Module 8: Topics in Long-Term Liabilities and Equity

What is a lease?

A contract that conveys the right to use an identified asset for a specified period in exchange for consideration.

What three conditions indicate that a contract contains a lease?

There must be an identified asset; the customer must obtain substantially all economic benefits from its use; and the customer must have the right to direct how and for what purpose the asset is used.

Who is the lessee?

The party that uses the leased asset and makes lease payments.

Who is the lessor?

The party that owns/provides the asset, grants the right to use it, and receives lease payments.

Why might a company lease rather than buy an asset?

Lower upfront cash requirement, potentially cheaper secured financing, greater flexibility, and reduced exposure to obsolescence risk.

What is obsolescence risk?

The risk that an asset becomes outdated or economically less useful; leasing can reduce the lessee's exposure because the asset may be returned at the end of the lease.

What is the economic intuition behind a finance lease?

It resembles buying an asset using borrowed money because substantially all risks and rewards of ownership effectively transfer to the lessee.

What is the economic intuition behind an operating lease?

It resembles a traditional rental arrangement.

What are the five indicators of a finance lease?

Ownership transfers; purchase option is reasonably certain to be exercised; lease covers a major part of economic life; PV of payments is substantially all of fair value; or the asset is specialized with little/no alternative use.

Does CFA Level I require the old 75% and 90% thresholds for finance-lease classification?

No. Focus on the qualitative terms "major part" and "substantially all."

What is the exam shortcut for identifying a finance lease?

Ask whether the arrangement economically looks like buying the asset using debt. If yes, think finance lease.

What does a lessee generally recognize at lease inception?

A right-of-use (ROU) asset and a lease liability.

What is a right-of-use (ROU) asset?

The lessee's recognized right to use the underlying leased asset during the lease term.

Does recognizing an ROU asset mean the lessee legally owns the underlying asset?

No. The ROU asset represents the right to use the asset, not necessarily legal ownership.

What is a lease liability?

The present value of required future lease payments.

What is the basic formula for the initial lease liability?

Lease liability = PV of future lease payments.

What discount rate is generally used to calculate a lease liability?

The rate implicit in the lease; if that cannot be determined, the lessee's incremental secured borrowing rate.

Are the ROU asset and lease liability generally equal at inception in the simplified CFA treatment?

Yes. They generally begin at the PV of future lease payments, subject to certain adjustments.

How is a lease liability subsequently amortized?

Using the effective interest method.

How is lease interest expense calculated?

Interest expense = Beginning lease liability × Discount rate.

How is the principal portion of a lease payment calculated?

Principal repayment = Lease payment − Interest expense.

How is the ending lease liability calculated?

Ending lease liability = Beginning lease liability − Principal repayment.

If beginning lease liability is $100,000, the discount rate is 5%, and the payment is $25,000, what is interest expense?

$100,000 × 5% = $5,000.

If a lease payment is $25,000 and interest expense is $5,000, what is principal repayment?

$25,000 − $5,000 = $20,000.

If beginning lease liability is $100,000 and principal repayment is $20,000, what is ending lease liability?

$100,000 − $20,000 = $80,000.

Why does lease interest expense generally decline over time?

Because principal repayments reduce the lease liability, so applying the same discount rate to a smaller beginning liability produces less interest.

How many major lessee accounting models does IFRS 16 use?

Essentially one model for most leases.

How does an IFRS lessee generally account for a lease?

Recognize an ROU asset and lease liability, then separately recognize ROU amortization/depreciation and interest expense.

What is the typical expense pattern for an IFRS lessee?

Front-loaded because ROU amortization is relatively stable while interest expense is higher in earlier years.

Under IFRS, where is lease principal repayment classified on the cash flow statement?

CFF.

Under the treatment in these notes, where may an IFRS lessee classify lease interest paid?

CFO or CFF, depending on the firm's consistently applied policy.

What two lease classifications does US GAAP retain for lessees?

Finance leases and operating leases.

Does a US GAAP operating lease generally create an ROU asset and lease liability?

Yes. Both operating and finance leases generally appear on the balance sheet.

What is a major difference between US GAAP operating and finance leases?

Income-statement presentation, expense pattern, and cash-flow classification differ even though both generally recognize an ROU asset and lease liability.

What does a US GAAP finance lease report on the income statement?

Separate ROU amortization/depreciation expense and interest expense.

What is the expense pattern of a US GAAP finance lease?

Front-loaded because interest expense is higher early in the lease.

Where is interest paid on a US GAAP finance lease classified?

CFO.

Where is principal repayment on a US GAAP finance lease classified?

CFF.

What is the memory trick for a US GAAP finance lease?

Finance = SPLIT: split amortization and interest on the income statement; split interest into CFO and principal into CFF on the cash flow statement.

What does a US GAAP operating lease report on the income statement?

A single straight-line lease expense.

Are interest and ROU amortization separately reported as interest and depreciation for a US GAAP operating lease?

No. They are combined into a single lease expense presentation.

What is the expense pattern of a US GAAP operating lease?

Straight-line total lease expense.

Where is the entire US GAAP operating lease cash payment classified?

CFO.

What is the memory trick for a US GAAP operating lease?

Operating = COMBINE: one combined lease expense and the entire cash payment in CFO.

Which generally has higher total lease expense in the early years under US GAAP: finance or operating?

Finance lease, because finance-lease expense is front-loaded.

Which generally produces lower early-year net income under US GAAP: finance or operating lease?

Finance lease, because its total expense is higher in the early years.

Which generally produces higher EBITDA under US GAAP: finance or operating lease?

Finance lease.

