CFA Level 1 Financial Reporting and Analysis Non-current Liabilities 2011, Associate Professor Ole Sørensen, Ph.d. Side 1
Coupon Bonds Promises two types of payments: periodic interest payments and a lumpsum payment when the bond matures. Face Value Coupon rate Periodic payment flow) Initial liability (proceeds) Effective interest rate Interest expense the bond liability the lump-sum payment due at maturity the stated cash interest rate Coupon Rate x Face Value (actual cash the amount paid to the issuer by the creditor the market rate at the time of issuance the market rate at the time of issuance times The balance sheet liability over time is a function of initial liability and relationship of periodic interest expense to the actual cash payments The balance sheet liability at any point in time is equal to the PV of the remaining payments, discounted at market rate in effect at the time of the issuance of the bonds 2011, Associate Professor Ole Sørensen, Ph.d. Side 2
Comparison of Financial Statement Effects of Coupon Bonds Issued at Par, Premium, and Discount. Bond Face Value $100,000 Maturity Coupon rate 3 years 10% (annual payments) Premium case: Market rate = 8% Discount case: Market rate = 12% Interest Expense Bond Issued at Balance Sheet Liability Bond Issued at Cash flow from (all cases) Year Par Premium Discount Par Premium Discount Operations Financing 20x1 10,000 8,388 11,452 100,000 103,630 96,535 10,000 20x2 10,000 8,256 11,632 100,000 101,886 98,167 10,000 20x3 10,000 8,114 11,833 100,000 100,000 100,000 10,000 100,000 Totals 30,000 24,758 34,917 30,000 100,000 2011, Associate Professor Ole Sørensen, Ph.d. Side 3
Misclassification of Cash Flows Bonds sold at premium (MR < Coupon rate) part of the coupon payment (10,000) is a reduction of principal and should be treated as financing cash outflow. Consequence: CFO is understated and CFF is overstated Bonds sold at discount (MR > Coupon rate) part of the discount amortisation represents additional interest expense. Consequence: CFO is overstated and CFF is understated In summary, the cash flow classification of debt payments depends on the coupon rate rates, not the effective interest rates. When these differ, CFO is misstated. 2011, Associate Professor Ole Sørensen, Ph.d. Side 4
Reclassification of Cash Flows for Coupon Bonds Year SFAS 95 Reclassification based on Interest Expense Functional Actual Cash Cash Flow All Bonds Premium Bond Discount Bond Reclassification for All Bonds Flow Operations Financing Operations Financing Operations Financing Operations Financing 20x1 10,000 10,000 0 8,388 1,612 11,452 (1,452) 0 10,000 20x2 10,000 10,000 0 8,256 1,744 11,632 (1,632) 0 10,000 20x3 110,000 10,000 100,000 8,114 101,886 11,833 98,167 0 110,00 Totals 130,000 30,000 100,000 24,758 105,242 34,917 95,083 0 130,000 2011, Associate Professor Ole Sørensen, Ph.d. Side 5
Premium Bond MR < CP PV = 105.242 PV = 105.242 FV = 100.000 5.242 3.630 D 1.612 1.886 Unarmortized premium D 1.744 D 1.886 Year 0 Year 1 Year 2 Year 3 10.000 1.612 1.744 Premium amortization 1.886 8.388 Interest paid 8.256 (CFO) 8.144 Interest expense Year 1 Year 2 Year 3 2011, Associate Professor Ole Sørensen, Ph.d. Side 6
Discount Bond MR < CP PV = 95.083 FV = 100.000 PV = 95.083 1.833 Unamortized discount 4.917 D 1.452 3.465 D 1.632 D 1.833 Year 0 Year 1 Year 2 Year 3 10.000 1.452 1.632 1.833 Discount amortization Interest paid (CFO) Interest expense Year 1 Year 2 Year 3 2011, Associate Professor Ole Sørensen, Ph.d. Side 7
Amortization Methods IFRS the effective interest method (required) US GAAP - the effective interest method (preferred) or straight line method Issuance Costs IFRS included in the measurement of the liability US GAAP Issuance costs are capitalized (prepaid expense) and amortized 2011, Associate Professor Ole Sørensen, Ph.d. Side 8
Zero-Coupon Bonds No periodic payments The lump-sum payment at maturity includes all unpaid interest (equal to he face value minus the proceeds) Proceeds at issuance equal the PV of the face amount, discounted at the market interest rate. Note: The interest on a zero-coupon bond never reduces CFO (as no interest is paid) Consequence: reported CFO is systematically overstated Adjustments: Reported CFO Less Zero-Coupon Interest (amortisation of discount) Adjusted CFO 2011, Associate Professor Ole Sørensen, Ph.d. Side 9
