Reading 34: Topics in Long-Term Liabilities and Equity

Book 2: FSA

What is a lease?

instead of buying an asset, a company can essentially rent it and then give it back to the lessor

Criteria for a contract to be considered a lease

1.) It must refer to a specific asset

2.) It must give the lessee effectively all the asset’s economic benefits during the term

3.) Must give the lessee the right to determine how to use the asset

Advantages of a lease

less initial cash flow

less costly financing

• The asset is the collateral itself, therefore, lower interest rate

less risk of obsolescence

• the asset is only rented for specified period of time, of which the asset should be completely useful if the lessee has done diligence

Does a lease require a downpayment

a small one if any

What does a guaranteed residual income clause do?

the risk of obsolescence is transferred back to the lessee

requires the lessee return the asset at a predetermined value, so the lessee can’t get careless and use up too much value

Finance Lease

when both the benefits and risks of ownership are transferred to the lessee

Criteria to be considered a financial lease (any)

ownership of the leased asset transfers to the lessee

lessee has an option to buy the asset and is expected to exercise it

the lease is for most of the asset’s useful life

the PV of the lease payments is greater than or equal to the asset’s fair value

the lessor has no other use for the asset

Operating Lease

when either the benefits or the risks of ownership are not transferred to the lessee

What is an arrear?

payments are made at the end of each period

What is the ROU asset equal to?

the PV of the lease payments

What is the Lease Liability equal to?

the PV of the lease payments

True or False: all financial leases require a ROU and Lease Liability to be created.

False

Leases less than 12 months (IFRS) are expensed as a rental expense using straight-line

How does a lease payment flow through the financial statements under Lessee Accounting?

Income Statement

• Amortization expense

• Interest expense

Balance Sheet

• ROU asset

• Lease Liability

Cash Flow Statement

• Principal Payment under CFF

• Interest Payment

  • IFRS ==> CFO or CFF

  • GAAP ==> CFO

Under a financial lease, how much is a lease liability deducted by under Lessee Accounting?

it is reduced each period by the principal payment

Under a financial lease, how much is a ROU deducted by under Lessee Accounting?

the balance is reduced by the amortized amount per period

What is the relationship between the ROU asset and lease liability under Lessee Accounting for a financial lease?

ROU < Lease Liability, at commencement: ROU = Lease Liability

• the ROU is amortized on a straight-line basis

• The lease liability is reduced by the principal payments which start out small but increase over time

What is the interest expense = to under Lessee Accounting for a financial lease?

Beg Lease Liability x Implied Interest Rate

How is an IFRS operating lease different from a financial lease under IFRS?

It’s not, they’re exactly the same

How is an Operating Lease under GAAP different from a financial lease under IFRS using Lessee Accounting?

Both the ROU asset and Lease Liability are amortized/reduced by the principal repayment over the lease.

This makes the balances equal and the amortization and interest expense are not reported separately as they are in a financial lease—combined and reported as a “lease expense”

The lease liability is treated the same while the ROU is treated differently

The lease expense is equal to the interest + principal and thus will be the same each period

How is the CFS affected when there is an Operating Lease under GAAP using Lessee Accounting?

the lease payment is reported under CFO

“Both operating and finance leases should be treated as financial liabilities and included in ________ measures.

leverage

ROU Asset

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Operating Lease

it is reduced by the principal repayment, not the amortized amount which is constant

the principal repayment is a % of the lease payment and thus decreases overtime as the interest payment is larger in the earlier years due to the larger liability balance earlier on as not as many payments have been made

Balance Sheet Liabilites

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Same

Both a finance lease and operating lease under GAAP allow the lease liability to be reduced by the principal repayment

Income Statement Earnings (early years)

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Operating Lease

the capitalized amount comprised of the amortization and interest expense is greater in the early for the financial lease as the ROU asset is amortized by the amortized amount which is constant and the lease liability is being expensed by a percentage of a greater liability balance earlier on

in essence, the operating lease subtracts less stuff from revenues

Income Statement Earnings (later years)

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Finance Lease

the liability lease balance has decreased a substantial amounts and thus the implied interest rate is being multiplied by a smaller liability balance

