<p>Non-current liabilities affect a company’s liquidity and solvency and have consequences for its long-term growth and viability. In this course, we will learn about long-term liabilities such as bonds, leases, and pension plans, and how they impact financial statements.</p>

Study Notes for Non-current (Long-term) Liabilities

Non-current (Long-term) Liabilities

A bond is an IOU between the issuer and the investors. An option free (straight line) bond is a simple form of bond. Straight bonds pay fixed periodic coupon (annual or semi-annual) over the life and return the principal on maturity date. For example, a bond issued by the Treasury for a par value of, say $1000, with a maturity period of five with an annual interest rate of six per cent on maturity value. In such a case, the issuer, in this case – the Treasury pays an annual interest of $60 for five years, till the bond attains a par value of $1,000 and the Treasury redeems the bond to the buyer at a value of $1000 after five years from date of issue.

Bonds can be classified as: premium bonds, par bonds, and discount bonds.
<ul>
 	<li>For a premium bond, price exceeds its face value. The market interest rate is less than the coupon rate. At maturity the price of a bond must equal its par value. For a premium bond, price must fall over its life.</li>
 	<li>For a par bond, price equals its face value. The market interest rate is equal to the coupon rate. The price of a par bond may remain the same over time.</li>
 	<li>For a discount bond, price is below its face value. The market interest rate is greater than the coupon rate. Price must rise to reach par value at maturity.</li>
</ul>
Remember that the price and yield of a bond are inversely related to each other. When yield increases, the price decreases and vice versa.

Bonds

The initial accounting and measurement of bonds is undertaken in the following way.

When the bond is issued, it could be issued at par, discount or premium depending on the difference between the market interest rate and the bond’s coupon rate.

The initial issuance of the bond impacts the balance sheet and the cash flow statement as follows:
<table>
<tbody>
<tr>
<td width="215"><strong>Financial Statement</strong></td>
<td width="401"><strong>Impact</strong></td>
</tr>
<tr>
<td width="215"><strong>Balance Sheet</strong></td>
<td width="401">Both assets and liabilities are increased by the amount of sales proceeds.

On the asset side, the cash is increased

On the liability side, a liability called Bonds Payable.

For a <a title="“Pull to Par” of Bond Prices" href="https://financetrain.com/pull-to-par-of-bond-prices/">par bond</a>, this is equal to the face value of the bond.

For a discount/premium bond, this is equal to the amount based on the current market price. The amount is shown as Face Value +/- Premium or Discount.</td>
</tr>
<tr>
<td width="215"><strong>Cash Flow Statement</strong></td>
<td width="401">The sales proceeds received are reported as financing activity.</td>
</tr>
</tbody>
</table>
The issuance costs related to the bond issue such as printing fees, legal expenses, and commissions are reported as follows:
<ul>
	<li>Under IFRS, issuance costs are included in the liability, bonds payable. The bond payables are reduced by the amount of issuance costs.</li>
	<li>Under US GAAP, issuance costs are shown as an asset (a deferred charge) which is amortized using straight-line method over the life of the bond.</li>
	<li>Under both<a title="Accrual Accounting Concept in IFRS and GAAP" href="https://financetrain.com/accrual-accounting-concept-in-ifrs-and-gaap/"> IFRS and US GAAP</a>, the cash outflow is reported as a financing activity. The amount is usually netted against the bond proceeds.</li>
</ul>

Recognition and Measurement of Bonds

Once a bond has been issued and<a title="Price Yield Relationship for Bonds" href="https://financetrain.com/price-yield-relationship-for-bonds/"> bonds</a> payable liability has been created, the company will pay periodic interest payments to the bond holders for the life of the bond.

The interest payments made to the bondholders are calculated using the coupon rate and the bond’s face value. For example, for a bond with a face value of $1,000 paying a 5% coupon rate, the coupon per year will be $50.

However, the amount of interest expense reported in the income statement will differ from this value depending on whether the bond is issued at par, discount or premium.
<table>
<tbody>
<tr>
<td width="206"><strong>Bond</strong></td>
<td width="410"><strong>Interest Expense</strong></td>
</tr>
<tr>
<td width="206"><strong>Bond issued at par</strong></td>
<td width="410">The interest expense reported on income statement for the period will be equal to the coupon payment.</td>
</tr>
<tr>
<td width="206"><strong>Bond issued at premium</strong></td>
<td width="410">Interest expense will be less than the coupon payment.

This is because the premium collected (Carrying value – Face value) is amortized over the life of the bond.

Total interest expense = Coupon payment – Premium amortized

The bond liability will be decreased every period equal to the premium amortized.</td>
</tr>
<tr>
<td width="206"><strong>Bond issued a discount</strong></td>
<td width="410">Interest expense will be greater than the coupon payment.

This is because the discount (Face value – Carrying value) is amortized over the life of the bond.

