Study Session 9 Liabilities

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Study Session 10
LiabiIities


A. Analysis of Income Taxes

a. define the key terms used in accounting for income taxes.

Here are key terms based on tax return:
Taxable income: Income tax subject to tax.
Taxes payable: Tax return liability resulting Irom current period taxable income.
FAS 109 calls this "current tax expense or beneIit."
Income tax paid: Actual cash Ilow Ior income taxes, including payments (reIunds)
Ior other years.
Tax loss carryforward: Tax return loss that can be used to reduce taxable income in
Iuture years.

Here are key terms based on Iinancial reporting:
Pretax income: Income beIore income tax expense.
Income tax expense: Expense resulting Irom current period pretax income;
includes taxes payable and deIerred income tax expense.
Deferred income tax expense: Accrual oI income tax expense expected to be
paid (or recovered) in Iuture years; diIIerence between taxes payable and income
tax expense. Under SAAS 109, this results Irom changes in deIerred tax assets
and liabilities.
Deferred tax asset: Balance sheet amounts expected to be recovered Irom Iuture
operations.
Deferred tax liability: Balance sheet amounts expected to result in Iuture cash
outIlows.
Valuation allowance: Reserve against deIerred tax assets based on likelihood
that those assets will be realized.
Timing difference: The result oI tax return treatment (timing or amount) oI
transaction that diIIers Irom Iinancial reporting treatment.
Temporary difference: DiIIerences between tax reporting and Iinancial reporting
that will aIIect taxable income when those diIIerences reverse. Similar to but
slightly broader than timing diIIerences.
Permanent difference: DiIIerences between tax reporting and Iinancial reporting
that will not reverse in the Iuture.





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b. explain why and how deferred tax liabilities and assets are created.

Tax reporting and Iinancial reporting are based on two diIIerent sets oI assumptions. This
is particularly true in the US because Iinancial reporting does not have to conIorm to tax
reporting, as in Japan, Germany & Switzerland. As a result, taxes payable Ior the period
are oIten diIIerent Irom the tax expenses recognized in the Iinancial statements.

Tax reporting is based on Internal Revenue Code (the tax code).
ModiIied cash basis oI accounting is used in tax reporting to determine the
periodic liability Irom currently taxable events.
Revenue and expense recognition methods used in tax reporting oIten diIIer
Irom those used in Iinancial reporting.

Financial reporting is based on GAAP.
Accrual accounting is used in Iinancial reporting to provide maximum
inIormation to allow evaluation oI a Iirm's Iinancial perIormance and cash
Ilows.
Management are allowed to select revenue and expense recognition methods.
A Iirm has a strong incentive to use methods to allow it to minimize taxable
income.

Basic Issue. should tax and cash Ilow eIIects oI revenues, expenses and other transactions
be recognized in the period in which they aIIect taxable income or in the periods in which
they are recognized in the Iinancial statements?

Because oI the diIIerences between tax accounting and Iinancial accounting, the Iinancial
statements may include tax liabilities or assets - allowances that have been made in the
Iinancial statements Ior taxes that have not yet been or have already been paid. Examples
include the results oI diIIerent depreciation methods employed (Accelerated Cost
Recovery System Ior tax vs straight line depreciation Ior Iinancial reporting) and
treatment oI warranty expenses (allowed Ior Iinancial reporting but not Ior tax reporting).

Deferred tax liabilities are required when Iuture taxable income is expected to exceed
pretax income, resulting an excess oI tax expense over taxes payable. Recall that taxes
payable is calculated based on taxable income, and tax expense is calculated based on
pretax income. DeIerred tax liabilities on an individual transaction are expected to be
reversed when these liabilities are settled, causing Iuture cash outIlows. Different
depreciation methods or estimates used in tax reporting and Iinancial reporting are the
most common way that deIerred tax liabilities are created.

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DiIIerences between Iinancial accounting and tax accounting can also give rise to
deferred tax assets when Iuture pretax income is expected to be more than taxable
income, resulting in an excess oI taxes payable over tax expense. DeIerred tax assets on
an individual transaction are expected to be reversed when these assets are recovered,
causing Iuture cash inflows. Different treatments of warrantv expenses in tax reporting
and Iinancial reporting are a common cause oI deIerred tax assets:

For tax reporting, warranty expenses cannot be recognized until they have been
incurred.
For Iinancial reporting, warranty expenses are recognized each year using accrual
accounting, regardless oI whether they are incurred or not.

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Two special issues about deIerred tax assets:
Treatment oI tax losses:
Tax losses occur when tax deductions exceed taxable revenues.
Tax losses can be carried back to prior periods or Iorward to Iuture periods.
When tax losses are carried Iorward to oIIset Iuture taxable income, the
expected beneIits are recognized as deIerred tax assets.
Valuation allowance: this is a reserve against deIerred tax assets iI there is a
likelihood that these assets may not be realized in the Iuture.
Valuation allowance is required iI it is more likely than not that some or
all oI the deIerred tax asset will not be realized.
Changes in the valuation allowance oIten aIIect reported earnings, and can
be used by management to manipulate earnings. For example, aggressive
Iirms may assume that no valuation allowance is necessary.





c. describe the liability method of accounting for deferred taxes.

The objectives are to recognize:
taxes payable or reIundable Ior the current year.
the deIerred tax liabilities and assets (adjusted Ior recoverability) measured as the
Iuture tax consequences oI events that have been recognized in Iinancial
statements or tax returns.
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The method is based on the balance sheet. It recognizes the deIerred tax consequences oI
temporary diIIerences.
DeIerred tax assets (liabilities) represent assets (liabilities) on the balance sheet.
They are calculated directly.
Income tax expense is calculated using deIerred tax assets and liabilities. There
should be no attempt to match income tax expense directly with pretax income.
Changes in tax rates (or other tax regulations) that aIIect the estimated Iuture tax
liability are recognized in reported income in the year the change is enacted.

