Reading 32 LOS's

Question 1

LOS 32a: Determine the initial recognition, initial measurement, and subsequent measurement of bonds

LOS 32b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments

Answer 1

There are two methods of accounting for noncurrent liabilites:

• The effective interest method results in a constant rate of interest over the life of the bond. It is required under IFRS and preferred by US GAAP. Under this method, the market interest rate issuance is applied to the carrying amount of the bonds to determine periodic interest expense. Further, the difference between interest expense and the actual coupon payment equals the amount of discount/premium amortized over the period
• The straight-line method which is also permitted under US GAAP, evenly amortizes the premium or discount over the life of the bond

The financial statement effects of bond issuance, as well as the effective interest and straight-line methods of amortizing bond premiums and discounts are illustrated below:

Bond Issued at Par

• balance sheet- the year-end value of the liability is listed on the balance sheet. For bonds issued at par, the liability remains at par throughout the life of the bond
• Income Statement - interest expense is deducted from operating income. For bonds issued at par, interest expense equals the coupon payment, and is constant over the life of the bond
• Statement of Cash flows
  
  • At issuance, bond proceeds are reported as inflows from financing activites (CFF)
  • During the tenur of the bond, coupon payments (not interest expense) are deducted from cash flow from operating (CFO) activites
  • At maturity, cash used to repay the principal amount is deducted from cash flow from financing activities (CFF)

For bonds issued at par, the inflows recorded at issuance udner CFF equals the outflows from CFF at maturity. Coupon payments are deducted from CFO every year

Bonds Issued at a Dicsount

• Balance sheet- the book value of the liability increases over the life of the bond. The entire discount is amortized over the life. The value of the liability at the end of maturity equals par value, which is the amount that must be paid to investors at maturity
• Income statement- Interest expense rises from year to year in line with the increasing book value of the liability. As the liability increases in book value, the increase in value is added to the coupon payment to determine interest expense
• Statement of Cash Flows - for bonds issued at a discount, the inflow recorded at issuance under CFF is lower than the outflow from CFF at maturity. Coupon payments are deducted from CFO every year

Bonds Issued at a Premium

• Balance sheet-, the book value of the liability decreases over the life of the bond. The premium is amortized over its life. The value of the liability at the end of maturity is equal to its par
• Income Statement interest expense declines every year in line with the decreasing book value of the liability
• Statement of Cash Flows For bonds issued at a premium, the inflow recorded at issuance under CFF will be greater than the outflow recorded at maturity. Coupon payments are deducted from CFO every year

Zero Coupon Bonds

These accrue interest over their terms. Zero-coupon bonds are steeply discounted instruments because coupon rates fall significantly short of the compensation required by the market for investing in them.

Treatment of Noncurrent Liabiliies under US GAAP and IFRS

Costs like printing, legal fees, and other charges are incurred when debt is issued. Under IFRS, these costs are included in the measurement of the liability. Under US GAAP, these costs are normally capitalized and written off over the bond’s term.

Under IFRS and US GAAP, cash outflows related to bond issuance costs are usually netted against bond proceeds and reported as financing cash flows

US GAAP requires interest payments on bonds to be classified under CFO, while IFRS allows it under either CFO or CFF.

Fair Value Reporting Option

When a company uses the effective interest method to amortize bond discounts and premiums, the book value of debt is based on market interest rates at issuance. Over time these market rates will most likely change, changing the market value of the bond.

Recently companies have been allowed to report financing liabilities at fair value. Companies that choose to report their financing liabilities at fair value report gains (losses) on their profit and loss statement (P&L) when market rates increase (decrease) as the carrying value of their obligations fall (rise)

Question 2

LOS 32c: Explain the Derecognition of Debt

Answer 2

If a company decided to retire bonds prior to maturity, the book value of the liability is reduced to zero and a gain or loss on extinguishment is computed by subtracting the amount paid to retire the bonds from their book value.

• Under US GAAP, because issuance costs are capitalized any unamortized issuance costs must also be subtracted from gains on extinguishment
• Under IFRS, issuance costs are included in the book value of the liability so there is no need to adjust the gain on extinguishment for these expenses

Question 3

LOS 32d: Describe the role of debt covenants in protecting creditors

Answer 3

Debt contracts often include clauses that protect bondholders by limiting the issuer’s ability to invest, pay dividends, or make other strategiv and operating decisions. Common covenants include:

• Maintenance of pledged collateral
• Restrictions on dividend payments
• Requirements to meet certain working capital levels
• Maximum levels of leverage.

