WEEK 9

ANALYSIS OF FINANCING LIABILITIES, LEASES AND OFF-BALANCE SHEET DEBT Introduction How do firms incur debt? Operating activities exchange of goods or services for later payment o Accounts Payable - Amounts owed for goods, supplies or services purchased on open account, generally recorded when title has passed and recorded at amount payable o Other operating and trade liabilities other credit granted to the company by its suppliers and liabilities o Advances from customers from customers who pay in advance for goods and services. Customers may pay deposits that guarantee the payment of expected future obligations or the performance of a future service. They are classified as either current or non-current liabilities depending on specific conditions Operating liabilities should be distinguished from other liabilities on the balance sheet as one will require a future cash outflow while the another will require future delivery of good or services. Operating liabilities are undiscounted.

Financing activities current receipt of cash in exchange of future payments of cash o Short-term debt from banks and credit markets expected to be repaid within one year o Current portion of long-term debt Off-balance sheet contracts rather than immediate cash exchanges / promise to purchase goods or services o Leases o Through put agreements Employee-Related Liabilities o Salaries or wages owed to employees at end of the accounting period, Payroll deductions owed, Short-term compensated absences, profit sharing and bonuses. Usually reported as current liabilities o Post-retirement obligations - resulting from the relationship between the firm and its employees

Recognition and Measurement A liability is present economic obligation for which the entity is the obligor. Thus: Obligation of an enterprise. There is little or no discretion to avoid the obligation. Arising from past transactions or events. Obligation arises from a transaction or event which has already occurred The settlement of which may result in the transfer or use of assets, provision of services, or other yielding of economic benefits in the future Based on this definition, liability would have three essential characteristics: Exists at present time (i.e. at balance sheet date) Represents economic burdens or obligations - Always includes unconditional obligations (including stand-ready obligations) These burdens / obligations are enforceable - Includes constructive obligations (obligations based on entitys present/past practices) Measurement rules are significantly different based on whether the liability is considered financial or non-financial. Financial liability is any liability that is a contractual obligation to either: Deliver cash or other financial asset to another party, or To exchange financial instruments with another party under conditions that are potentially unfavorable Financial liabilities Initial Measurement Subsequent Measurement At fair value. Generally at amortized cost (except those held for trading, such as derivatives, where fair value is used) Non-financial liabilities Measured at best estimate of payment that would be required to settle the obligation at balance sheet date Best estimate of payment that would be required to settle the obligation at balance sheet date

Financing liabilities are classified on the balance sheet as either; Current Liabilities - Current liabilities are due within one year or one operating cycle and result from both operating and financing activities of a firm. Under IFRS, liabilities are classified as current when they meet any one of the following conditions: Expected to be settled within normal operating cycle Held primarily for trading Due within 12 months from balance sheet date No unconditional right to defer settlement for at least 12 months after balance sheet date Current maturities of long-term debt The portion of long-term debt maturing within 12 months from the balance sheet date is reported as a current liability 1

Portions of long-term debts should not be reported as current liabilities if, by contract, they are retired by assets not classified as current assets Any liability due on demand, or due on demand within a year or operating cycle, is reported as a current liability

Short-term debt expected to be refinanced Debt due within 12 months is classified as current, unless at balance sheet date the company has the intent and a right (under existing contract, and solely in its discretion) to refinance with long-term debt Dividends Payable Cash Dividend - Becomes legal obligation on declaration date / Classified as current liability Preferred Dividends in Arrears - Cumulative preferred dividends that have not been declared require note disclosure / Not recognized as a liability Stock Dividends - Not a liability; does not meet the definition of a liability as no future outlays of assets/services / Recorded only through equity accounts i.e. represents a transfer of equity from retained earnings to contributed capital OR, Non-current Liabilities / Long-Term Debt - Current liabilities are due after one year or one operating cycle and also result from both operating and financing activities of a firm. Sources include public issuance; private placement; long-term credit agreement with a bank or financial institution. These may be secured on a specific asset of the firm (mortgage) or on the general claim of assets of the firm. Project financing is repaid solely from a particular activity. Common borrowings include: Bank Overdraft - An extension of credit from a lending institution when an account reaches zero. An overdraft allows the company to continue withdrawing money even if the account has no funds in it. Basically the bank allows people to borrow a set amount of money. Term Loan /Commercial Loan - A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate. Term loans almost always mature between one and 10 years. For example many banks have term-loan programs that can offer small businesses the cash they need to operate from month to month. Often a small business will use the cash from a term loan to purchase fixed assets such as equipment used in its production process.

Mortgage - A debt instrument that is secured by the collateral of specified real estate property and that the borrower is obliged to pay back with a predetermined set of payments. Individuals and businesses to make large purchases of real estate without paying the entire value of the purchase up front use mortgages.

Commercial Paper - An unsecured, short-term debt instrument issued by an entity, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days (9 moths). The debt is usually issued at a discount, reflecting prevailing market interest rates. Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.

Project Finance / Project Debt - The financing of long-term infrastructure, industrial projects and public services (factory, building, pipeline, real estate, etc) based upon a non-recourse (i.e. dependent of the project cash flows and if non-successful, the lender may not claim payment from any other source) or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project. In other words, project financing is a loan structure that relies primarily on the project's cash flow for repayment, with the project's assets, rights, and interests held as secondary security or collateral.

