at maturity; the carrying amount would equal face value. Upon repayment, bonds payable is reduced by the carrying amount at maturity (face value) of the bonds and cash is reduced by an equal amount. Repayment of the bonds appears in the statement of cash flows as a financing cash outflow.If a company decides to redeem bonds before maturity and thus extinguish the liability early, bonds payable is reduced by the carrying amount of the redeemed bonds. The difference between the cash required to redeem the bonds and the carrying amount of the bonds is a gain or loss on the extinguishment of debt. Under IFRS, debt issuance costs are included in the measurement of the liability and are thus part of its carrying amount. Under U.S. GAAP, debt issuance costs are accounted for separately from bonds payable and are amortized over the life of the bonds. Any unamortized debt issuance costs must be written off at the time of redemption and included in the gain or loss on debt extinguishment.

20debt covenantsCovenants protect creditors by restricting activities of the borrower.Affirmative covenantsNegative covenantsIf a borrower violates a debt covenant, depending on the severity of the breach and the terms of the contract, lenders may choose to waive the covenant, be entitled to a penalty payment or higher interest rate, renegotiate, or call for immediate repayment of the debt.

Copyright 2013 CFA Institute21LOS. Explain the role of debt covenants in protecting creditors. Pages 621622

Borrowing agreements (the bond indenture) often include restrictions called covenants that protect creditors by restricting activities of the borrower. Debt covenants benefit borrowers to the extent that they lower the risk to the creditors and thus reduce the cost of borrowing. Affirmative covenants restrict the borrowers activities by requiring certain actions (e.g., may require that the borrower maintain certain financial ratios above a specified amount or perform regular maintenance on real assets used as collateral). Negative covenants require that the borrower not take certain actions (e.g., may restrict the borrowers ability to invest, pay dividends, or make other operating and strategic decisions that might adversely affect the companys ability to pay interest and principal).Common covenants: Limitations on how borrowed monies can be used, maintenance of collateral pledged as security (if any), restrictions on future borrowings, requirements that limit dividends, and requirements to meet specific working capital requirements. Covenants may also specify minimum acceptable levels of financial ratios, such as debt to equity, current, or interest coverage.If a company violates a debt covenant, it is a breach of contract. Depending on the severity of the breach and the terms of the contract, lenders may choose to waive the covenant, be entitled to a penalty payment or higher interest rate, renegotiate, or call for payment of the debt. 21Issuers financial statement presentation of debtCopyright 2013 CFA Institute22

Excerpt from 2011 and 2010 balance sheets of Colgate-Palmolive Inc.LOS. Discuss the financial statement presentation of and disclosures relating to debt.Pages 622625

The noncurrent (long-term) liabilities section of the balance sheet usually includes a single line item of the total amount of a companys long-term debt due after one year, with the portion of long-term debt due in the next 12 months shown as a current liability. This slide shows an excerpt from the balance sheet of Colgate Palmolive, which has $4,430 million in Long-term debt and $346 million in Current portion of long-term debt in Current liabilities.22Issuers Note disclosures relating to debtCopyright 2013 CFA Institute23

Brief excerpt from Note 5 of Colgate Palmolives 2011 financial statements.LOS. Discuss the financial statement presentation of and disclosures relating to debt.Pages 622625

Notes to the financial statements provide more information on the types and nature of a companys debt. These note disclosures can be used to determine the amount and timing of future cash outflows. The notes generally include stated and effective interest rates, maturity dates, restrictions imposed by creditors (covenants), and collateral pledged (if any). The amount of scheduled debt repayments for the next five years also is shown in the notes.The slide shows a brief excerpt from Note 5 of Colgate Palmolives 2011 financial statements. Most of the companys long-term debt is in the form of notes due between 2012 and 2078.The note discloses that Commercial paper is classified as long-term debt as the Company has the intent and ability to refinance such obligations on a long-term basis.23LeasesLeasing an asset is an alternative to purchasing.Rather than borrowing and buying the asset, a company arranges to lease the asset.Advantages to leasing an asset compared with purchasing it: Leases can provide less costly financing; usually require little, if any, down payment; and are often at fixed interest rates. The negotiated lease contract may contain less restrictive provisions than other forms of borrowing. Leasing can reduce the risks of obsolescence, residual value, and disposition to the lessee.Certain types of leases have perceived financial reporting advantages.

