Financial Reporting & Analysis

Long Term Liabilities And

Leases
Reading - 32

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Bonds Payable
A Bond is a contract between a borrower and a lender that
obligates the borrower to make payments to the lender over the
term of the bond.
Payments are of two types:
Interest Payments
Principal Repayments
Par Value or Face Value Amount that the borrower has to pay
back at the maturity of the bond. It does not necessarily equal the
amount that the issuer receives upon issuing the debt
Coupon Rat or stated Rate Is multiplied by the par value of the
bond to compute the periodic coupon payment
Market interest Rate Rates to value the bond. These rates
incorporate various types of risks inherent in the bond.

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Market Interest Rates
To value a companys debt obligations at a particular point in time,
we discount the remaining payments at current market interest
rates.
For accounting purposes, the book value of the liability recognized
on a firms balance sheet upon debt issuance equals the present
value of its obligations discounted at market interest rates at
issuance
Market interest rates at issuance determine how much the
company receives in bond proceeds.
If market interest rates equal the bonds coupon rate, the bond will be
issued at par
If the market interest rate is greater than the coupon rate , the bond
will be issued at a discount
If the market interest rate is lower than the coupon rate the bond will
be issued at a premium

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Interest Expense versus Coupon Payments
Interest Expense for a given period is calculated as the book
value of the liability at the beginning of the period multiplied
by market rates at issuance. Interest expense is charged every
year on the income statement
Coupon payments are calculated as the coupon rate times the
par value of the bonds. Coupon payments are classified as
outflows from operating activities on the cash flow statement

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Effects of Issuing a Par Bond on Financial Statements
Balance Sheet Impact Year end value of the liability is listed
on the balance sheet . For bonds issued at par, the liability
balance remains at par throughout the life of the bond.
Income Statement Impact Interest expense is deducted from
operating profits. For bonds issued at par, interest expense
equals the coupon payment, and is constant over the life of
the bond
Cash Flow statement Impact
At issuance the bond proceeds are reported as inflows
from financing activities
During the term of the bond coupon payments ( not
interest expense) are deducted from CFO
At maturity cash used to repay the principal amount (par
value) is deducted from CFF.

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Effects of Issuing a Par Bond on Financial Statements

Question
ABC Company issues a 5 year $1000 par value bond with an annual coupon of 10% at
$1000. The effective market interest rate is 10%.
Solution
Years = 5
Coupon Rate = 10%
Effective
Market Rate = 10%
Par Value = 1,000
Beginning Liability Interest Coupon Interest Ending Liability
Years
on Balance Sheet Expense Paid Amortized on Balance Sheet
1 1,000 100 100 0 1,000
2 1,000 100 100 0 1,000
3 1,000 100 100 0 1,000
4 1,000 100 100 0 1,000
5 1,000 100 100 0 1,000

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Effects of Issuing a Discount Bond on Financial
Statements
Balance Sheet Impact The liability increases over the life of
the bond as the discount is amortized over the term of the
bond. The value of the liability at bond maturity equals par.
Income Statement Impact Interest expense rises each year
in line with the increasing balance of the liability
Cash Flow statement Impact
Inflows recorded at issuance under CFF are lower than outflows
at maturity from CFF. Coupon payments are deducted from CFO
every year.

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Effects of Issuing a Discount Bond on Financial Statements

Question
ABC Company issues a 5 year $1000 par value bond with an annual coupon of 8% at
$924.18. The effective market interest rate is 10%.
Solution
Years = 5
Coupon Rate = 8%
Effective
Market Rate = 10%
Par Value = 1,000
Beginning Liability Interest Coupon Interest Ending Liability
Years
on Balance Sheet Expense Paid Amortized on Balance Sheet
1 924.18 92.42 80.00 12.42 936.60
2 936.60 93.66 80.00 13.66 950.26
3 950.26 95.03 80.00 15.03 965.29
4 965.29 96.53 80.00 16.53 981.82
5 981.82 98.18 80.00 18.18 1,000.00

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Effects of Issuing a Zero Coupon Bond on Financial Statements

