Practice Problems 233

PRACTICE PROBLEMS

The following information relates to questions

1-3
An analyst is studying the impairment of the manufacturing equipment of WLP
Corp., a UK-based corporation that reports under IFRS. He gathers the following
information about the equipment:

Fair value GBP16,800,000

Costs to sell GBP800,000
Value in use GBP14,500,000
Net carrying amount GBP19,100,000

1. Based on this information, the amount of impairment loss that WLP will need to
report on its income statement related to the manufacturing equipment is closest
to:
A. GBP2,300,000.

B. GBP3,100,000.

C. GBP4,600,000.

2. Under IFRS, an impairment loss on a property, plant, and equipment asset is

measured as the excess of the carrying amount over the asset’s:
A. fair value.

B. recoverable amount.

C. undiscounted expected future cash flows.

3. The impairment of intangible assets with finite lives affects:

A. only the balance sheet.

B. only the income statement.

C. both the balance sheet and the income statement.

The following information relates to questions

4-7
Melanie Hart, CFA, is a transportation analyst. Hart has been asked to write a
research report on Altai Mountain Rail Company (AMRC). Like other companies
in the railroad industry, AMRC’s operations are capital intensive, with significant
investments in long-lived tangible assets as property, plant, and equipment. In
November of 2021, AMRC’s board of directors hired a new team to manage the
234 Learning Module 7 Analysis of Long-Term Assets

company. In reviewing the company’s 2022 annual report, Hart is concerned

about some of the accounting choices that the new management has made. These
choices differ from those of the previous management and from common indus-
try practice. Hart has highlighted the following statements from the company’s
annual report:

Statement 1 “In 2022, AMRC spent significant amounts on track replace-

ment and similar improvements. AMRC expensed rather than
capitalized a significant proportion of these expenditures.”

Statement 2 “AMRC uses the straight-line method of depreciation for both

financial and tax reporting purposes to account for plant and
equipment.”

Statement 3 “In 2022, AMRC recognized an impairment loss of €50 million

on a fleet of locomotives. The impairment loss was reported as
‘other income’ in the income statement and reduced the carry-
ing amount of the assets on the balance sheet.”
Exhibit 1 and Exhibit 2 contain AMRC’s 2022 consolidated income statement
and balance sheet. AMRC prepares its financial statements in accordance with
International Financial Reporting Standards.

Exhibit 1: Consolidated Statement of Income

2022 2021
For the Years Ended 31 Euros Revenues Euros Revenues
December millions (%) millions (%)
Operating revenues 2,600 100.0 2,300 100.0
Operating expenses
Depreciation (200) (7.7) (190) (8.3)
Other operating expense (1,590) (61.1) (1,515) (65.9)
Total operating expenses (1,790) (68.8) (1,705) (74.2)
Operating income 810 31.2 595 25.8
Other income (50) (1.9) 0.0
Interest expense (73) (2.8) (69) (3.0)
Income before taxes 687 26.5 526 22.8
Income taxes (272) (10.5) (198) (8.6)
Net income 415 16 328 14.2

Exhibit 2: Consolidated Balance Sheet

As of 31 December 2022 2021

Euros Assets Euros
Assets millions (%) millions Assets (%)
Current assets 500 9.4 450 8.5
Property & equipment:
Land 700 13.1 700 13.2
Plant & equipment 6,000 112.1 5,800 109.4
Practice Problems 235

Total property & equipment 6,700 125.2 6,500 122.6

Accumulated depreciation (1,850) (34.6) (1,650) (31.1)
Net property & equipment 4,850 90.6 4,850 91.5
Total assets 5,350 100.0 5,300 100.0
Liabilities and
Shareholders’ Equity
Current liabilities 480 9.0 430 8.1
Long-term debt 1,030 19.3 1,080 20.4
Other long-term provisions
and liabilities 1,240 23.1 1,440 27.2
Total liabilities 2,750 51.4 2,950 55.7
Shareholders’ equity
Common stock and
paid-in-surplus 760 14.2 760 14.3
Retained earnings 1,888 35.5 1,600 30.2
Other comprehensive losses (48) (0.9) (10) (0.2)
Total shareholders’ equity 2,600 48.6 2,350 44.3
Total liabilities & sharehold-
ers’ equity 5,350 100.0 5,300 100.0

4. With respect to Statement 1, which of the following is the most likely effect of
management’s decision to expense rather than capitalize these expenditures?
A. 2022 net profit margin is higher than if the expenditures had been
capitalized.

B. 2022 total asset turnover is lower than if the expenditures had been
capitalized.

C. Future profit growth will be higher than if the expenditures had been
capitalized.

5. With respect to Statement 2, what would be the most likely effect in 2023 if
AMRC were to switch to an accelerated depreciation method for both financial
and tax reporting?
A. Net profit margin would increase.

B. Total asset turnover would decrease.

C. Cash flow from operating activities would increase.

6. With respect to Statement 3, what is the most likely effect of the impairment loss?
A. Net income in years prior to 2022 was likely understated.

