Level I - Financial Reporting and Analysis

om 1
Non-Current (Long-Term) Liabilities

.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
www.ift.world

.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
1
 Introduction and Contents
1. Introduction

2. Bonds Payable

3. Leases

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
4. Pensions and Other Post Employment Benefits

ak / C
ah 58 ok
.m 1 o
w 11 B
5. Evaluating Solvency

w 4
w 20
99
www.ift.world 2
 2. Bonds Payable
Bonds are contractual promises made by a company to pay cash in the future to its
lenders (bondholders) in exchange for receiving cash in the present. Terms of the
bond contract are contained in a document called an indenture.

What is the risk?

Bond Required return?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
market rate of interest at issuance
ssuance

ak / C
ah 58 ok
$$$ effective interest rate
e

.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 3
 Bond Issuance: Coupon Rate = Effective Interest Rate

Face Value (Par Value) = 100

Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually

<Details of issuer’s obligations>

om 1
.c 60
oo 6 r
ib 20 te
When the bond is issued, investors

ks 65
al 98 en
require a return of 10%. What are the

ak / C
ah 58 ok
sales proceeds? How is the issuance

.m 1 o
w 11 B
reflected in the financial statements?

w 4 li
w 20 aka
coupon rate = effective
tive interest
interest rate

99 ah
Bond is issued at face
e value
va ue

M
www.ift.world 4
 Bond Issuance: Coupon Rate < Effective Interest Rate

Face Value (Par Value) = 100

Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually

<Details of issuer’s obligations>

om 1
.c 60
oo 6 r
ib 20 te
When the bond is issued, investors

ks 65
al 98 en
require a return of 11%. What are the

ak / C
ah 58 ok
sales proceeds? How is the issuance

.m 1 o
w 11 B
reflected in the financial statements?

w 4 li
w 20 aka
coupon rate < effective
ctive
e interest
interest rate

99 ah
Bond is issued at a discount
disco nt

M
www.ift.world 5
 Bond Issuance: Coupon Rate > Effective Interest Rate

Face Value (Par Value) = 100

Issue Date = 1 January, 2011
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually

<Details of issuer’s obligations>

om 1
.c 60
oo 6 r
ib 20 te
When the bond is issued, investors

ks 65
al 98 en
require a return of 9%. What are the

ak / C
ah 58 ok
sales proceeds? How is the issuance

.m 1 Bo
reflected in the financial statements?

w 4 li
w 20 aka
coupon rate > effective
tive interest
inter
i rest rate
r

w 1
99 ah
prremium
Bond is issued at a premium

M
www.ift.world 6
Accounting for Bond Amortization, Interest Expense and Interest Payments

Once the bond has been issued, the company needs to make coupon payments. How
are these payments accounted for?
Amortizing a Bond Discount

Face Value (Par Value) = 100 Carrying Carrying

Amount Interest Interest Amortization Amount
Issue Date = 1 January, 2011 Year (Begin) Expense Payment of Discount (End)
Maturity Date = 31 December, 2013
Coupon Rate = 10% paid annually
2011 97.56 10.73 10.00 0.73 98.29
2012 98.29 10.81 10.00 0.81 99.10
When the bond is issued, investors require a

om 1
.c 60
2013 99.10 10.90 10.00 0.90 100.00
100.00

oo 6 r
return of 11%. Show the following:

ib 20 te
ks 65
al 98 en
1. Interest payments

ak / C
2. Interest expense Balance Sheet

ah 58 ok
.m 1 o
3. Reported bond value

w 11 B
Income Statement

w 4 li
w 20 aka
How are the above numbers reflected in the

99 ah
financial statements? Cash Flow Statement

M
www.ift.world 7
 Example
Amortizing a Bond Premium
Face Value (Par Value) = 100
Issue Date = 1 January, 2011 Carrying Carrying
Maturity Date = 31 December, 2013 Amount Interest Interest Amortization Amount
Coupon Rate = 10% paid annually Year (Begin) Expense Payment of Premium (End)