Analysis of Financing Liabilities Effects of Changes in Interest Rates - Estimating the market value of debt Retirement of Debt Prior to Maturity Motives: Declining interest rates permit the reduction of interest costs Increasing CFO permits debt retirement earlier than expected Sale of assets or additional equity generates funds and the firm decides to reduce financial leverage Accounting for Debt Retirement The difference between the book value of the liability and the amount paid at retirement (gain or loss) is reported as a part of continuing operations 2011, Associate Professor Ole Sørensen, Ph.d. Side 10
Accounting for Leases Classifying Leases as Capital or Operating Under US GAAP a lease is a capital lease of any of the following is true: 1. The lease transfers ownership of the property to the lessee at the end of the lease term 2. The lease contains a bargain purchase option 3. The lease term is equal to 75% or more of the estimated economic life of the leased property (not applicable to land or when the lease terms begins within the final 25% or the economic life of the asset) 4. The PV of the minimum lease payments (MLPs) equals or exceeds 90% of the fair value of leased property to lessor. Otherwise the lease is classified as an operating lease. Under IFRS the classification is determined by examining the economic substance of the transaction 2011, Associate Professor Ole Sørensen, Ph.d. Side 11
Reporting and disclosure considerations for lessees For operating leases, lease payments are reported as rent expenses when they become due and no assets or liability is shown on the balance sheet for future amounts to be paid. Future minimum lease payments (MPL s) are disclosed. For capital leases, present value of future lease payments is shown as an asset and liability on the balance sheet and payments are shown as interest expense and principal repayment. The leased asset is depreciated. 2011, Associate Professor Ole Sørensen, Ph.d. Side 12
Financial reporting by Lessee Example Lease beginning December 31, 20X0 Annual MLPs of $ 10,000 made at the end of each year for four years Discount rate 10% Operating lease No entry is made at the inception of the lease Over the life of the lease, only the annual rental expense of $ 10,000 will be charged to income and CFO Capital Lease At the inception of the lease, an assets and liability equal to the PV of the lease payments, $31,700, is recognised Over the life of the lease: 1. The annual rental expense of $ 10,000 will be allocated between interest and principal payments on the $31,700 leasehold liability according to the following amortisation schedule: Allocation of Payment of $ 10,000 Year Opening Liability Interest Principal Closing Liability 20X0 31,700 20X1 31,700 3,170 6,830 24,870 20X2 24,870 2,487 7,513 17,357 20X3 17,357 1,735 8,265 9,092 20X4 9,092 909 9,092 0 2. The costs of the leasehold assets of $31,700 is charged to operations (annual depreciation is $7,925) using the straight-line method over the term of the lease. 2011, Associate Professor Ole Sørensen, Ph.d. Side 13
Comparative analysis of Capitalized and Operating Leases Balance Sheet Effect of Lease Capitalization 20X0 20X1 20X2 20X3 20X4 Assets Leased Assets 31,700 31,700 31,700 31,700 31,700 Accumulated Depreciation 0 7,925 15,850 23,775 31,700 Leased Assets, net 31,700 23,775 15,850 7,925 0 Liabilities Current portion of lease obligation 6,830 7,513 8,265 9,092 0 Long-term debt: lease obligation 24,870 17,357 9,092 0 31,700 24,870 17,357 9,092 0 Note: No assets or liabilities are recognised if the lease is treated as an operating lease. Lease capitalization increases assets balances, resulting in lower asset turnover and ROA. Leverage ratios: As lease obligations are not recognised for operating leases, leverage ratios are understated. Lease capitalization adds both current and non-current liabilities to debt, resulting in a corresponding decrease in working capital and increase in the debt-to-equity ratio. 2011, Associate Professor Ole Sørensen, Ph.d. Side 14