When a company violates a covenant it is said to be in default. In this even bondholders can choose to waive the covenant, renegotiate, or call for repayment

Question 4

LOS 32e: Describe the financial Statement presentation of and disclosures relating to debt

Answer 4

On the balance sheet, long-term liabilities are listed as one aggregate figure for all liabilites due after one year. Financial statement footnotes provide more information on the nature and types of long-term debt issued by the company. They usually include:

• Stated and Effective interest rates
• Maturity Dates
• restrictions imposed by creditors
• PLedged collateral
• Scheduled repayments over the next 5 years

Question 5

LOS 32f: Explain the motivations for leasing assets instead of purchasing them

Answer 5

A lease is a contract between the owen of the asset (lessor) and another party that wants to use the asset (leasee). Leasing holds the following advantages over purchasing:

• Leases often have fixed interest rates
• THey require no down payment so they conserve cash
• At the end of the lease, the asset can be returned to the lessor so the lessee escapes the risk of obsolescene and is not burdened with having to find a buyer for the asset
• The lessor may be in a better position to value and dispose of the asset
• Negotiatied lease contracts usually have less restrictions than borrowing contracts
• The lessor can take advantage of the tax benefits of ownership such as depreciation and interest
• In the US, leases can be structured as synthetic leases, where the company can gain tax benefits of ownership while not reflecting the asset on its financial statements
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Question 6

LOS 32g: Distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee

LOS 32h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases

Answer 6

Lessee”s Perspective

US GAAP requires a lessee to classify a lease as a capital lease if any of the following conditions hold:

1. The lease transfers ownership of the asset to the lessee at the end of the term
2. A bargain purchase option exists
3. THe lease term is greater than 75% of the asset’s useful economic life
4. The present value of the lease payments at inception exceeds 90% of the fair value of the leased asset

If none of these conditions hold, the lessee may treat the lease as an operating lease

Under IFRS, classification of a lease depends on whether all the risks and rewards of ownership are transferred to the lessee. If they are, the lease is classified as a finance lease; if they are not the lease is classified as an operating lease

Operating Lease (Lessee’s Perspective)

The accounting treatment for an operating lease is similar to that of simply renting an asset for a period of time. The asset is not purchased, instead payments are made for using it.

Accounting entries at inception:

• Balance sheet- none, because no asset or liability is recognized
• Income Statement- none because the asset has not been used yet
• Cash Flow Statement- none, because there has been no cash transaction

Accounting Entries Every Year During the Term of the Lease

• Balance Sheet none, because no lease-related assets and liabilites are recognized
• Income Statement- Leasehold (rental) expense is charged every year
• Cash Flow the lease payment is classified as a cash outflow from operating activities

Capital or Finance Lease ( Lessee’s Perspective).

A finance lease requires the company to recognize a lease-related asset and liability on its balance sheet at inception of the lease. The accounting treatment for a finance lease is similar to that of purchasing an asset and financing the purchase with a long-term loan

accounting entries at inception

• Balance Sheet - the present value of lease payments is recognized as a long-lived asset. The same amount is also recognized as a noncurrent liability
• Income statement- none, because the asset has not been used yet
• Cash Flows none because no cash transaction has occurred. Disclosure of inception is required as a “significant noncash financing and investing activity”

Accounting Entries Every Year during the Term of the Lease

• Balance Sheet the value of the asset falls every year as it is depreciated. Interest is charged on the liability. The excess of the lease payment over the year’s interest expense reduces the liability
• Income Statement Depreciation expense and interest expense are charged every year
• Cash Flows the portion of the lease payment equal to the interest expense is subtracted from CFO, while the remainder that serves to reduce the liability is subtracted from CFF

Accounting effects of a finance lease vs operating lease

• Balance Sheet While an operating lease will never have an effect on the balance sheet, a financing lease will increase assets and liabilities at inception, and then gradually decrease them over the time of the lease
• Income Statement in an operating lease, the annual lease payment is recognizedas an operating expense, while in a finance lease, the asset is depreciated and interest expense is charged against operating income (EBIT)
• Cash Flows- Under an operating lease payments are deducted from CFO, while for a finance lease the interest expense portion of the lease payment is deducted from CFO and the remainder that serves to decrease the value of the liability is deducted from CFF

Lessor’s Perspective

Under IFRS the lessor must classify the lease as a finance lease if all the risks and rewards of ownership are transferred to the lessee.

Under US GAAP, lessors are required to recognize capital leases when any one of the four previously mentioned criteria for recognition of a capital lease by the lessee hold, and the following two criteria also hold:

• Collectability of the lease payments is predictable
• There are no significant uncertainties regading the amount of costs still to be incurred by the lessor under the provisions of the lease agreement

If the lessor classifies the lease as an operating lease, it records lease revenue when earned, continues to list the asset on its balance sheet, and depreciates it every year on its income statement.