II constant tax rate is assumed, the procedures are:
Compute taxes payable: taxable income x tax rate.
IdentiIy two types oI temporary diIIerences: those creating deIerred tax liabilities
(pretax income ~ taxable income), and those creating deIerred tax assets (pretax
income taxable income).
DeIerred tax assets: cumulative temporary diIIerences that create deIerred tax
assets x tax rate.
DeIerred tax liabilities: cumulative temporary diIIerences that create deIerred tax
liabilities x tax rate.
Compute tax expense: taxes payable change in deIerred tax liabilities (current
year deIerred tax liabilities - previous year's) - change in deIerred tax assets
(current year deIerred tax assets - previous year's).

Treatment oI operating losses:

Tax losses can be carried back and applied to prior years to obtain reIunds oI taxes paid.
They can also be carried Iorward to Iuture periods. Because the realization oI tax loss
carryIorwards depends on Iuture taxable income, the expected beneIits are recognized as
deIerred tax assets. Such assets are recognized in Iull but a valuation allowance may be
required iI recoverability is unlikely.

Valuation allowance:

DeIerred tax assets are reduced by a valuation allowance to amounts that are "more likely
than not" to be realized, taking into account all available positive and negative evidence
about the Iuture. For determining whether deIerred tax assets must be reduced by a
valuation allowance, all available positive and negative evidence must be considered.
InIormation concerning recent pretax accounting earnings generally is critical. E.g. iI the
Iirm has been recording material cumulative losses recently it will be hard to justiIy a
conclusion that tax credits can be realized in the near Iuture C this will be evidence Ior
the use oI a valuation allowance (this is 'negative evidence'). It is not necessary to
quantiIy positive evidence Ior the conclusion that a valuation allowance is not required
unless signiIicant negative evidence exists. Where both positive and negative exist,
judgment must be used in evaluating what evidence is more persuasive. More weight
should be given to objectively veriIiable evidence.

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d. explain the factors that determine whether a company's deferred tax liabilities
should be treated as a liability or as equity for purposes of financial analysis.

A Iirm's deIerred tax liability that occurs during an accounting period represents the
portion oI income tax expense that has not been paid. ThereIore, Irom a pure accounting
perspective, deIerred tax liabilities are an accounting liability. However, Irom a Iinancial
analyst's perspective, whether deIerred tax liabilities should be considered as liabilities or
not depends on whether they will reverse in the Iuture. II they will and result in a cash
outIlow, then they should be treated as liabilities. II not, then they should be treated as
equity! As deIerred tax liabilities are created by temporary diIIerences, reversal oI a
deIerred tax liability depends on the reversal oI the temporary diIIerence that created it.

Changes in a Iirm's operations or tax law may result in deIerred taxes that are never paid
or recovered. For example, the use oI accelerated depreciation methods Ior tax reporting
creates a temporary diIIerence. Normally when less depreciation is taken in later years,
the deIerred tax liability created by more depreciation in earlier years will be reversed.
However, Ior Iirms with high growth rates, increased investments in Iixed assets result in
ever-increasing new deIerred tax liabilities, which replace the reversing one. That is, a
Iirm's growth may continually generate deIerred tax liabilities. In this case the deIerred
taxes are unlikely to be paid. ThereIore, Ior such high-growth Iirms deIerred tax
liabilities will not reverse, and should be treated as equity.

DeIerred tax liabilities are recorded at its stated value. Even iI deIerred taxes are
eventually paid, payments typically occur Iar into the Iuture. The present value oI those
payments is considerably lower than the stated amounts. Thus, the deIerred tax liability
should be discounted at an appropriate interest rate, and the diIIerence should be treated
as equity.

In some cases, Iinancial statement depreciation understates the value oI economic
depreciation. Instead, the accelerated depreciation in tax reporting is a better measure.
Such cases include equipment obsolescence due to technology innovation, or rising price
levels. Consequently deIerred tax liabilities are neither liabilities nor equity iI they are not
expected to reverse, and should be ignored by Iinancial analysts.

They are not liabilities since they will not reverse.
They are not equity since adding the entire tax liabilities to equity overstates the
value oI the Iirm.
To the extent that deIerred taxes are not a liability, then they are stockholders'
equity.

In practice, the Iinancial analyst must decide on the appropriate treatment oI deIerred
taxes on a case-by-case basis.




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e. distinguish between temporary and permanent differences in pretax financial
income and taxable income.

Numerous items create diIIerences between pretax income and taxable income. These
diIIerences can be divided into two types:

Temporary differences, which cause deIerred tax liabilities or assets. They occur
only iI both oI the Iollowing conditions are met:
A revenue or expense item is recognized Ior both tax reporting and Iinancial reporting;
and
DiIIerent methods are used in tax reporting and Iinancial reporting to allocate the
revenue or expense to accounting periods.

Note that the total revenue or expense is the same, but it is allocated to accounting
periods diIIerently. The diIIerences are temporary in a sense that such diIIerences will be
reversed some time in the Iuture. DiIIerent depreciation methods or estimates used in tax
reporting and Iinancial reporting are a common cause oI temporary diIIerences.

Permanent differences, which do not cause deIerred tax liabilities or assets. They
occur iI a revenue or expense item:
is recognized Ior tax reporting but never Ior Iinancial reporting; or
is recognized Ior Iinancial reporting but never Ior tax reporting.

