7/28/22, 4:31 PM Kaplanlearn - Reading 24: Key Concepts by LOS

SCHWESERNOTES - BOOK 2

Reading 24: Key Concepts by LOS

LOS 24.a

When a bond is issued, assets and liabilities both initially increase by the bond proceeds. At any point in time, the book
value of the bond liability is equal to the present value of the remaining future cash flows (coupon payments and
maturity value) discounted at the market rate of interest at issuance. The proceeds are reported in the cash flow
statement as an inflow from financing activities.

A premium bond (coupon rate > market yield at issuance) is reported on the balance sheet at a value greater than its
face value. As the premium is amortized (reduced), the book value of the bond liability will decrease until it reaches its
face value at maturity.

A discount bond (market yield at issuance > coupon rate) is reported on the balance sheet at less than its face value.
As the discount is amortized, the book value of the bond liability will increase until it reaches its face value at maturity.

LOS 24.b

Interest expense includes amortization of any discount or premium at issuance. Using the effective interest rate
method, interest expense is equal to the book value of the bond liability at the beginning of the period multiplied by the
bond's yield at issuance.

For a premium bond, interest expense is less than the coupon payment (yield < coupon rate). The difference between
interest expense and the coupon payment is subtracted from the bond liability on the balance sheet.

For a discount bond, interest expense is greater than the coupon payment (yield > coupon rate). The difference
between interest expense and the coupon payment is added to the bond liability on the balance sheet.

LOS 24.c

When bonds are redeemed before maturity, a gain or loss is recognized equal to the difference between the redemption
price and the carrying (book) value of the bond liability at the reacquisition date.

LOS 24.d

Debt covenants are restrictions on the borrower that protect the bondholders' interests, thereby reducing both default
risk and borrowing costs. Covenants can include restrictions on dividend payments and share repurchases; mergers
and acquisitions; sale, leaseback, and disposal of certain assets; and issuance of new debt in the future. Other
covenants require the firm to maintain ratios or financial statement items at specific levels.

LOS 24.e

The firm separately discloses details about its long-term debt in the footnotes. These disclosures are useful for
determining the timing and amount of future cash outflows. The disclosures usually include a discussion of the nature of
the liabilities, maturity dates, stated and effective interest rates, call provisions and conversion privileges, restrictions
imposed by creditors, assets pledged as security, and the amount of debt maturing in each of the next five years.

LOS 24.f

Advantages of leasing rather than purchasing an asset may include, a smaller initial cash outflow, lower-cost financing,
and less risk of obsolescence.

LOS 24.g

A finance lease is a lease that transfers the benefits and risks of ownership to the lessee. A lease that does not transfer
these benefits and risks is an operating lease.

Under IFRS, for both finance and operating leases, except for short-term leases, a lessee reports a right-of-use asset
and a lease liability on its balance sheet, both equal to the present value of the promised lease payments. The interest
portion of each lease payment is reported as interest expense, while the principal-repayment portion of each payment
reduces the lease liability. For short-term or low-value leases, rent expense is reported on the income statement and no
balance sheet entries are required.

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7/28/22, 4:31 PM Kaplanlearn - Reading 24: Key Concepts by LOS
Under U.S. GAAP, reporting for a finance lease is the same as under IFRS. For an operating lease, the reporting is the
same as under IFRS except that the entire lease payment is recorded as a lease expense. For short-term leases, rent
expense is reported on the income statement and no balance sheet entries are required.

LOS 24.h

A lease that is classified as finance or operating by the lessee is classified the same way by the lessor.

Under both IFRS and U.S. GAAP, with a finance lease, the lessor removes the leased asset from its balance sheet and
adds a lease receivable asset. The lessor reports the interest portion of the lease payments as income. For an
operating lease, the lessor keeps the leased asset on its balance sheet, reports lease payments as income, and reports
depreciation and other costs as expenses.

LOS 24.i

A firm reports a net pension liability on its balance sheet if the fair value of a defined benefit plan's assets is less than
the estimated pension obligation, or a net pension asset if the fair value of the plan's assets is greater than the
estimated pension obligation. The change in the net pension asset or liability is reflected in a firm's comprehensive
income each year.

Pension expense for a defined contribution pension plan is equal to the employer's contributions.

LOS 24.j

Analysts use solvency ratios to measure a firm's ability to satisfy its long-term obligations. In evaluating solvency,
analysts look at leverage ratios and coverage ratios.

Leverage ratios, such as debt-to-assets, debt-to-capital, debt-to-equity, and the financial leverage ratio, focus on the
balance sheet.

Debt-to-assets ratio = total debt / total assets

Debt-to-capital ratio = total debt / (total debt + total equity)

Debt-to-equity ratio = total debt / total equity

Financial leverage ratio = average total assets / average total equity

Coverage ratios, such as interest coverage and fixed charge coverage, focus on the income statement.

Interest coverage = EBIT / interest payments

Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments)

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