Debt Denominated in Foreign Currency These are motivated by either more favorable terms in foreign markets, or assets denominated in the foreign currency and debt denominated in the same currency can hedge against exchange rate movements The carrying value of foreign currency debt is adjusted for exchange rates. This adjustment for exchange rate is separate from adjustment to current market value. Market value adjustments are based on changes in market interest rates. Convertible Bonds and Warrants - Convertible bonds are accounted for as if they were unconvertible and they only lower interest expense. When they are converted, the entire proceeds are reclassified from debt to equity. However, in financial analysis, the equity feature should be considered. When the bond price is significantly greater than the conversion price, it is likely that the debt will not have to be repaid, and convertible bond should be treated as equity rather than debt when calculating solvency ratios, such as debt-to-equity. When the bond price is significantly below the share price, the bond should be treated as debt. At bond price levels close to conversion price, the instrument has both debt and equity features. When warrants and bonds are issued together, the accounting treatment differs from that of convertible bonds. The proceeds must be allocated between the two financial instruments. The fair value of the bond portion is the recorded liability. The fair value of the warrant is included in equity capital and has no income statement impact. When the warrants are exercised, the additional cash increases equity capital.

Commodity Bonds - This occurs where interest and principle payments on bond issues are tied to the price of a commodity such as oil, gold, silver, etc. Producers of these commodities commonly issue such bonds as a strategy. A higher commodity price increases payment to bondholders but is offset by higher profitability. These bonds, therefore, convert interest from fixed to variable cost.

Perpetual Debt - This is a debt with no stated maturity. When debt does not have a maturity date, for analytical purposes, it may be considered preferred equity rather than a liability. An exception would be cases where debt covenants are likely to force repayment or refinancing of debt.

Notes payable - Notes payable are written promises to pay a sum of money on a specified future date. They rises from purchases, financing or other transactions. Notes payable may be classified as either short-term or long-term. Notes payable may
be interest bearing or zero-interest-bearing (non-interest-bearing). For zero-interest-bearing notes, the difference between the present value of the note and the face value of the note represents the discount on the note payable and the related interest. The discount is the interest expense recorded over the life of the note. In both cases, interest expense is determined whenever financial statements are prepared. BONDS A bond is a contract or written agreement that obligates the borrower (bond issuer) to make certain payments to the lender (bondholder) over the life of the bond. Payments include interest (usually semi-annual) and lump sum when the bond matures. Basic Principles: Debt equals the present value of the remaining future stream of payments interest and principle. Interest expense is the amount paid by the borrower to the lender in excess of the amount borrowed. The amount borrowed (proceeds from an issue) depends on the market rate of interest for bonds of a similar maturity and risk as well as payment stream. It is the current market rate that allocates payments between interest and principle. The market rate may be less than, equal to, or greater than the coupon rate. It is the current market interest that allocates payments between interest and principle. Face Value = the lump sum due at maturity Coupon rate = stated cash interest rate (but not necessarily the actual rate of return) Periodic Payment = Coupon Rate X Face Value Points to be noted: 1. The initial liability amount is the amount paid to the issuer by the bondholder (present value of the stream of payments discounted at the market rate), not necessarily the face value of the debt. 2. The effective interest rate on the bond is the market (not the coupon) rate at the time of issuance, and interest expense is that market times the bond liability. 3. The coupon rate and face value determine the actual cash flows (stream of payments from the issuer). 4. Total interest expense is equal to the payments by the issuer to the creditor in excess of the amount received. 5. The balance sheet liability over time is a function of the initial liability and the relationship of interest expense to actual cash payments. 6. The balance sheet liability at any point in time is equal to the PV of the remaining payments, discounted at the market rate in effect at the time of issuance of the bonds. Bonds can be issued at par, at a premium, or at a discount. Issue at par - when the market rate is equal to coupon rate Issue at premium when the market rate is less than the coupon rate Issue at a discount when the market rate is greater than the coupon rate Issuance at par when the market rate is equal to the coupon rate; proceeds equal to the face value. Introduction to Discounting / Present Value Tables: Table Calculation Example Amount of 1 Future Value of 1 to be received after n years; a = (1 + If the interest rate is 10 percent per year, the I)n investment of Shs. 1 today will be worth Shs. 1.6105 at year 5 Present Value of 1 Present Value of 1 to be received after n years; pn = 1/ If the interest rate is 10 percent per year, the present (1 + I)n value of Shs. 1 received at year 5 is Shs. 0.6209 Future amount of Ordinary Annuity PV of an Ordinary Annuity Future value of 1 invested at a continuously compounded rate n for t years; An,i = [(1 + i)n - 1]/i Present value of 1 per year for each of n years; Pn,i = {[1- 1/(1 + i)n]/i} - {(1-Pn)/i} The future value of an ordinary annuity of Shs. 1 in five years at 10 % is Shs. 6.1051 If the interest rate is 10 percent per year, the investment of Shs. 1 received in each of the next 5 years is Shs. 3.7907