ThereIore, permanent diIIerences result Irom revenues and expenses that are reportable
on either tax returns or in Iinancial statements but not both. Permanent diIIerences arise
because the tax code excludes certain revenues Irom taxation and limits the deductibility
oI certain expenses. In the US, Ior example, interest income on tax-exempt bonds,
premiums paid on oIIicer's liIe insurance, and amortization oI goodwill (in some cases)
are included in Iinancial statements but are never reported on the tax return. Similarly,
certain dividends are not Iully taxed, and tax or statutory depletion may exceed cost-
based depletion reported in the Iinancial statements. Tax credits are another type oI
permanent diIIerence. Such credits directly reduce taxes payable and are diIIerent Irom
tax deductions that reduce taxable income. These diIIerences are permanent because they
will not reverse in Iuture periods.

No deIerred tax consequences are recognized Ior permanent diIIerence; however, they
result in a diIIerence between the eIIective tax rate and the statutory tax rate that should
be considered in the analysis

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f. compute income tax expense, income taxes payable, deferred tax assets, and deferred
tax liabilities.

See basic questions please.



g. calculate the adjustment to the financial statements for a change in the tax rate.

When tax rates change, the deIerred tax liability or asset has to be adjusted to the new
amount that is now expected, based upon the new expected tax consequences. The eIIect
oI this change in estimate will be included in the income Irom continuing operations.

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The desired balance oI the deIerred tax asset or liability is computed using the new Iuture
tax rate, and the debit or credit to the deIerred tax asset or liability is the amount
necessary to bring it to the desired balance. Income taxes payables are computed based
on the tax law in eIIect in the current year. Income tax expense is the amount needed to
balance the journal entry.





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B. Analysis of Financing Liabilities

a. compute the effects of debt issuance and amortization on the income statement,
balance sheet, and cash flow statement.

Debt is classiIied as short-term and long-term.

Current liabilities result Irom both operating and Iinancing activities.

Those caused by operating activities include accounts payable and advances
Irom customers. Operating and trade debt is reported at the expected
(undiscounted) cash Ilow and is an important exception to the rule that liabilities
are recorded at present value. Note that advances Irom customers are the
consequence oI operating decisions, the result oI normal activity. They should
be distinguished Irom other payables when analyzing a Iirm's liquidity.
Advances are a prediction oI Iuture revenues rather than cash outIlows.

Those resulting Irom Iinancing activities include short-term debt and the current
portion oI long-term debt. They are recorded at present value. Note that the
current portion oI long term (LT) debt is the consequence oI Iinancing activity
and indicate a need Ior cash or reIinancing. A shiIt Irom operating to Iinancing
indicates beginning oI liquidity problems, and inability to repay ST credit is a
sign oI Iinancial distress.

Long-term debt results Irom Iinancing activities. It may be obtained Irom many
sources that may diIIer in interest and principal payments. Some claims are below or
subordinated to others while other claims may be senior or have priority. Whatever
the diIIerent payment terms are, there are two basic principles:

Debt equals present value oI the Iuture interest and principal payments. For
book values the discount rate is the rate when debt was incurred. For market
values the discount rate is the current rate.

Interest expense is the amount paid to the creditor in excess oI the amount
received. Though total to be paid is known, allocation to speciIic time periods
may be uncertain. The coupon rate is just the stated cash interest rate.

In this los we Iocus on debt resulting Irom Iinancing activities.

At the time oI issuance, the Iirm receives proceeds Irom issuing the bond. A bond
payable is valued at the present value oI its Iuture cash Ilows (periodic coupon payments
and principal repayment at maturity). These cash Ilows are discounted at the market rate
of interest at issuance. ThereIore, the value oI the bond depends on the market rate oI
interest. For example, iI the market rate oI interest is higher than coupon rate, the bond
value will be less than its Iace value, and the bond is issued at a discount.

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Balance sheet: initial liability is the amount paid to the issuer by the lender. The
amount may not equal to the Iace value oI the bond.
Cash Ilow statement: CFF increases by the amount received.

At the end oI each semiannual payment period, the Iirm makes a coupon payment:

Income statement: interest expense is reported here. The eIIective interest rate is
the market rate at the time oI issuance, and the interest expense is market rate
multiplied by the bond liability at the beginning oI this 6-month period.

Cash Ilow statement: CFO decreases by the coupon payment. The coupon rate
and Iace value are used to calculate actual cash Ilows only.

Balance sheet: the bond liability is adjusted iI necessary. Liability over time is a
Iunction oI (1) initial liability and the relationship oI (2) interest expense to (3) the
actual cash payments. That is, the diIIerence between interest expense and coupon
payment represents the change in bond liability during this period: change in bond
liability interest expense - coupon payment. The ending bond liability
beginning bond liability change in bond liability.

The bond premium or discount is amortized over the liIe oI the bond by what is
known as the interest method - it results in a constant rate oI interest (not a
constant interest expense) over the liIe oI the bond.

II the bond is issued at a premium, interest expense is always lower than
coupon payment, and decreases over time. In this case the interest expense is
only one component oI the coupon payment. The rest oI the coupon payment
is used to amortize the bond's premium.

II the bond is issued at a discount, interest expense is always higher than
coupon payment, and increases over time. In this case the interest expense has
two components: the coupon payment, and amortization amount oI the bond's
discount.

II the bond is issued at par, interest expense equals coupon payment.

At any point in time the liability on the B/S will equal the present value oI the
remaining cash Ilow payments to the creditor discounted at the eIIective market
interest rate.