B. Net profit margins in years after 2022 will likely exceed the 2022 net profit
margin.

C. Cash flow from operating activities in 2022 was likely lower due to the
impairment loss.

7. Based on Exhibit 1, the best estimate of the average remaining useful life of the
236 Learning Module 7 Analysis of Long-Term Assets

company’s plant and equipment at the end of 2022 is:

A. 20.75 years.

B. 24.25 years.

C. 30.00 years.

The following information relates to questions

8-13
Brian Jordan is interviewing for a junior equity analyst position at Orion Invest-
ment Advisors. As part of the interview process, Mary Benn, Orion’s Director of
Research, provides Jordan with information about two hypothetical companies,
Alpha and Beta, and asks him to comment on the companies’ financial state-
ments and ratios. Both companies prepare their financial statements in accor-
dance with International Financial Reporting Standards (IFRS) and are identical
in all respects except for their accounting choices.
Jordan is told that, at the beginning of the current fiscal year, both companies
purchased a major new computer system and began building new manufactur-
ing plants for their own use. Alpha capitalized and Beta expensed the cost of the
computer system; Alpha capitalized and Beta expensed the interest costs associ-
ated with the construction of the manufacturing plants.
Benn asks Jordan, “What was the impact of these decisions on each company’s
current fiscal year financial statements and ratios?”
Jordan responds, “Alpha’s decision to capitalize the cost of its new computer
system instead of expensing it results in lower net income, lower total assets, and
higher cash flow from operating activities in the current fiscal year. Alpha’s de-
cision to capitalize its interest costs instead of expensing them results in a lower
fixed asset turnover ratio and a higher interest coverage ratio.”
Jordan is told that Alpha uses the straight-line depreciation method and Beta
uses an accelerated depreciation method; both companies estimate the same
useful lives for long-lived assets. Many companies in their industry use the
units-of-production method.
Benn asks Jordan, “What are the financial statement implications of each depre-
ciation method, and how do you determine a company’s need to reinvest in its
productive capacity?”
Jordan replies, “All other things being equal, the straight-line depreciation meth-
od results in the least variability of net profit margin over time, while an acceler-
ated depreciation method results in a declining trend in net profit margin over
time. The units-of-production can result in a net profit margin trend that is quite
variable. I use a three-step approach to estimate a company’s need to reinvest in
its productive capacity. First, I estimate the average age of the assets by dividing
net property, plant, and equipment by annual depreciation expense. Second, I
estimate the average remaining useful life of the assets by dividing accumulated
depreciation by depreciation expense. Third, I add the estimates of the average
remaining useful life and the average age of the assets in order to determine the
total useful life.”
Jordan is told that at the end of the current fiscal year, Alpha revalued a manu-
facturing plant; this increased its reported carrying amount by 15 percent. There
was no previous downward revaluation of the plant. Beta recorded an impair-
ment loss on a manufacturing plant; this reduced its carrying value by 10 percent.
Practice Problems 237

Benn asks Jordan “What was the impact of these decisions on each company’s
current fiscal year financial ratios?”
Jordan responds, “Beta’s impairment loss increases its debt to total assets and
fixed asset turnover ratios, and lowers its cash flow from operating activities.
Alpha’s revaluation increases its debt to capital and return on assets ratios, and
reduces its return on equity.”

8. Jordan’s response about the financial statement impact of Alpha’s decision to

capitalize the cost of its new computer system is correct with respect to:
A. lower net income.

B. lower total assets.

C. higher cash flow from operating activities.

9. Jordan’s response about the ratio impact of Alpha’s decision to capitalize interest
costs is most likely correct with respect to the:
A. interest coverage ratio.

B. fixed asset turnover ratio.

C. interest coverage and fixed asset turnover ratios.

10. Jordan’s response about the impact of the different depreciation methods on net
profit margin is most likely incorrect with respect to:
A. accelerated depreciation.

B. straight-line depreciation.

C. units-of-production depreciation.

11. Jordan’s response about his approach to estimating a company’s need to reinvest
in its productive capacity is most likely correct regarding estimating the:
A. average age of the asset base.

B. total useful life of the asset base.

C. average remaining useful life of the asset base.

12. Jordan’s response about the effect of Beta’s impairment loss is incorrect with
respect to the impact on its:
A. debt to total assets.

B. fixed asset turnover.

C. cash flow from operating activities.

13. Jordan’s response about the effect of Alpha’s revaluation is most likely correct
with respect to the impact on its:
A. return on equity.

B. return on assets.

C. debt to capital ratio.

238 Learning Module 7 Analysis of Long-Term Assets

The following information relates to questions

14-19
A financial analyst at BETTO S.A. is analyzing the result of the sale of a vehicle
for 85,000 Argentine pesos (ARP) on 31 December 2021. The analyst compiles
the following information about the vehicle:

Acquisition cost of the vehicle ARP100,000

Acquisition date 1 January 2019
Estimated residual value at acquisition date ARP10,000
Expected useful life 9 years
Depreciation method Straight-line

14. The result of the sale of the vehicle is most likely:

A. a loss of ARP 15,000.

B. a gain of ARP 15,000.

C. a gain of ARP 18,333.

15. CROCO S.p.A sells an intangible asset with a historical acquisition cost of EUR12
million and an accumulated amortization of EUR2 million and reports a loss on
the sale of EUR3.2 million. Which of the following amounts is most likely the sale
price of the asset?
A. EUR6.8 million

B. EUR8.8 million

C. EUR13.2 million

16. The gain or loss on a sale of a long-lived asset to which the revaluation model has
been applied is most likely calculated using sales proceeds less:
A. carrying amount.