Total interest expense =<a title="Calculate the Value of a Zero-coupon Bond" href="https://financetrain.com/calculate-value-zero-coupon-bond/"> Coupon</a> payment + Discount amortized

The bond liability will be increased every period equal to the discount amortized.</td>
</tr>
</tbody>
</table>
&nbsp;
<h3>Methods for Amortizing Premium/Discount</h3>
There are two methods for amortizing the premium or<a title="Discounting of Cash Flows" href="https://financetrain.com/discounting-of-cash-flows/"> discount of bonds</a>. They are effective interest method and the straight line method.

The straight line method is just like the straight line method for depreciation. The total premium/discount is divided equally over the life of the bond and these equal amounts are amortized every year.

Under the effective interest method, the interest expense is calculated by multiplying the carrying value of the liability at the beginning of the period by the bond’s yield at issuance.

The amortization amount is then calculated as the difference between the bond interest expense and the bond interest paid

<img class="aligncenter  wp-image-21597" src="https://financetrain.com/wp-content/uploads/Method-of-amortization.png" alt="Method of amortization" width="625" height="137" />

The effective interest method is required under IFRS. Under US GAAP both straight line and effective interest method are allowed but the effective interest method is preferred.

Under US GAAP, cash interest paid is reported as an operating cash flow. Under IFRS, cash interest paid can be reported as operating or financing cash flow.
<h4><strong>Example</strong></h4>
Widgets, Inc. sold $100,000, five-year, 10% bonds on January 1, 2013, for $98,000.  The effective-interest rate is 10.53% and interest is payable on Jan. 1 of each year

We can prepare the bond discount amortization schedule as follows:
<table width="608">
<tbody>
<tr>
<td width="73"><strong>Interest Periods</strong></td>
<td width="143"><strong>Interest to be paid
(10% * 100,000)</strong></td>
<td width="143"><strong>Interest Expense to be recorded
(10.53% * Preceding bond carrying value)</strong></td>
<td width="91"><strong>Discount Amortization</strong></td>
<td width="95"><strong>Unamortized discount</strong></td>
<td width="64"><strong>Bond Carrying Value</strong></td>
</tr>
<tr>
<td width="73"><strong>Issue Date</strong></td>
<td width="95">2000</td>
<td width="64">98000</td>
</tr>
<tr>
<td width="73"><strong>1</strong></td>
<td width="143">10000</td>
<td width="143">10319</td>
<td width="91">319</td>
<td width="95">1681</td>
<td width="64">98319</td>
</tr>
<tr>
<td width="73"><strong>2</strong></td>
<td width="143">10000</td>
<td width="143">10353</td>
<td width="91">353</td>
<td width="95">1328</td>
<td width="64">98672</td>
</tr>
<tr>
<td width="73"><strong>3</strong></td>
<td width="143">10000</td>
<td width="143">10390</td>
<td width="91">390</td>
<td width="95">937</td>
<td width="64">99063</td>
</tr>
<tr>
<td width="73"><strong>4</strong></td>
<td width="143">10000</td>
<td width="143">10431</td>
<td width="91">431</td>
<td width="95">506</td>
<td width="64">99494</td>
</tr>
<tr>
<td width="73"><strong>5</strong></td>
<td width="143">10000</td>
<td width="143">10477</td>
<td width="91">506</td>
<td width="95">0</td>
<td width="64">100000</td>
</tr>
<tr>
<td width="143"><strong>50000</strong></td>
<td width="143"><strong>51971</strong></td>
<td width="91"><strong>2000</strong></td>
</tr>
</tbody>
</table>
For premium bonds, the amortization works exactly the same way. The only difference is that the interest expense will be lower than the coupon payment by the amount of amortization. The bond carrying value will finally reduce to the bond’s face value.

For a zero-coupon bond, the amortization is exactly like the discount bond. The only difference is that the bond is issued at a deep discount and there are no coupon payments. So, the total interest expense for the year comprises the discount amortization for the year.
<h3>Fair Value Reporting</h3>
When a bond is issued, the book value of the bond is the fair value of the bond based on the market interest rate. Depending on where market interest rates stand vis-à-vis bond’s coupon rate, the bond’s carrying value is at premium, par, or discount.

However, if interest rates change, the market value/fair value of bonds will also change. Under both IFRS and US GAAP, the firms have the revocable option to report debt at fair value. Due to a change in market yield, the change in market value of the bond is reported in the income statement as a gain or loss.

&nbsp;

&nbsp;

Bond Amortization, Interest Expense, and Interest Payments

The issuer of a bond can either hold the bond till maturity or redeem it before maturity. Let’s look at the accounting treatment in both situations.
<h3>Bond Matures</h3>
If the bond matures, then the carrying value of the bond would be the same as its face value. Any premium or discount would have been fully amortized. The cash outflow to repay the bond would be shown as a financing activity on the cash flow statement.
<h3>Bond Redeemed Before Maturity</h3>
The issuer may decide to redeem the bond before maturity if the interest rates have fallen or if the firm has surplus funds.