Example: Face Value: Shs. 1,000,000 Coupon: 10% Interest Payment: Semiannual Term: 3 years The purchaser expects 6 payments of interest (each payment is Shs. 50,000) and a final payment of Shs. 1M. (For simplicity ignore underwriting costs and expenses associated with bond issuance. The costs are normally capitalized and amortized over the life of the bond issue) (a) Issue at par = when the market rate (10%) is equal to coupon rate (10%) (a) (b) (c) (d) =5% X (a) FC X CR =(b) - (c) Period Ending Year 1, 30th Jun. Year 1, 30th Dec. Year 2, 30th Jun. Year 2, 30th Dec. Year 3, 30th Jun. Year 3, 30th Dec. Liability (Opening) 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Interest Expense 50,000 50,000 50,000 50,000 50,000 50,000 300,000 Coupon Payment 50,000 50,000 50,000 50,000 50,000 50,000 300,000 Change in Liability 0 0 0 0 0 0

(e) =(a) + (d)

(f) FV

Liability Face Value of the (Closing) Bond 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

Calculations of proceeds PVA of Shs 50,000 for 6 periods, discounted at 5% 50,000 X 5.07569 = 253,785 PV of Shs 1,000,000 for 6 periods, discounted at 5% 1,000,000 X 0.74622 = 746,215 Total 1,000,000 The investor in the bond is willing to pay Shs. 1m., being the present value of the stream of payments and face value of the bond. Since the debt has been issued at the market rate of 10%, periodic interest expense equals periodic cash payments. The liability remains at Shs. 1m throughout the life of the bond. (b) Issue at premium = when the market rate (8%) is less than the coupon rate (10%) (a) (b) (c) (d) (e) (f) =4% X (a) FC X CR =(b) - (c) =(a) + (d) FV Period Ending Year 1, 30th Jun. Year 1, 30th Dec. Year 2, 30th Jun. Year 2, 30th Dec. Year 3, 30th Jun. Year 3, 30th Dec. Liability (Opening) 1,052,421 1,044,518 1,036,299 1,027,751 1,018,861 1,009,615 Interest Expense 42,097 41,781 41,452 41,110 40,754 40,385 247,579 Coupon Payment 50,000 50,000 50,000 50,000 50,000 50,000 300,000 Change in Liability (7,903) (8,219) (8,548) (8,890) (9,246) (9,615) (52,421)

(g) FV

Liability Face Value of Closing (Closing) the Bond Premium 1,052,421 1,000,000 52,421 1,044,518 1,000,000 44,518 1,036,299 1,000,000 36,299 1,027,751 1,000,000 27,751 1,018,861 1,000,000 18,861 1,009,615 1,000,000 9,615 1,000,000 1,000,000 0

PVA of Shs 50,000 for 6 periods, discounted at 4% 50,000 X 5.24214 = 262,107 PV of Shs 1,000,000 for 6 periods, discounted at 4% 1,000,000 X 0.79031 = 790,315 Total 1,052,421 The investor is willing to pay Shs. 1,052,421 for the bond. After the first six months, the bondholder earns Shs. 42,097 (4% of Shs. 1,052,421) but receives Shs. 50,000 (coupon rate times the face value). This Shs. 50,000 is made up of interest expense of Shs. 42,097 and principal repayment of Shs. 7,903, reducing the liability to Shs. 1,044,518. At the time of maturity the bond value will have reduced to Shs. 1,000,000. The process whereby the bond premium or discount is amortized over the life of the bond is known as the effective interest method.

(c) Issue at a discount = when the market rate (12%) if greater than the coupon rate (10%) (a) (b) (c) (d) (e) (f) =6% X (a) FC X CR =(b) - (c) =(a) + (d) FV Period Ending Year 1, 30th Jun. Year 1, 30th Dec. Year 2, 30th Jun. Year 2, 30th Dec. Year 3, 30th Jun. Year 3, 30th Dec. Liability (Opening) 950,827 957,876 965,349 973,270 981,666 990,566 Interest Expense Coupon Payment Change in Liability 7,050 7,473 7,921 8,396 8,900 9,434 49,173

(g) FV

57,050 50,000 57,473 50,000 57,921 50,000 58,396 50,000 58,900 50,000 59,434 50,000 349,173 300,000

Liability Face Value of Closing (Closing) the Bond Discount 950,827 1,000,000 (49,173) 957,876 1,000,000 (42,124) 965,349 1,000,000 (34,651) 973,270 1,000,000 (26,730) 981,666 1,000,000 (18,334) 990,566 1,000,000 (9,434) 1,000,000 1,000,000 -

