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AYB311 W7 L.docx

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Queensland University of Technology

LECTURE 7 – DEBT, EQUITY AND OFF BALANCE SHEET ISSUES  Note: With tutorial homework this week, the last question about profit is a previous exam question. This should give an idea of a potential exam style questions. o The final revision lecture will go over the types of questions provided in the final exam, the marks allocated and the approach to take when answering it.  When doing the case study for this week – only consider the issue from an Accounting perspective NOT from a land rights, environmentalist etc approach. o Refer to the new upload of lecture slides on BB is unsure. Liabilities  AASB 137 defines a liability as: o a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits  More difficult than assets – there are more areas of contention and it is less well defined.  Key characteristics o Existence of present obligation  Either contractively or substantively o Obligation involves sacrifice of economic benefits in the future  Or a reduction of an asset o Obligation arises from past transaction or event  Does not have to be contractual – ie a legal obligation. But there must be a degree of firmness in a contract. Placing an order does not incur a liability as it can be cancelled, then the time for cancelling runs out then the order can be classed as a liability Recognition Criteria  An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; (b) the item has a cost or value that can be measured with reliability. (AASB Framework, para 83)  EXACTLY THE SAME AS FOR ASSETS  RC more likely to be satisfied where the obligation is mature or unconditional and settlement is certain o In terms of probability that future economic benefit will flow is more certain when looking at maturity or unconditional settlement  A liability that fails the RC may warrant note disclosure  Low levels of uncertainty associated with borrowing, accounts payable and accruals for expenses – the business will have to pay it back. Lot of certainty surrounding the fact that an outflow will be required.  Provisions are more uncertain – for example, long service leave. Different firms have different approaches to this as the liability for long service leave usually tends to start to accrue after 2-3 years. There is not a certainty at this point that there will be a liability that arises from this. The certainty for long service leave does not start until the amount can be accessed by the employee. This is also affected by people’s changing attitudes to workplaces and jobs and the longevity associated with that.  Contingent liabilities are the most uncertain – very high levels. This would be disclosed in a note rather than in the balance sheet. This provides high levels of uncertainty about economic resources and the amount associated with this. This is seen most in annual reports regarding legal action pending. For example, BP will disclose claims and costs associated with fixing the oil leak in Mexico as a contingent liability. At this point, the entity does not know whether in fact they will have a liability or not and the most certainly will not know how much the amount will be. These factors influence how much is provided in the note disclosure. o This is important for the case study and when analysing balance sheet information Recognition of Provisions  How much to recognise? AASB 137 para 36 o The amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the reporting date.  Appendix C of AASB 137 provides examples of recognition of liability provisions.  A provision is nearly always an estimate  A common provision is provided for warranties. All firms must account for some degree of fault in their items. This is an estimate because although the entity may be able to do research and find a certain percentage will be faulty, this figure is largely uncertain. Measurement of Liabilities  Some disagreement among accounting theorists about how liabilities should be measured  To measure a liability is to determine the weight or burden of the obligation on the balance sheet date. This burden is the lowest amount for which the obligation could be effectively discharged o These factors should be considered. This is how CFO’s think about liabilities o Note use of the lowest amount – this may not be the face value of the obligation.  Should be compatible with the way assets measured o This makes sense to allow for comparability. However, as per previous lecture, there can be a number of different measurement models. o This method is unlikely – it would be difficult to employ  In the absence of specific accounting standards, ultimate choice of measurement basis should be determined by reference to: o The objective of general purpose financial reporting; and o The qualitative characteristics of financial information  Think about if the decision is useful and if it is helping users to make better decisions. Is it relevant, reliable, comparable and understandable?  This is important when looking at financial instruments. General Principles of Measurements:  Current liabilities o Recognised at face value of the obligation be settled in the future  Loan for $10m = pay back $10m to the bank at some time in the future  Non-Current liabilities o Recognised at present value (NPV)  Usually involves some ammortised cost which takes into account the time value of money  Market value o May differ from NPV because the market uses current interest rates. The cost of capital for the business may be quite different to the market’s perception of the cost of capital.  This is used in financial intstrument Why is the classification important?  Balance Sheet effects o A balance sheet without numbers doesn’t make sense? o Classification of current or noncurrent is not as simple as it may seem o There are issues around the impact of this on the balance sheet – refer to Centro example  Contracting consequences Leases – Off Balance Sheet Financing?  