At the maturity date, the Iirm repays the Iace value oI the bond. The treatment and eIIects
oI the last coupon payment are the same as shown above.
Balance sheet: the bond liability is reduced by the Iace value.
Cash Ilow statement: similar to the treatment oI initial cash received, the Iinal
Iace value payment is treated as cash Irom Iinancing (CFF).
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Total interest expense is equal to amounts paid by the issuer to the creditor in excess oI
the amount received.

For bonds issued at a premium or discount, reporting coupon payments as cash outIlow
Irom operations is inappropriate. For example, iI a bond is sold at a premium, part oI the
coupon payment is used to amortize the premium and reduce the principal, and thereIore
should be treated as a Iinancing cash outIlow. As a result, CFO is understated and CFF is
overstated by the amortization amount oI the bond's premium.






b. discuss the effect on reported cash flows of issuing zero-coupon debt.

Zero Coupon Bond (ZCB) has no periodic interest payments and is issued at a large
discount Irom par. The proceeds at issuance equal the present value oI the Iace value,
discounted at the market value oI interest at issuance. Repayment at maturity includes all
the (implied) interest expense (equal to Iace value minus the proceeds) Irom the time oI
issuance: Total Implied Interest Par Value - Proceeds Received.

In essence, zero-coupon bonds are a special type oI discount bonds. ThereIore, their
eIIects on Iinancial statements are similar to those oI discount bonds.

The interest expense on a zero-coupon bond never reduces operating cash Ilow.
Reported CFO is systematically "overstated" when a zero-coupon (or deep-
discount) bond is issued, while CFF is understated by the amortization amount oI
the discount and should be adjusted accordingly.

Unlike discount bonds (whose reported CFO is reduced by the coupon payments),
they make no coupon payments so they have no eIIect on reported CFO.

Solvency ratios, such as cash-basis interest coverage, are improved relative to the
issuance oI par bonds. The cash eventually required to repay the obligations may
become a signiIicant burden.





c. compute and describe the effects on financial statements and ratios of the issuance
and the conversion of convertible bonds, warrants, and convertible preferred stock.

Convertible Bonds
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Convertible bonds can be converted into common stock oI the bond issuer at the holder's
option during some speciIied period oI time. The conversion option is not detachable -- it
cannot be traded separately. The conversion Ieature lowers interest expense.

Convertibility Ieature is completely ignored when a convertible bond is issued, so
the entire proceeds oI a bond are treated as a liability. The interest expense is
recorded as iI the bond were not convertible.

When the bond is converted into common stock, the proceeds Irom bond issuance
are reclassiIied Irom debt to equity. Consequently, the debt-to-equity ratio oI the
issuer decreases and the interest coverage ratio increases.

However, when we evaluate leverage ratios such as debt-to-equity, we should consider
three scenarios regarding the conversion Ieature prior to conversion:
When the stock price is higher than conversion price, it should be treated as
equity - when converted into equity, the proceeds are treated as equity (no longer
debt or bond).
When the stock price is signiIicantly less than conversion price it should be
treated as debt.
However, as the price level close to the conversion price, the instrument has both
debt and equity Ieatures, and its treatment becomes a more diIIicult issue. An
analyst may Iirst treat the bond as debt and then as equity to examine the
diIIerences.

Exchangeable Bonds

Some bond issues are convertible into shares oI another Iirm rather than those oI the
issuing Iirm. Exercise oI the conversion privilege results as:
extinguishment oI the debt.
elimination oI the investment in the underlying shares.
recognition oI gain or loss Irom the "sale" (via debt conversion) oI the underlying
shares.

The motivation Ior such bond issues may include:
the desire to obtain cash while retaining the underlying shares Ior strategic
reasons.
minimizing the market eIIect oI sales: the underlying shares are sold over time as
bonds are exchanged.
Iinancial beneIits: the interest rate is lower due to the Ieature, and the exercise
price will contain a premium over the current market price.
delayed recognition oI a large unrealized gain: recognition is postponed until the
exchange privilege is exercised.

Bonds with Warrants

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Warrants are certiIicates entitling the holder to buy shares oI common stock at a speciIied
price within a stated period. Firms oIten bundle warrants with bonds to entice investors to
accept lower interest rates. Bonds with warrants diIIer Irom convertible bonds in two
aspects:
Upon exercise oI the warrants, the bondholder has to pay a certain amount oI cash
to obtain the shares. In contrast, no additional cash is paid when convertible bonds
are exchanged Ior the shares.
Warrants are typically detachable Irom the associated bonds. However the
conversion Ieature is not detachable.

When bonds with warrants are issued, the proceeds must be allocated between bonds and
warrants.
The Iair value oI the bond portion is the reported liability. As a result, the bond is
accounted Ior as iI it were issued at a discount. The reported liability is lower than
total proceeds. Interest expense includes amortization oI the discount.
The Iair value oI the warrants is included in equity and has no income statement
impact. When warrants are exercised the additional cash increases equity capital.

Comparison:

Interest Expense B/L Liability CFO
greater than equal to less than
Bond with warrants Convertible bond Convertible bond
greater than greater than equal to
Convertible bond Bond with warrants Bond with warrants


All else equal:

Both a bond with warrants and a convertible bond have lower interest rate than a
straight bond, thereby reporting lower interest expense. For a bond with warrants,
amortization oI the bond's discount represents additional interest expense.
ThereIore, its interest expense is higher than that oI a convertible bond.

A convertible bond and a straight bond are recorded in the same amount, since the
conversion Ieature is completely ignored at issuance. A bond with warrants is
recorded at a lower value since part oI the proceeds received is allocated to
warrants.

A convertible bond and a bond with warrants oIIer the same amount oI coupon
payments, so they have the same impact on CFO. A straight bond has a higher
coupon rate than the other two bonds so it causes a higher operating cash outIlow,
resulting in lower CFO.