Question
ABC Company issues a 5 year $1000 par value zero coupon bond at $620.92. The effective
market interest rate is 10%.
Solution
Years = 5
Coupon Rate = 0%
Effective
Market Rate = 10%
Par Value = 1,000
Beginning Liability Interest Coupon Interest Ending Liability
Years
on Balance Sheet Expense Paid Amortized on Balance Sheet
1 620.92 62.09 0.00 62.09 683.01
2 683.01 68.30 0.00 68.30 751.31
3 751.31 75.13 0.00 75.13 826.45
4 826.45 82.64 0.00 82.64 909.09
5 909.09 90.91 0.00 90.91 1,000.00

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Effects of Issuing a Premium Bond on Financial
Statements
Balance Sheet Impact The liability decreases over the life of
the bond as the premium is amortized over the term of the
bond. The value of the liability at maturity equals par.
Income Statement Impact Interest expense declines every
year in line with decreasing balance of the liability.
Cash Flow statement Impact
Inflows recorded at issuance under CFF are greater than the
outflows at maturity from CFF . Coupon payments are deducted
from CFO every year.

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Effects of Issuing a Premium Bond on Financial
Statements
Question
ABC Company issues a 5 year $1000 par value bond with an annual coupon of 12% at
$1075.82. The effective market interest rate is 10%.
Solution
Years = 5
Coupon Rate = 12%
Effective
Market Rate = 10%
Par Value = 1,000
Beginning Liability Interest Coupon Interest Ending Liability
Years
on Balance Sheet Expense Paid Amortized on Balance Sheet
1 1,075.82 107.58 120.00 -12.42 1,063.40
2 1,063.40 106.34 120.00 -13.66 1,049.74
3 1,049.74 104.97 120.00 -15.03 1,034.71
4 1,034.71 103.47 120.00 -16.53 1,018.18
5 1,018.18 101.82 120.00 -18.18 1,000.00

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Debt Extinguishment
If a company decides to redeem bonds before maturity, a gain
or loss on extinguishment is computed by subtracting the
amount paid to retire the bonds from the book value of the
liability.

Balance Sheet Carrying Value XXX

Cash Paid (Repurchase) (YYY)
Gain / (Loss) ZZZ
Unamortized issuance Costs (X)
Gain / (Loss) on repurchase Z

If repurchase amount > Carryng Value = Loss is reported

If repurchase amount < Carryng Value = Gain is reported

The details about an extinguishment of debt is

provided in the Management Discussion and Analysis
section or in footnotes of the financial reports
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Covenants
Borrowing agreements often include restrictions called covenants
that protect creditors by restricting a companys ability to invest,
pay dividends or make other operating and strategic decisions that
might adversely affect the companys ability to pay interest and
principal
Common Covenants include:
Limitations on how borrowed money can be used
Maintenance of collateral pledged as security
Restrictions on future borrowings
Requirements that limit dividends
Requirements to meet specific working capital needs
Accounting based covenant include:
Maintenance of liquidity and solvency ratios
Maintenance of Debt to equity , current and interest coverage ratios
above or below a predefined limit
Covenants are disclosed in footnotes

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Disclosure of Long Term Debt
Debt is disclosed in the long term liabilities by a single line
item as Borrowings and in the current liabilities as current
portion of long term debt.
Detailed breakup of the debt is available in the footnotes
section
Details provided are:
Maturity dates
Stated and effective interest rates
Call provisions and conversion privileges
Restrictions imposed by creditors
Assets pledged as security
Debt repayment schedule the amount of debt maturing in
each of the next five years.

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Book Value versus Market Value
Book Value of debt is based on the market interest rate at the
time of issuance of debt
As market rates fluctuate over time the actual value of the
firms debt deviates from its reported book value
Changes in the interest rates do not affect balance sheet or
income statement
E.g If interest rates rise the current value of debt falls. The
reported book value f the debt is higher than true economic
value of the firms obligations. Using book value overstates
leverage levels as the firm is actually better off than its
financial statements indicate