2011
When the bond is issued, investors require a
return of 9%. Show the following: 2012
1. Interest payments 2013
2. Interest expense

om 1
.c 60
oo 6 r
3. Reported bond value

ib 20 te
Balance Sheet

ks 65
al 98 en
ak / C
How are the above numbers reflected in the

ah 58 ok
Income Statement

.m 1 o
financial statements?

w 11 B
w 4 li
Cash Flow Statement

w 20 aka
99 ah
M
www.ift.world 8
 Example
Zero Coupon Bond
Face Value (Par Value) = 100
Issue Date = 1 January, 2011 Carrying Carrying
Maturity Date = 31 December, 2013 Amount Interest Interest Amortization Amount
No coupon payments are made Year (Begin) Expense Payment of Discount (End)

2011
When the bond is issued, investors require a
return of 10%. Show the following: 2012
1. Reported bond value 2013
2. Interest expense

om 1
.c 60
oo 6 r
ib 20 te
Balance Sheet

ks 65
al 98 en
How are the above numbers reflected in the

ak / C
financial statements?

ah 58 ok
Income Statement

.m 1 o
w 11 B
w 4 li
Cash Flow Statement

w 20 aka
99 ah
M
www.ift.world 9
 Issuance Costs
• There are costs associated with issuing a bond

• Under both IFRS and U.S. GAAP, companies initially report

bonds as a liability on their balance sheet at the amount of
the sales proceeds net of issuance costs

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 10
 Miscellaneous Points
• Effective interest rate does not change
during the life of the bond

• Book value of bond rises for a discount

bond and falls for premium bond

• Link between bond amortization and

om 1
.c 60
oo 6 r
ib 20 te
amortization of long-lived assets

ks 65
al 98 en
ak / C
ah 58 ok
• Effective interest rate method versus

.m 1 o
w 11 B
w 4 li
straight-line method

w 20 aka
99 ah
M
www.ift.world 11
 Example
A company issued a five-year 8.50% coupon bond two years ago. At the time of
issuance the effective interest rate was 8.00%. Today the interest rate is 9.00%. The
bond was most likely issued at:
A. par
B. a discount
C. a premium

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 12
 Example
A company issued a five-year 8.50% coupon bond two years ago. At the time of
issuance the effective interest rate was 8.00%. Today the interest rate is 9.00%. The
book value of the bond today is most likely:
A. par
B. above par
C. below par

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 13
 Current Market Rates and Fair Value Reporting Option
Discussion so far has focused on reporting bonds at amortized historical costs; this method reflects
the market rate at the time the bonds were issued

Under IFRS and US GAAP companies have the option to report financial liabilities at fair value

Two major reasons for why bonds’ fair value might diverge from reported value

om 1
.c 60
oo 6 r
ib 20 te
1. Change in market rates

ks 65
al 98 en
ak / C
2. Change in credit risk

ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 14
 Derecognition of Debt
• Once bonds are issued, a company may leave the bonds outstanding until maturity or redeem the
bonds before maturity

• Gains and losses are recognized for bonds redeemed before maturity
ƒ Loss = Redemption price – book value of the bond liability at the reacquisition date
ƒ Example: Redemption Price = 1,020,000, Book value = 990,000, Loss = 30,000

• Gain or loss from extinguishing debt is reported in the income statement in a separate line item
where amount is material

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
• Dealing with bond issuance costs

ak / C
ƒ U.S. GAAP: Unamortized bond issuance costs must be written off and included in gain/loss calculations

ah 58 ok
.m 1 o
ƒ IFRS: No write-off because issuance cost is included in book value of bond liability

w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 15
 Debt Covenants
• Restrictions on the issuer that protects the bond holder’s interest