Preferred Stock:
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When calculating the net worth oI a company with preIerred shares outstanding, the
analyst should:
subtract the liquidating value oI the preIerred, not the stated value, which may be
lower.
subtract any cumulative dividends that are in arrears.

PreIerred shares are almost always callable by the issuer. Many issues are, however,
redeemable by the preIerred shareholders oIten over a period oI years. Because oI these
"sinking Iund" provisions, redeemable preIerreds should be treated as debt Ior analysis.
SEC requires that redeemable preIerred shares be excluded Irom stockholders' equity.
However, since Iirms cannot be Iorced to pay the dividends or redeem the preIerred
shares, the SEC does not require their classiIication as debt either. In practice analysts
should evaluate such instruments on a case-by-case basis and decide whether to treat
them as debt or equity. II they are treated as debt, their dividend payments should be
treated as interest expense, resulting a higher debt-to-equity ratio and lower interest
coverage ratio.





d. discuss the effect of changing interest rates on the market value of debt and on
financial statements and ratios.

Debt reported on the balance sheet is equal to the present value oI Iuture cash payments
discounted at the market value on the date oI issuance. Increases (decreases) in the
current market value rate decrease (increase) the market value oI the debt. This economic
gain or loss is NOT reIlected in either the income statement or balance sheet.

For some analytic purposes the market value oI a company's debt may be more relevant
than its book value. For example, consider two Iirms that issued par bonds (coupon rate
equals the market rate oI interest at issuance). Firm A issued the bond when interest rates
were high, and Iirm B issued the bond when interest rates were low. Both Iirms report the
same book value oI debt, which is equal to the Iace value. ThereIore, all else equal, both
Iirms will have the same debt-to-equity ratio based on their balance sheets. However,
Iirm B has a lower Iuture coupon payment obligation, indicating stronger borrowing
capacity. For the purpose oI Iinancial analysis, the lower market value oI debt results in a
lower debt-to-equity ratio, which reIlects the Iirm's true borrowing capacity.





e. state why the gain or loss resulting from retirement of debt prior to maturity is
treated as an extraordinary item.

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Conditions may change aIter a Iirm issues a debt, so the Iirm may choose to retire debt
beIore the original maturity. Retirement oI bonds prior to maturity may produce a
diIIerence between book and market value and is treated as an extraordinary gain or loss
in the I/S under SFAS4 only iI all oI the Iollowing conditions are met:
The gain or loss is both unusual and inIrequent; and
The gain or loss is material in amount.

Under the latest US GAAP, debt retirement transactions that do not meet all oI the above
conditions are treated as a component oI continuing operations.

Why treat such transactions as extraordinary? They are not Irom a Iirm's ordinary
business activities, and they typically have signiIicant impact on earnings and are oIten
used by management to manipulate earnings.

A callable bond allows issuer to buy back the bond Irom holder at predetermined date
and price - usually at a premium over bond's Iace value. Gains or losses on the calling oI
debt are typically ignored by the analyst because the accounting treatment (i.e., loss on
the I/S) does not agree with the economic beneIits.
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C. Leases and Off-Balance-Sheet Debt

a. classify a lease as capital or operating.

Incentives For Leasing

When purchasing an asset the buyer acquires ownership oI the asset and all beneIits and
risks embodied in the asset. A Iirm may acquire use oI the asset, including some or all the
beneIits and risks Ior speciIied periods oI time, by making payments through contractual
arrangement called a lease. Using leases, a Iirm can avoid tying up too much capital in
Iixed asset investment. Some incentives are:

Tax incentives.

Non-tax incentives:
Favors Operating lease:
1. Period oI use is short relative to overall liIe oI asset.
2. Lessor has comparative advantage in reselling the asset.
3. Corporate bond covenants contain speciIic covenants relating to
Iinancial policies that the Iirm must Iollow. OL results in lower
leverage ratios and higher asset turnover ratios.
4. Management compensation contracts contain provisions
expressing compensation as a Iunction oI returns on invested
capital.


General incentives Ior leasing:
1. Lessee ownership is closely held so that risk reduction is
important.
2. Lessor has market power and can generate higher proIits by
leasing the asset than selling it.
3. Asset is not specialized to the Iirm.
4. Asset's value is not sensitive to use or abuse (as owner takes
better care oI asset than lessee).

Operating leases (OL) allow the lessee to use the property Ior only a portion oI its
economic liIe. OLs are accounted Ior as contracts. Lessee reports only the required lease
payments as they are made. There is no B/S recognition oI the property. For the lessor
payments received are recognized as income, the property remains on the B/S and is
depreciated over time.

BeneIits oI OL:
Leasing asset avoids recognition oI debt on lessee's BS;
OLs result in higher proIitability ratios and reduce reported leverage Ior lessees.

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Capital leases (CL) involve eIIective transIer oI all risk and beneIits oI property to the
lessee. The lessor Iinances the transaction through the leased asset. CL are economically
equivalent to sales, and are treated as sales (on credit) Ior accounting purposes. The asset
and associated debt are reported on the B/S oI the lessee and the asset is depreciated over
its liIe. Lease payments are treated by lessee as payment oI both principal and interest.

BeneIits oI CL:
Lessors have earlier recognition oI revenue and income by reporting a completed
sale though the substance oI the transaction is similar to installment sales or
Iinancing.

In an operating lease the lessee expenses the payments as they are made. In a capital lease
the value oI the lease is booked to Iixed assets and to long and short term debt.