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Convertible Bonds
These are bonds that can be converted into common shares
of the issuing company, usually at a pre-specified ratio.
They typically have low coupon rates and the investor is
compensated for these low rates by giving an option to
convert the bonds into ordinary shares of the company,
usually at a discount to the market price.
US GAAP
Security treated as liability
Entire proceeds classified as equity on conversion
IFRS
The fair value of bond is reported as liability
The difference e between the issue proceeds and the fair value
of the liability is reported separately as equity on the balance
sheet
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Convertible Debt
Example
ABC Company has 17.5 million of long term debt on its books
and an equity of 5.5 million. Details of the debt are shown as
below. Conversion Price
(Per Share) 2010 2009
10% Senior Note due 2011 N/A 10,000,000 10,000,000
5% Convertible Notes due 2012 6 4,500,000 4,500,000
6.5% Convertible Notes due 2015 12 3,000,000 3,000,000
Total Long Term Debt 17,500,000 17,500,000

Estimate the additional number of shares that would be issued

if all the convertible bonds are converted to common stock
What will be the equity and debt values for full conversion in
2010
Estimate Debt to equity ratio in 2010 for full conversion
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Convertible Debt
Solution

Conversion Convertible Additional Shares

Price Debt if converted
5% Convertible Notes due 2012 6 4,500,000 750,000
6.5% Convertible Notes due 2015 12 3,000,000 250,000
Total Convertible Debt 7,500,000 1,000,000

Adjusted for
Current
full conversion
Shareholders' Equity 5,500,000 13,000,000
Long Term Debt 17,500,000 10,000,000
D/E Ratio 3.18 0.77

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Bonds with Warrants
A warrant is a security that gives the holder the right to buy
stock of the issuing company at a specified price, at a
specified date in the future.
It is very similar to a call option. Warrants are frequently
attached to bonds as sweeteners allowing the issuer to pay
lower interest, while giving the holders the option to
participate in any future appreciation of the companys stock
Bonds issued with warrants
Bond fair value is classified as a liability
Difference between issue proceeds and fair value of debt to be
classified as warrants and reported under equity

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Leases
A lease is a contract between he owner (Lessor) and another party
that wants to use the asset (Lessee).
The lessee gains the right to use the asset for a period of time in
return for a periodic lease payment
Leasing an asset holds the following advantages over owing it:
Leases often have fixed interest rates
No down payment is required
At the end the asset can be returned to the lessor, thus lessee escapes
from the risk of obsolescence
Operating leases do not require recognition of asset or liabilities on
the balance sheet, so improved performance is seen in ratios
In US synthetic leases can be structured where company gets tax
benefit without reflecting the assets in its financial statements

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Types of Leases
Operating Lease
Agreement allowing the lessee to use some asset for a period of time
It acts like a rental
Do not require recognition of asset or liabilities on the balance sheet
Financing Lease
Purchase of some asset by the buyer (lessee) that is directly financed
by the seller (lessor)
US accounting standards to define a financing lease should comply
with one of the requirements mentioned below:
Ownership of the asset transfers to the lessee at the end
Lease contains an option for the lessee to purchase the leased asset
cheaply
Lease term is 75% or more of the useful life of the leased asset
Present value of the leased asset is 90% or more of the fair value of
the leased asset

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Lessee Perspective Operating Lease
Operating lease is similar to renting an asset for a defined period of
time
No entries on the balance sheet for the lease
Accounting Entries at inception
Balance Sheet: None as no asset or liability is recognized
Income Statement: None as no payments are made (payments happen
at end of first year)
Cash Flow statement: None as no cash transaction is taking place
Accounting entries every year during the lease term
Balance Sheet: None as no asset or liability is recognized
Income Statement: Leasehold rental is charged every year
Cash Flow Statement: Lease-related expense is classified as cash
outflow from operating activities

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Lessee Perspective Finance Lease
Financing lease requires company to recognize a lease related asset
and liability at the inception.
Treat the asset as if it were purchased with debt
Accounting entries at inception
Balance Sheet: PV of lease payments is recognized as an asset and
same amount is recognized as a long term liability
Income Statement: No payment as the asset is still not used
Cash Flow Statement: None as no cash transaction has taken place.
Disclosure of lease inception is reported as significant noncash
financing and investing activity
Accounting entries during the tar of lease
Balance Sheet: The value of the asset falls every year as it is
depreciated. Interest is charged on the liability. Excess of lease
payment over the interest expense reduces the liability
Income Statement: Deprecation expense and interest expense charged
every year
Cash Flow Statement: Portion of lease payment attributable to interest
expense is deducted from CFO, remainder is shown in CFF as a
repayment of lease liability
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Lessee Perspective
Example
ABC company enters into a lease agreement for a piece of
machinery on 1 January 2008. The useful life of the machine is four
years and lease requires 4 annual payments of $28679 starting on 1
Jan 2008. The present value of lease payments and fair value of
equipment is $100,000. Lease payments happen at the start of the
year.
Before the lease company has liability of $100,000 and equity of
$200,000. The company receives a total revenue of $50,000 each
year. Tax rate applicable to the company is 30%. Discount rate for
the companies is 10%.
Analyze the financial statements if this is a finance lease for the lessee
Analyze the financial statements if this is an operating lease for the
lessee