Copyright 2013 CFA Institute24LOS. Discuss the motivations for leasing assets instead of purchasing them.LOS. Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.Pages 625644

There are several advantages to leasing an asset compared with purchasing it. Leases can provide less costly financing; they usually require little, if any, down payment and often are at lower fixed interest rates than those incurred if the asset was purchased. This financing advantage is the result of the lessor having advantages over the lessee and/or another lender. The lessor may be in a better position to take advantage of tax benefits of ownership, such as depreciation and interest. The lessor may be better able to value and bear the risks associated with ownership, such as obsolescence, residual value, and disposition of asset. The lessor may enjoy economies of scale for servicing assets. As a result of these advantages, the lessor may offer attractive lease terms and leasing the asset may be less costly for the lessee than owning the asset. Further, the negotiated lease contract may contain less-restrictive provisions than other forms of borrowing.Companies also use certain types of leases because of perceived financial reporting and tax advantages. Although they provide a form of financing, certain types of leases are not shown as debt on the balance sheet. 24LeasesThere are two main classifications of leases: finance (or capital) and operating leases. Finance lease is IFRS terminology, and capital lease is U.S. GAAP terminology.A lessee treats capital leases as on-balance-sheet obligations.A lessee does not show operating leases on the balance sheet.

Copyright 2013 CFA Institute25LOS. Discuss the motivations for leasing assets instead of purchasing them.LOS. Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.Pages 625644

There are two main classifications of leases: finance (or capital) and operating leases. The economic substance of a finance (or capital) lease is very different from an operating lease, as are the implications of each for the financial statements of the lessee and lessor. In substance, a finance (capital) lease is equivalent to the purchase of some asset (lease to own) by the buyer (lessee) that is directly financed by the seller (lessor). An operating lease is an agreement allowing the lessee to use some asset for a period of time, essentially a rental. Finance lease is IFRS terminology, and capital lease is U.S. GAAP terminology.25Leases from lessees perspectiveBalance SheetIncome StatementStatement of Cash FlowsLesseeOperating LeaseNo effect.Reports rent expense.Rent payment is an operating cash outflow.Finance Lease under IFRS (capital lease under U.S. GAAP)Recognizes leased asset and lease liability.Reports depreciation expense on leased asset.Reports interest expense on lease liability.Reduction of lease liability is a financing cash outflow.

Interest portion of lease payment is either an operating or financing cash outflow under IFRS and an operating cash outflow under U.S. GAAP.Copyright 2013 CFA Institute26LOS. Discuss the motivations for leasing assets instead of purchasing them.LOS. Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.Pages 625644

This slide summarizes the financial statement impact of operating and financing leases on the lessee.26Leases from lessors perspectiveBalance SheetIncome StatementStatement of Cash FlowsOperating LeaseRetains asset on balance sheet.Reports rent incomeand depreciation expense on leased asset.Rent payments received are an operating cash inflow.Copyright 2013 CFA Institute27LOS. Discuss the motivations for leasing assets instead of purchasing them.LOS. Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.Pages 625644

This slide summarizes the financial statement impact of operating leases on the lessor.27Balance SheetIncomeStatementStatement of Cash FlowsFinance Lease: When present value of lease payments equals the carrying amount of the leased asset (called a direct financing lease in U.S. GAAP)Removes asset from balance sheet.

Recognizes lease receivable.Reports interest revenue on lease receivable.Interest portion of lease payment received is either an operating or investing cash inflow under IFRS and an operating cash inflow under U.S. GAAP.Receipt of lease principal is an investing cash inflow.Copyright 2013 CFA Institute28Leases from lessors perspectiveLOS. Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.Pages 625644

This slide summarizes the financial statement impact of finance leases on the lessor when the present value of lease payments = carrying amount of leased asset.U.S. GAAP distinguish between a direct financing lease and a sales-type lease, but IFRS do not. The accounting is the same for IFRS and U.S. GAAP regardless of this additional classification under U.S. GAAP.28Balance SheetIncome StatementStatement of Cash FlowsFinance Lease: When present value of lease payments exceeds the carrying amount of the leased asset (called a sales-type lease in U.S. GAAP)Removes asset. Recognizes lease receivable.Reports profit on sale.Reports interest revenue on lease receivable.Interest portion of lease payment received is either an operating or investing cash inflow under IFRS and an operating cash inflow under U.S. GAAP. Receipt of lease principal is an investing cash inflow.Copyright 2013 CFA Institute29Leases from lessors perspectiveLOS. Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee.Pages 625644

The slide summarizes the financial statement impact of finance leases on the lessor when the present value of lease payments = carrying amount of leased asset.U.S. GAAP distinguish between a direct financing lease and a sales-type lease, but IFRS do not. The accounting is the same for IFRS and U.S. GAAP despite this additional classification under U.S. GAAP.If providing leases is part of a companys normal business activity, the cash flows related to the leases are classified as operating cash.29Lessees Lease disclosures: example30

Copyright 2013 CFA InstituteLOS. Compare and contrast the disclosures relating to finance and operating leases.Pages 625644

