Financial Reporting

SESSION 5

Liabilities

1
Objectives
• Revise the concept of liabilities

• Learn how to distinguish between provisions and contingent liabilities

• Discuss bond loans and its accounting treatment

• Learn about lease contracts

• Learn what a sale and leaseback is

• Introduce asset securitisation

2
Concepts
• Liabilities represent, beside shareholders’ equity, the other source of funding for
the business

• What is the definition of liabilities in GAAP?

• Present obligation arising from past events
• Probable future outflow of resources resulting from the settlement of
present obligation
• The amount of which the settlement will take place can be measured
reliably
• If one or more of the above criteria is not met, a liability is contingent (a loss
contingency). It is not recognized on the balance sheet but is disclosed as an off
balance sheet item

3
Contingent liabilities – off balance sheet
• Examples of contingent liabilities that could not be recognized on the
balance sheet (as they do not pass one of the defining criteria):

• A commitment to purchase non-current assets next year (unless

there is a legally binding contract)
• A remote, but potential liability for a defective product, where no
court action has yet commenced
• A guarantee given to support the bank overdraft for another
company, where there is very little likelihood of being called upon to
meet the guarantee

4
 Provisions - on the balance sheet
• Sometimes, the amount of an obligation may not be certain even
though its existence is certain or highly likely

• Recall the prudence principle: A degree of caution/conservatism

should be applied in exercising judgment and making the necessary
estimates

• When future expenditure is certain or highly likely to be incurred for

which there is uncertainty about the amount and/or the timing of
payment a provision should be created

• Provision is the best estimate of a future expected loss of resources

on the basis of available information

• Recording a provision in the B/S means creating a liability

• The I/S counterpart is the recognition of an expense

5
Provisions
IAS 37 – Provisons. Defines provisions as liabilities of uncertain timing
or amount

A provision should be recognised when, and only when:

(a) an entity has a present obligation as a result of a past event;

(b) it is probable (i.e., more likely than not) that an outflow of resources
embodying economic benefits will be required to settle the obligation;
and

(c) a reliable estimate can be made of the amount of the obligation

6
Provisions
• These include:
– Restructuring provisions (e.g. future termination of a line of business, a
business in a country)

– Environmental provisions (e.g. environmental liabilities, such as remediation

costs, related to past mining activities)

– Decommissioning provisions (e.g. oil rig or nuclear power station needs to be

dismantled at the end of its life)

– Litigation and other legal claims

7
Provisions
Example
• Alfa plc is preparing 2019 financial statements. The company is
engaged in a legal suit concerning compensation of former employees.
The legal advisors estimated the required settlement to be around
£100,000

• Although the company is not yet contractually obliged to make this

settlement, the prudence concept requires that a provision is established to
record the best estimate of the future liability

• Assume that in 2020, the dispute is settled and the company agreed to
pay £90,000.

8
Provisions – accounting entries
Assets = Liabilities + Equity
Cash Provision Profit Retained
(I/S) profit
2019
Recognition provision 100,000 (100,000)
Transfer to ret.profit 100,000 (100,000)
Closing balance 100,000 0 (100,000)
2020
Opening balance 100,000 (100,000)
Settlement / cancel
provision (90,000) (100,000) 10,000
Transfer to ret.profit (10,000) 10,000
Closing balance (90,000) 0 0 (90,000)

9
Quick exercise: Monte dei Paschi di Siena

September 2015

Monte dei Paschi di Siena, the world’s oldest lender, took legal action
against Japanese bank Nomura in March 2013 over a controversial
derivatives trade dating from the financial crisis in 2009. The Italian
bank claimed that Nomura colluded with former Monte dei Paschi
executives to conceal substantial losses. In September 2015 Nomura
settled the lawsuit and agreed to pay $290m.

Suppose Nomura has a provision of $250m in its 2014 accounts concerning these
charges. What accounting entries did Nomura do in 2015 accounts (after settling the
lawsuit)?