In this case: 1) The premium or discount wouldn’t have fully amortized and the carrying value will be different from the face value. 2) The issuer may have to reacquire the bonds at a price different from face value.

For example, let’s say the carrying value of the bonds is $997,500. The issuer reacquires the bonds at 101%, i.e., at $1,010,000. The accounting treatment will be as follows:
<ol>
	<li>Recognize a loss of $12,500 (1,010,000 – 997,500) in the income statement in a separate line item (Gain/loss on debt extinguishment)</li>
	<li>Cash paid to redeem the bonds is reported as financing activity</li>
	<li>If cash flow statement is prepared using indirect method, any gain (loss) is subtracted (added) from the net income to calculate cash flow from operating activities.</li>
</ol>
<h3>Treatment of Debt Issuance Costs</h3>
Remember that under US GAAP, issuance costs are shown as an asset (a deferred charge) which is amortized using straight-line method over the life of the bond. Any unamortized bond issuance cost must be written off and included in gain/loss calculation. This will reduce gain/increase loss.

Under IFRS, issuance costs are included in the liability, bonds payable. So, no write off is needed.

&nbsp;

Derecognition of Debt

A bond indenture is a formal written agreement between the issuer of the bond such as a corporation and the bondholders.

This agreement specifies in detail the obligations of the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond issue.) These rights and obligations are known as covenants and protect creditors by restricting activities of the borrower.

<strong>Affirmative Covenants: </strong>These are the borrower promises to bond holders, for example, the borrower may be required to maintain a minimum of certain ratios, such as minimum interest coverage ratios, or minimum cash flow levels. The borrower also promises the timely payment of principal and interest.

<strong>Negative Covenants:</strong> These covenants constrain borrowers form certain activities. They are also called restrictive covenants as they restrict borrower activity. Common restrictive covenants include various limitations on the company’s ability to incur additional debt. Bondholders may want to include limits on the absolute dollar amount of debt that may be outstanding. The bondholders may also want to put a restriction on sale of assets that are pledged as collateral.

Role of Debt Covenants

<h3>Presentation</h3>
The non-current (Long-term) debt usually appears as a single line item on the balance sheet which shows the total long-term debt of the company due after one year. Portion of the long-term debt due within the next 12 months is reported as a current liability.

The detailed break-up of the debt is disclosed in the notes to financial statements.
<h3>Disclosures</h3>
The disclosures will include a detailed listing and description of each significant issue, including the amounts outstanding, the type of borrowing, the stated and effective interest rate, payment terms, call provisions, covenants, collateral pledged and final maturity date. The notes also show the amount of debt repayment schedules in the next 5 years.

An analyst can also find some discussion on the firm’s long-term debt under Management Discussion and Analysis section.

Presentation and Disclosures Related to Debt

A firm may choose to purchase outright a long-lived asset, such as an airplane or an office building, giving the firm full benefit and risk from asset ownership; however it may also enter into a lease agreement with another firm, to lease an asset and assume partial benefit and risk associated with the asset.

A Lease represents a contractual agreement between the party owning the asset who wants to earn a return on its investment (the “Lessor”) and the party desiring to use the asset (the “Lessee”). The lessor grants the lessee the right to use the asset in exchange for a series of lease payments. The lessee expects that it will earn a return on the use of the asset that is greater than the cost of the lease. In many respects, this transaction is similar to a company purchasing an asset and financing the purchase with the issuance of a bond.

Lessee is the “borrower” of the leased asset. Lessor is the “lender” of the leased asset.

Leasing Vs. Purchasing Assets

A lease can be an operating lease or a capital lease.

<strong>Operating Lease</strong> – Typically a short-term lease where the lessor retains most of the benefits and risks associated with owning the asset. In operating lease, no asset and liability are recorded on the lessee’s balance sheet. Lease payments are reported as expense when paid.

<strong>Capital Lease</strong> – Typically a long-term lease where the lessee assumes most of the benefits and risks associated with owning the asset. In capitalizing a lease, an equal balance sheet asset and liability are created and both are reduced over the term of the lease; these reductions are expensed to the income statement. Note that ‘Capital lease’ is the term used by US GAAP. Under IFRS it is called ‘Finance lease’.

<strong>Lessees and Operating Leases</strong> – A company may be incented to treat leases as operating leases because the financial commitment associated with the operating lease contract is not recorded on the balance sheet as a liability.  Operating leases can be seen as a form of off-balance sheet financing for a company.  If a lease is capitalized by a lessee, the resulting liability will have debt-like impacts on a company’s financial ratios.