B. carrying amount adjusted for impairment.

C. historical cost net of accumulated depreciation.

17. According to IFRS, all of the following pieces of information about property,
plant, and equipment must be disclosed in a company’s financial statements and
footnotes except for:
A. useful lives.

B. acquisition dates.

C. amount of disposals.

18. According to IFRS, all of the following pieces of information about intangible
assets must be disclosed in a company’s financial statements and footnotes except
for:
A. fair value.
Practice Problems 239

B. impairment loss.

C. amortization rate.

19. Which of the following is a required financial statement disclosure for long-lived
intangible assets under US GAAP?
A. The useful lives of assets

B. The reversal of impairment losses

C. Estimated amortization expense for the next five fiscal years

The following information relates to questions

20-23
After reading the financial statements and footnotes of a company that reports
under IFRS, an analyst identified the following three intangible assets:
■ product patent expiring in 40 years;
■ copyright with no expiration date; and
■ goodwill acquired 2 years ago in a business combination.

20. Which of the three assets is an intangible asset with a finite useful life?
A. Patent

B. Goodwill

C. Copyright

21. Intangible assets with finite useful lives mostly differ from intangible assets with
infinite useful lives with respect to accounting treatment of:
A. revaluation.

B. impairment.

C. amortization.

22. Costs incurred for intangible assets are generally expensed when they are:
A. internally developed.

B. individually acquired.

C. acquired in a business combination.

23. Under US GAAP, when assets are acquired in a business combination, goodwill
most likely arises from:
A. contractual or legal rights.

B. assets that can be separated from the acquired company.

240 Learning Module 7 Analysis of Long-Term Assets

C. assets that are neither tangible nor identifiable intangible assets.

Solutions 241

SOLUTIONS
1. B is correct. The impairment loss equals GBP3,100,000, calculated as:
Impairment = max(Fair value less costs to sell; Value in use) – Net carrying
amount
= max(16,800,000 – 800,000; 14,500,000) – 19,100,000
= –3,100,000.

2. B is correct. Under IFRS, an impairment loss is measured as the excess of the

carrying amount over the asset’s recoverable amount. The recoverable amount
is the higher of the asset’s fair value less costs to sell and its value in use. Value
in use is a discounted measure of expected future cash flows. Under US GAAP,
assessing recoverability is separate from measuring the impairment loss. If the
asset’s carrying amount exceeds its undiscounted expected future cash flows, the
asset’s carrying amount is considered unrecoverable and the impairment loss is
measured as the excess of the carrying amount over the asset’s fair value.

3. C is correct. The carrying amount of the asset on the balance sheet is reduced by
the amount of the impairment loss, and the impairment loss is reported on the
income statement.

4. C is correct. Expensing, rather than capitalizing, an investment in long-term

assets will result in higher expenses and lower net income and net profit margin
in the current year. Future years’ incomes will not include depreciation expense
related to these expenditures. Consequently, year-to-year growth in profitability
will be higher. If the expenses had been capitalized, the carrying amount of the
assets would have been higher and the 2022 total asset turnover would have been
lower.

5. C is correct. Switching to an accelerated depreciation method would increase

depreciation expense and decrease income before taxes, taxes payable, and net
income. Cash flow from operating activities would increase because of the result-
ing tax savings.

6. B is correct. 2022 net income and net profit margin are lower because of the
impairment loss. Consequently, net profit margins in subsequent years are likely
to be higher. An impairment loss suggests that insufficient depreciation expense
was recognized in prior years, and net income was overstated in prior years. The
impairment loss is a non-cash item and will not affect operating cash flows.

7. A is correct. The estimated average remaining useful life is 20.75 years, calculated
as:
Estimate of remaining useful life = Net plant and equipment ÷ Annual deprecia-
tion expense
Net plant and equipment = Plant & equipment – Accumulated depreciation
= EUR6,000 – EUR1,850 = EUR4,150
Estimate of remaining useful life = Net P & E ÷ Depreciation expense
= EUR4,150 ÷ EUR200 = 20.75

8. C is correct. The decision to capitalize the costs of the new computer system re-
sults in higher cash flow from operating activities; the expenditure is reported as
an outflow of investing activities. The company allocates the capitalized amount
over the asset’s useful life as depreciation or amortization expense rather than
expensing it in the year of expenditure. Net income and total assets are higher in
242 Learning Module 7 Analysis of Long-Term Assets

the current fiscal year.

9. B is correct. Alpha’s fixed asset turnover will be lower because the capitalized
interest will appear on the balance sheet as part of the asset being constructed.
Therefore, fixed assets will be higher and the fixed asset turnover ratio (total
revenue/average net fixed assets) will be lower than if it had expensed these
costs. Capitalized interest appears on the balance sheet as part of the asset being
constructed instead of being reported as interest expense in the period incurred.
However, the interest coverage ratio should be based on interest payments, not
interest expense (earnings before interest and taxes/interest payments) and
should be unchanged. To provide a true picture of a company’s interest coverage,
the entire amount of interest expenditure, both the capitalized portion and the
expensed portion, should be used in calculating interest coverage ratios.