If the lesor classifies the lease as a finance lease, it records a receivable equal to the present value of lease payments on its balance sheet and removes the asset from long-lived assets in its books

Under US GAAP, lessors can classify leases into two types:

1. Some manufacturers offer their customers financing options to purchase their products. These sales-type leases result in a gross profit, which is recognized at inception of the lease, and interest income as payments are received over the lease term
2. Financial institutions and leasing companies offer financial leases that generate interest income only. These are known as direct financing leases, where the present value of lease payments equals the carrying value of the asset. Further there is no gross profit recognition at lease inception

Question 7

LOS 32i: Compare the disclosures relating to finance and operating leases

Answer 7

Disclosures

Under US GAAP, given the explicit standards required to classify a lease as a capital lease, companies can easily structure the terms of a lease in a manner that allows them to report it as an operating lease.

Lease disclosures require a company to list these obligation of the firm for the next 5 years under all operating and finance leases. These disclosures allow analysts to evaluate the extent of off-balance sheet financing used by the company

Under IFRS, companies are required to :

• Present finance lease obligations as a part of debt on the balance sheet
• Disclose the amount of total debt attributable to obligations under finance leases
• Present Information about all lease obligations

Question 8

LOS 32j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans

Answer 8

Define contribution plans are pension plans in which the company is required to contribute a certain amount of funds into the plan. However, the company makes no commitment regarding the future value of plan assets. Further investment decisions are left to employees, who bear all the investment risk. Accounting for this is relatively straightforward:

• Balance sheet the company records a decrease in cash. If the agreed-upon amount is not deposited into the plan during a particular period, the outstanding amount is recognized as a liability
• Income Statement the company recognizes the amount it is required to contribute into the plan as pension expense for the period
• Cash Flow the outflow is treated as an operating cash flow

A defined-benefit plan has the company promise to pay future benfits to the employee during retirement. The annual payment may be based on a formula that considers the final salary at retirement and the number of years of service provided by the employee to the company.

The company estimates the total amount of benefits that it expects to pay out to an employee during her retirement and then allocates the present value of these payments over the employees employment as a part of pension expense.

Defined- benefit pension plans are typically funderd through a separate legal entity. The company makes payments into the fund and invests these assets with a view to accumulating sufficient assets in the plan to meet payment obligations

Net Pension Asset or Net Pension Liability

• If the fair value of plan assets are greater than the pension obligation, the plan has a surplus, so the company’s balance sheet will reflect a net pension asset
• If it is the other way, then it is a liability

Under IFRS, the change in net pension asset or liability each period has 3 general components:

• Employee Service costs- This refers to the present value of the increase in pension benefit earned by the employee as a result of providing one more year of service to the company. These are recognized as pension expense in profit and loss
• Net Interest Expense or Income - This is calculated as the net pension liability or asset at the beginning of a period multiplied by the discount rate used to estimate the pension obligation. These are also recognized as pension expense on profit and loss
• Remeasurements- these include 1) actuarial gains and losses and 2) the actual return on plan assets less any return included in net interest expense or income
  
  • Actuarial gains and losses arise when changes are made in any of the assumptions used to estimate the company’s pension oblidation
  • The actual return on plan assets typically differs from the amount included in net interest expense or income

Under US GAAP the change in net pension asset or liability each period has 5 general components:

1. Employee service costs for the period- these are recognized in profit and loss in the period incurred
2. Interest Expense accrued on the beginning pension obligation- interest costs are added to pension expense because the company does not pay out service costs earned by the employee over the year until her retirement.
3. Expected return on plan assets- this reducesthe amount of pension expense recognized in profit and loss for the period
4. Past service costs- these are recognized in other comprehensive income in the period during which they are incurred, and are subsequentyl amortized into pension expense over the future service period of employees covered by the plan
5. Actuarial gains and losses - these are alos recognized in other comprehensive income in the period in which they occur and amortized into pension expense over time

Question 9

LOS 32k: Calculate and interpret leverage and coverage ratios

Answer 9

Solvency refers to the ability of a company to satisfy its long-term debt obligation. Ratio analysis is frequently used to evaluate a company’s solvency levels relative to its competitors

Leverage ratios are derived from balance sheet numbers and measure the extent to which a company uses debt rather than equity to finance its assets. Higher leverage ratios indicate weaker solvency

Coverage Ratios focus more on income statement and cash flow numbers to measure the company’s ability to service its debt. Higher coverage ratios indicate stronger solvency.

These ratios are further explained in reading 28