FSA 8 Topics in Long-Term Liabilities and Equity

Non-current liabilities come from many financing sources. The reporting of ordinary bonds and loans is settled in the prerequisite material, so this reading concentrates on the harder cases: leases, postemployment obligations, and share-based pay. All three have grown into a large slice of how companies finance assets and pay people, and each is governed by two rule makers whose treatments overlap but are not identical: the International Accounting Standards Board, author of IFRS, and the Financial Accounting Standards Board, author of US GAAP.

A lease is a contract that grants a party the use of a named asset over a fixed span in return for payment. The party that uses the asset and pays is the lessee; the party that owns the asset, grants the usage right, and collects payment is the lessor. For the lessee, a lease is financing that behaves much like buying an asset with a note payable. For the lessor, it is an investment that also widens the market for a product, since many customers would rather pay in installments than buy outright.

When a contract is a lease

A contract is, or contains, a lease only when three conditions hold together. It must point to a specific identified asset; it must give the customer substantially all of the economic benefits from that asset across the contract term; and it must let the customer, rather than the supplier, decide how and for what purpose the asset is used. A contract that names a specific truck, reserves it for the customer, and lets the customer direct its use is a lease. A contract that merely pays a carrier a fee to ship goods is not, because no particular truck is identified and the customer does not capture the asset’s benefits.

Why firms lease

Leasing carries several advantages over an outright purchase. It ties up little cash at the start, since a down payment is often small or absent. It tends to be a cheaper form of borrowing, because a lease is effectively secured: if payments stop, the lessor takes the asset back, so the built-in interest rate usually undercuts an unsecured loan or bond. It also shifts some ownership risks, such as obsolescence, onto the lessor. From the other side, a lessor that leases rather than sells earns interest across the term and reaches buyers who could not or would not pay the full price up front.

Finance versus operating classification

A lease can look like a financed purchase or like a rental. A ten-year lease on a vehicle with a ten-year life, priced so the payments add up to at least the vehicle’s fair value, is really a debt-funded purchase. A one-year lease on a machine that lasts twenty years is a rental. The first is a finance lease; the second is an operating lease. The dividing line is a set of five criteria, identical under IFRS and US GAAP and applied the same way by lessees and lessors. Meeting even one of them makes the lease a finance lease; if none is met, the lease is operating.

1. Ownership of the asset passes to the lessee.
2. The lessee holds a purchase option it is reasonably certain to exercise.
3. The term covers a major part of the useful life of the asset.
4. The lease payments, in present value, reach at least substantially all of the asset’s fair value.
5. The asset is so specialized that the lessor could put it to no other use.

How a lessee reports a lease turns on the accounting framework and, under US GAAP, on the finance-or-operating split. Before that, note two relief options open to lessees only: a lease whose term is twelve months or shorter (IFRS and US GAAP), or a low-value asset up to about USD5,000 in sales price (IFRS only), may simply be expensed straight-line, with no asset or liability recorded. Lessors do not get these exemptions.

Lessee accounting under IFRS

IFRS uses one model for every lease. At inception the lessee records a right-of-use (ROU) asset alongside a lease liability of equal size, each set to the present value of the future lease payments, discounted at the rate implicit in the lease or, failing that, an estimated secured borrowing rate.

The liability then unwinds by the effective interest method. Each payment splits into interest, equal to the outstanding liability times the discount rate, and principal, which is whatever the payment leaves over.

The ROU asset is amortized separately, usually straight-line across the term. Because principal reduction and straight-line amortization follow different paths, the liability and the asset start equal but drift apart in later years. On the statements, the lessee shows the net liability and net asset on the balance sheet, reports interest expense and amortization expense as separate income-statement lines, records the principal portion of each payment as a financing outflow, and classifies the interest portion as either operating or financing cash flow by policy.

The two schedules make the drift concrete. The liability is retired by the effective interest method, so its principal reductions start small and grow, while the asset falls by an equal EUR75,816 every year. As a result the liability sits slightly above the asset through the middle years, and the two meet again at zero.

Lessee accounting under US GAAP

US GAAP keeps two models. Its finance-lease model is identical to the IFRS approach above. Its operating-lease model differs in one place: the ROU asset amortization is set equal to the payment minus interest, not to a straight-line charge. That single change has three consequences. Total reported expense, interest plus amortization, equals the lease payment every year, so the income statement shows a flat, straight-line lease cost. The asset and the liability stay equal throughout, because they are both reduced by the same amount. And the income statement shows one combined line called lease expense, an operating expense, rather than separate interest and amortization.

On the cash flow statement the whole payment is an operating outflow, with no split between interest and principal. This contrasts with the finance lease, where only interest touches operating cash flow and principal sits in financing.

Lessor accounting is effectively the same under IFRS and US GAAP. The lessor first classifies the lease as finance or operating, and that classification drives the reporting. US GAAP labels finance leases either sales-type or direct financing, but the distinction rarely matters to an analyst.