10. A is correct. Accelerated depreciation will result in an improving, not declining,

net profit margin over time, because the amount of depreciation expense declines
each year. Under straight-line depreciation, the amount of depreciation expense
will remain the same each year. Under the units-of-production method, the
amount of depreciation expense reported each year varies with the number of
units produced.

11. B is correct. The estimated average total useful life of a company’s assets is calcu-
lated by adding the estimates of the average remaining useful life and the average
age of the assets. The average age of the assets is estimated by dividing accumu-
lated depreciation by depreciation expense. The average remaining useful life
of the asset base is estimated by dividing net property, plant, and equipment by
annual depreciation expense.

12. C is correct. The impairment loss is a non-cash charge and will not affect cash
flow from operating activities. The debt to total assets and fixed asset turnover
ratios will increase, because the impairment loss will reduce the carrying amount
of fixed assets and therefore total assets.

13. A is correct. In an asset revaluation, the carrying amount of the assets increases.
The increase in the asset’s carrying amount bypasses the income statement and is
reported as other comprehensive income and appears in equity under the head-
ing of revaluation surplus. Therefore, shareholders’ equity will increase but net
income will not be affected, so return on equity will decline. Return on assets and
debt to capital ratios will also decrease.

14. B is correct. The result on the sale of the vehicle is a gain of 15,000, calculated as:
Gain or loss on the sale = Sale proceeds – Carrying amount
= Sale proceeds – (Acquisition cost – Accumulated depreciation)
= 85,000 – {100,000 – [((100,000 – 10,000)/9 years) × 3 years]}
= 15,000.

15. A is correct. Gain or loss on the sale = Sale proceeds – Carrying amount. Rear-
ranging this equation, Sale proceeds = Carrying amount + Gain or loss on sale.
Thus, Sale price = (12 million – 2 million) + (–3.2 million) = 6.8 million.

16. A is correct. The gain or loss on the sale of long-lived assets is computed as the
sales proceeds minus the carrying amount of the asset at the time of sale. This is
true under the cost and revaluation models of reporting long-lived assets. In the
absence of impairment losses, under the cost model, the carrying amount will
equal historical cost net of accumulated depreciation.

17. B is correct. IFRS do not require acquisition dates to be disclosed.

Solutions 243

18. A is correct. IFRS do not require fair value of intangible assets to be disclosed.

19. C is correct. Under US GAAP, companies are required to disclose the estimated
amortization expense for the next five fiscal years. Under US GAAP, there is no
reversal of impairment losses. Disclosure of the useful lives—finite or indefinite
and additional related details—is required under IFRS.

20. A is correct. A product patent with a defined expiration date is an intangible asset
with a finite useful life. A copyright with no expiration date is an intangible asset
with an indefinite useful life. Goodwill is no longer considered an intangible asset
under IFRS and is considered to have an indefinite useful life.

21. C is correct. An intangible asset with a finite useful life is amortized, whereas an
intangible asset with an indefinite useful life is not amortized. Rather, they are
carried on the balance sheet at historical cost and are tested at least annually for
impairment.

22. A is correct. The costs to internally develop intangible assets are generally ex-
pensed when incurred.

23. C is correct. Under both IFRS and US GAAP, if an item is acquired in a business
combination and cannot be recognized as a tangible asset or identifiable intan-
gible asset, it is recognized as goodwill. Under US GAAP, assets arising from
contractual or legal rights and assets that can be separated from the acquired
company are recognized separately from goodwill.
LEARNING MODULE

8
Topics in Long-Term Liabilities and Equity
by Elizabeth A. Gordon, PhD, MBA, and Elaine Henrik, Phd, CFA.
Elizabeth A. Gordon, PhD, MBA, CPA, is at Temple University (USA), and Elaine Henrik,
Phd, CFA, is at Stevens Institute of Technology (USA).

LEARNING OUTCOMES
Mastery The candidate should be able to:

explain the financial reporting of leases from the perspectives of

lessors and lessees
explain the financial reporting of defined contribution, defined
benefit, and stock-based compensation plans
describe the financial statement presentation of and disclosures
relating to long-term liabilities and share-based compensation

