CFA Level 1 - Liabilities

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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:

• 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.
 • 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 five-
year 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

• 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
• 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.

• 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 Bonds Payable at par

- Unamortized Discount + Unamortized Premium
Carrying Value 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.

• 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.

• 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.

• 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:

• 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.

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

• 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:

 • 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:

• 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:

• 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:

• 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.
 • 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:

• 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

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-to-
equity 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 direct-

financing 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.