• Reduce default risk and decrease interest cost

• Affirmative covenants (certain requirements to be fulfilled e.g. interest payments

on time)

om 1
• Negative covenants (restrictions on an entity’s actions e.g. no additional borrowing)

.c 60
wingg)

oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
• Technical default

ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 16
 Presentation and Disclosure of Long-Term Debt
• Firms usually combine their long term debt outstanding into a single line item
• The portion of liability due within one year is shown as a current liability
• Footnotes disclose more information about long term debt:
ƒ The nature of the liabilities
ƒ Maturity dates
ƒ Stated and effective interest rates
ƒ Call provisions and conversion privileges
ƒ Restrictions imposed by creditors

om 1
.c 60
ƒ

oo 6 r
Assets pledged as security

ib 20 te
ks 65
al 98 en
ƒ Amount of debt maturing in next five years

ak / C
• MD&A provides other information about a company’s capital resources,

ah 58 ok
s, incl
including
uding

.m 1 o
w 11 B
debt financing and off-balance sheet financing

w 4
w 20
99
www.ift.world 17
 3. Leases

Lessor Payments over Lessee

lease term
(Asset Owner) (Asset User)

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
A lease can be classified as an operating or finance (capital) lease

.m 1 o
w 11 B
The accounting treatment is different depending on how the lease se is categorized
categgoriz

w 4 li
w 20 aka
99 ah
M
www.ift.world 18
 Advantages of (Operating) Leases
Lessee Perspective
• Less costly financing: lease requires no
initial payment
• Lessee typically pays less financing
cost relative to purchasing on credit
• Reduced risk of obsolescence
• Improves the leverage ratios
Lessor Perspective
• Lessor might have a tax advantage by
keeping asset on its balance sheet
• Possibly more efficient for lessor to
maintain asset

om 1
.c 60
compared to borrowing the funds to

oo 6 r
ib 20 te
ks 65
al 98 en
purchase the asset

ak / C
• Tax reporting advantages: in the U.S.,

ah 58 ok
.m 1 o
w 11 B
firms can create a synthetic lease.
Asset shown on balance sheet for tax
purposes.

w 4
w 20
99
www.ift.world 19
 Finance Lease vs. Operating Lease
• Traditionally under IFRS, if the risk/reward associated with the asset was transferred to the lessee, the
lease would be categorized as a finance (capital) lease

• IFRS 16 requires lessees to record both finance and operating leases in an identical manner

• U.S. GAAP: A lease must classified by lessee as finance (capital) lease if any one of these four criteria
are met:
ƒ Ownership transfer

om 1
ƒ Bargain purchase option

.c 60
oo 6 r
ib 20 te
ƒ

ks 65
Lease term 75% or more of useful life

al 98 en
ƒ

ak / C
Present value of lease payments is 90% or more of fair value of leased asset

ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
Lessor generally preferss fina
finance
ance lleases
eases
Lessee generally prefers operating
efers oper ating leases

99 ah
M
www.ift.world 20
 Reporting by Lessee (Operating Lease)
• Balance Sheet: No entry
ƒ Off-balance sheet transaction

• Income Statement: Rent expense equal to the lease payment

om 1
• Cash Flow Statement: Cash flow from operations

.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4
w 20
99
www.ift.world 21
 Reporting by Lessee (Finance Lease)
• Balance Sheet
ƒ At inception, lower of the present value of future lease payments and
the fair value of the leased asset is recognized as an asset and a liability.
ƒ Asset is depreciated and lease payable is amortized

• Income Statement
ƒ Interest expense = liability at the beginning of period x interest rate

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
• Cash Flow Statement

ak / C
ah 58 ok
ƒ Interest expense reduces CFO

.m 1 o
w 11 B
w 4 li
ƒ Rest of the lease payments reduces CFF

w 20 aka
99 ah
M
www.ift.world 22
 Example
You lease a machine on 1 January 2011 for 4 years and pay 100 at the start of every
year. The fair value is 340. Relevant internet rate is 10%. How should this lease be
categorized? What is the impact on the financial statements? Assume straight line
depreciation.