The slide shows an excerpt from Note 10 of Starbucks 2011 financial statements.Disclosures include rental expense and future commitments under noncancellable operating leases.Analysts typically consider noncancellable operating lease obligations as equivalent to on-balance-sheet obligations and use information from footnote disclosures to make adjustments. (The methodology for this adjustment is discussed in other readings.)30Lessees Lease disclosures: exampleWe have subleases related to certain of our operating leases. During fiscal 2011, 2010, and 2009, we recognized sublease income of $13.7 million, $10.9 million, and $7.1 million, respectively.We had capital lease obligations of $1.4 million and $2.6 million as of October 2, 2011, and October 3, 2010, respectively. Capital lease obligations expire at various dates, with the latest maturity in 2014. The current portion of the total obligation is included in other accrued liabilities and the remaining long-term portion is included in other long-term liabilities on the consolidated balance sheets. Assets held under capital leases are included in net property, plant, and equipment on the consolidated balance sheets.

31Copyright 2013 CFA InstituteLOS. Compare and contrast the disclosures relating to finance and operating leases.Pages 625644

The slide shows the remaining portion of Note 10 of Starbucks 2011 financial statements.Disclosures explain that the capital lease obligation is shown as a liability (current and long-term portions, separately) and as an asset under property, plant, and equipment (PP&E).Disclosure highlights that capital leases are equivalent to owning the asset.31types of postemployment benefits: pension plans Copyright 2013 CFA Institute32Amount ofFuture Benefit to EmployeeContribution from EmployerDefined contribution pension planDefined benefit pension planDepends on investment performance of plan assetsAmount (if any) is defined in each periodDepends on current period estimate and investment performance of plan assetsDefined based on plans formulaLOS. Describe defined contribution and defined benefit pension plans.Pages 644648

Pension plans may be either defined contribution or defined benefit. Under a defined contribution (DC) pension plan, specific defined contributions are made to an employees pension plan by employer (and employee).Typically, an individual account is established for each participating employee and the accounts are invested through a financial intermediary, such as an investment management company or an insurance company. The amount of future benefit depends on the future value of the plans assets, which depends on the performance of the investments within the plan. Gains or losses on those investments accrue to the employee. Under a defined benefit (DB) pension plan, the amount of pension benefit to be provided is defined, usually by reference to age, years of service, compensation, and so on. For example, a DB pension plan may provide for the retiree to be paid, annually until death, an amount equal to x percent of the final years salary times the number of years of service. 32presentation and disclosure for pension plans Copyright 2013 CFA Institute33Type of Pension PlanBalance SheetIncome StatementFootnote DisclosureDefined contributionNoneCompany's contributionMinimalDefined benefitNet funded positionPeriodic expenseExtensiveLOS. Describe defined contribution and defined benefit pension plans.LOS. Compare and contrast the presentation and disclosure of defined contribution and defined benefit pension plans.Pages 644648

For a defined contribution plan: Balance sheet: There is typically no liability (None); however, if some portion of the agreed-upon amount has not been paid by fiscal year-end, a liability would be recognized on the balance sheet. The only other impact on the balance sheet is a decrease in cash.Income statement: The agreed-upon company contribution is the pension expense. The amount paid (contributed to the plan) is treated as an operating cash outflow. Footnote disclosure is minimal.For a defined benefit plan:Balance sheet: The net funded position (with adjustments in some circumstances) is shown on the balance sheet. The net funded position is the net of estimated future pension obligation minus pension fund assets.Income statement: The pension expense reflects the increase in the estimated future pension obligation, net of earnings on the pension assets.Footnote disclosure is extensive, including information on pension fund asset allocation, breakdown of periodic pension expense, assumptions used in estimating future pension obligation, and so on.33leverage and coverage ratiosCopyright 2013 CFA Institute34Solvency: Companys ability to meet its long-term debt obligations.Two types of commonly used solvency ratios: Leverage ratios Focus on the balance sheet Measure relative amount of debt in the companys capital structureCoverage ratiosFocus on the income statement and cash flowsMeasure the ability of a company to cover its debt-related paymentsLOS. Calculate and interpret leverage and coverage ratios.Pages 648651