INTRODUCTION
Non-current liabilities arise from different sources of financing and different types of
1
creditors. While the financial reporting of bonds and loans is straightforward and is
covered in the prerequisite materials, the reporting of leases and postemployment lia- The two major accounting
bilities is more complex. Leases are an alternative to asset ownership and have become standard setters are as follows:
a common means of financing real estate and capital equipment. Postretirement and 1) the International Accounting
stock-based compensation are a large and growing share of employee compensation Standards Board (IASB) who
establishes International
and operating expenses. Given their importance, this learning module introduces the
Financial Reporting Standards
reporting of leases, pension plans, and stock-based compensation under International (IFRS) and 2) the Financial
Financial Reporting Standards (IFRS) and US GAAP. It concludes by reviewing the Accounting Standards Board
presentation and disclosure requirements for these items. (FASB) who establishes US GAAP.
Throughout this learning module
both standards are referred to
LEARNING MODULE OVERVIEW and many, but not all, of these
two sets of accounting rules
■ Leasing has several advantages over purchasing an asset are identified. Note: changes
outright: less upfront cash commitment, typically low in accounting standards as
financing costs, and lower risks associated with ownership, such as well as new rulings and/or
obsolescence. pronouncements issued after
the publication of this learning
■ Under IFRS and US GAAP, leases are classified as operating or finance module may cause some of the
leases. Finance leases resemble an asset purchase or sale while operat- information to become dated.
ing leases resemble a rental agreement.
246 Learning Module 8 Topics in Long-Term Liabilities and Equity

■ The financial reporting of a lease depends on whether the party is the

lessee or lessor, whether the party reports with IFRS or US GAAP, and
the classification of the lease as finance or operating.
■ US GAAP and IFRS share the same accounting treatment for lessors
but differ slightly for lessees. IFRS has a single accounting model for
both operating leases and finance lease lessees, while US GAAP has an
accounting model for each.
■ Two types of pension plans are defined contribution plans and defined
benefits plans. In a defined contribution plan, the amount of employer
contribution into the plan is specified (i.e., defined) and the amount
of pension that is ultimately paid by the plan (received by the retiree)
depends on the performance of the plan’s assets. In a defined ben-
efit plan, the amount of pension that is ultimately paid by the plan
(received by the retiree) is defined, usually according to a benefit
formula.
■ In a defined contribution plan, employees bear investment risks (i.e.,
the potential for investment returns on plan assets to differ from
expectations) and actuarial risks (i.e. the potential for retirement and
death timing to differ from expectations). In a defined benefit plan,
employers bear both investment and actuarial risks.
■ Under a defined contribution pension plan, the cash payment made
into the plan is recognized as pension expense.
■ For defined benefit pension plans, companies must report the dif-
ference between the defined benefit pension obligation and the fair
value of pension assets as an asset or liability on the balance sheet. An
underfunded defined benefit pension plan is shown as a non-current
liability. The change in the net asset or liability between balance sheet
dates is recognized as a cost of the period, with service cost and net
interest expense or income recognized in profit and loss and remea-
surement changes recognized in other comprehensive income. There
are modest differences in accounting treatment under US GAAP.
■ Employee compensation packages are structured to fulfill various
objectives, including satisfying employees’ needs for liquidity, retain-
ing employees, and providing incentives to employees.
■ Share-based compensation serves to align employees’ interests with
those of the shareholders. It typically includes stock grants and stock
options, which have the advantage of requiring no current-period cash
outlays. Stock-based compensation is measured using fair value at the
grant date and recognized as compensation expense over the vesting
period.
■ The valuation technique, or option pricing model, that a company
uses is an important choice in determining fair value of options used
in a compensation agreement and is disclosed in the notes to financial
statements. Key inputs into option pricing models include such items
as exercise price, stock price volatility, estimated life of each award,
estimated number of options that will be forfeited, dividend yield, and
the risk-free rate of interest.
Leases 247

LEASES
2
explain the financial reporting of leases from the perspectives of
lessors and lessees

Firms typically acquire the rights to use assets by outright purchase. As an alterna-
tive, a lease is a contract that conveys the right to use an asset for a period of time in
exchange for consideration. The party who uses the asset and pays the consideration
is the lessee, and the party who owns the asset, grants the right to use the asset, and
receives consideration is the lessor.
Leasing is a way to obtain the benefits of the asset without purchasing it outright.
From the perspective of a lessee, it is a form of financing that resembles acquiring
an asset with a note payable. From the perspective of a lessor, a lease is a form of
investment and can also be an effective selling strategy, because customers generally
prefer to pay in installments.
After reviewing the contractual requirements for a lease, this lesson examines the
advantages and classification of leases and their financial reporting.

Requirements for Lease Accounting

For a contract to be a lease or contain a lease, it must
■ identify a specific underlying asset;
■ give the customer the right to obtain largely all of the economic benefits
from the asset over the contract term; and
■ give the customer, not the supplier, the ability to direct how and for what
objective the underlying asset is used.
For example, a contract between a customer and a trucking company is a lease if
the contract identifies a specific truck, allows the customer exclusive use of it during
the contract term, and lets the customer direct its use. If, however, the customer
contracts with a trucking company to ship goods for a fee, the contract would not be
a lease, because a specific truck is not identified nor does the customer obtain largely
all of the economic benefits from the truck over the contract term.

Examples of Leases
Leasing is among the most prevalent forms of financing. Most companies are lessees
of real estate and information technology assets. In 2014, the International Accounting
Standards Board found that more than 14,000 publicly listed companies were lessees
and that they owed more than USD3.3 trillion in future lease payments in aggre-
gate.1Exhibit 1 illustrates several examples of these arrangements.