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 Lessee Perspective Financing Lease
2007 2008 2009 2010 2011

Solution: Rev 50,000 50,000 50,000 50,000

Statement
Income
Int Exp 7,132 4,977 2,607 0
Depeciation 25,000 25,000 25,000 25,000
Tax 5,360 6,007 6,718 7,500
Profit 12,508 14,016 15,675 17,500

Cash Flow Statement

Depreciation (CFO) 25,000 25,000 25,000 25,000

Lease liability reduction (CFF) 21,547 23,702 26,072 28,679

Working Notes: Net Change in cash 15,960 15,314 14,603 13,821

BOP - 15,960 31,275 45,878
2007 2008 2009 2010 2011
EOP 15,960 31,275 45,878 59,698
Lease Liability 100,000 71,321 49,774 26,072 0
Interest expense 7,132 4,977 2,607 0 Cash 15,960 31,275 45,878 59,698
Repayment 21,547 23,702 26,072 28,679 PPE, Gross 100,000 100,000 100,000 100,000
Total Lease Payment 28,679 28,679 28,679 28,679 Acc Dep 25,000 50,000 75,000 100,000
PPE, Net 75,000 50,000 25,000 -
Other Assets 300,000 300,000 300,000 300,000 300,000
Balance Sheet

Total Assets 300,000 390,960 381,275 370,878 359,698

Lease Payable 78,453 54,751 28,679 0

Equity 200,000 212,508 226,523 242,198 259,698
Other Liabilities 100,000 100,000 100,000 100,000 100,000
Total Liabilitites 300,000 390,960 381,275 370,878 359,698

Checksum - - - - -

ROE 0.0% 6.1% 6.4% 6.7% 7.0%

Ratios

D/E 0.50 0.84 0.68 0.53 0.39

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Lessee Perspective Operating Lease
2007 2008 2009 2010 2011

Solution: Rev 50,000 50,000 50,000 50,000

Statement
Income
Int Exp 28,679 28,679 28,679 28,679
Depeciation
Tax 6,396 6,396 6,396 6,396
Profit 14,925 14,925 14,925 14,925
Cash Flow Statement

Depreciation (CFO) - - - -

Lease liability reduction (CFF)

Net Change in cash 14,925 14,925 14,925 14,925

BOP - 14,925 29,849 44,774
EOP 14,925 29,849 44,774 59,699

Cash 14,925 29,849 44,774 59,699

PPE, Gross - - - -
Acc Dep - - - -
PPE, Net - - - -
Other Assets 300,000 300,000 300,000 300,000 300,000
Balance Sheet

Total Assets 300,000 314,925 329,849 344,774 359,699

Lease Payable - - - -
Equity 200,000 214,925 229,849 244,774 259,699
Other Liabilities 100,000 100,000 100,000 100,000 100,000
Total Liabilitites 300,000 314,925 329,849 344,774 359,699

Checksum - - - - -

ROE 0.0% 7.2% 6.7% 6.3% 5.9%

Ratios

D/E 0.50 0.47 0.44 0.41 0.39

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Lessees Perspective Finance v/s Operating Lease
Income Statement Item Finance Lease Operating Lease
EBIT Higher Lower
Expenses - Early years Higher Lower
Expenses - Later years Lower Higher
Net Income - early years Lower Higher
Net Income - later years Higher Lower

Balance Sheet Item Finance Lease Operating Lease

Assets Higher Lower
Current Liabilities Higher Lower
Long Term Liabilities Higher Lower
Total Cash Same Same