<strong>Lessors and Capital Leases</strong> – Companies who act as lessors may be incented to treat leases as sales-type capital leases in order to show higher net income.

Capital Leases and Operating Leases

Under US GAAP, lessee is required to capitalize a lease if ANY of the following conditions are met:
<ul>
	<li>Lease ownership is transferred to the lessee at the end of the lease term.</li>
	<li>There is a bargain purchase option in the lease contract where the lessee may buy the asset at or below fair market value at the end of the lease.</li>
	<li>The present value of the lessee’s minimum payments, over the life of the lease, equal 90% or more of the asset’s fair market value.</li>
	<li>The lease’s term is equal to 75% or more of the useful economic life of the asset.</li>
</ul>
<img class="aligncenter  wp-image-21612" src="https://financetrain.com/wp-content/uploads/lease-accounting.gif" alt="lease accounting" width="483" height="202" />
<h3><strong>Operating Lease Accounting for the Lessee</strong></h3>
The annual rental expense appears on the lessee’s income statement and there is no balance sheet asset and liability associated with the lease.
<ul>
	<li>An operating lease affects the lessee’s balance sheet only in an indirect matter.  The rental expense lowers net income, which in turn lowers the company’s retained earnings in the equity section of the balance sheet.</li>
	<li>Rental payments on an operating lease are treated as part of operating cash flows.</li>
</ul>
<h3><strong>Capital Lease Accounting for the Lessee</strong></h3>
If one of the above four conditions is met in the US, the lessee is required to account for the transaction as if it were a long-lived asset purchased on credit.
<ul>
	<li>The lessee’s capital lease creates journal entries for interest expense, lease repayment (which decreases the lease obligation on the balance sheet over time), and depreciation.</li>
	<li>Typically, a capital lease will front load expenses associated with the asset, which causes the lessee’s net income to rise over time.</li>
	<li>At a capital lease’s expiration, the lessee’s balance sheet will be no different than the balance sheet where the lease was classified as operating, but in the time between lease initiation and expiration, the capital lease creates a balance sheet asset and liability.</li>
	<li>Under a capital lease, the interest expense attributed to the lease payment is an operating cash flow, but the principal repayment of the lease obligation is a financing cash outflow.</li>
	<li>The capital lease payment to be made within one year is separated as a short-term liability and the remaining lease balance is classified as a long-term liability on the balance sheet.</li>
</ul>
U.S. and international accounting standards may require some form of financial statement footnote disclosure regarding the company’s lease accounting practices.

A common financial statement adjustment made by analysts is to capitalize operating leases presented in the footnotes, creating a balance sheet asset and liability equal to the future payments required by the operating leases.

Lessee Accounting

The table below summarizes the effects of operating and capital leases on selected financial reporting items for <strong><em>lessees</em></strong>.
<table width="610">
<tbody>
<tr>
<td><strong>ITEM</strong></td>
<td width="199"><strong>OPERATING LEASE</strong></td>
<td width="310"><strong>CAPITAL LEASE</strong></td>
</tr>
<tr>
<td><a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/"><strong>Balance Sheet</strong></a></td>
<td width="199">No impact.</td>
<td width="310">Leased asset and lease liability are created.</td>
</tr>
<tr>
<td><a title="Income Statement" href="https://financetrain.com/income-statement/"><strong>Income Statement</strong></a></td>
<td width="199">Rent expense occurs over the life of the least; this may be a constant value.</td>
<td width="310">Interest and depreciation expenses are recognized. In the initial years expenses will be higher than an operating lease, but over the full lease term the two lease types have the name total effect.</td>
</tr>
<tr>
<td><a title="Significance of Cash Flows" href="https://financetrain.com/significance-of-cash-flows/"><strong>Cash Flows</strong></a></td>
<td width="199">Total change in cash is the same, but the full rent expense is treated as an operating cash flow.</td>
<td width="310">Total change in cash is the same, but the lease payment is divided between an interest component (an operating cash flow) and a principal repayment (a financing cash flow). The amount assigned to deprecation is a non-cash charge.</td>
</tr>
<tr>
<td><strong>Profit Margin</strong></td>
<td width="199">Higher in the early years, but lower in the later years, as compared to a capital lease.</td>
<td width="310">Lower in the early years because the total expense associated with the lease is higher than the actual payment, but profit margin will climb in later years of the capital lease.</td>
</tr>
<tr>
<td><a title="Fixed Asset and Total Asset Turnover Ratio" href="https://financetrain.com/fixed-asset-and-total-asset-turnover-ratio/"><strong>Asset Turnover Ratios</strong></a></td>
<td width="199">Higher because the operating lease records no balance sheet assets.</td>
<td width="310">Lower because a balance sheet asset is recorded, but the ratio will rise over time as the asset is depreciated.</td>
</tr>
<tr>
<td><a title="Common Ratios in Financial Analysis" href="https://financetrain.com/common-ratios-in-financial-analysis/"><strong>Debt-to-Equity Ratio</strong></a></td>
<td width="199">Lower because there is no liability recorded on the balance sheet for an operating lease.</td>
<td width="310">Higher because a lease obligation liability is recorded on the balance sheet, but the ratio will decline over time as the lease is repaid.</td>
</tr>
<tr>
<td><a title="Common Ratios in Financial Analysis" href="https://financetrain.com/common-ratios-in-financial-analysis/"><strong>ROA &amp; ROE</strong></a></td>
<td width="199">Higher in the early years because assets are lower and earnings are higher.</td>
<td width="310">Lower in the early years because earnings are lower and assets are higher.</td>
</tr>
<tr>
<td><a title="Financial Statement Analysis – Ratio Analysis" href="https://financetrain.com/financial-statement-analysis-ratio-analysis/"><strong>Interest Coverage Ratios</strong></a></td>
<td width="199">Higher because a firm incurs no interest expense from an operating lease.</td>
<td width="310">Lower because a firm allocates a portion of the lease expense to interest.</td>
</tr>
</tbody>
</table>
A company may prefer to account for leases as operating leases when:
<ul>
	<li>Management is partially compensated based on return on assets.</li>
	<li>A firm wants to keep debt-like liabilities off its balance sheet.</li>
</ul>
A company may prefer to account for leases as capital leases when it wants to show a higher cash flow from operations.