1 IFRS, “IASB Shines Light on Leases by Bringing Them onto the Balance Sheet,” 13 January 2016, www​
.ifrs​.org/​news​-and​-events/​2016/​01/​iasb​-shines​-light​-on​-leases​-by​-bringing​-them​-onto​-the​-balance​-sheet.
248 Learning Module 8 Topics in Long-Term Liabilities and Equity

Exhibit 1: Examples of Leases

Lessee Lease Disclosure Excerpt

Alibaba “The Company entered into operating lease agreements pri-

marily for shops and malls, offices, warehouses, and land.”
Copa Airlines “The Company leases some aircraft under long-term lease
agreements with an average duration of 10 years. Other
leased assets include real estate, airport and terminal facili-
ties, sales offices, maintenance facilities, and general offices.”
Meta (formerly Facebook) “We have entered into various non-cancelable operating
lease agreements for certain of our offices, data center, land,
colocations, and equipment.”
Standard Bank “The group leases various offices, branch space, and ATM
space.”

Sources: Companies’ 2020 and 2019 annual reports.

Lessors are often real estate investment companies or banks, although there are inde-
pendent specialist leasing companies, such as AerCap Holdings N.V., which describes
itself as “the global leader in aircraft leasing.” As of 30 June 2022, the company owned
1,557 passenger aircraft that are leased to airlines.2

Advantages of Leasing
There are several advantages to leasing an asset compared with purchasing it:
■ Less cash is needed up front. Leases typically require little, if any, down
payment.
■ Cost effectiveness: Leases are a form of secured borrowing; in the event of
non-payment, the lessor simply repossesses the leased asset. As a result,
the effective interest rate for a lease is typically lower than what the lessee
would pay on an unsecured loan or bond.
■ Convenience and lower risks associated with asset ownership, such as
obsolescence.3
From the perspective of a lessor, leasing has advantages over selling outright, which
include earning interest income over the lease term and increasing the addressable
market for its product by offering customers the ability to use or control an asset
while paying smaller amounts over time.

Lease Classification as Finance or Operating

Leases can resemble either the purchase of an asset or a rental contract. For example,
a ten-year lease of an automobile with a ten-year useful life for monthly payments that,
in aggregate, are equal to or greater than the fair value of the automobile is effectively
a debt-financed purchase of that automobile. In contrast, a one-year lease of a machine
with a twenty-year useful life resembles a rental contract. A lease that resembles a
purchase is classified as a finance lease. All other leases are operating leases.

2 AerCap Holdings N.V. annual report for the fiscal year ended 31 December 31 2019 on Form 20-F.
3 Lessors are aware of asset obsolescence, however, and impound its costs and risks in lease payments.
Leases 249

More specifically, a lease is a finance lease if any of the following five criteria are
met. These criteria are the same for IFRS and US GAAP. If none of the criteria are
met, the lease is an operating lease. The same criteria are used by lessees and lessors
in classifying a lease.
1. The lease transfers ownership of the underlying asset to the lessee.
2. The lessee has an option to purchase the underlying asset and is reasonably
certain it will do so.
3. The lease term is for a major part of the asset’s useful life.
4. The present value of the sum of the lease payments equals or exceeds sub-
stantially all of the fair value of the asset.
5. The underlying asset has no alternative use to the lessor.

EXAMPLE 1

Lease Identification and Classification

Company C enters a contract with Company D that requires Company C to
pay JPY100 million at the end of each of the next two years to Company D for
exclusive use of a specific machine over that time period. The present value of
the payments is JPY186 million. At the end of the contract, Company C will
return the machine to Company D. The contract does not contain a purchase
option. The machine can be used in many applications by many types of cus-
tomers. The remaining useful life of the machine is four years, and its fair value
is JPY190 million.

1. This contract is:

A. not a lease.
B. an operating lease.
C. a finance lease.
Solution:
C is correct. This contract is a lease because a specific asset is identified,
Company C will exclusively use it, and Company C will have the ability to
direct its use. The contract is a finance lease because one of the five criteria
is met: The present value of the lease payments equals substantially all of the
fair value (186/190 = 98%).

2. If the fair value of the machine in question 1 was JPY300 million, would the
classification of the contract change?
A. No
B. Yes, from an operating lease to a finance lease
C. Yes, from a finance lease to an operating lease
Solution:
C is correct. This change would result in the lease not meeting any of the
five criteria for a finance lease. If a lease does not meet any of the five crite-
ria, it is an operating lease.
250 Learning Module 8 Topics in Long-Term Liabilities and Equity

Financial Reporting of Leases

The financial reporting of a lease depends on whether the party is the lessee or lessor,
whether the party reports with IFRS or US GAAP, and the classification of the lease as
finance or operating. Additionally, for lessees, there are lease accounting exemptions
for certain lease contracts: If its term is 12 months or less (IFRS and US GAAP) or it
is for a “low-value asset,” up to USD5,000 in sales price (IFRS only), then the lessee
can elect to simply expense the lease payments on a straight-line basis. These exemp-
tions are not available to lessors. Exhibit 2 illustrates the different permutations for
lease accounting.

Exhibit 2: Lease Classifications for Lessee and Lessor

Lessee

Qualify for lease IFRS US GAAP

accounting
exemption?