10
Quick exercise: Monte dei Paschi di Siena
Accounting entries:

Assets Liabilities + Equity

Profit
(I/S)
2014
Provisions for legal
disputes

2015

11
Quick exercise: MPS - solution
Accounting entries:

Assets Liabilities + Equity

Profit
(I/S)
2014
Provisions for legal 250 (250)
disputes

2015

Payment and cancellation (290) (250) (40)

of the provision

12
 Liabilities (provisions) versus contingencies

• The accounting treatment of an obligation depends on

whether the obligation is:

A = L + E (I/S)
Accrual (provision) - Provision expense

13
 Liability or contingency?

• Chevron Corp. signs a throughput contract with an oil pipeline company to ship
at least 10,000 barrels of crude oil per month for the next three years. Chevron
promises to pay for the pipeline services even if it does not ship the oil.

• Alcoa of Australia (AofA) is party to a number of natural gas and electricity

contracts that expire between 2017 and 2025. Under these take-or-pay
contracts, AofA is obliged to pay for a minimum amount of natural gas or
electricity even if these commodities are not required for operations.

• Held Up Ltd manufactures designer belts.  A competitor company has raised a

court action claiming that Held Up Ltd has infringed its copyright on a buckle
design.  The lawyers acting for Held Up Ltd are confident that the competitor will
not be successful in its court action. 

14
 Liability or contingency?
• Chevron Corp. signs a throughput contract with an oil pipeline company to ship
at least 10,000 barrels of crude oil per month for the next three years. Chevron
promises to pay for the pipeline services even if it does not ship the oil.
Liability
• Alcoa of Australia (AofA) is party to a number of natural gas and electricity
contracts that expire between 2017 and 2025. Under these take-or-pay
contracts, AofA is obliged to pay for a minimum amount of natural gas or
electricity even if these commodities are not required for operations.
Liability

• Held Up Ltd manufactures designer belts.  A competitor company has raised a

court action claiming that Held Up Ltd has infringed its copyright on a buckle
design.  The lawyers acting for Held Up Ltd are confident that the competitor will
not be successful in its court action. 
No disclosure but note on contingency permitted
15
 Liabilities or contingencies or no disclosure?

• Boise Cascade and Georgia-Pacific start a joint venture to process pulp. The joint
venture uses the purchase commitments of Boise Cascade and Georgia Pacific to
obtain a loan for the facility.

• Andox Ltd., a supplier of medical equipment gives a one year warranty on one of
its products. Experience shows that these products are extremely reliable and
none has ever been returned within the warranty period.

• A company has acted as guarantor for an overdraft facility taken out by one of its
subsidiaries.  The subsidiary has gone into liquidation owing the bank £500,000. 
The subsidiary has no other assets and it is likely that the company will require to
fulfil the guarantee. 

16
 Liabilities or contingencies or no disclosure?

• Boise Cascade and Georgia-Pacific start a joint venture to process pulp. The joint
venture uses the purchase commitments of Boise Cascade and Georgia Pacific to
obtain a loan for the facility.
No disclosure or a note on contingency
• Andox Ltd., a supplier of medical equipment gives a one year warranty on one of
its products. Experience shows that these products are extremely reliable and
none has ever been returned within the warranty period.
No disclosure or a note on contingency
• A company has acted as guarantor for an overdraft facility taken out by one of its
subsidiaries.  The subsidiary has gone into liquidation owing the bank £500,000. 
The subsidiary has no other assets and it is likely that the company will require to
fulfil the guarantee. 
Liability

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 Liabilities or contingencies or no disclosure?

• A company is facing a legal claim for £750,000.  The company’s lawyers estimate
that there is a 30% chance of successfully defending the claim.
• Should the firm make a provision in its B/S?
• What would be the best estimate of the provision if it is made?

• Goods are sold by a firm under warranty agreements. Previous pattern of

warranty repairs shows that 80% of goods will have no defects, 15% will have
small defects and 5% will have major defects. The costs of rectifying the defects
in all goods sold are £5m for small and £9m for major defects.
• Should the firm make a provision in its B/S?
• What would be the best estimate of the provision if it is made?

18
 Liabilities or contingencies or no disclosure?

• A company is facing a legal claim for £750,000.  The company’s lawyers estimate
that there is a 30% chance of successfully defending the claim.
• Should the firm make a provision in its B/S?
Yes
• What would be the best estimate of the provision if it is made?
£750,000
• Goods are sold by a firm under warranty agreements. Previous pattern of
warranty repairs shows that 80% of goods will have no defects, 15% will have
small defects and 5% will have major defects. The costs of rectifying the defects
in all goods sold are £5m for small and £9m for major defects.
• Should the firm make a provision in its B/S?
• What would be the best estimate of the provision if it is made?
• Provision estimate = (80% x 0) + (15% x £5m) + (5% x £9m) = £1.2m
19
 Liabilities – quick exercise
• In which of the following cases would a company recognise a liability?