Effects of Leases on Selected Financial Reporting Items for Lessees

Under US GAAP, a lessor must capitalize a lease if any of the four lessee conditions for capitalization are present, PLUS BOTH of the following requirements are met:
<ul>
	<li>The lessor can reasonably expect to collect the minimum lease payments; and</li>
	<li>The lessor has no material uncertainties regarding the amount of un-reimbursable costs yet to be incurred, as part of the lease agreement.</li>
</ul>
If these conditions are not met, then the lessor normally must classify the lease as an operating lease.  In reality, it is common for the lessor and lessee to use the same accounting treatment for leases.
<h3><strong><a title="Lessor Accounting for Leases" href="https://financetrain.com/lessor-accounting-for-leases/">Lessor Accounting</a> for Operating Leases</strong></h3>
Payments received from the lessee are treated as rental revenue on the lessor’s income statement and the lessor continues to account for the leased asset as a fixed asset on its balance sheet.

<img class="aligncenter size-full wp-image-21635" src="https://financetrain.com/wp-content/uploads/lessor-accounting.gif" alt="lessor accounting" width="478" height="202" />
<h3><strong>Lessor Accounting for Capital Leases</strong></h3>
There are two types of lessor capital leases:
<ol>
	<li><strong>Sales-Type Lease:</strong>The lessor firm is typically a dealer or manufacturer who leases its equipment rather than selling the equipment outright.  Under a sales-type lease, the lessor will recognize a profit or loss on the sale of the leased product and recognize on-going interest income from the capitalized lease over the lifetime of the lease.</li>
	<li><strong>Direct Financing Lease: </strong>The lessor firm leases to other companies at cost and the income from the lease is interest income.  An example of this business model would be a financial institution that owns an aircraft leasing unit which leases aircrafts to other companies at a rate the covers the cost of the airplane plus interest.  The income from the lease is recognized as interest income on the lessor’s income statement, representing the lessor’s return on investment in the capital lease.</li>
</ol>
Classifying a lease as a capital lease or operating lease by a lessor is a materially significant accounting policy, as the balance sheet, the income statement, the statement of cash flows, and key financial ratios will be different under the different methods.

Lessor Accounting for Leases

When a lessor enters a sales-type capital lease, several journal entries will be made to account for the transaction:
<ul>
	<li>An investment in lease asset is created on the balance sheet (NOTE: this value is greater than the reduction to inventory, so the lessor’s assets on the balance sheet have grown as a result of the transaction).</li>
	<li>A cost of goods sold expense is calculated and recognized (NOTE: COGS is netted against sales revenue to determine gross profit or loss on the “sale”).</li>
	<li>Sales revenue is recognized.</li>
	<li>The inventory asset account on the balance sheet is reduced.</li>
</ul>
<h3><strong>Cash Flows for Lessor’s with Sales-Type <a title="Lessors and Direct Financing Capital Leases" href="https://financetrain.com/lessors-and-direct-financing-capital-leases/">Capital Leases</a></strong></h3>
NOTE: Local accounting regulations may vary in treatment of these cash flows for a sales-type capital lease.
<ul>
	<li>Over the term of the lease, most of the lessee’s payment is applied to reducing the investment in lease asset (as the lessee is fulfilling its financial obligation to repay principal).  The remaining portion of the lessee’s payment is treated as interest income by the lessor.</li>
	<li>At lease signature, it is quite possible that no cash flows occur, however with the sales-type method, the lessor shows the investment in the lease as an investing cash outflow and the gross profit on the sale as an operating cash inflow.</li>
	<li>As the lessee pays the lessor during the lease term, the interest income portion of the payment may be treated as an operating cash inflow and the principal pay-down portion of the lessee’s payment may be treated as an investing cash inflow.</li>
</ul>
&nbsp;

&nbsp;

Lessors and Sales-Type Capital Leases

When a financing firm enters into a direct financing capital lease, the lessor reduces PPE shown on its balance sheet and creates an investment in lease asset; the total value of assets on the lessor’s balance sheet is unchanged.