PVA of Shs 50,000 for 6 periods, discounted at 6% 50,000 X 4.91732 = 245,866 PV of Shs 1,000,000 for 6 periods, discounted at 6% 1,000,000 X 0.70496 = 704,961 Total 950,827 When the market rate exceeds the coupon rate, the bondholder is unwilling to pay the full face value of the bond. The bondholder can purchase a 12% bond and receive periodic payments of Shs. 60,000. The periodic payments form this bond are Shs. 50,000. Thus an investor will only purchase this bond at a discount. At a 12% market rate, this bond will be issued at a discount of Shs. 49,173, and the proceeds and initial liability will be Shs. 950,827. Interest expense for the first six month will be Shs. 57,050, but cash interest paid will only be Shs. 50,000. The shortfall is added to the balance sheet liability. This continues until the bond matures. At that point the initial principle of Shs. 950,827 plus the accumulated unpaid interest of Shs. 49,173 equals the face value payment that retires the debt. (d) Effects on the Income Statement, Balance Sheet and Cash Flows (If interest is classified under CFO) Income Statement Balance Sheet Cash Flows (Interest Expense) (Bond / Long-Term Debt) (For ALL Cases) Par Premium Discount Par Premium Discount CFO CFF Year 1 100,000 83,878 114,522 1,000,000 1,036,299 965,349 100,000 Year 2 100,000 82,562 116,317 1,000,000 1,018,861 981,666 100,000 Year 3 100,000 81,139 118,334 1,000,000 1,000,000 1,000,000 100,000 1,000,000 300,000 247,579 349,173 For bonds issued at a premium, interest expense decreases over time. For bonds issued at a discount, interest expense increases over time. The increases/decreases are a direct function of the increasing/decreasing balance sheet liability At any point in time, the balance sheet liability is equal to the PV of the remaining payments discounted at the effective interest rate at issuance Cash flow classifications of debt payments depend on the coupon rates, not the effective interest rate. When these differ CFO is misstated. Not that amortization of premium or discount is non-cash flow and is included in the income statement. Analytical Reclassifications (If interest is classified under CFO) (i) Reclassification Based on Interest Expense Cash Flows - IFRS (For ALL Cases) CFO CFF 100,000 100,000 100,000 1,000,000 300,000 1,000,000 Premium Bond CFO CFF 83,878 16,122 82,562 17,438 81,139 1,018,861 247,579 1,052,421 Discount Bond CFO CFF 114,522 (14,522) 116,317 (16,317) 1,118,334 (18,334) 1,349,173 (49,173) (ii) Functional Reclassification for ALL Bonds CFO CFF 100,000 100,000 100,000 0 300,000

Year 1 Year 2 Year 3

Zero-Coupon Debt A zero-coupon bond has no periodic payments (coupon rate = 0). For that reason, it must be issued at a deep discount to face value. The lump sum payment at maturity includes all unpaid interest (equal to face value less the proceeds) The proceeds at issuance equal to the PV of the face amount, discounted at the market interest rate. 5

Using the class example; (a) Liability (Opening) 746,215 783,526 822,702 863,838 907,029 952,381 (b) (c) =5% X (a) FC X CR Interest Expense Coupon Payment (d) =(b) - (c) Change in Liability (e) =(a) + (d) (f) FV (g) FV Closing Discount (253,785) (216,474) (177,298) (136,162) (92,971) (47,619) 0

Period Ending Year 1, 30th Jun. Year 1, 30th Dec. Year 2, 30th Jun. Year 2, 30th Dec. Year 3, 30th Jun. Year 3, 30th Dec.

37,311 0 37,311 39,176 0 39,176 41,135 0 41,135 43,192 0 43,192 45,351 0 45,351 47,619 0 47,619 253,785 0 253,785 The interest on the zero-coupon bond never reduces operating cash flows. This has significant analytic consequences. Reported CFO is systematically overstated when zero-coupon (or deep discount) bond is issued. Moreover, solvency ratios, such as cash-basis interest coverage, are improved relative to issuance of bonds at par. It should also be notable that cash required to repay the obligation may become a significant burden (interest expense increases cash flow by generating income tax deductions).

Liability Face Value of (Closing) the Bond 746,215 1,000,000 783,526 1,000,000 822,702 1,000,000 863,838 1,000,000 907,029 1,000,000 952,381 1,000,000 1,000,000 1,000,000

Effects of Changes in Interest Rates Debt reported on the balance sheet is equal to the present value of future cash payments discounted at the market rate on the date of issuance. Changes in the current market rates affect the market value of the debt. Increases in the rate decrease the market value of the debt. For financial analysis the market value of the debt may be more relevant than its book value. An analysis of a firms relative debt and borrowing capacity are based on market conditions. Variable-Rate Debt Some debt issues do not have a fixed coupon payment. The periodic interest payment varies with the level of interest rates. Such debt instruments are generally designed to trade at their face value. Fixed- Versus Variable-Rate debt and Interest and Rate Swaps Borrowers can issue either fixed-rate or variable-rate debt directly. Alternatively, they can enter into interest rate swap agreements that convert fixed-rate obligation to floating-rate or vice versa. Reasons To match variability of its earnings When management beliefs that interest will fall Swaps are contractual obligations that supplement existing debt agreements. Each firm remain liable for its original debt, makes all payments on the debt, and carries that debt on its books. Estimating Market Value of Debt Readily available for traded debt, else: Publicly traded debt of a company having same maturity, using the market rate to discount the debt Publicly traded debt of equivalent companies in the same industry Estimate of risk premium over government debt/bonds of the same maturity Retirement of Debt Prior to Maturity When firma retire debt prior to maturity, the difference between the book value of the liability and the amount paid at the retirement of that debt is treated as an extraordinary gain or loss in the income statement. Bond Covenants Nature Creditors use debt covenants to protect their interests by restricting activities of the borrower that could jeopardize the creditors position. Auditors and management must certify that the firm has not violated the debt covenants. An analyst must take into account the nature of debt covenants and the risk that the firm may violate them. Given that most of the covenants are accounting-based, they may affect managements choice of accounting policies. Debt covenants commonly place limits on one or more of the following: (a) Activities: Payment of dividends including repurchases Production and investment (mergers, acquisitions, leasebacks, and outright disposal of assets) Issuance of new debt and/or incurrence of new liabilities Payoff patterns (including establishment of sinking funds) (b) Attribute: Accounting-Based: Measured As: Limits 6