• A commitment to buy equipment next year

• A remote possibility of court action arising from the sale of a
defective product
• A guarantee to support the bank overdraft of a subsidiary company
where there is very little likelihood of being called upon to meet the
guarantee
• Repairs to a factory are made before the year end but the invoice
from the contractor is not received until two months after the year
end

20
 Liabilities – solution
• In which of the following cases would a company recognise a liability?

• A commitment to buy equipment next year

• A remote possibility of court action arising from the sale of a
defective product
• A guarantee to support the bank overdraft of a subsidiary company
where there is very little likelihood of being called upon to meet the
guarantee
• Repairs to a factory are made before the year end but the invoice
from the contractor is not received until two months after the year
end

21
 Liabilities – quick exercise
• Which of the following events would not normally result in a liability?

• Receiving a supplier’s invoice after taking delivery of goods

• Overdrawing the bank account
• A decision to purchase equipment
• Taking out a loan and receiving the borrowed funds

22
 Liabilities – solution
• Which of the following events would not normally result in a liability?

• Receiving a supplier’s invoice after taking delivery of goods

• Overdrawing the bank account
• A decision to purchase equipment
• Taking out a loan and receiving the borrowed funds

23
Long Term versus Current Liabilities

24
Liabilities - classification
• It is conventional to classify liabilities into current and non-
current (or long-term) liabilities

• Current liabilities
• Expected to be settled in the entity’s normal operating
cycle
• Held primarily for the purpose of being traded
• Due to be settled within one year of the balance sheet
date
• Non-current liabilities – if none of the above

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 Liabilities
• Current or non-current?

• Accounts payable
• Bonds
• Short-term borrowings
• Long-term loans
• Mortgages
• Current portion of long-term debt
• Deposits
• Deferred Revenues
• Capital Leases
• Warranties

26
 Liabilities
• Current liabilities
• Reported on balance sheet at nominal value

• Non-current liabilities
• Reported on the balance sheet at present value based
on interest rate when initiated

• How do we compute present values? How do we compute

interest expense?

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Present value (revision)
• LT liabilities are usually valued using the present value concept

• Present value represents the value today of cash flows that will be
received or paid in future periods

• The time-value of money:

• One unit of money in the future is not equivalent to the same unit of
money today
• Receiving £1 today is preferred to receiving £1 in 1 year time

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Time value of money
Receiving £1 today and investing it for 1 year with an interest rate (r) of
10%:
£1 ?
time 0 1
today year

• The future value of £1 today = £1 x (1 + r) = £1 x (1+10%) = £1.10  

• What is the present value of £1.10 to be received one year from now?

• The present value of £1.10 one year from now = £1.10 / (1 + 10%) = £1  

29
Present value
Suppose you were offered £1,000 for your next birthday in exactly one
year time
? + £1,000 Cash flows
time 0 1
today year

• The present value of £1,000 to be received in one year is the amount of

money you would have to be offered today in order to make you indifferent
between having £1,000 in one year or today 

• Analytically:

Where: PV = present value

X = cash flow
r = discount rate or rate of return
1 / (1 + r) = discount factor
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 Present value
Suppose you were offered £1,000 for your next birthday in exactly one
year time
? + £1,000 Cash flows
time 0 1
today year

If the discount rate is 10%, the PV of £1,000 in one year is:

PV = 1,000 / (1 + 0.1)
The discount rate takes into
= 1,000 x 0.909 = 909.09 (aprox.)
account factors such as
interest rates, risk,
opportunity cost

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Present value
Suppose now that will receive the £1,000 only in three years time

? + £1,000 Cash flows

0 1 2 3

PV = 1,000 / (1 + 0.1)3
= 1,000 x 0.7513 = 751.31

Generically, the PV at time 0 of future cash flows occurring in

n periods of time is:

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Present value for multiple cash flows
What would you prefer:
a) receive £1,000 in 3 years time or;
b) receive £500 in 2 years time plus £500 in 3 years time ?