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 23
 Example
You lease a machine on 1 January 2011 for for 4 years and pay 100 at the start of every year. The fair
value is 348.69. Relevant interest rate is 10%. How should this lease be categorized? What is the
impact on the financial statements? Assume straight line depreciation.

Asset Lease Liability

Interest
Carrying Carrying Lease Lease Expense Reduction Lease
Amount Depreciaton Accumulated Amount Liability Payment For Prior of Lease Liability (31
Year (1 Jan) Expense Depreciation (31 Dec) (1 Jan) (1 Jan) Year Liability Dec)

om 1
.c 60
oo 6 r
ib 20 te
ks 65
2011 348.69 87.17 87.17 261.52 348.69 100.00 0.00 100.00 248.69

al 98 en
ak / C
2012 261.52 87.17 174.34 174.35 248.69 100.00 24.87 75.13 173.56
73.5
56

ah 58 ok
.m 1 o
2013 174.35 87.17 261.51 87.18 173.56 100.00 17.36 82.64 90.91
90 91

w 11 B
w 4 li
2014 87.18 87.17 348.68 0.01 90.91 100.00 9.09 90.91
1 0.01

w 20 aka
99 ah
CFO CFF

M
www.ift.world 24
 Example
You lease a machine for 4 years and pay 100 at the start of every year. The fair value is 340. Relevant
internet rate is 10%. Show the total expense under the two different categorizations.

Operating Lease Finance Lease

Year Expense Depreciation Interest Total
2011 100 87.17 24.87 112.04
2012 100 87.17 17.36 104.53

om 1
.c 60
oo 6 r
2013 100 87.17 9.09 96.26

ib 20 te
ks 65
al 98 en
2014 100 87.17 0.00 87.17

ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 25
 Financial Statement Impact of Lease Accounting for Lessee

Finance Lease Operating Lease

Assets Higher Lower
Liabilities (current and long term) Higher Lower
Net income (in the early years) Lower Higher
Net income (later years) Higher Lower
Total net income Same Same

om 1
EBIT (operating income) Higher Lower

.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
Cash flow from operation Higher Lowerr

ak / C
ah 58 ok
Cash flow from financing Lower Highe
Higherr

.m 1 o
w 11 B
Total cash flow Same Same
Same

w 4 li
w 20 aka
99 ah
M
www.ift.world 26
 Ratio Impact of Lease Accounting
Finance Lease Operating Lease
Current ratio Lower Higher
Working capital Lower Higher
Asset turnover Lower Higher
Return on assets * Lower Higher
Return on equity * Lower Higher

om 1
.c 60
Debt/Assets Higher Lower

oo 6 r
ib 20 te
ks 65
al 98 en
Debt/Equity Higher Lower

ak / C
ah 58 ok
.m 1 o
w 11 B
* In early years

w 4 li
w 20 aka
99 ah
M
www.ift.world 27
 Reporting by Lessor
• Operating lease:
ƒ Record revenue when earned
ƒ Report leased asset on balance sheet
ƒ Depreciation expense on income statement

• Finance lease:
ƒ Any one from the four criteria plus the additional revenue recognition criteria

om 1
.c 60
oo 6 r
ib 20 te
ƒ Direct finance lease

ks 65
al 98 en
ak / C
ƒ Sales type lease

ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 28
 Reporting by Lessor
Direct finance lease: present value of lease payments = carrying value of lease asset
ƒ Lessor earns interest expense
ƒ At inception record a lease receivable

Sales type lease: present value of lease payments > carrying value of lease asset
ƒ Lessor “sells” the asset to lessee

om 1
.c 60
oo 6 r
ƒ Provides financing on the sale

ib 20 te
ks 65
al 98 en
ƒ Reports profit on sale and reports interest revenue on lease receivable

ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 29
 Direct Financing Lease - Lessor Perspective
You lease a machine for 4 years and receive 100 at the start of every year. Relevant
interest rate is 10%. What are the accounting entries assuming this is a direct
financing lease.
Lease Receivable - Lessor Perspective

Lease
Receivable Lease Payment Interest Income Reduction of Lease Lease Receivable
(1 Jan) (1 Jan) for Prior Year Receivable (31 Dec)

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
348.69 100.00 0.00 100.00 248.69

ak / C
ah 58 ok
248.69 100.00 24.87 75.13 173.56

.m 1 o
w 11 B
173.56 100.00 17.36 82.64 90.91

w 4 li
w 20 aka
90.91 100.00 9.09 90.91 0.00
0

99 ah
M
www.ift.world 30
 Disclosures for Finance and Operating Leases
• Lease disclosures show payments under both capital and operating
leases for the next five years and after that

• Disclosures can help estimate extent of a company’s off-balance-sheet

lease financing through operating leases

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4
w 20
99
www.ift.world 31
 4. Pensions and other Post-Employment Benefits
Pensions and other post-employment benefits give rise to non-current liabilities
reported by many companies. Pension plans can be divided in two major categories:

1. Defined Contribution: Company contributes an agreed-upon amount to the plan

ƒ Pension expense on the income statement
ƒ Operating cash outflow

om 1
2. Defined Benefit: Company makes promises of future benefits to be paid to

.c 60
oo 6 r
ib 20 te
ks 65
employees

al 98 en
ak / C
ƒ Company make a contribution to pension fund (Plan Assets); pension payments aree made
made from
from

ah 58 ok
.m 1 o
this fund

w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 32
 Disclosures for Defined Benefit Plans
• Funded Status = Plan Assets - Defined Benefit Obligation
ƒ If positive Æ overfunded or net pension asset
ƒ If negative Æ underfunded or net pension liability
• Net pension asset or liability is reported on the balance sheet
• Each period the change in net pension asset or liability is recognized either in profit
or loss or in other comprehensive income
• Under IFRS, the change in the net pension asset or liability has three components

om 1
ƒ Employee service costs

.c 60
oo 6 r
ib 20 te
ks 65
ƒ Net interest expense or income

al 98 en
ak / C
ƒ Re-measurements

ah 58 ok
• Under U.S. GAAP, the change in the net pension asset or liability has five

.m 1 o
ivee

w 11 B
components

w 4
w 20
99
www.ift.world 33
 Example
On 31 December 2012 a company has pension obligation of 100 and pension assets
are 90. What will the company report on the balance sheet under IFRS? Under U.S.
GAAP?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 34
 5. Evaluating Solvency

Solvency Ratios Numerator Denominator

Debt to assets ratio Total debt Total assets
Debt to capital ratio Total debt Total debt + Total shareholders equity
Debt to Equity ratios Total debt Total shareholders equity
Financial leverage ratios Average total assets Average total equity

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
Coverage Ratios Numerator Denominator

.m 1 o
w 11 B
Interest coverage EBIT Interest payments

w 4 li
w 20 aka
Fixed charge coverage EBIT + lease payments Interest payments + lease payments
paym
ments

99 ah
M
www.ift.world 35
 Summary
• Bonds
ƒ Issuance
ƒ Par, Discount, Premium
ƒ Amortization
• Leases
ƒ Lessee, Lessor
ƒ Advantages of leasing

om 1
.c 60
oo 6 r
ƒ Accounting for operating and finance leases

ib 20 te
ks 65
al 98 en
• Pensions

ak / C
ah 58 ok
.m 1 o
• Evaluating Solvency

w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 36
 Conclusion
• Read summary

• Review learning objectives

• Examples

om 1
.c 60
oo 6 r
ib 20 te
• Practice problems: good but not enough

ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
• Practice questions from other sources

w 4
w 20
99
www.ift.world 37