Retained Earnings Net Assets Working Capital Debt-to-Equity

Restricted retained earnings Net tangible assets or net assets Minimum working capital or current ratio Debt-to-equity ratio

Payment of dividends or stock repurchases below minimum level of restricted retained earnings Investments, dividend payments, and new debt issues if net assets fall a certain level Mergers and acquisitions, dividend payments, and new debt issues if working capital or the current ratio fall below a certain level Issuance of additional debt

Costs and effects of constraint violations Although creditors have a right to demand immediate payment when an accounting based debt covenant is violated, they rarely do so. Creditors ma renegotiate the terms of the debt to demand: Accelerated principle repayments An increase in interest rate Liens on assets (such as debtors) New covenants increasing restrictions on the firms investing, borrowing and dividend paying ability Presentation and Disclosure of Current Liabilities Disclose separately: bank loans, trade creditors and accrued liabilities, taxes, dividends, deferred revenue, future income taxes, amounts owing to related parties Identify secured liabilities and related assets pledged Analysis of Current Liabilities Ref Liquidity ratios

LEASES (IAS 17 LEASES) Definition A lease is an agreement in which the lessor (owner of the property) conveys the right to use property, plant, or equipment, for a stated period of time, to the lessee (user of the property). Motivation operating lease (a) Avoid recognition of the asset and liability from the balance sheet (the benefit does not accrue in case of a finance lease) (b) Report lower leverage by not recognizing the liability operating lease (c) Lessors prefer to report all leases as capital and therefore recognize a sale (installment sale) (d) Off-Balance-Sheet Financing - Higher profitability ratios and indicators of operating efficiency Motivation finance lease (a) Up to100% Financing at Fixed Rates - No down payment required / Rate charged is fixed for the term of the lease (b) Protection against obsolescence - Property can be upgraded (c) Flexibility - Lease may be structured to meet different needs (e.g., cash flow) (d) Less costly financing (e) Tax Advantages Classification From both the lessor and lessee points of view, a lease may be classified as EITHER:

(a)
OR,

Operating or short-term leases allow the lessee to use the asset for only a portion of its economic life. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership.

(b)

Finance or Capital leases effectively transfer, or substantially all the risks and rewards of leased property to the lessee. All leases other than finance leases are classified as operating leases. No mathematical thresholds are used to determine whether a lease should be classified as a finance or as an operating lease. An overall analysis of the transaction needs to be performed, at inception of the contract, to determine whether it is an operating or finance lease. Classification is made at the inception of the lease. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Lease classification is not intended to be alternatives. However, management actively negotiates the provisions of lease agreements and the preferred accounting treatment is an important element of contractual negotiations. When a lease include both land and buildings elements, an entity assesses the classification of each element as a finance or an operating lease separately. In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life. Use judgment to evaluate individual circumstances and conditions Whenever necessary in order to classify and account for a lease of land and buildings, the minimum lease payments (including any lump-sum upfront payments) are allocated between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception of the lease. Special issues when land and building are leased together and title is not transferred: Land lease cannot be a finance lease; building lease can be If value of leased interest in land is immaterial, treat as building If material, allocate payments between land and building based on relative values of leased interests in each Situations (individually or in combination) that would normally lead to a lease being classified as a finance lease include the following:

Risks and rewards of ownership - The lease transfers ownership (risks and rewards) of the asset to the lessee by the end of the lease term. Risks include; losses from idle capacity, technological obsolescence, changes in value due to changing economic conditions, etc. Rewards include; expectation of service potential or profitable operation over the assets economic life, gain from appreciation in value, realisation of a residual value, etc. Title transfer / rights and obligations at end of lease / BPO - The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised. (Bargain Price Option - A BPO gives the lessee the option to purchase the leased asset at a price sufficiently less than the expected fair value of the asset that the exercise of the option appears reasonably assured.) Renewal options - The lease term is for the major part of the economic life of the asset, even if title is not transferred (The lease term is normally considered to be the non-cancelable term of the lease plus any periods covered by bargain renewal options.) 8

Recovery of investment - At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset Asset nature -The lease assets are of a specialized nature such that only the lessee can use them without major modifications being made

Other indications that it is a finance lease include:

If the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments) The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent

Accounting by Lessees The following principles should be applied in the financial statements of lessees: (a) Finance Lease:

A capital lease is treated as the purchase of an asset the lessee records both an asset and liability at inception of the lease. At commencement of the lease term, finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the entity's incremental borrowing rate). Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability (the finance charge to be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability). The depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease - the asset should be depreciated over the shorter of the lease term or the life of the asset. Executory costs include cost of ownership like maintenance, insurance, taxes, and other costs. If the lease agreement makes the lessee responsible for the executory costs, the lessee treats them as expenses. In some cases, the lessor pay executory costs, and the lessee will reimburse the lessor through higher periodic lease payments. These costs are excluded in determining the minimum lease payment.