Option a)
PV = 751.31

Option b)
PV = 500 / (1 + 0.1)2 + 500 / (1 + 0.1)3 = 788.88

Because the time-value of money, cash flows can only be added

when they are referred to the same moment in time (i.e., at present
value)
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Present value for multiple cash flows
Exercise

Calculate the present value of a loan that requires an annual payment of

£3,000 in one year time, a payment of £2,000 in two years time and a
payment of £1,500 in three years time. Assume a discount rate of 5%

PV0 = ?

34
Present value for multiple cash flows
Exercise

Calculate the present value of a loan that requires an annual payment of

£3,000 in one year time, a payment of £2,000 in two years time and a
payment of £1,500 in three years time. Assume a discount rate of 5%

PV0 = 3,000 / (1.05) + 2,000 / (1.05)2 + 1,500 / (1.05)3 = 5,967

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Bonds

36
Bonds
Bond
Debt security, in which the issuer (the borrower) owes the bond holder (the
lender) a debt and is obliged to repay the principal and interest (the
coupon) at a later date, termed maturity

– Bonds are generally issued for a fixed term (the maturity) longer than one year
– Companies issue bonds to obtain large amount of financing. It is not realistic for
individuals and small business to issue bonds
– Bond issue is costly to the issuer and usually requires a financial institution to set
the operation and act as intermediary
– It involves more than one bondholder (many investors), which are not known by
the company. In a traditional loan a single borrower and a single lender relate
directly

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Bonds
• Bonds
• Period interest payments and face value due at maturity
• Face value (amount)
• Principal amount due at maturity
• Interest payments
• Coupon rate times face value of bond
• Coupon rate is the interest rate stated in the note. It is used to
calculate interest payments
• Market interest rate
• The interest rate demanded in the market given the risk
characteristics of the bond
• Can be higher or lower than the coupon rate

38
Bond value
• Bond value is determined by the interest rate demanded by the
market (i.e., effective interest rate) relative to the interest rate offered
by the firm (i.e., stated interest rate)
 
• Relative to the face value of a bond, the bond price can be equal to
(at par), below (at a discount) or above (at a premium) the face value
or nominal value : 
   par stated rate = effective rate 
    discount stated rate < effective rate
    premium stated rate > effective rate

39
Accounting treatment of bonds
The bond liability (or any held to maturity debt instrument) is recognised in the
B/S at amortised cost. Interests are recognised in the I/S based on the
effective interest method (IAS 39)

• In the B/S, the bond issuance will be recorded as a liability (“bond payable”)
measured at amortised cost
Amortised cost at the end of period =
amortised cost at the beginning of period
+ interest expense (income)
- interest cash flow
• In the I/S, interest expense is recorded based on the effective interest rate method
Interest expense (income) =
amortised cost at the beginning of period
x effective interest rate
40
Accounting for bond issued at par
Example
On 1 Jan X1, company issues £100m bonds with annual coupon at
9%, paid at the end of each year. Market interest rate is 9%. The
principal is repaid on 31 Dec X2.

• Coupon (stated interest) rate 9% = Effective (market) rate 9%.

• As prospective investors require a rate of return of 9%, the bond
is issued at face value, i.e., bond price = face value
• PV (bond price) on 1 Jan X1 = 9 / (1.09) + 109 / (1.09)2 = £100

41
Accounting for bond issued at par
Coupon rate (9%) is equal to the market rate required by investors (9%)

• Cash flow to bond issuer at the bond issue date

• PV of cash flows to bondholders discounted at the MARKET interest
rate of 9% is the amount that investors would be willing to pay for a
bond with £100 face value:
• £ 100 [PV = 9 / (1.09) + 109 / (1.09)2 ]

• Transactions at the time of the bond issue:

Dr Cash 100
Cr Bond Payable 100

42
Accounting for bond issued at par
• Cash flow to bondholders over two years:

• Cash interest payments = Face Value x Coupon rate = £9

• Bond payable recorded at the present value of future cash flows
(interest and principal)
• Interest expense = Bond payable x effective interest rate
• Difference between interest expense and cash interest payments is
added to Bond payable (no difference for bonds issued at par)

• At maturity:
• Cash interest and entire principal (face value) balance are paid = £9 +
£100
43
Accounting for bond issued at par
• At the end of period X1
• Interest expense = £100 x 9%
• Cash interest payment = £100 x 9%