A lease meeting anv of the following criteria at inception must be classiIied as a capital
lease by the lessee:
1. The lease transIers ownership oI the property to the lessee at the end oI the term.
2. The lease contains a bargain purchase option that the lessee may purchase the
leased asset Ior a price that is signiIicantly below its Iair market value at the end
oI the lease term.
3. The lease term exceeds 75 oI the asset's economic liIe.
4. The PV oI the minimum lease payments (MLPs) equals or is greater than 90 oI
the asset's Iair market value, using the lessee's incremental borrowing rate or the
implicit rate oI the lease.

From a lessor's perspective, a lease is classiIied as a capital lease iI at the inception the
lease meets anv oI the above Iour criteria, and both oI the Iollowing two revenue
recognition criteria:
Collectibility oI lease payments is reasonably predictable.
There are no signiIicant uncertainties regarding the amount oI un-
reimbursed costs yet to be incurred by the lessor. That is, Iuture costs are
reasonably predictable, so the lessor's perIormance is substantially
complete.

A lease that does not meet any oI the Iour criteria is classiIied by the lessor as an
operating lease.





b. calculate the effects of capital and operating leases on financial statements and
ratios.

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Suppose a non-cancelable lease begins on Dec. 31, 19X0 with annual MLPs oI $10,000
made at the end oI each year Ior Iour years. Ten percent is assumed to be the appropriate
discount rate.

Operating Lease for a Lessee:
No entry is made at the inception oI the lease.
Over the liIe oI the lease, only the annual rental expense (an operating expense) oI
$10,000 will be charged to income and CFO.

Operating Lease for a Lessor
The leased asset is reported on the lessor's balance sheet, because the lessor still
retains the ownership oI the asset. Accordingly, the lessor will depreciate the asset
during the term oI lease.
Over the liIe oI the lease, periodic lease payments Irom the lessee are reported as
rental revenue on the income statement. They are recorded as operating cash
Ilows.

Capital Lease For a Lessee:
At the inception oI the lease, an asset (leasehold asset) and liability (leasehold
liability) equal to the present value oI the lease payments, $31,700, is recognized.
The implicit interest rate of the lease is the discount rate that set the aggregate
present value oI lease payments to be equal to the Iair market value oI the leased
asset.
Over the liIe oI the lease:
1. The annual rental expense oI $10,000 will be allocated between interest
and principal payments on the $31,700 leasehold liability according to the
amortization schedule.
Interest payment Beginning lease obligation x implicit discount
rate. It is accounted Ior as interest expense, which reduces income
and cash Ilow Irom operating activities.
Principal repayment Lease payment - Interest payment. It
reduces lease liability and cash Ilows Irom Iinancing activities. It
has no eIIect on the income statement.
Ending lease obligation Beginning lease obligation - principal
repayment
2. The cost oI the leasehold asset oI $31,700 is charged to operating (annual
depreciation is $7,925) using the straight-line method over the term oI the
lease. Depreciation is charged to income, but has no eIIect on cash Ilows.

Amortization schedule:

Year Opening Liability Interest Principal Closing Liability
X0 $31,700
X1 $31,700 $3,170 $6,830 $24,870
X2 $24,870 $2,487 $7,513 $17,357
X3 $17,357 $1,735 $8,265 $9,092
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X4 $9092 $909 $9092

Financial eIIects:

B/S eIIects:

When a lease is a CL, gross ($31,700) and net amounts are reported at each BS date.
CL increases asset balances, resulting in lower asset turnover and lower ROA,
compared to OL classiIication.
The current liability is the principal portion oI the Iirst lease payment. Non-current
liability is the rest oI the principal. At lease's inception leased assets and liabilities
(A&L) are equal at $31,700.
A most important eIIect oI a CL is the impact on leverage ratios which result in an
increase in debt to equity and other leverage ratios. As lease obligations aren't
recognized Ior OL leverage ratios are understated.

Income statement (IS) eIIects:

An OL charges constant rental payments to expense as accrued, whereas a CL
recognizes and apportions depreciation and interest expense over the term oI the lease.

Operating income:
Capitalization results in a higher EBIT as the straight line depreciation
expense oI $7,925 is lower than the Operating Lease rental expense oI
$10,000.
Total expense & net income:
CL interest expense Ialls over time and depreciation expense is constant
(straight-line depreciation) or declining (accelerated depreciation method).
Total expense Ior CL declines over the lease term. Initially it's higher than
OL expense but over time it becomes lower. Tax expense and net income
Ior an OL are constant over time. Tax expense and net income Ior a CL
increase and Ior a CL one also reports an accumulating deIerred tax
expense.
In general, compared to a CL, Iirms using an OL generally report higher
proIits, interest coverage and ROA. Lease expense (Ior CL$11,095)
exceeds lease payments (Ior OL$10,000) so there will be a deIerred tax
credit. DeIerred tax amount increases until lease expense is less than lease
payments, and then the account declines and is eliminated by the end oI
the lease.
No deIerred tax is reported Ior OL since the amount deductible Ior taxes
and reported lease expense are always the same. Total (interest and
depreciation) expense Ior CL must equal total rental expense on a OL,
over the liIe oI the lease. Net income is not aIIected by CL but CL reports
lower income earlier in lease term and higher income later.

Cash Ilows:
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Under OL all cash Ilows are operating and there is an operating cash outIlow oI
$10,000 per year. Annual payments oI $10,000 create a tax beneIit oI $3,500 per
year which is deductible regardless oI lease method used. CL produces operating
cash Ilows (CFO) and Iinancial cash Ilows (FCF). The $10,000 paid under CL is
allocated between interest and amortization oI the lease obligation (reported as
cash Irom Iinancing).
For CL as interest expense declines over lease and an increasing portion is
allocated to the lease obligation, the diIIerence in CFO increases over the lease.
CL thereIore decreases operating cash outIlow while increasing Iinancing cash
outIlow.