Income Statement Effects of Lease Classification Operating Capital Lease Lease Operating = Total Expense Operating Expense Nonoperating Expense Rent Depreciation Interest Total Expense 20X1 10,000 7,925 3,170 11,095 20X2 10,000 7,925 2,487 10,412 20X3 10,000 7,925 1,735 9,660 20X4 10,000 7,925 909 8,834 Totals 40,000 31,700 8,300 40,000 Note: Capitalization results in higher EBIT In general, firms with operating leases report higher ROE, ROA and interest coverage ratio 2011, Associate Professor Ole Sørensen, Ph.d. Side 15
Cash flow effect of lease Classification Operating Lease Year Operations CFO Operations CFO Capital Lease Financing CFF 20X0 20X1 10,000 3,170 6,830 20X2 10,000 2,487 7,513 20X3 10,000 1,735 8,265 20X4 10,000 909 9,091 Note: That at the inception of the lease (year 20X0), no cash flows are reported. Capital lease reports higher CFO compared to those reported using the operating method. 2011, Associate Professor Ole Sørensen, Ph.d. Side 16
Ratios Capital Lease Operating Lease Current ratio Lower Higher Net Working Capital Lower Higher Asset Turnover Lower Higher ROA Lower Higher ROE Lower Higher DE/E Higher Lower Statements Totals Assets Higher Lower Liabilities Higher Lower Net Income Lower Higher (yearly years) CFO Higher Lower CFF Lower Higher Total cash flows Same Same 2011, Associate Professor Ole Sørensen, Ph.d. Side 17
Financial Reporting by Lessors Lease classification: Lessor Sale-Type Leases versus Direct Financing Balance sheet effects Income statement effects Cash flow effects Capital Lease if any of the four criteria holds plus The collectability of lease payment is predictable All costs are incurred Sales type-lease: Lessor is a dealer and seller and the leased equipment Direct financing lease: Lessor is not a dealer in the leased asset (e.g. a financing company) 2011, Associate Professor Ole Sørensen, Ph.d. Side 18
Sales-Type-Lease Three year lease End-of-year lease payments $1,000 Implicit interest rate 10% Cost price $2,283 Accounting recognition (lessor) At inception: Sales revenue 2,487 COGS 2,283 Gross Profit 204 Gross investment in lease 3,000 Unearned income (513) Net investment in lease 2,487 Lessor amortisation Schedule Sales Type Lease Annual Payment Received Interest Income Reduction In investment Net Investment Year 0 2,487 1 1,000 248 751 1,736 2 1,000 174 826 910 3 1,000 91 910 0 Total 3,000 513 2,487 2011, Associate Professor Ole Sørensen, Ph.d. Side 19
Balance sheet effect Sales-Type Lease Direct Financing Lease Net investment in Leases Year Current Long-term Total Current Long-term Total 0 751 1,736 2,487 658 1,625 2,283 1 826 910 1,736 756 870 1,625 2 910 0 910 870 0 870 3 Income Statement Effects Sales-Type Lease Direct Financing Lease Year Income Income 0 Gain on 204 Gain on 0 sale sale 1 Interest 248 Interest 342 2 Interest 174 Interest 244 3 Interest 91 Interest 130 Total 717 717 Cash Flow Statement Effects Sales-Type Lease Direct Financing Lease Year CFO CFI Total CFO CFI Total 0 204 (204) 0 0 0 0 1 248 751 1,000 342 658 1,000 2 174 826 1,000 244 756 1,000 3 91 910 1,000 130 870 1,000 Total 717 2,283 3,000 3,000 2011, Associate Professor Ole Sørensen, Ph.d. Side 20
At Inception Sales-Type Direct Financing Profit Yes (Selling price cost) None Assets Increase No Change During Lease Term: Interest Revenue Less More Total Cash Flow Same Same CFO Less More CFI More Less Total gross profit And interest income Same Same 2011, Associate Professor Ole Sørensen, Ph.d. Side 21
Lessor Operating Lease Balance Sheet Assets under lease Depreciation Net Year 0 2.283 0 2.283 Year 1 2.283 761 1.522 Year 2 2.283 761 761 Year 3 2.283 761 0 Income Statement Rental revenue Depreciation Income Year 0 0 Year 1 1.000 761 239 Year 2 1.000 761 239 Year 3 1.000 761 239 Sum 3.000 2.283 717 Cash flow Statement CFO Year 0 Year 1 1.000 Year 2 1.000 Year 3 1.000 Sum 3.000 2011, Associate Professor Ole Sørensen, Ph.d. Side 22