Finance lease lessor

At inception the lessor records a lease receivable equal to the present value of future payments, using the rate implicit in the lease, and removes the leased asset from its books. Any gap between the receivable and the asset’s carrying amount is recognized at once as a gain or loss. The receivable then unwinds by the effective interest method: each receipt splits into interest income, equal to the outstanding receivable times the discount rate, and principal proceeds, the remainder. The balance sheet shows the net receivable, the income statement shows interest income (reported as revenue when leasing is a primary activity, as at banks and specialist lessors), and the entire cash receipt is operating cash flow.

Operating lease lessor

An operating lease is treated as a rental. The lessor keeps the asset on its books, recognizes lease revenue straight-line across the term, and continues to depreciate the asset. No interest income arises, because the arrangement is not a financing. The balance sheet is unaffected apart from ongoing depreciation, and the whole cash receipt is again operating cash flow, exactly as in a finance lease.

Employee pay is built to serve several goals at once: meeting workers’ need for liquidity, holding on to them, and rewarding performance. Its usual parts are salary, bonuses, insurance premiums and other non-monetary benefits, pension contributions, and share-based awards. Salary, most non-monetary benefits, and cash bonuses vest immediately or soon after grant, so accounting is simple: when the pay is earned, the firm records an expense at fair value and either pays cash or books a current accrued-compensation liability. Expense and cash outflow line up closely.

Deferred compensation and the two pension types

Deferred compensation vests over time and is harder to report, because service and cash payout can be years apart and the eventual amount may hinge on a future salary or a future share price. Pensions are the classic case, and they come in two shapes. Under a defined-contribution plan the employer pays an agreed amount into the plan, often a match to what the employee contributes. That contribution is the entire pension expense and an operating cash outflow; the only balance-sheet effect is the cash reduction, plus an accrued liability for any amount promised but unpaid at year end. Once the contribution is made the employer has no further obligation, so the employee bears the investment risk (returns may miss expectations) and the actuarial risk (retirement and lifespan may differ from forecasts).

Under a defined-benefit plan the employer instead promises a future benefit, for instance an annual pension equal to 70 percent of final salary until death. Measuring that promise takes many assumptions about future salary and longevity; the estimated future payments are discounted to a present value at a rate tied to high-quality corporate bond yields. Most such plans are funded through a separate trust the employer pays into and retirees draw from. Comparing the trust’s assets with the obligation gives the funded status reported on the balance sheet.

A surplus is shown as a net pension asset; a deficit as a net pension liability. Here the employer, not the employee, carries both the investment and the actuarial risk.

Reporting the change under IFRS

Under IFRS the periodic movement in the net position, whether asset or liability, divides into three parts. Two hit the income statement as pension expense: the service cost, which is the present value of the extra benefit earned by one more year of employee service (including any past service cost from plan changes), and the net interest on the opening net asset or liability, calculated as that balance times the discount rate. The third part, remeasurements, goes to other comprehensive income and is never recycled into profit or loss. Remeasurements gather actuarial gains and losses (from revised assumptions such as turnover, mortality, or pay growth) and the gap between the actual return on plan assets and the return already captured in net interest.

Reporting the change under US GAAP

US GAAP breaks the same change into five parts. Three reach the income statement as they are incurred: service cost, interest expense on the opening obligation, and the expected return on plan assets, which reduces expense. The remaining two, actuarial gains and losses together with past service costs, go first to other comprehensive income and are then amortized into pension expense over time, which smooths their effect (US GAAP does allow immediate recognition of actuarial gains and losses in profit or loss). Reported pension expense is spread by function, so a manufacturer routes production-worker pension cost through inventory and cost of sales and other pension cost through selling, general, and administrative expense. Because of this, the figure is rarely a single visible line, and the detail lives in the notes.

Share-based compensation is deferred pay meant to line employees’ incentives up with those of shareholders, and it tends to concentrate among senior staff such as executives and directors. Its headline appeal is that it can require no cash outlay. Even so, it is still an expense that lowers earnings, and by issuing shares it can dilute earnings per share; some arrangements are cash-settled and instead build up a liability.

The alignment case has limits worth naming. Issuing shares dilutes existing owners. Recipients often have little sway over the market value they are paid in, especially over broad market moves, so the reward can be poorly matched to their own effort. Larger ownership can also push managers toward caution, avoiding risky but profitable projects to protect their own wealth; option awards can do the opposite, since an option’s payoff rewards the upside while the downside stops at zero, tempting excessive risk taking.

Common ground on measurement

Under both IFRS and US GAAP the firm estimates the fair value of the award at the grant date and expenses it evenly over the vesting schedule. Movements in the share price after the grant date do not change the reporting. The mechanics then depend on the award type.