Rapid growth in leasing as an alternative form of financing o 1/3 of all new PP&E is leased rather than purchased by an organization  When it became common occurrence for leasing to occurs there were concerns about the off-balance sheet nature of leases and diversity in accounting practices o Primarily raised by accountants, shareholders and creditors o Previously, it had been recognized in more of a rental situation  Difficulties in classifying and measuring leases o Some were leases, some where quasi-purchases o How can this information enhance decision making? Lease Agreement  Specifies the rights and obligations of contracting parties o Both the leasor and the lessee o Who has the right to use the item and have access to the economic benefits  Typically includes: o Lease period o Timing and amount of lease payments o Who bears the cost of maintenance o Contingent rentals  This is found in shopping centers. It depends on the amount of revenue the individual shop earns. o Options e.g. cancellability, asset purchase, renewal  Because an issue when people began using not relevant information o Lease term termination penalties/conditions Comparison of Accounting Treatment Purchasing Leasing Balance Sheet Asset No Asset Liability No Liability Income Statement Depreciation Lease rental payments Interest Expense  These treatments have a TOTALLY different effect on the financial ratios of entities but in essence the firms were doing the same thing - economic substance of the transactions was the same - acquiring an asset for use in the business. Lease Classification  Leases classified as “operating” or “finance”  Operating lease o the lessor effectively retains substantially all the risks and rewards incidental to ownership o legitimate rental type situation for a number of months – there is no ideas that the entity will be taking over ownership, they only want to hold it for a small period of time (not its entire useful life)  Finance lease o economic substance of the agreement indicates that substantially all the risks and rewards incidental to ownership of the leased asset transfer to the lessee  where the organisation has acquired the use of the asset as if it had been bought even though it has not  The initial description between the two was difficult. To be a finance lease, the lease had to be non cancellable (ie people would use the north pole has to reach 100 degrees – this was later removed to say it had to be realistic), if the lease term was greater than 75% of the useful life of the asset or the present value of the minimum lease payments was more than 90% of the value of the asset, then the amount is a finance lease. o This resulted in leases being written for 74.999% of the useful life etc to avoid the classification of finance leases to keep the amounts off the balance sheet o IFRS now talks about the risks and rewards rather than precise figures such as this.  This is why it is crucial to examine the lease agreement.  Risks and rewards are now the ONLY criteria  Indicators of a finance lease: o Lease transfers ownership of the asset to the lessee at the end of the lease term o The lessee has the option to purchase the asset at a bargain price o The lease term is for a major part of the asset’s life  There is now no number so that people cannot work around o At the start of the lease, the present value of the minimum lease payments amounts to at least substantially all of the asset’s fair value o The leased assets are of such a specialised nature that only the lessee can use them  Less prescriptive, more emphasis on risks and rewards. Accounting Issues Caused by Leases  Operating leases (off-balance sheet): o No lease assets or liabilities are recognised  Finance leases (on-balance sheet): o Entity’s debt ratio is increased o Performance measures will be reduced due to amortisation and interest payments. This results in higher expenses, thus impacting profit  This is crucial in the earlier years  Rate on return of assets and equity will decrease  This will impact on management remuneration and debt contracts  Managers have incentives to favour operating leases o Managers do not want the on balance sheet effect of the financial lease and their performance measures to be reduced o A firm may legitimately determine that something if an operating lists but an analysist may re-do the calculation and call them finance leases regardless.  There is significant push currently that all leases should be recognized as finance leases.  Woolworths has $13, 169 million dollars worth of leases that are not provided on the balance sheet although this is an undeniable uncancellable amount. Under the reported figures on the balance sheet, the debt to asset ratio was 60%. The impact of adding the lease amount to this calculation results in a significant increase in assets and the debt to asset ratio being equal to 78%. As a user, this is probably considerable information that would impact decision making. Most debt convenants suggest 60% is ok but 78% is too high regardless of industry. Equity  The residual interest in the assets of the entity after deducting all its liabilities o E = A – L  Amount assigned to equity is always the difference between assets and liabilities  Recognition criteria for assets and liabilities are also (by default) criteria for equity recognition  Measurement of equity also depends on the measurement basis for assets and liabilities Issues Associated with Equity  Measurement Issues  Classification Issues – debt v equity Liabilities versus Equity  Need to consider underlying substance and economic reality, not merely legal form o Leases consider the differences between the two types of transactions – this same idea is applied here  Firms take considerable steps to make liabilities look like equity  Income Notes o Woolworths example – notes did not change in legal form though the trust deed changed slightly. o As part of their interest bearing liabilities there is an amount of $42.9 m (2005) which was not there in 2004. This amount was issued in 2004 but had then be classified as equity. Due to the changes of the trust deed and ASIC implications, Woolworths were required to reclassify the amount as a liabilitiy. This effected the balance sheet and the income statement – profit is reduced and liabilities increased. The impact of this on the debt to asset ratio – 2004: 66.6% and in 2005: 68.8% if equity. When treated as debt, debt to asset ratio was 76.1% in 2004 and 75.5% in 2005. This has contracting implications and impacts profit by decreasing it by almost 5% as there has been no change in the legal form or economy, rather a change in the perceived economic substance of the transaction. o This is crucial to the reporting of entities and also the calculation of ratios. This impacts dividends to shareholders. Implications of Classification of Debt or Equity  Equity o associated distributions are dividends i.e. distribution of profits o not an expense  Debt o associated payments treated as interest (an expense), o reduces profits Economic Consequences  Higher liabilities increases risk of breaching debt covenants o e.g. debt-to-asset o Interest coverage ratio  Incentives to classify items as equity rather than debt o Lower debt-to-asset o Lower expense o Higher profit What is a Financial Instrument (FI)?  Most important issue = how they are used to blur the ‘line’ between liabilities and equity  The issue around disclosure is caused by the way in which it should be made due to the
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