Solvency refers to a companys ability to meet its long-term debt obligations, including both principal and interest payments.In evaluating a companys solvency, ratio analyses can provide information about the relative amount of debt in the companys capital structure (using leverage ratios) andthe adequacy of earnings and cash flow to cover interest expense and other fixed charges (such as lease or rental payments) as they come due (using coverage ratios).Ratios are useful to evaluate a companys performance over time compared with the performance of other companies and industry norms. Ratio analysis has the advantage of allowing the comparison of companies regardless of their size and reporting currency.The two primary types of solvency ratios are leverage ratios and coverage ratios. Leverage ratios focus on the balance sheet and measure the extent to which a company uses liabilities rather than equity to finance its assets. Generally, higher implies a greater proportion of debt in capital structure and thus greater risk and weaker in terms of solvency. But it must be evaluated in the context of optimal capital structure.Coverage ratios focus on the income statement and cash flows and measure the ability of a company to cover its debt-related payments. Higher implies a greater capacity to cover interest charges and thus stronger in terms of solvency.34leverage and coverage ratiosSolvency RatiosNumeratorDenominatorLeverage ratiosDebt-to-assets ratioTotal debtTotal assetsDebt-to-capital ratioTotal debtTotal debt + Total shareholders equityDebt-to-equity ratioTotal debtTotal shareholders equityFinancial leverage ratioAverage total assetsAverage shareholders equityCoverage ratiosInterest coverage ratioEBITInterest paymentsFixed charge coverage ratioEBIT + Lease paymentsInterest payments + Lease paymentsCopyright 2013 CFA Institute35LOS. Calculate and interpret leverage and coverage ratios.Pages 648651

The slide shows calculations for commonly used solvency ratios.35Evaluating Solvency RatiosNokia( millions)Ericsson(SEK millions)2008200720082007Short-term borrowings3,5787141,6392,831Current portion of long-term interest bearing debt131733,9033,068Long-term interest bearing debt86120324,93921,320Total shareholders equity14,20814,773140,823134,112Total assets39,58237,599285,684245,117EBIT4,9667,98516,25230,646Interest payments155591,6891,513Copyright 2013 CFA Institute36Debt to assets for 2008: 11.2%. Debt to assets for 2007: 2.9%.Debt to assets for 2008: 10.7%.Debt to assets for 2007: 11.1%. LOS. Calculate and interpret leverage and coverage ratios.Pages 648651

For NokiaDebt to assets for 2008: 11.2% = (3,578+13+861)/39,582.Debt to assets for 2007: 2.9% = (714+173+203)/37,599.

For EricssonDebt to assets for 2008: 10.7% = (1,639+3,903+24,939)/(285,684).Debt to assets for 2007: 11.1% = (2,831+3,068+21,320)/(245,117).

Nokias leverage ratios all increased from 2007 to 2008, suggesting weakening solvency. Comparing debt year to year, we observe that leverage ratios increased because of a significant increase in short-term borrowings and an increase in long-term interest bearing debt without a similar increase in shareholders equity. In fact, shareholders equity declined.On the other hand, Ericssons leverage ratios appear fairly similar for 2007 and 2008. During 2008, it appears as though Ericsson shifted away from short-term borrowings to long-term debt.In 2007, all three of Nokias leverage ratios (not shown on slide) were lower than Ericssons. In 2008, the opposite was true. Ericssons capital structure seems fairly constant over the two years, whereas Nokias capital structure has shifted toward more debt.36Evaluating Solvency RatiosNokia( millions)Ericsson(SEK millions)2008200720082007Short-term borrowings3,5787141,6392,831Current portion of long-term interest bearing debt131733,9033,068Long-term interest bearing debt86120324,93921,320Total shareholders equity14,20814,773140,823134,112Total assets39,58237,599285,684245,117EBIT4,9667,98516,25230,646Interest payments155591,6891,513Copyright 2013 CFA Institute37Interest coverage ratio for 2008: 32.0Interest coverage ratio for 2007: 135.3 Interest coverage ratio for 2008: 9.6Interest coverage ratio for 2007: 20.3LOS. Calculate and interpret leverage and coverage ratios.Pages 64651

For NokiaInterest coverage ratio for 2008: 32.0 = (4,966/155).Interest coverage ratio for 2007: 135.3 = (7,985/59).

For EricssonInterest coverage ratio for 2008: 9.6 = (16,252/1,689).Interest coverage ratio for 2007: 20.3 = (30,646/1,513).

Nokias interest coverage ratio decreased from 2007 to 2008 because of a decrease in EBIT and an increase in interest payments. Even with the decrease, Nokia appears to have sufficient operating earnings to cover interest payments. Similarly, Ericssons interest coverage ratio decreased from 2007 to 2008, primarily because of a decrease in EBIT. Ericsson also appears to have sufficient operating earnings to cover interest payments.Nokias ability to cover interest payments is greater than Ericssons, although both companies appear to have sufficient operating earnings to cover interest payments.37SummaryBonds are valued as the present value of future cash flows.Market interest rates reflect the risk of the issuer and the instrument.A bond discount or premium is amortized by using the effective interest method.Analysts treat noncancellable operating leases as equivalent to on-balance-sheet debt.Defined benefit pension plans with a net unfunded position give rise to liabilities.Leverage and coverage ratios are used in assessing a companys solvency.

Copyright 2013 CFA Institute3838$100$100$100$100$1,100

012345

Long-Term Liabilities

Bonds Payable$1,000

Less: Discount $72$928