EBIT

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Finance Lease

Only the depreciation hits EBIT while the interest expense is after

the operating lease combines the interest and principal into one expense which hits EBIT

Interest Expense

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Finance lease

There is no interest expense for an operating lease

CFO

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Finance lease

only the interest payment is allocated to CFO while both the principal and interest is allocated to the CFO for an operating lease

CFF

Which is greater: Finance Lease (IFRS and GAAP) or Operating Lease (US GAAP)

Operating Lease

nothing is allocated to CFF under an operating lease

Sales-Type Lease

when the dealing in the leased equipment is the main business operation, the sales proceeds are included in revenue and the carrying value of the asset will be a cost of sale

In a sales-type lease, what happens if the lessor is a financing company?

a gain or loss is not recognized on initiation and is deferred over the life of the lease as interest income or expense

called a Direct Financing Lease

What changes in a financial lease when it is from the perspective of Lessor Accounting?

ROU ==> Lease receivable

Interest expense ==> interest income

lease payment ==> lease payment received

In Lessor Accounting, what is the Year 0 End Lease Receivable equal to in a financial lease?

the residual value

In Lessor Accounting, in a financial lease how much is a the lease receivable reduced by?

the principal payment

What lease is created/added on to when a lease receivable is created?

none, the asset leased is removed from the balance sheet

Under Lessor Accounting, what is the difference between a a finance lease and operating lease?

the asset leased is not removed from the balance sheet under an operating lease

Pension Plan

employees earn deferred compensation through servive

Types of pension plans

Defined Contribution Plan

Defined Benefit Plan

Defined Contribution Plan

retirement plan in which the firm contributes a sum each period to the employee’s retirement account

Core difference between defined contribution plan defined benefit plan?

the risk in a contribution plan is all on the employee as they make the investments, thus, the future value is no guaranteed in a contribution plan

Defined benefit Plan

firm promises to make periodic payments to employees after retirement

Funded Status

how much is in a defined benefit plan

can be overfunded or underfunded

Overfunded

fair value of plan’s assets > estimated pension obligation

Underfunded

fair value of plan’s assets < estimated obligation

How are changes in net pension assets or net pension gains treated?

they are added to net income or added to other comprehensive income

What are accounting adjustments for a defined benefit plan?

Service Costs

Net Interest Expense of Income

Remeasurements

Service Cost

the PV of additional employee benefits entitled to after retirement when employees work an additional year

Past Service Costs

changes to the benefits earned in previous period from alterations to the current plan

What is the net interest expense of income equal to?

net pension assets x plan’s discount rate

Types of Remeasurements

Actuarial gains/losses

Difference between actual and expected returns

What are actuarial gains/losses

change in salary growth

discount rate

retirement age

Which adjustments to defined benefit plans are allocated to net income and other comprehensive income under IFRS?

net income

• Service costs

• Net Interest Expense or Income

AOCI

• remeasurements

Accounting adjustments for defined benefit plans under GAAP

Income Statement

• service costs for the current period

• Interest expense or income

• Expected return on plan assets

AOCI

• Past service costs

• Actuarial gains/losses

How is the SBC value determined?

estimate the fair value at the grant date and expense it over the vesting period

Vesting period

time between grant date and when the employee receives the stock or can first exercise it

Service Period

the time between grant date and vesting date

Stock Grants

shares awarded outright, with no restrictions or contingency on performance

Restricted Stock Units (RSUs)

stock grants that do not vest until certain criteria are met

When is the fair value established for SBC?

the grant date

Performance Shares

stock grants that depend on meeting a set performance target

Employee Stock Options

options to invest in a company’s stock at a given price

Does the company issue new shares when an employee exercises his stock options?

yes

How are the financial statements effected when a stock option is exercised?

retained earnings is reduced but the the equity amount is increased by the same amount

Stock-Based Appreciation Rights (SARs)

employee receives payments based on the change in the stock without needing to hold the stock

Solutions and problems that arise from SARs

Solution: align’s employee’s and shareholders interests without diluting existing shareholders

Problem: the company has to pay cash when the stock does well

Phantom Stock

non-exchange traded firms use a substitute for SARs where the cash payments are related to the performance of a hypothetical stock