All Leases Finance Leases Operating Leases

Lessor

IFRS US GAAP

Finance Leases Operating Leases Finance Leases Operating Leases

Fortunately, lessor accounting under both IFRS and US GAAP is substantially identical,
and the differences in treatment for lessees are modest.

Lessee Accounting—IFRS
Under IFRS, there is a single accounting model for both finance and operating
leases for lessees. At lease inception, the lessee records a lease payable liability and a
right-of-use (ROU) asset on its balance sheet, both equal to the present value of future
lease payments. The discount rate used in the present value calculation is either the
rate implicit in the lease or an estimated secured borrowing rate.
The lease liability is subsequently reduced by each lease payment using the effective
interest method. Each lease payment is composed of interest expense, which is the
product of the lease liability and the discount rate, and principal repayment, which
is the difference between the interest expense and lease payment.
The ROU asset is subsequently amortized, often on a straight-line basis, over the
lease term. So, although the lease liability and ROU asset begin with the same carrying
value on the balance sheet, they typically diverge in subsequent periods because the
principal repayment that reduces the lease liability and the amortization expense that
reduces the ROU asset are calculated differently.
The following list shows how the transaction affects the financial statements:
■ The lease liability net of principal repayments and the ROU asset net of
accumulated amortization are reported on the balance sheet.
Leases 251

■ Interest expense on the lease liability and the amortization expense related
to the ROU asset are reported separately on the income statement.
■ The principal repayment component of the lease payment is reported as a
cash outflow under financing activities on the statement of cash flows, and
depending on the lessee’s reporting policies, interest expense is reported
under either operating or financing activities on the statement of cash flows.

EXAMPLE 2

Lease Impact on Balance Sheet and Income Statement

Proton Enterprises, a hypothetical manufacturer based in Germany, is offered
the following terms to lease a machine: five-year lease with an implied interest
rate of 10 percent and an annual lease payment of EUR100,000 per year pay-
able at the end of each year. The present value of the machinery is therefore
EUR379,079 (in Microsoft Excel, the formula is =PV(10%,5,-100,000). The asset
will be amortized over the five-year lease term on a straight-line basis. Proton
reports under IFRS.

1. What would be the impact of this lease on Proton’s balance sheet at the
beginning of the year?
Solution:
Proton would report a EUR379,079 lease liability and ROU asset.

2. What would be the impact of this lease on Proton’s income statement during
the following year?
Solution:
Interest expense and amortization expense are reported on the income
statement. In Year 2, interest expense is EUR31,699 and amortization ex-
pense is EUR 75,816, as illustrated in the following tables:
​

Interest Expense
Lease (10% × Lease Principal Repayment Lease
Payment Liability) (Payment – Interest) Liability

FO.1 FO.2 FO.3 FO.4

Year 0 379,079
Year 1 100,000 37,908 62,092 316,987
Year 2 100,000 31,699 68,301 248,685
Year 3 100,000 24,869 75,131 173,554
Year 4 100,000 17,355 82,645 90,909
Year 5 100,000 9,091 90,909 0
Total 500,000 120,921 379,079
​

Amortization Expense ROU Asset

Straight-Line F.1 F.2

Year 0 379,079
Year 1 75,816 303,263
Year 2 75,816 227,447
Year 3 75,816 151,631
252 Learning Module 8 Topics in Long-Term Liabilities and Equity

Amortization Expense ROU Asset

Year 4 75,816 75,816
Year 5 75,816 0
Total 379,079
​

Note: Totals may not sum due to rounding.

3. What would be the impact of this lease on Proton’s statement of cash flows
during the following year?
Solution:
Principal repayments are reported as a cash outflow under financing activ-
ities on the statement of cash flows, and depending on Proton’s reporting
policies, interest expense is reported under operating or financing activities
on the statement of cash flows. From the previous tables, Year 2 principal
repayment is EUR68,301 and interest expense is EUR31,699, for a total of
EUR100,000.

Lessee Accounting—US GAAP

Under US GAAP, there are two accounting models for lessees: one for finance leases
and another for operating leases. The finance lease accounting model is identical to the
lessee accounting model for IFRS. The operating lease accounting model is different.
At operating lease inception, the lessee records a lease payable liability and a corre-
sponding right-of-use asset on its balance sheet that are subsequently reduced by the
principal repayment component of the lease payment and amortization, respectively,
in the same manner that an IFRS lessee would.
The key difference between an operating lease and a finance lease is how the
amortization of the ROU asset is calculated. For an operating lease, the lessee’s ROU
asset amortization expense is the lease payment minus the interest expense. The
implication is that the total expense reported on the income statement (interest plus
amortization) will equal the lease payment and that the lease liability and the ROU
asset will always equal each other because the principal repayment and amortization
are calculated in an identical manner.
The following list shows how the transaction appears on the financial statements:
■ The lease liability net of principal repayments and the ROU asset net of
accumulated amortization are reported on the balance sheet.
■ Interest expense on the lease liability and the amortization expense related
to the ROU asset are reported as a single line titled “lease expense” as an
operating expense on the income statement. The interest and amortization
components are not reported separately, nor are they grouped with other
types of interest and amortization expense (e.g., interest on a bond, amorti-
zation of an intangible asset).
■ The entire lease payment is reported as a cash outflow under operating
activities on the statement of cash flows. The interest and principal repay-
ment components are not reported separately.
Leases 253

EXAMPLE 3

Lessee Accounting—Operating Lease under US GAAP

Consider the differences in accounting if Proton Enterprises classified the lease
of the machinery from Example 2 as an operating lease.