Cash Flow Item Finance Lease Operating Lease

CFO Higher Lower
CFF Lower Higher
Total Cash Flow Same Same
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Lessors Perspective
Lessors are required to recognize finance leases when any one of
the four previously defined criteria are met and one of the
following two conditions are met:
Collectability of the lease payments is predictable
No significant uncertainties regarding the amount of costs still to be
incurred by the lessor under the provisions of the lease agreement
Direct Financing Lease
Generate only interest income
Present value of the lease payments equals the carrying value of the
asset
Operating Lease
Lease revenue is recorded every period
Assets are depreciated and liability is paid off

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Lessor Perspective
Example
ABC company leases a machinery to PQR company on 1 January
2008. The useful life of the machine is four years and lease requires
4 annual payments of $28679 starting on 1 Jan 2008. The present
value of lease payments and fair value of equipment is $100,000.
Lease payments happen at the start of the year.
Before the lease company has liability of $100,000 and equity of
$200,000. The company receives a total revenue of $50,000 each
year. Tax rate applicable to the company is 30%. Discount rate for
the companies is 10%.
Analyze the financial statements if this is a direct financing lease for
the lessor
Analyze the financial statements if this is an operating lease for the
lessor

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 Lessor Perspective Direct Financing Lease
2007 2008 2009 2010 2011

Solution Rev 50,000 50,000 50,000 50,000

Statement
Income
Int Income 7,132 4,977 2,607 0
Depreciation
Tax 17,140 16,493 15,782 15,000
Profit 39,992 38,484 36,825 35,000

Cash Flow Statement

Interest Receivable (CFO) (7,132) 2,155 2,370 2,607

Annual Lease Payment Received (CFF) 28,679 21,547 23,702 26,072

2007 2008 2009 2010 2011 Net Change in cash 61,540 62,186 62,897 63,679
Lease Receivable 100,000 78,453 54,751 28,679
BOP - 61,540 123,725 186,622
Interest Income 7,132 4,977 2,607 0
EOP 61,540 123,725 186,622 250,302
Reduction in Lease Receivable 21,547 23,702 26,072 28,679
End Lease Receivable 78,453 54,751 28,679 0
Annual lease 28,679 28,679 28,679 28,679 Cash 61,540 123,725 186,622 250,302
Interest Receivable Lease Receivable 78,453 54,751 28,679 0
7,132 (2,155) (2,370) (2,607)
Increase / (Decrease)

Other Assets 300,000 300,000 300,000 300,000 300,000

Balance Sheet

Total Assets 300,000 439,992 478,477 515,302 550,302

Borrowings 100,000 100,000 100,000 100,000

Equity 200,000 239,992 278,477 315,302 350,302
Other Liabilities 100,000 100,000 100,000 100,000 100,000
Total Liabilitites 300,000 439,992 478,477 515,302 550,302

Checksum - - - - -

ROE 0.0% 18.2% 14.8% 12.4% 10.5%

Ratios

D/E 0.50 0.83 0.72 0.63 0.57

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Lessor Perspective Operating Lease
2007 2008 2009 2010 2011

Solution: Rev 50,000 50,000 50,000 50,000

Statement
Income
Lease Receivable 28,679 28,679 28,679 28,679
Depreciation 25,000 25,000 25,000 25,000
Tax 16,104 16,104 16,104 16,104
Cash Flow Statement Profit 37,575 37,575 37,575 37,575

Depreciation 25,000 25,000 25,000 25,000

Annual Lease Payment Received

Net Change in cash 62,575 62,575 62,575 62,575

BOP - 62,575 125,151 187,726
EOP 62,575 125,151 187,726 250,301

Cash 62,575 125,151 187,726 250,301

PPE, Gross 100,000 100,000 100,000 100,000
Acc Dep 25,000 50,000 75,000 100,000
PPE, Net 75,000 50,000 25,000 -
Other Assets 300,000 300,000 300,000 300,000 300,000
Balance Sheet

Total Assets 300,000 437,575 475,151 512,726 550,301

Borrowings 100,000 100,000 100,000 100,000

Equity 200,000 237,575 275,151 312,726 350,301
Other Liabilities 100,000 100,000 100,000 100,000 100,000
Total Liabilitites 300,000 437,575 475,151 512,726 550,301

checksum - - - - -

ROE 0.0% 17.2% 14.7% 12.8% 11.3%

Ratios

D/E 0.50 0.84 0.73 0.64 0.57

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