Dr Interest expense 9
Cr Cash 9

• At the end of period X2

Dr Interest expense 9
Cr Cash 9
Dr Bond payable 100
Cr Cash 100

44
Accounting for bond issued at par
• In this case, stated rate = effective rate; interest expense = interest payment

Assets Liabilities Equity

Bonds Profit Retained

Cash payable (I/S) profit
Year X1
Bond issuance 100 100
Interest expense (9) (9)
Transfer to ret.profit 9 (9)
Closing balance 91 100 (9)
Year X2
Opening balance 91 100 (9)
Interest expense (9) (9)
Principal repayment (100) (100)
Transfer to ret.profit 9 (9)
Closing balance (18) (18)

45
Accounting for bond issued at discount
Stated rate is less than effective rate

• The required rate of return by the market (effective rate) is 12%

• The stated rate (coupon rate) is 9%

• Cash flow to bondholders

• Cash interest payments = Coupon rate x Face value = £9
• Principal at maturity = £100
• PV of cash flows discounted at the MARKET interest rate of 12% is the
amount that investors would be willing to pay for a bond with £100 face
value:
• £ 94.93 [ PV = 9 / (1.12) + 109 / (1.12)2 ]

46
Accounting for bond issued at discount
• Proceeds from bond issue

• The firm receives £94.93 which is less than the bond face value of
£100 because it is not offering the market rate
• The discount of £5.07 (£100 - £94.93) can be viewed as the PV of
the interest rate ‘shortfall’
• Bond payable £100
• Less Discount (£5.07)
• Amortized cost (net bond payable) £94.93

Dr Cash 94.93
Cr Bond payable 94.93

47
 Accounting for bond issued at discount
The following table shows the amortised cost, interest expense, cash flow
of the bond in each period

Period Amortised Interest Cash Amortised

cost at the expense flow cost at the
beginning end

a b = a x ef.rate c d = a+b-c
X1 94.93 11.39 ≠ 2.39 9 97.32
X2 97.32 11.68 ≠2.68 109 0

≠5.07
Total interest expense: 11.39 + 11.68 = 23.07 The discount is recognised in I/S during
Total cash flow: 9 + 9 = 18 the life of the bond (matching principle)
23.07 - 18 = 5.07

48
Accounting for bond issued at discount
• In periods after the bond issue:
• The bond issuer pays Cash interest payments = Face Value x
Coupon rate
• The bond issuer accounts for the Interest expense in the I/S =
Bond payable for that year x effective interest rate
• Difference between interest expense and cash interest
payments is added to Bond payable
• At maturity:
• Interest and entire principal balance are paid

49
Accounting for bond issued at discount
• At the end of period X1

• Interest expense
• Amortized cost (net bond payable) x 12% = 94.93 x 12% = 11.39

Dr Interest expense 11.39

Cr Cash 9
Cr Bond payable 2.39

• Amortized cost (net bond payable) = 94.93 +11.39 – 9 = 97.32

50
Accounting for bond issued at discount
• At the end of period X2

• Interest expense
• Amortized cost (net bond payable) x 12% = 97.32 x 12% = 11.68

Dr Interest expense 11.68

Cr Cash 9
Cr Bond payable 2.68

• Amortized cost (net bond payable) = 97.32 +11.68 – 9 = 100

51
Accounting for bond issued at discount
Implications on financial statements for a bond issuer:
Assets Liabilities Equity

Bonds Profit Retained

Cash payable (I/S) profit
Year X1
Bond issuance 94.93 94.93
Interest expense (9) 2.39 (11.39)
Transfer to ret.profit 11.39 (11.39)
Closing balance 85.93 97.32 (11.39)
Year X2
Opening balance 85.93 97.32 (11.39)
Interest expense (9) 2.68 (11.68)
Principal repayment (100) (100)
Transfer to ret.profit 11.68 (11.68)
Closing balance (23.07) 0 (23.07)

52
Zero Coupon Bonds
Zero Coupon Bonds
Do not pay any interest in cash, only repayment of nominal value at
maturity

Example
Assume a zero-coupon bond that pays £1,000 in three years’ time is
issued on 31 December 2019. Market interest rate is 10%.
What is the present value of such a bond at the time of issue?
Calculate the interest expense to recognise in the I/S and the
amortised cost of the bond (net bond payable) to recognise in the
B/S