Why does a finance lease generally produce higher EBITDA than an operating lease?

Finance-lease interest and amortization/depreciation are excluded from EBITDA, whereas the single operating lease expense reduces EBITDA.

Which generally produces higher CFO under US GAAP: finance or operating lease?

Finance lease.

Why is CFO generally higher for a US GAAP finance lease than an operating lease?

For a finance lease only interest is in CFO while principal is in CFF; for an operating lease the entire payment is in CFO.

Does lease classification change the total contractual cash paid?

No. Classification changes financial-statement presentation, not the contractual cash payment.

Over the full lease term, does total expense differ between finance and operating treatment in the simplified example?

No. The major difference is the timing of expense recognition.

What is the short-term lease exemption?

A qualifying lease of 12 months or less may be expensed straight-line without recognizing an ROU asset and lease liability.

Is the short-term lease exemption available under both IFRS and US GAAP according to the notes?

Yes.

What additional lease exemption is available under IFRS?

A low-value asset lease exemption.

Does US GAAP have the same low-value monetary lease exemption as IFRS?

No.

What is the key economic question for lessor accounting?

Does the lessor remain economically the owner, or is it essentially providing financing?

What happens to the underlying asset under a lessor operating lease?

The lessor keeps the underlying asset on its balance sheet and continues to depreciate it.

What does an operating lessor recognize on the income statement?

Rental/lease income and depreciation expense on the underlying asset.

What happens at inception under a lessor finance lease?

The lessor derecognizes the underlying asset and recognizes a lease receivable.

What is a lease receivable?

The present value of lease payments the lessor expects to collect; economically it resembles a loan receivable.

How is a finance lessor's lease receivable subsequently accounted for?

Using the effective interest method.

What are the two components of a payment received by a finance lessor?

Interest income and principal collection.

What happens to the lessor's lease receivable when principal is collected?

The lease receivable decreases.

What income does a finance lessor recognize over the lease term?

Interest income on the lease receivable.

What is the mirror-image relationship between lessee and lessor finance accounting?

The lessee has a lease liability and interest expense; the lessor has a lease receivable and interest income.

According to the supplied notes, how are lessor lease cash receipts classified?

The entire cash receipt is CFO for both finance and operating lessor leases.

What is a sales-type lease?

A finance lease in which the lessor is effectively also selling the asset, such as a manufacturer/dealer, and may recognize selling profit at inception.

What is the simplified formula for selling profit on a sales-type lease?

Selling profit ≈ PV of lease payments − Carrying value of underlying asset.

What is a direct financing lease in the notes?

A finance lease where the lessor is primarily providing financing rather than manufacturing/dealing the asset; no upfront selling profit is recognized in the simplified treatment.

Which lessor classification can produce the highest revenue at inception?

A sales-type lease because selling profit/revenue may be recognized immediately.

What is deferred compensation?

Compensation employees earn in the current period but receive as cash or shares in a future period.

What two areas in this reading are examples of deferred compensation?

Pensions and stock-based compensation.

What is a defined contribution (DC) pension plan?

A plan in which the employer promises a specified contribution to the employee's retirement account.

Who bears investment risk in a defined contribution plan?

The employee.

Why does the employee bear investment risk in a DC plan?

Once the employer makes the promised contribution, its obligation is essentially complete; the employee's eventual retirement benefit depends on investment performance.

What is pension expense for a defined contribution plan?

Pension expense = Employer contribution for the period.

Where is an employer's DC pension contribution classified on the cash flow statement?

CFO outflow.

What happens if the employer has recognized a DC contribution expense but has not yet paid the full amount?

The unpaid portion is recognized as an accrued compensation liability.

If the employer recognizes $100,000 of DC contribution expense but pays only $80,000, what liability remains?

$20,000 accrued compensation liability.

What is the memory trick for a defined contribution plan?

DC = Define what I Contribute.

What is a defined benefit (DB) pension plan?

A plan in which the employer promises a specified future retirement benefit.

Who bears investment and actuarial risk in a defined benefit plan?

The employer.

What is the memory trick for a defined benefit plan?

DB = Define the Benefit the employee receives.

Why is DB pension accounting more complicated than DC accounting?

The employer must estimate future obligations using assumptions such as mortality, salary growth, retirement age, turnover, investment performance, and discount rates.

What is the defined benefit obligation (DBO)?

The present value of future defined-benefit payments earned by employees to date.

What term is commonly used for the pension obligation under US GAAP in these notes?

Projected Benefit Obligation (PBO).

What are pension plan assets?

The fair value of assets held in a pension trust to fund future pension payments.

What is the formula for funded status?

Funded status = Fair value of plan assets − DBO/PBO.

What does a positive funded status indicate?

The plan is overfunded and the employer reports a net pension asset.

What does a negative funded status indicate?

The plan is underfunded and the employer reports a net pension liability.

If plan assets are $90 million and DBO is $100 million, what is funded status?

$90m − $100m = −$10m, so the employer has a $10m net pension liability.

What is the memory trick for funded status?

What I HAVE − What I OWE. Positive = asset; negative = liability.

What three broad components make up defined benefit pension cost under IFRS?

Service cost, net interest, and remeasurements.

Where is IFRS service cost recognized?

P&L.

What is pension service cost?

Broadly, the present value of additional pension benefits earned through employee service, including the applicable treatment of past service costs.

Where is IFRS net interest recognized?

P&L.

How is IFRS net interest calculated in the simplified CFA framework?

Beginning net pension asset or liability × Discount rate.

What does a beginning net pension liability produce under IFRS?

Net interest expense.

What can a beginning net pension asset produce under IFRS?

Net interest income.