(b) Operating Lease For operating leases, the lease payments should be recognized as an expense in the income statement over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user's benefit. Therefore we simply record the rent payments.

Advance payments are considered prepayments of rent. They are deferred and allocated to rent over the lease term. Leasehold improvements - Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. If a lessee constructs a new building on or makes modifications to existing structures, that cost represents an asset just like any other capital expenditure. Like other assets, its cost is allocated as depreciation expense over its useful life to the lessee, which will be the shorter of the physical life of the asset or the lease term.

In Summary: Finance Lease Balance Sheet Asset Lease Obligation Accumulated Depreciation Reduction in Lease Obligation N/A Economic Outturn Account Finance Charge Depreciation Expense

Operating Lease

Rental Expense

Sale and Leaseback Transactions Entity owns asset Sells it and leases it back Decision by seller-lessee: finance lease or operating lease? Sale and leaseback are interdependent transactions For a sale and leaseback transaction that results in a finance lease, any excess of proceeds over the carrying amount is deferred and amortized over the lease term. Leaseback is an operating lease 9

Sale made at FV - recognize gain or loss in current income Sale < FV and lease payments are at FV recognize loss in current income Sale < FV and lease payments are lower to compensate defer loss & amortize on same basis as lease payments Sale > FV excess over FV is deferred and amortized over period of expected use If FV < carrying amount, impairment; recognize loss currently

Financial Reporting by Lessees: Capital Versus Operating Leases Example; Non-cancelable lease beginning 1 January 2010, with annual MLPs of Shs. 10,000 made at the end of each year for four years. Discount rate of 10% Operating lease: No entry is made at the inception of the lease Over the life of the lease, only the lease payments (expense) of Shs. 10,000 will be charged to income and CFO. Finance Lease: At the inception of the lease, an asset (lease asset) and liability (leased liability) equal to the present value of lease payments, Shs. 31,699 is recognized. Over the life of the lease: o The annual lease payment of Shs. 10,000 will be allocated between interest and principle payments on the Shs. 31,699 leased liability. (Lease amortization schedule) Closing Liability Year 0 31,699 Year 1 31,699 3,170 6,830 24,869 Year 2 24,869 2,487 7,513 17,355 Year 3 17,355 1,736 8,264 9,091 Year 4 9,091 909 9,091 0 The Cost of the leasehold asset of Shs 31,699 is depreciated using a policy consistent with other company assets or if there is no certainty that the asset will be acquired at the expiry of the lease, on straight-line method over the lease term. Interest Principle Opening Liability

Comparative Analysis of Capitalized and Operating Leases Balance Sheet / Income Statement Lease transactions impact several financial ratios: Debt to equity ratio Lease liabilities are recorded Rate of return on assets Lease assets are recorded Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet. Statement of Cash Flows Sales-type leases The lessor recognizes the interest revenue in the operating activities section of the statement and the principal reduction in the investing section. In addition, the lessor has sales revenue and cost of goods sold recognized in the operating activities section. Year 0 Assets Lease Asset Accumulated Depreciation Liabilities Current portion of lease obligation Long-term portion of lease obligation 31,699 0 31,699 6,830 24,869 31,699 Year 1 31,699 7,925 23,774 7,513 17,355 24,869 Year 2 31,699 15,850 15,849 8,264 9,091 17,355 Year 3 31,699 23,775 7,924 9,091 0 9,091 Year 4 31,699 31,699 0 0 0 0

Financial ratios Lease capitalization increases asset balances resulting in lower assets turnover and return on assets Income statement capitalization results in higher operating income (EBIT) Operating Lease Operating = Total Expense 10,000 10,000 Operating Expense 3,170 2,487 Finance Lease Non -Operating Expense 7,925 7,925 10 Total Expense 11,095 10,412

Year 1 Year 2

Year 3 Year 4

10,000 10,000

1,736 909

7,925 7,925

9,660 8,834

Disclosure: Lessees - Finance and Operating Leases Separately for finance and operating leases, disclosure is required for: Carrying amount of asset Reconciliation between total minimum lease payments and their present value Amounts of minimum lease payments at balance sheet date and the present value thereof, for: o The next year o Years 2 through 5 combined o Beyond 5 years Contingent rent recognized as an expense Total future minimum sublease income under non-cancelable subleases General description of significant leasing arrangements, including contingent rent provisions, renewal or purchase options, and restrictions imposed on dividends, borrowings, or further leasing NON-FINANCIAL LIABILITIES Decommissioning and restoration obligations (asset retirement obligation, ARO or site restoration obligation) - Obligation associated with retirement of a long-lived asset must be recognized when incurred. Existing legal obligations include those related to dismantling, restoring, and reclamation of oil and gas properties, certain closure, reclamation, and removal costs of mining facilities, closure and postclosure costs of landfills, decommissioning nuclear facilities, etc Initial measurement at is at best estimate of the expenditure required to settle the present obligation at balance sheet date. Future costs are discounted (i.e. present value). Capitalized costs are not recorded in separate account but are added to the carrying amount of the underlying asset and amortized over underlying assets useful life.

