FR&A - Long-term Liabilities and Leases

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Long Term Liabilities and Leases

Bonds

• Balance sheet liability of a bond = PV of remaining cash flows discounted at market rate of interest at time of issuance
• At maturity, liability = face value of bond
• Balance sheet liability also called book value or carrying value
• Interest expense = book value at beginning of period * market rate of interest when bond issued
• Market = coupon means bond issued at par
• Market > coupon means bond issued at discount
• Market < coupon means bond issued at premium

Bond issued at par

• At issuance both assets and liabilities increase by amount of bond proceeds
• On income statement, interest expense equal to coupon interest paid since market and coupon rate are same
• CF statement, issue proceeds are an inflow in financing, coupon payments are outflows from operating.  At maturity, repayment is an outflow in financing.

Bonds issued at discount/premium

• PV is not equal to face value
• Assets and liabilities again increased by amount of bond proceeds
• Book value at any point will equal PV of remaining future cash flows discounted at market rate of interest at issuance
• Bonds at premium are reported at higher than face, and decrease over time until it reaches face value at maturity
• Discount bonds reported on BS at less than face and increase over time.

Interest expense

• Must INCLUDE amortization of any discount/premium
• Effective Interest Rate method
• Book value of bond at beginning of period * market rate at time of issuance
• For a premium bond:
• Coupon interest lower than effective rate
• Difference is amortization - amort is then subtracted from balance sheet amount
• Interest expense will decrease over time
• For a discount bond:
• Coupon interest higher than effective rate
• Difference is added to balance sheet amount
• Interest expense will increase over time

Impact on cash flow

• Amortization is noncash - so any indirect method presentation must remove this from net income
• GAAP - interest expense is a cash flow operating activity
• IFRS - operating or financing
• Might need to reclassify interest exp to make firms comparable
• For a premium bond, cash component of interest expense is overstated
• CFO is understated because you subtract coupon of full amount when true interest expense is smaller
• While CFO is understated, CFF will be overstated
• Over life of bond, CFO is understated by same amount CFF is overstated

Zero coupon bonds

• Similar to discount but impact is even larger because discount is larger
• If two companies are similar but one uses zero coupons, you need to make them comparable somehow otherwise in early years the zero coupon will seem to have far better cash flows

Amortization methods

• EIR is required under IFRS
• GAAP - one may use straightline if results are not materially different

Issuance costs

• IFRS - included in measure of liability, therefore increasing EIR
• GAAP - firms capitalize issuance costs (prepaid exp) and amortize over life of bond

Extinguishing Debt

• When redeemed before maturity, gain/loss is recognized
• Subtract redemption price from book value of bond liability at acquisition date
• US GAAP - any remaining unamortized issuance costs must also be written off
• No writeoff necessary in IFRS - already included in book value of liability
• Gain or loss is recorded in income statement (continuing ops)
• Not usually part of day to day - so you eliminate gain/loss for forecasting purposes
• Gain/loss is accounted for in indirect method
• Reacquisition price is reported as an outflow in financing activities

Interest rate changes

• Balance sheet value no longer equals market
• Increase in interest rate will decrease fair value of a liability
• IFRS and GAAP allow companies to report at fair value
• Decreasing value to market will increase equity

Convertible debt

• Converts have additional right to exchange for stock
• Option has value so converts will get lower interest rate (all else equal)
• US GAAP, there is no difference in reporting
• If later converted, stock is recorded at book value of extinguished bond liability
• Simply transfer from debt to equity
• No gain or loss
• Conversion has no cash flow effects
• IFRS, bond liability and conversion option are separated
• Value of conversion option can be derived from subtracting value of the bond without the convert
• Value of conversion option is recorded in equity
• Converts should be treated as equity (likely to convert) when stock price is well above exercise
• Treat as debt when stock price is low
• If close, calculate both; also consider purpose of analysis/timeframe