Capital Lease for a Lessor: see los I please.

Summary (For a Lessee):

CL increases CFO (as only interest expense is deducted) and decreases FCF.
Comparing CL to OL:
For CL, current ratio decreases; debt equity ratio increases and times interest
coverage ratio decreases.
For an OL, lease payments (-L) go to CFO. CL: Only interest portion (-I) goes to
CFO. Since -L ~ -I (negatively) CFO will be overstated in CL.
For an OL, no asset is reported; no liability recognized; leverage ratios are
unaIIected; lease payments are expenses and Iully deductible, so no deIerred taxes
are required; all cash Ilows are operating cash Ilows.

All else equal, Iirms reporting operating leases will report better perIormance because:
Their balance sheet will report less debt.
They will report higher proIits, which appear to be generated by a relatively
smaller investment in assets.

Summary (For a Lessor): see los I please.





c. discuss the factors that determine whether a company would tend to favor capital or
operating leases.

See LOS a please.






Study Session 9 Liabilities
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d. describe types of off-balance-sheet financing.

Off-balance-sheet (OBS) financing is an attempt to borrow money in such a way that
liabilities are kept oII a Iirm's balance sheet and the associated interest expense oII its
income statement. The nature oI OBS Iinancing activities: the emphasis on accounting
assets and liabilities (A&L) rather than recognition oI economic resources and
obligations limits the useIulness oI Iinancial statements and encourages Iirms to keep
resources and obligations oII the B/S.

Why pursue OBS Iinancing? Historical cost B/Ss oIten underestimate the true value oI
assets, understating the Iirm's equity. Since the B/S lists the cost but not gain oI assets
there is little incentive to put assets on the BS in the Iirst place.

Avoid reporting high debt and leverage ratios (i.e. lower debt-to-equity ratio and
higher interest coverage ratio), and to reduce the probability oI technical deIault
under restrictive debt covenants.
Keep assets and potential gains oII the Iinancial statements but under the control
oI management.
To acquire these assets because they contribute to the operations oI the Iirm.
Assets excluded Irom the Iinancial statements do contribute to the operations oI
the Iirm.

Examples oI OBS Iinancing transactions:

Finance subsidiaries: Legally separate and Iully owned Iinance subsidiaries have
been used to purchase receivables Irom parents, which use the proceeds to retire
debt. II the parent Iirm owns more than 50 oI a Iinance subsidiary, the parent
controls the Iinance subsidiary, and the Iinancial statements oI the parent and its
Iinance subsidiary must be consolidated. II no more than 50, then the
consolidation is not required. For the purpose oI Iinancial analysis, the pro rata
share oI assets and liabilities in an uncontrolled Iinancial subsidiary should be
added back to the parent's balance sheet.

A Iirm can sell its receivables to an unrelated party, and use the proceeds to pay
oII its liabilities. Typically, the Iirm continues to service the original receivables,
and transIers payments oI those receivables to the buyer. The buyer is normally a
Iinancial institution or investor group. Sale of receivables to unrelated parties is
simply collateralized borrowing because receivables sold that have not yet been
collected should be considered as the selling Iirm's oII-balance-sheet short-term
liabilities. However, such transactions are recorded as sales under US GAAP, as
long as there has been a legal transIer oI ownership Irom the seller to the buyer.
To qualiIy Ior sale recognition, the seller typically sets up a nonconsolidated trust
or subsidiary that its creditors cannot access in the event oI bankruptcy. Such a
bankruptcy-remote subsidiary is reIerred to as a qualifying special-purpose
entity (QSPE). By reporting such transactions as sales, the seller can reduce
accounts receivable and increase cash Ilow Irom operations in the period oI sale.
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By using the proceeds Irom sale oI receivables to pay oII debt, a Iirm can reduce
accounts receivables and debt, and increase cash Irom operations (CFO). As a
result, sale oI receivables reduces the debt-to-equity ratio and increases
receivables turnover. Since uncollected receivables are in Iact its short-term
borrowing, the Iirm may report higher liquidity ratios (e.g. quick ratio) than iI
those receivables were not sold.

Take-or-pay contracts ensure long term availability oI raw materials and other
inputs necessary Ior operations. Under these arrangements, the purchasing Iirm
commits to buy a minimum quantity oI an input (raw materials Ior a take-or-pay
arrangement, and service such as pipeline transportation Ior a throughput
arrangement) over a speciIic time period. The purchaser must make speciIied
minimum payments even iI it does not take delivery oI the goods. Input prices
may be Iixed by contract or may be related to market prices. Natural resources
companies use throughout arrangements with pipelines or processors (such as
reIiners) to ensure Iuture distribution or processing requirements.

In essence, they are the purchaser's debt obligations, though kept oII the balance
sheet. These contracts are oIten used as collateral Ior bank or other Iinancing by
unrelated suppliers or by investors in joint ventures. The contract serves as an
indirect guarantee oI the related debt. However, neither the assets nor the debt
incurred to obtain operating capacity are reIlected on the balance sheet oI the
purchaser. The eIIect is to allow Iirms to acquire use oI operating capacity
without showing associated A&Ls on the B/S, resulting lower debt-to-equity
ratios Ior these Iirms. Analysts should add the present value oI minimum Iuture
commitments to both property and debt.

Commodity linked bonds: Firms may Iinance purchases oI inventory with debt
linked to some underlying commodity to serve as a natural hedge against changes
in commodity and inventory prices. These bonds' interest payments and/or
principal repayments depend on the price oI the underlying commodities.
Changes in commodity prices should be monitored to determine their impact on
the related debt. For the purpose oI Iinancial analysis, any change in debt value
should be reIlected in the balance sheet.