NOTE: Local accounting regulations may vary in treatment of these cash flows for a direct financing capital lease.
<ul>
	<li>Over the life of the direct financing capital lease, the lessor receives a payment from the lessee.  A portion of the payment is classified as interest income on the income statement and the remaining portion of the payment is used to reduce the investment in lease asset on the balance sheet.</li>
	<li>Unlike the cash flows described in the sales-type lease above, the statement of cash flows are not impacted at the time the lease is entered for a direct financing lease.</li>
	<li>When the regular payments are made by the lessee towards the direct finance lease, the lessor reports the interest income as an operating cash flow and the investment in lease asset pay down as an investing cash inflow.</li>
</ul>

Lessors and Direct Financing Capital Leases

The table below summarizes the effects of <a href="https://financetrain.com/lessor-accounting-for-leases/">operating</a>, <a href="https://financetrain.com/lessors-and-sales-type-capital-leases/">sales type capital leases</a>, and <a href="https://financetrain.com/lessors-and-direct-financing-capital-leases/">direct financing capital lease</a> on financial statements for <strong>lessor</strong> firms at lease initiation.
<table width="610">
<tbody>
<tr>
<td><strong>ITEM</strong></td>
<td><strong>OPERATING LEASE</strong></td>
<td><strong>SALES TYPE CAPITAL LEASE</strong></td>
<td><strong>DIRECT FINANCE CAPITAL LEASE</strong></td>
</tr>
<tr>
<td><strong>Asset size on balance sheet at initiation.</strong></td>
<td>No change because no asset is recorded.</td>
<td>Increase because the investment in lease asset is larger than the reduction to inventory.</td>
<td>No change because the investment in lease asset is equal to the reduction to PPE.</td>
</tr>
<tr>
<td><strong>Income during year of lease initiation.</strong></td>
<td>No change because no gain on sale is recognized.</td>
<td>Higher than an operating or direct finance capital lease because lessor recognizes a gain on the sale.</td>
<td>Higher than an operating or direct finance capital lease because lessor recognizes a gain on the sale.</td>
</tr>
<tr>
<td><strong>Operating cash flow impact upon lease initiation.</strong></td>
<td>No impact, as no cash changes hand on initiation.</td>
<td>Higher than the other two methods; while no cash may change hands at lease initiation, the lessor will recognize a gross profit on the “sale” of the asset, but this is offset by an outflow to investing cash flows for the investment in leased asset.</td>
<td>No impact, as no cash changes hands on initiation.</td>
</tr>
</tbody>
</table>

Effect of Leases on Financial Statements for Lessors

Both Lessor and Lessee are required to provide disclosures related to Capital and Operating leases. The following disclosures are required under US GAAP.
<h3>Disclosure Requirements for Lessees</h3>
<h4><strong>Lessee Capital Lease Disclosure Requirements</strong></h4>
<ul>
	<li>A description of the general leasing arrangements</li>
	<li>Disclosure of the gross amount of assets recorded under capital leases presented by major asset class and the total amount of accumulated depreciation.</li>
	<li>Separate identification of related obligations as capital lease obligations in the balance sheet with classification as current or non-current as appropriate.</li>
	<li>Disclosure of the minimum future lease payments in total and for each of the next five years, presenting a deduction for the amount of imputed interest to reduce the net minimum future lease payments to their present value</li>
</ul>
<h4><strong>Lessee Operating Lease Disclosure Requirements</strong></h4>
<ul>
	<li>A description of the general leasing arrangements</li>
	<li>Disclosure of the future minimum rental payments in total and for each of the next five years for non-cancellable leases of more than one year</li>
	<li>Disclosure of current year rental costs</li>
</ul>
<h3>Disclosure Requirements for Lessors</h3>
<h4><strong>Lessor Capital Lease Disclosure Requirements</strong></h4>
<ul>
	<li>A description of the general leasing arrangements</li>
	<li>The total future minimum lease payments receivable with separate deductions for executory costs and uncollectibles</li>
	<li>Unguaranteed residual values accruing to the government</li>
	<li>Minimum lease receipts for each of the five succeeding fiscal years</li>
	<li>Any unearned income offset against initial direct costs</li>
	<li>Total contingent rentals of the period</li>
</ul>
<h4><strong>Lessor Operating Lease Disclosure Requirements</strong></h4>
<ul>
	<li>A description of the general leasing arrangements</li>
	<li>Cost and carrying amount of leased assets</li>
	<li>Depreciation on leased assets</li>
	<li>For non-cancelable leases, minimum future rentals in the aggregate and for each of the five succeeding fiscal years</li>
	<li>Total contingent rentals of the period</li>
</ul>