53
Zero Coupon Bonds
• PV of 1,000 to be received in three years time:
1,000 / (1 + 10%)3 = 751.31

• At the time of bond issue (31 Dec. 2019)

Dr Cash 751.31
Dr Bond payable 248.69
Cr Bond payable 1,000
• B/S presentation:
• Bond payable 1,000
• Less discount (248.69)
• Amortized cost (net bond payable) 751.31
54
Zero Coupon Bonds
• At the end of year 1 (31 Dec. 2020)
• Interest expense = 751.31 x 10% = 75.131
• Cash interest payment = 0

Dr Interest expense 75.131

Cr Bond payable 75.131

• B/S:
• Bond payable at the beginning of year 1 751.31
• Plus interest expense 75.131
• Minus cash payment 0
• Amortized cost (net bond payable) 826.44
55
Zero Coupon Bonds
• PV of 1,000 in three years time:
1,000 / (1 + 10%)3 = 751.31

• Interest expense and amortised cost are as follows:

Period Amortised Interest Cash Amortised
cost at the expense flow cost at the
beginning end

a b = a x ef.rate c d = a+b-c
31.12.2019 751.31 0 0 751.31
31.12.2020 751.31 75.13 0 826.44
31.12.2021 826.44 82.64 0 909.08
31.12.2022 909.08 90.92 1,000 0

B/S opening I/S B/S closing

effect 56
balance balance
Leases

57
Leases
Lease is a contract between a lessor and a lessee. The lessor is the legal
owner of the asset and the lessee rents the asset from the lessor. The
lessor keeps the ownership of the asset and agrees to rent the asset to
the lessee for an agreed period of time for a rental payment.

Examples: motor vehicles, aeroplanes, ships, machines, computer

equipment

Asset
Lessor is Lessee has the
the legal Lessor Lessee economic
owner of benefits of the
the asset Rent asset

58
Economic Rationale for Leases
Operational advantages to the lessee:
• Flexibility: leasing avoids having to buy the asset that will
be required only seasonally, temporarily or sporadically
(leasing contract can be tailored)
• Lessor might be better positioned to lease the equipment again
• Leasing for short periods protects against obsolescence
(e.g, computer equipment)
• But lease payments are accordingly higher
• Leasing ready-to-use equipment can be more attractive if
the asset requires lengthy preparation and set-up

59
Economic Rationale for Leases
Financial advantages to the lessee
• Tax advantages: certain tax advantages when assets are
leased rather than purchased (in the UK it can attract 100%
relief of payments made against tax)
• Improves cash flow:
• lease payments can be tailored to suit the lessee’s cash flows (up
to 100% financing, instead of an e.g., 80% limit by banks)
• leasing avoids need to find large sums of cash either to buy the
asset outright or for deposits

60
Disadvantages of Leasing
Disadvantages to the lessee:
• Leased ready-to-use equipment may be of a lower quality
than custom build (resulting in lower quality products and
lower sales)
• High quality equipment might be unavailable for leasing
• Seasonal leasing may affect equipment availability and prices
• Premium must be paid for the protection against
obsolescence

61
Accounting treatment of leases
Finance lease
If the lease agreement is for more than 12 months it is regarded
as a finance (capital) lease
• Lessee records the leased asset in the balance sheet and reflects
the corresponding lease obligation
• Depreciation expense and interest expense is recognised in the I/S

Operating lease
If not a finance lease, treatment is as any other rent.
• No recognition in the balance sheet
• Lessee accrues rent expenses in the I/S

62
Finance lease
Example

• Contract lease with a term of 3 years. The agreement is non-cancellable,

requiring equal rent at the end of the year of £21,709
• The fair value of the equipment is £47,000. Its estimated useful life is 4 years
• The lessor company pays all of the executory costs except for the property
taxes of £2,000 per year, which are included in the annual payment to the
lessor
• The lease contains no renewal option, and the equipment reverts to the lessor
at the termination of the lease
• The lessee’s implicit interest rate is 15% and it is equal to the rate used by the
lessor
• The asset is not specific to the lessee activity

63
 Finance lease
Example

What is the value of the leased asset for the lessee?