1oint Ventures: Firms acquire operations via joint ventures with other Iirms.
Financing may involve direct or indirect guarantees oI debt, which is not
recognized on the balance sheet oI any sponsoring Iirm. For the purpose oI
Iinancial analysis, debt guarantees (or proportionate share oI debt guarantees)
should be added to the debt oI the sponsoring Iirm.

Investment in affiliates: A Iirm may hold stock in another Iirm, and also issue
debt which it can exchange Ior the shares in the other Iirm, which should lower
their borrowing cost, deIer capital gains and give a tax break on dividends Irom
the shares. It still owns the investment and can use the cash.

Study Session 9 Liabilities
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e. determine how take-or-pay contracts, throughput arrangements, and the sale of
receivables affect selected financial ratios.

See LOS d please.






f. distinguish between a sales-type lease and a direct-financing lease.

For a lessor, the lease must be capitalized iI it meets anv one oI the Iour criteria speciIied
Ior capitalization by lessee and both oI the Iollowing revenue recognition criteria:
1. Collectability oI the minimum lease payments is reasonably predictable.
2. There are no uncertainties regarding the amount oI unreimbursable cost yet to be
incurred by the lessor.

Sale-leaseback (S-L) transactions are sales oI property by the owner who then leases it
back Irom the buyer-lessor. The seller leases its own property, rather than selling it
outright. Such leases involve two transactions:
Selling the property at the time the lease is initiated.
Providing Iinancing to the lessee.

At the inception oI the lease, a manuIacturer treats the transaction as iI it sold the asset to
exchange Ior an investment in a capital lease. It recognizes a gross proIit Irom the sale oI
the asset:
Sales present value oI lease payments. The total lease payments (un-discounted)
is known as the lessor's Gross Investment in Lease.
Cost oI goods sold cost oI leased asset - present value oI residual value.
Gross proIit (manuIacturer's proIit) sales - cost oI goods sold.
In balance sheet it also records an asset: net investment in lease present value
oI lease payment present value oI residual value. The diIIerence between gross
investment in lease and net investment in lease is the unearned interest income,
which is the Iinancing income component oI the manuIacturer's total proIit.

Periodic transactions:
Each year over the liIe oI the lease, interest income is recognized using the
Iollowing Iormula: interest income the year's beginning value oI net investment
in lease x implicit interest rate oI the lease. It is a cash Ilow Irom operations.
The diIIerence between lease payment and interest income represents the portion
oI Net Investment in Lease recovered during the year. Recovery in Net
Investment in Lease in an investment cash Ilow.
The Net Investment in Lease at the end oI the year is: the year's beginning value
oI Net Investment in Lease - Net Investment Recovery.
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In a direct financing lease, a leasing company purchases a property Irom a manuIacturer,
and then leases the equipment to the lessee. The distinction between a sales-type lease
and a direct Iinancing lease is the presence /absence oI a manuIacturer's or dealer's proIit.
In a direct Iinancing lease, the cost oI the leased asset equals its market value, so only
Iinancing income is involved. In a sales-type lease, the cost oI the leased asset is less than
its market value (the present market value oI lease payments), creating a manuIacturer's
or dealer's proIit in addition to Iinancing income.

As in a direct Iinancing lease the lessor's original cost or carrying value (prior to the lease)
oI the asset approximates the market value oI the leased asset (the present value oI the
MLPs), such leases are pure Iinancing transactions and Iinancial reporting Ior direct
Iinancing leases reIlects this Iact. No sale is recognized at the inception oI the lease, and
there is no manuIacturing or dealer proIit. Only Iinancing income is reported.

EIIects oI Sales-Type and Operating Leases on Lessor's Financial Statements

Balance Sheet:

Operating Lease: the book value oI the asset is reported on the balance sheet as a
long-term asset, net oI accumulated depreciation.
Sales-Type Lease: Net investment in lease in reported in the balance sheet, and is
amortized over the liIe oI the lease. It is greater than the book value oI the asset.
The current and noncurrent components oI the net investment in lease are reported
separatelly. The current component is the amount oI net investment to be
recovered in the next year. The gain Irom sale oI the asset recognized at the
inception oI the lease increases shareholder's equity.
ThereIore, sales-type lease results in higher total asset and higher shareholders'
equity.

Income Statement:

Operating Lease: at the inception oI the lease, no income is recognized. Over the
liIe oI the lease, income tends to be constant iI straight-line depreciation is used.
Sales-Type Lease: at the inception oI the lease, the gain Irom the sale oI the lease
asset is recognized. Over the liIe oI the lease, interest income tends to decline
over time.
The sales-type lease reports substantially higher income at the inception oI the
lease, thus recognizing income earlier than an operating lease. However, total
income over the liIe oI the lease is the same Ior both oI them.

Cash Flow Statement:

Operating Lease: at the inception oI the lease, no cash Ilow occurs. Over the term
oI the lease, the entire lease payment is reported as an operating cash inIlow.
Sales-Type Lease: at the inception oI the lease, gain Irom the sale oI the leased
asset is reported as an operating cash inIlow. This cash inIlow is oIIset by a net
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cash outIlow Ior investment (net lease investment less cost oI leased asset). Net
cash Ilow remains zero. Over the term oI the lease, the lease payment Irom the
lessee is allocated to interest income (operating cash inIlow) and net investment
recovery (investing inIlow).
Sales-type lease reports higher operating cash Ilow at the inception oI the lease,
but lower operating cash Ilow over the lease term.