Disclosures for Capital and Operating Lease

Company provision of employee retirement (or post-employment) benefits often takes one of two forms:
<ul>
	<li>Defined contribution (DC) plans</li>
	<li>Defined benefits (DB) plans</li>
</ul>
<h3>Defined Contribution (DC) Plans</h3>
DC plans outline the periodic amounts than a retirement plan sponsor (the employing company) contributes to the retirement plan and how those contributions are provided to employees.
<ul>
	<li>
<h4><strong>DC Plan Example:</strong></h4>
In the U.S., a common form of DC plan is the 401(k) plan, where the employer will contribute a percentage of the employee’s salary to the plan or will match contributions made by the employee.  Each individual employee will have a personal account under the employer’s 401(k) and the employer must provide a range of investments, into which the employee can allocate his/her 401(k) funds.  Commonly U.S. employers offer a range of mutual fund options to employees.  Employees withdraw funds from their individual 401(k) plans after retiring, in order to pay for their living expenses.</li>
	<li><strong>DC Plan &amp; the Income Statement:</strong>Companies with DC plans will make annual contributions based on the plan’s formula and these contributions will be expensed as incurred.</li>
	<li><strong>DC Plan &amp; Cash Flows:</strong>The pension expense = cash outflow.</li>
	<li><strong>DC Plan &amp; the Balance Sheet:</strong>DC Plans do not create assets and liabilities, so the employer’s balance sheet is not affected.</li>
	<li><strong>DC Plan Management &amp; Risk:</strong>Under a DC plan, the employee assumes all retirement funding risk, as he/she must ensure that enough is saved to the account to fund retirement.  Commonly, the employee makes the plan’s asset investment choices and losses due to asset value declines are absorbed by the employee.</li>
</ul>
<h3>Defined Benefit (DB) Plans</h3>
Under a DB plan, the employer/plan sponsor commits to providing a specified amount of benefits to employees after they retire.  In the U.S., when someone refers to a “pension plan”, the individual is probably referring to a defined benefits plan.
<ul>
	<li><strong>DB Plan Benefits Allocation:</strong>DB plans commonly allocate benefit amounts to employees based on factors such as the employee’s number of years with the company and the employee’s later years’ salary levels.  Employees may be required to work for the company for some specified minimum number of years before they become “vested” in the plan and eligible for plan benefits.</li>
	<li><strong>DB Plan Accounting:</strong>Compared to DC plan accounting, DB plan accounting is significantly more complicated.</li>
	<li><strong>DB Plan Management &amp; Risk:</strong>DB plans are managed by the plan sponsor, which is the employing company. The company must ensure that the plan is funded and promises made to employees represent a legal obligation that must be publicly reported on financial statements.  Funding is the process by which the employer contributes assets into the DB plan.  The amount that a company contributes to a DB plan is not the same as the DB plan’s expense.</li>
	<li><strong>DB Plan Types (2):</strong>Most commonly, the DB plans are <strong>pay-related</strong> (1), whereby an employer will provide a regular pension check to retirees based on some past salaries.  Less commonly, some DB plans are <strong>non-pay related</strong> (2), where the pension benefits is not based on historic employee pay.  Non-pay related DB plans are rare.</li>
</ul>

Defined Benefits Plans vs. Defined Contribution Plans

Pension Expense = Increase in the DBO/PBO during the accounting period.