PV of an equal payment debt instrument:

PV = (21,709 – 2,000) x 2.28323 = 45,000

Fair value = 47,000
PV amounts for 95.7% of fair value

64
Accounting for finance lease
• Depreciation expense = 45,000 (PV) / 3 years (contract life ) = 15,000
• Interest expense and lease liability =

Period Amortised Interest Cash Amortised

cost at the expense flow cost at the
beginning end

a b = a x ef.rate c d = a+b-c
1 45,000 6,750 19,709 32,041
2 32,041 4,806 19,709 17,138
3 17,138 2,571 19,709 0

65
 Accounting for finance lease
Accounting entries

Assets Liabilities Equity

Cash Assets Assets Lease Profit Retained

(at cost) (acc. depr.) payable (I/S) profit
Year 1
Lease contract 45,000 45,000
Depreciation expense (15,000) (15,000)
Property tax payment (2,000) (2,000)
Lease annual payment (19,709) (12,959) (6,750)
Transfer to ret.profit 23,750 (23,750)
Closing balance (21,709) 45,000 (15,000) 32,041 (23,750)

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Lease: financial reporting implications
Lessee:
Balance Sheet

• The asset and the loan are recognised at inception

Income Statement
• Interest expense and depreciation are recognised

Cash flow statement

• The payment is split into: interest expense (financing or operating cash outflow)
and capital repayment (financing cash outflow)

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Finance lease – quick exercise
A company enters into a 3 year finance lease of a machine
with a fair value of £4,800.  The useful life of the machine is
4 years.
The present value of the minimum lease payments
amounts to £4,500.  At the end of the lease the machine is
expected to have a residual value of £400.  The lessee’s
interest in the residual value is 75%. 
What will be the depreciation expense (using the straight
line method) for the machine in the lessee’s I/S?

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Finance lease – solution

(4,500 – 300)/3 = 1,400

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Finance lease – quick exercise
A machine is leased for four years at a rental of £1,000 per
year payable in advance.  The fair value of the machine is
£3,828 and the present value of the minimum lease
payments is £3,486.  Legal fees incurred in arranging the
lease amounted to £500. 
At what value would the machine be recognised in the
lessee’ Balance Sheet?

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Finance lease – solution

£3,486 + £500 = £3,986

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Sale and leaseback
Sale and leaseback agreement enables a company to raise cash by selling a
major asset such as land or property while retaining use of it

• If the lessee leases the asset for more than one year the accounting
treatment is similar to other leases

• Any gain obtained with the sale of the asset should not be recognised
immediately in the I/S. Instead, the excess is deferred and amortised
during the lease term

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Asset sale versus loan
• Sometimes a sale of an asset can be interpreted as a loan
i.e. the company obtains funding giving an asset as security

• For accounting purposes the derecognition (selling) of an asset implies

that the company has transferred all risks and rewards, namely the rights
to receive the cash flows generated by the asset, and that there is no
control over the asset

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Asset securitisation
Example 1

Ragueneau has a balance of £10m in trade debtors (accounts receivable).

Lise Asset Finance agrees to buy this balance for £9.5m. After that sale
Ragueneau has no right to receive the money from the trade debtors, nor
has it any further obligation to Lise Asset Finance.

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Asset securitisation
Example

Since after that sale Ragueneau has no right to receive the money from
the trade debtors, nor has it any further obligation to Lise Asset Finance,
we can record it as a sale:

Assets Equity

Cash Accounts Profit

receivable (I/S)

9.5 (10.0) (0.5)

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Asset securitisation
Example 2

On 1 January 2019 Ragueneau has a balance of £10m in trade debtors.

Lise Asset Finance (LAF) agrees to buy this balance for £9.5m.
Ragueneau and LAF also agree that Ragueneau will pay LAF at the end
of the year £10m in return for all the money collected by LAF.

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Asset securitisation
Example 2

Effectively, Ragueneau retains all the risks of bad debt. It also retains the
benefits arising from the asset (i.e., future cash collections). Therefore,
this is not a sale transaction, but rather a loan

Assets Liabilities Equity

Cash Loan Profit

(I/S)
01.01.2018 9.5 9.5

31.12.2018 (10) (9.5) (0.5)

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Summary
In this session we:

• Learned the difference between provisions and contingent liabilities

• Learned about present value calculations and how to apply it to valuation of

long-term liabilities

• Understood about bonds and its accounting treatment

• Learned the financial reporting implications of leases

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