Debt with warrants

• More common outside the US
• Warrants have value just like convertible option - thus also receive lower rate of interest
• Differences from converts
• Unlike conversion option, warrants can usually be separated
• If warrant exercised, debt component still remains - holder has both debt and equity
• Investor must pay exercise price for warrants - no such payment for convertibles
• Valuation and accounting is same under GAAP/IFRS
• Valuation of warrant = proceeds minus value of straight bond
• Value of warrant is recorded in equity
• Bond with warrants basically results in lower leverage all else equal because there is some equity component to it rather than all straight debt

Other instruments with debt/equity like components

• If instrument requires repayment of principal in the future, must be reported as liability
• Preferred stock (mandatory redemption) is an example
• Dividend payments are recorded as interest expense
• If firm has issued securities that require equity be repurchased at a specific price the repurchase amount is also a liability

Finance (Capital) Leases and Operating Leases

• Finance lease is in substance purchase of an asset that has been financed with debt
• Lessee should add equal amounts to assets and liabilities at purchase
• Recognize depreciation expense on asset and interest exp on liability
• Operating lease is essentially a rental agreement
• No asset/liability reported
• Lease payments are rental expense
• Benefits of leasing
• Less costly financing - no initial payment
• Reduce risk of obsolescence
• Less restrictive provisions than typical financing
• Operating leases are like off-balance sheet financing - better ratios
• Tax reporting - in US, firms can make a synthetic lease - lease is treated as ownership position for tax purposes
• Can deduct depreciation and interest for tax purposes
• For financials, lease is treated as rental agreement, and there is no liability on the balance sheet
• Classification as Finance Lease: If any ONE of the following apply:
• Title to lease asset is transferred to lessee at end of lease
• Bargain purchase option exists: lessee can purchase at a significant discount to market
• Lease period is 75% or more of asset's economic life
• PV of lease pmts is 90% or more of the fair value of the asset
• Interest rate is lower of lessee's incremental borrowing rate or lessor's implicit lease rate 
• Under IFRS classification is not as clear - depends on economic substance

Reporting by Lessee

• Operating lease
• No entry at inception
• Record rent to income statement expense and operating cash flow
• Finance lease
• PV of future minimum lease pmts = asset and liability on balance sheet
• Asset depreciated on income statement and recognize interest exp
• Int exp = lease liability at beginning of pd * implicit lease interest rate
• On CF statement, lease separated into interest and principal
• Principal portion = total payment less interest expense
• Int exp is in operating cash flow
• Principal payment is in financing

Example

• ABC leases machine for 4 years with annual pmts of $10,000.  Interest rate 6%.  At end of lease, machine is returned to lessor who sells for scrap.
• Calculate impact on IS and BS for each of 4 years.  Assume lease pmts at end of year and straight-line depreciation.

Answer

• Classify as finance lease - we know asset is being leased for 75% or more of useful life because lessor sells it for scrap
• PV = $34,651 record this immediately on balance sheet as both asset and liability
• Important - note that if pmt is at beginning of year, PV calc is different
• Depreciation = $34,651 / 4 = $8,663 per yr
• Interest yr 1 = 6% * 34,651 = 2,079.  Principal = 10,000 - 2,079 = 7,921
• Principal yr 1 = 34,651 - 7,921 = 26,730
• Interest yr 2 = 6% * 26730 = 1,603.8.  Principal = 10,000 - 1,603.8 = 8,396.2
• Principal yr 2 = 26,730 - 8,396.2 = 18,334
• Interest yr 3 = 6% * 18,334 = 1,100.  Principal = 10,000 - 1,100 = 8,900
• Principal yr 3 = 18,334 - 8,900 = 9,434
• Interest yr 4 = 6% * 9,434 = 566.  Principal = 10,000 - 9,434 = 566.
• Principal yr 4 = 566 - 566 = 0