Product goods or liability o o

guarantees and customer programs - Continuing obligation results when an entity provides customer programs requiring that services be provided after the initial product or service is delivered. There are two approaches to accounting for the outstanding Expense approach - Liability is measured at cost of meeting the obligation, and expense is matched against period revenues (current) Revenue approach - Liability is measured at value of the service to be provided (not cost) and recognized in revenue as earned (future)

Warranty obligations Warranty (product guarantee) is a promise made by a seller to correct problems experienced with a products quantity, quality, or performance. These are stand-ready obligations at reporting date that result in future post-sale costs o Use of Cash Basis - Acceptable for accounting purposes when warranty costs are immaterial, or warranty period is relatively short. Warranty costs charged to the period in which the costs are paid. No estimated liability recorded or reported. o Warranty Sold Separately - Applies to extended product warranties; or warranties sold as separate product (or having stand-alone value). Accounted for using revenue approach whereby revenue from warranty sale deferred and recognized over life of the warranty generally using straight-line method Customer loyalty programs - Many companies offer customer loyalty programs (such as supermarket points, frequent flyer miles, discounts, etc). Revenues from original sales that give rise to loyalty points (or other award credits) should be allocated. Fair value of award credits should be deferred as unearned revenue and recognized when exchanged for promised rewards. Premiums and rebates - Premiums, coupons, contests, and other benefits have generally been accounted for under the expense approach. In the future, standards may focus on measuring such obligations at their value (not estimated cost). Contingencies and uncertain commitments - A contingency is an existing condition or situation involving uncertainty as to possible gain or loss that will ultimately be resolved when one or more future events occur or fail to occur. Loss contingencies involve situations of possible loss at the balance sheet date. A liability incurred as a result of a loss contingency is a contingent liability. Estimated losses from loss contingencies are accrued as liabilities (called provisions) if the occurrence of the confirming future event is probable (less strict than likely), and amounts are reliably measurable. Measurement of liability is made using the expected value method (takes into account probabilities of possible outcomes). Term contingent liabilities is used only for possible obligations that are not recognized. Disclosure required unless likelihood is remote Litigation, claims, and assessments - To determine whether a liability should be recorded, evaluate the time period in which the underlying cause of action occurred, the probability of an unfavorable outcome, the ability to make a reasonable estimate of loss. To evaluate the likelihood of an unfavorable outcome, consider nature of litigation and progress of case, opinion of legal counsel, experience in similar cases, company response to the lawsuit Financial guarantees (example: standby letter of credit guaranteeing anothers payment of a loan) - recognize guarantee at fair value. Key focus is to give users information about risks assumed by being a guarantor

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Commitments - Executory contracts are agreements where neither party has yet performed. These commitments are not considered liabilities as at balance sheet date, but they do represent a contractual obligation of future funds. Disclosure is required for abnormal commitments or ones that carry significant risks Unearned revenues - When cash is received before the product is delivered or service is rendered. Examples include gift certificates, prepayment for subscription

OFF-BALANCE SHEET FINANCING ACTIVITIES Many economic transactions and events are not recognized in the financial statements because they do not qualify as accounting assets or transactions under IFRS. But these unreported assets and liabilities have real cash flow consequences. They are used as a financing, liquidity or risk-sharing technique. They are the means through which companies typically incur risks of loss that may not fully transparent to investors. The impact of off-balance sheet financing activities is the reduction of assets and liabilities. This boosts leverage (debt/equity), profitability (ROA), and activity (sales/assets) ratios.

Operating lease Classifying a lease as an operating lease provides a company with the opportunity to utilize the leased asset and assume a contractual obligation to pay the lessor during a specific period of time without having to report the asset and the liability. Take-or-pay (TOP) Firms use take-or-pay contracts to ensure the long-term availability of raw materials and other inputs necessary for operations. Under these arrangements, the purchasing firm commits to buy a minimum quantity of an input for a specified period. Input prices may be fixed or determinable from market. These contracts are often used as collateral for financing the supplier. TOP arrangements are common in oil and gas, pulp and paper, metals, minerals. Buyer effectively receives the use of a productive asset without reporting it on its balance sheet. Disclosure rules require firms to report the minimum future payments. To reflect economic reality of TOP contracts an analyst should add the PV of the minimum payments to both the assets and liabilities. This increases leverage and reduces asset turnover. Throughput arrangements - Natural-gas companies use throughput arrangements with pipelines or processors to ensure distribution or processing. The effects are the same as take-or-pay contracts. Sale of receivables securitization of debts can be used to raise capital or in borrowing. That is a firm sells its debtors to a buyer (normally a financial institution). The seller uses the proceeds from the sale for operations or to reduce existing debt. Most sales of receivables provide the buyer with a limited recourse to the seller. However, the recourse provision is generally well above the expected loss ratio on the receivables (allowance for doubtful accounts). The potential liability associated with the buyer-recourse provision is not displayed on the balance sheet. Sale of receivables no-recourse basis - Truly removed from balance sheet. Sale of receivables limited recourse basis - Firms recorded them by reducing accounts receivables and increasing CFO. The seller is exposed to the collecting risk and so economically they are just collateralized loans. To reflect economic reality of sale of receivables limited recourse basis, an analyst should; add back sold receivables to receivables and create a current liability equal to the proceeds of sale; subtract sold receivables from CFO and CFF; and increase revenues and interest expense by effective interest paid on the transaction. These adjustments reduce the current ratio, increase the leverage and reduce the interest coverage.