Stock grants

Stock may be awarded outright, subject to restrictions, or tied to performance targets. An outright grant carries compensation expense equal to the grant-date fair value, generally the market price, spread over the service period (assumed to be the current period unless future service, say three years, is required to vest). A restricted stock grant makes the employee forfeit the shares if conditions, such as staying a set time or hitting targets, go unmet; expense is again grant-date fair value over the service period. Performance shares tie the award size to a metric such as return on assets or accounting earnings rather than the share price, which answers the complaint that the price lies outside employees’ control, though it can invite manipulation of the accounting numbers. In each case the charge is grant-date fair value spread over the service period. Over recent years firms have leaned more on restricted stock units and less on options, since a grant keeps value as long as the price is above zero while an option can expire worthless.

Stock options

Options are also expensed at fair value, but that value must be estimated with a model, because employee options differ enough from traded options that market prices do not apply. The choice of model, such as Black-Scholes or a binomial lattice, is one of the most consequential inputs; standards prescribe no single model but require that it suit fair value measurement, rest on sound financial-economic theory, and capture the award’s substantive features. Once a model is chosen, the firm sets its inputs: exercise price, share-price volatility, expected life, expected forfeitures, dividend yield, and the risk-free rate. Some, like the exercise price, are known; others, like volatility and expected life, are highly subjective and swing the answer. Higher volatility, a longer expected life, and a higher risk-free rate all raise the estimated fair value, while a higher assumed dividend yield lowers it.

GSK values its savings-related options with a Black-Scholes model.

Four dates govern option accounting: grant, vesting, exercise, and expiration. The grant date is when options are awarded and, if the number of shares and the price are known, when expense is measured. The service period usually runs from grant to vesting, and the fair value is expensed over it; awards that vest immediately are expensed at once. At exercise, the option’s market price on that day is irrelevant, since the expense was already fixed at grant-date fair value. The firm takes in the exercise-price cash and issues shares; over the award’s life the expense reduces retained earnings while paid-in capital rises by the same route, so recognizing option expense has no net effect on total equity.

Cash-settled forms

Some awards track the share value without handing over shares. Stock appreciation rights (SARs) pay an employee based on the rise in the share price: they keep the motivating upside, limit downside like options, and do not dilute ownership. Phantom stock works similarly but pays on the performance of hypothetical rather than real shares, which lets private companies, non-traded business units, or highly illiquid firms use it. Both are measured at fair value with expense spread over the service period, and both are cash-settled, so they can create a liability rather than added equity.

For leases, pensions, and share-based pay, most of the analytical detail lives in the notes. Across all three, the disclosure aim is the same: give users enough to judge the amount, timing, and uncertainty of the related cash flows.

Lease disclosures

On the balance sheet a lessee typically shows a right-of-use asset among non-current assets and a lease liability among long-term liabilities, though smaller amounts may be folded into other assets or other liabilities. Under IFRS 16 a lessee also discloses, for the period, the carrying amount of ROU assets by asset class, the total cash paid on leases, the interest borne on lease liabilities, depreciation of ROU assets by class, and additions to those assets, together with a maturity analysis of lease liabilities kept separate from other debt, plus qualitative detail on leasing activity, off-balance-sheet exposures, covenants, and any sale-and-leaseback deals. A lessor discloses, for finance leases, any selling profit or loss plus finance income earned on the net investment, and for operating leases, lease income; both come with maturity analyses of the amounts receivable, listing undiscounted amounts for each of the first five years and then a total for the years beyond.

From Apple’s 2021 lease note. The weighted-average remaining term was 10.8 years and the discount rate 2.0 percent in 2021.

Postemployment disclosures

Notes carry the pension detail, far more of it for defined-benefit than defined-contribution plans. For a defined-contribution plan, IAS 19 asks only for the amount recognized as expense in the period, though regulators may require more (the US SEC, for example, requires a separate Form 11-K for employee benefit plans). For defined-benefit plans, IAS 19 sets three objectives: explain the plans and their risks, identify and explain the amounts they put on the statements, and describe how they affect the timing and uncertainty of future cash flows. Though principles-based, it still prescribes specifics: the nature of the benefits and governance, a reconciliation of the opening and closing net asset or liability with separate roll-forwards for plan assets and the obligation, a sensitivity analysis of key assumptions such as the discount rate, the composition of plan assets by category, and an indication of the effect on future cash flows.

Share-based compensation disclosures

IFRS 2 requires enough disclosure for users to grasp the nature and extent of the arrangements and their expected cash flows and expenses. That includes a description of each type of arrangement with its terms, such as vesting requirements, the maximum option term, and whether settlement is in cash or equity; a roll-forward of option numbers and weighted-average exercise prices covering options outstanding at the start, granted, forfeited, exercised, expired, outstanding at the end, and exercisable at the end; and, for other equity instruments granted, their number and weighted-average fair value at the measurement date along with how that value was found. A company such as Apple discloses this through a restricted-stock-unit roll-forward and its total unrecognized compensation cost with the weighted-average period over which it will be recognized.