Financial statement effect

• Ratios/balance sheet
• Leverage ratios will be higher for finance leases
• Turnover ratios that use total assets in denominator will be lower for finance leases
• Return on assets also lower
• Principal due w/in one yr = current liability, reduces current ratio and working capital
• Since operating leases don't appear on balance sheet, sometimes called 'off balance sheet financing activities'
• Income statement
• All else equal, EBIT higher for companies that use financing lease
• With operating lease, entire lease pmt is opex
• Finance lease, only depreciation is opex
• Total expense over life will be same - lease expenses equals depreciation plus interest
• In early yrs, finance lease will result in higher total expense, then lower
• Cash flow is unaffected
• Finance lease, CFO is higher and CFF is lower (in op lease, everything is in operations; in finance lease, only interest exp is in CFO, rest is CFF)
• In sum:
• All ratios are worse when lease is capitalized
• Only improvement from financing lease is higher EBIT, higher CFO and higher net income in early years

Notes

• Adding an equal amount of assets and liabilities will tend to worsen ratios because companies typically have greater assets than debt; thus adding equal amounts to numerator and denominator will make the denominator proportionally larger
• W/r/t current ratio and working capital, you are recognizing a current liability with no corresponding current asset

Required disclosures

• Must disclose future lease payments
• Can use this and present value of future minimum lease payments to derive interest rate
• Can then use this to see what would happen if you converted operating leases to finance leases

From lessor's perspective: sales type and direct financing leases

• Both fall under category of financing lease

Sales type

• Treated as if lessor sold asset and provided the financing to the buyer
• PV of lease payments exceeds carrying value of asset
• At inception, lessor recognizes sale equal to present value of lease payments and COGS equal to carrying value of asset
• Difference is gross profit
• Removed asset (inventory) and create a lease receivable equal to PV of lease pmts
• As pmts are received, principal portion of pmt reduces the receivable
• Also recognizes interest revenue of lease receivable balance * interest rate
• Interest revenue is an inflow in operating activities
• Principal reduction is an inflow from investing, just like any loan

Direct Financing lease

• No gross profit recognized by lessor at inception
• Simply providing a financing function to lessee
• PV of lease pmts = carrying value of the asset
• At inception, lessor removes asset from BS and makes lease receivable in same amt
• As pmts received, principal portion reduces lease receivable
• Income statement - recognize interest income, calculated same way as above
• CF - interest revenue is an inflow in operating, principal inflow is inflow from investing

Operating Lease

• Lessor simply treats lease payments as rental income
• Lessor keeps asset on balance sheet and depreciates over time
• Income statement effect versus direct financing lease is basically the same
• Direct financing, you just have interest income
• Op lease, you have rental income, depreciation, and difference is op lease income
• Total op lease income = total interest income
• However total interest income is higher in beginning yrs, then reverses
• Total cash flow is same
• However in direct financing, most of CF returns is in investing
• In op lease, it is all in CFO
• Note: from lessee's perspective, principal is a financing outflow - thus from lessor's perspective, principal is a return of capital invested in the lease - thus it is an investing inflow

Off balance sheet agreements

• Operating leases are just one example

Take or Pay Contract (aka throughput arrangement)

• Buyer commits to buying a minimum quantity of input or specified period of time
• Pmts must be made even if they don't want the product
• Must be disclosed in MD&A
• Should add the sum of required purchase amts to both debt and total capital in the debt/capital ratio
• Can also take present value to be more precise

Sale of receivables with recourse

• Sell AR to an unrelated party but continue to service and remit collections to buyer of receivables
• Buyer of receivables has not taken on risk of non-pmt - seller retains credit risk
• In essence this is just borrowing collateralized by the receivables
• Should treat sale of receivables as collateralized borrowing
• Before computing ratios, AR and current liabilities should be increased by amt of receivables sold
• In CF statement, classify sale of receivables as cash from financing, not cash from ops

Off balance sheet financing

• Should add PV of minimum purchase obligations to both LT assets and LT liabilities
• Sale of receivables reduces AR and ST borrowings
• Leverage ratios too low, AR turnover too high, and current ratio is too high
• Receivables and ST debt should be added back to AR and current liabilities
• Say a company sells $170,000 of AR with recourse, debt interest rate 9%
• Add back debt
• Reinstate receivables
• Increase both interest income and expense by $170,000 * 9% = $15,300
• Net income not affected - just EBIT and int expense are both higher
• Cash flow
• Reduce operating by $170,000, increase financing by $170,000

End

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