Finance subsidiaries Financial obligations of unconsolidated subsidiaries (because they are not wholly owned by the parent) may also be off-balance sheet. These involve use of legally separate but wholly owned finance subsidiaries to borrow funds to finance the parent company. Finance subsidiaries enable the parent company to generate sales by granting credit to dealers and customers for the purchase of its goods or services. Firms often manipulate accounts by shifting their assets and liabilities out to subsidiaries. Some types of off-balance-sheet accounting move debt to a newly created company specifically for that purpose. These are called special purpose entities (SPEs). Analyst should add back proportionate share of the asset or liability for debt-to-equity ratio, receivable turnover, interest coverage ratio.

Joint ventures and investment affiliates facilitate sharing of economies of scale, technological and operating risks. Enables firms to also share production and distribution capacities. These may create obligations for parent firms if any direct or indirect guarantees are given to secure financing. Analyst should add guaranteed debt or proportionate non-guaranteed share of debt Consignment inventory - Consignment inventory is an arrangement where inventory is held by one party (says a distributor) but is owned by another party (for example a manufacturer or a finance company). Sale and repurchase agreements - These are arrangements under which the company sells an asset to another person on terms that allow the company to repurchase the asset in certain circumstances. If the seller has the right to the benefits of the use of the asset, and the purchase terms are such that the purchase is likely to take place, the transaction should be accounted for as a loan. Sale and leaseback transaction - involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually negotiated as a package. The accounting treatment depends on the types of lease involved. If it is a financial lease, then it is in substance a loan from the lessor to the lessee. If it is operating lease and the transaction has been conducted at fair value, then it can be regarded as normal sale transaction. Other Off-Balance Sheet Activities other executory contracts, employment agreements, consulting agreements, licenses, royalty contracts, guarantees under customer contracts, and employee pension plan and postretirement benefit arrangements 12

Accounting for Long Term Liabilities IFRS versus GAAP Listed below are some of the major differences between International Financial Reporting Standards (IFRS) and U.S. GAAP in accounting for longterm liabilities. This material is excerpted from Wiley IFRS 2010: Interpretation and Application of International Financial Reporting Standards. U.S. GAAP: Long Term Liabilities Convertible debt classified as liability Entities should reassess at the end of each reporting period whether an embedded derivative should be separated Non-current presentation of defaulted debt if waiver granted before statement issuance date IFRS: Long Term Liabilities Convertible debt assigned to both debt and equity based on relative fair values Entities should reassess at the end of each reporting period whether an embedded derivative should be separated only if there is a change in the terms that significantly modifies the cash flows Non-current presentation of defaulted debt if waiver granted before balance sheet date only

Equity-like instruments giving holder right to demand cash settlement, or Similar to U.S. GAAP with defined cash settlement terms, must be classed as liabilities Joint project with IASB to address instruments with attributes of both liabilities and equity is ongoing. Accounting for Leases IFRS versus GAAP Listed below are some of the major differences between International Financial Reporting Standards (IFRS) and U.S. GAAP in accounting for leases. This material is excerpted from Wiley IFRS 2010: Interpretation and Application of International Financial Reporting Standards. U.S. GAAP: Accounting for Leases Capital lease accounting is required if one of four defined conditions are met; otherwise, operating lease No additional factors that parallel those under IFRS for determination of financing (capital) treatment by lessor IFRS: Accounting for Leases Similar to U.S. GAAP; finance lease treatment if risks and rewards are transferred to lessee; also if property is special purpose for lessee use If lessee to bear lessors loss upon lease cancellation, or lessee will shoulder gain or loss from change in residual value of leased asset, or lessee has bargain renewal right, then lease may be deemed financing transaction for lessor Joint project with FASB to address instruments with attributes of both liabilities and equity is ongoing.

Third-party guarantees cannot be included in minimum lease payments to Third-party guarantees must be included in minimum lease payments to determine whether capital lease criteria are met determine whether capital lease criteria are met Lessors must use implicit rate and lessees generally would use incremental borrowing rate to calculate the present value of minimum lease payments More guidance provided on specialized topics; deferral of profit on saleleasebacks is required Separate accounting for land and building in combined lease depends on terms and materiality of land Output contracts are leases Leasehold interest in land accounted for as prepayment Present value of lease payments computed using implicit rate (if unknown, incremental rate can be used) Only general guidance; profit recognition on sale-leasebacks permitted if fair value priced Separation of land and building components of lease is mandatory under recent provisions Output contracts are not leases Leasehold interest in land can be accounted for as investment property, valued at fair value with changes in current earnings; or else as prepayment Gain on sale/leaseback amortized over term of financing lease, but recognized at once if operating leaseback

Gain on sale/leaseback not recognized in current earnings, but deferred and amortized, unless seller retains use of much of asset, in which case gain is recognized (immediate recognition of loss also commonly required) Lease obligations disclosures more extensive than under IFRS

Lease obligations disclosures less than under U.S. GAAP

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