<strong>Five Components of Company Pension Expense</strong>
<ol>
	<li><strong>Current Service Cost</strong> = Amount by which a company’s defined benefit obligation increases as a result of employee service during the accounting period.  The current service cost is fully and immediately recognized for the accounting period.</li>
	<li><strong>Interest Cost</strong> (same as the discount rate discussed later) = Amount by which a company’s existing defined benefit obligation increases as a result of the passage of time.  The interest cost is fully and immediately recognized for the accounting period.</li>
	<li><strong>Return on Plan Assets</strong> = Amount of returns generated by plan assets during the accounting period.  Typically, companies apply <em><strong>EXPECTED</strong></em> <em><strong>return on plan assets</strong></em> when calculating pension expense.  Long-term expected return will better reflect the plan’s investment strategy and reduce year to year volatility in the pension expense.  The use of expected returns is allowed by GAAP and IFRS.  Since this is an asset return, the return on plan assets component acts as a contra expense, offsetting other costs.</li>
	<li><strong>Amortization of Past Service Cost</strong> = The difference in the DBO after a plan amendment has been adopted and the DBO before the plan amendment.  The plan amendment could reduce costs, creating a benefit that reduces the pension expense.</li>
</ol>
<ol>
<ul>
	<li><strong>GAAP:</strong> This is recorded as a direct to equity adjustment outside of net income, as part of other comprehensive income for the accounting period in which the amendment took place.  A periodic past service cost expense is then amortized to the pension expense over the remaining service lives of the employees covered by the amendment.</li>
	<li><strong>IFRS:</strong> If the amendment affects any vested obligations, then the vested percentage of the past service cost is incorporated into the pension expense for the accounting period of the amendment and the remaining past service cost for unvested obligations is amortized to future pension expense calculations over the course of the related vesting period.</li>
</ul>
	<li><strong>Amortization of Actuarial Gains and Losses.</strong></li>
</ol>
<ol>
<ul>
	<li>Actuarial gains and losses arise from:</li>
</ul>
</ol>
<ol>
<ul>
<ul>
	<li>Differences between expected plan returns and actual plan returns (see #2 of 5); and</li>
	<li>Changes in actuarial assumptions that impact the current service cost (see #1 of 5). Examples: employee life expectancy, salary growth forecasts, interest cost component assumptions, retirement dates, etc.</li>
</ul>
	<li><strong>GAAP:</strong> Actuarial gains and losses are recognized as part of other comprehensive income during the period of gain or loss, on the company’s statement of changes in shareholder’s equity.</li>
	<li><strong>IFRS:</strong> Actuarial gains and losses do not flow to equity, but are applied to assets or liabilities and are incorporated in the calculation of a net asset or liability on the balance sheet.  A net pension asset is reported as pre-paid pension expense; a net liability is accrued pension expense.</li>
	<li><strong>10% Amortization Expense “Rule”</strong> – Companies will not begin to incorporate an amortization gain/loss into its calculation of pension expense until the gain/loss from asset return differences or the benefit/cost from changes to the plan exceeds the greater of 10% of the value of plan assets or 10% of the DBO.</li>
</ul>
</ol>
<strong> </strong>

Pension Expense (both GAAP & IFRS) for the Income Statement

A Net Asset or a Net Liability Exists (unless DBO value = value of Plan Assets)
<h3><strong>DBO End of Period</strong></h3>
Recall that the defined benefit obligation represents the present value of company retirement compensation promises for vested and un-vested employees, with assumptions for future salary increases (GAAP term is projected benefit obligation).

&nbsp;

For accounting purposes, the DBO is liability and should be analyzed as such, but GAAP and IFRS require companies to report net position of the plan’s funded status (which can also be positive and thus an asset for public financial reporting purposes).  The funded status is based on the difference between the fair value of plan assets and the DBO.

The ending value for the accounting period’s DBO is outlined below.

<img class="aligncenter size-full wp-image-21705" src="https://financetrain.com/wp-content/uploads/dob1.gif" alt="dob1" width="502" height="310" />

<strong>Plan Assets End of Period</strong>

Plan assets are investments made on behalf of the interests of the pension beneficiaries in order to provide funding of retirement benefits for current and future retirees.

The ending value for the accounting period’s plan assets is outlined below:

<img class="aligncenter size-full wp-image-21706" src="https://financetrain.com/wp-content/uploads/dob2.gif" alt="dob2" width="502" height="226" />

&nbsp;
<h3><strong>A Plan’s Funded Status – the net asset or net liability on the balance sheet</strong></h3>
Funded Status = FV of Plan Assets – DBO

Net Balance Sheet Asset: FV Plan Assets &gt; DBO

Net Balance Sheet Liability:   FV Plan Assets &lt; DBO

When appropriate actuarial assumptions are applied, the funded status represents the net economic position of the pension plan.
<h3><strong>Funded Status: IFRS &amp; GAAP</strong></h3>
Under both<a title="Differences in IFRS and US GAAP Frameworks" href="https://financetrain.com/differences-in-ifrs-and-us-gaap-frameworks/"> IFRS and GAAP</a>, the net position of the pension is shown on a single side of the balance sheet (either an asset or liability).

It can be argued that separately reporting the plan assets as a standalone asset and the DBO as a standalone liability is more useful for analytical purposes.

There are technical differences between GAAP and IFRS reporting for a defined benefit plan’s funded status and other disclosures and these are attempted to be reconciled as part of the IASB-FASB convergence project.

Defined Benefit Plans & the Company Balance Sheet

This quiz is a part of the CFA Level 1 reading 'Non-current (Long-term) Liabilities'. 

Non-Current Long Term Liabilities

This frontmatter description will appear below the title

COURSE

Non-Current Long Term Liabilities

Course Resources

Course Quizzes

Lessons

R Programming Bundle: 25% OFF

Course Resources

Course Quizzes