1. How would its financial statements differ, if at all?

Solution:
The first step is to construct the lease liability and ROU asset amortization
tables under an operating lease scenario. The lease liability amortization is
the same as the finance lease columns FO.1–FO.4 in Example 2.
​

Amortization Expense Lease Expense

(Lease Payment – Interest) ROU Asset (Amortization + Interest)

0.1 0.2 0.3

Year 0 379,079
Year 1 62,092 316,987 100,000
Year 2 68,301 248,685 100,000
Year 3 75,131 173,554 100,000
Year 4 82,645 90,909 100,000
Year 5 90,909 0 100,000
Total 379,078 500,000
​

Now we can compare the financial statement impacts under both finance
and operating lease scenarios.
​

Balance Sheet Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
ROU asset, net: F.2 303,263 227,447 151,631 75,816 0
Lease liability, net: FO.4 316,987 248,685 173,554 90,909 0
Operating lease:
ROU asset, net: O.2 316,987 248,685 173,554 90,909 0
Lease liability, net: FO.4 316,987 248,685 173,554 90,909 0
​

The ROU asset is lower in each period under a finance lease because the
amortization expense is higher.
​

Income Statement Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Amortization: F.1 75,816 75,816 75,816 75,816 75,816
Interest: FO.2 37,908 31,699 24,869 17,355 9,091
Total 113,724 107,515 100,685 93,171 84,907
Operating lease:
Lease expense: O.3 100,000 100,000 100,000 100,000 100,000
​

Total expense is higher for a finance lease in Years 1–3 but lower in Years 4
and 5. The largest difference is classification; amortization and interest are
presented separately for a finance lease, whereas operating lease expense is
an operating expense.
254 Learning Module 8 Topics in Long-Term Liabilities and Equity

Statement of Cash
Flows Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Cash flow from
operating activities (37,908) (31,699) (24,869) (17,355) (9,091)
Cash flow from
financing activities (62,902) (68,301) (75,131) (82,645) (90,909)
Total (100,000) (100,000) (100,000) (100,000) (100,000)
Operating lease:
Cash flows from
operating activities (100,000) (100,000) (100,000) (100,000) (100,000)
​

The difference on the statement of cash flows is only in classification, be-

cause in both cases the total cash outflow is equal to the lease payment.

2. How would the classification, all else equal, affect EBITDA margin, total
asset turnover, and cash flow per share?
Solution:
The following table shows how the classification affects the indicated finan-
cial ratios.
​

Impact of Using an Operating

Lease Instead of a Finance
Ratio Formula Lease

EBITDA margin EBITDA ​

___________
​   Lower: Lease expense is clas-
Total revenues
sified as an operating expense
rather than interest and
amortization.
Asset turnover ​Total revenues ​
___________
   Lower: Total assets are higher
Total assets
under an operating lease
because the ROU asset is amor-
tized at a slower pace in Years
1–3.
Cash flow per share Cash flow from operations
____________________
  
​   ​ Lower: Cash flow from
Shares outstanding operations is lower because
the entire lease payment is
included in operating activities
versus solely interest expense
for a finance lease.
​

Lessor Accounting
The accounting for lessors is substantially identical under IFRS and US GAAP. Under
both accounting standards, lessors classify leases as finance or operating leases, which
determines the financial reporting. Although lessors under US GAAP recognize finance
leases as either “sales-type” or “direct financing,” the distinction is immaterial from
an analyst’s perspective.
Leases 255

At finance lease inception, the lessor recognizes a lease receivable asset equal to
the present value of future lease payments and de-recognizes the leased asset, simul-
taneously recognizing any difference as a gain or loss. The discount rate used in the
present value calculation is the rate implicit in the lease.
The lease receivable is subsequently reduced by each lease payment using the
effective interest method. Each lease payment is composed of interest income, which
is the product of the lease receivable and the discount rate, and principal proceeds,
which equals the difference between the interest income and cash receipt.
The transaction affects the financial statements in the following ways:
■ Lease receivable net of principal proceeds is reported on the balance sheet.
■ Interest income is reported on the income statement. If leasing is a primary
business activity for the entity, as it commonly is for financial institutions
and independent leasing companies, it is reported as revenue.
■ The entire cash receipt is reported under operating activities on the state-
ment of cash flows.
The accounting treatment for an operating lease is different: because the contract
is essentially a rental agreement, the lessor keeps the leased asset on its books and
recognizes lease revenue on a straight-line basis. Interest revenue is not recognized
because the transaction is not considered a financing.
The transaction affects the financial statements in the following ways:
■ The balance sheet is not affected. The lessor continues to recognize the
leased asset at cost net of accumulated depreciation.
■ Lease revenue is recognized on a straight-line basis on the income state-
ment. Depreciation expense continues to be recognized.
■ The entire cash receipt is reported under operating activities on the state-
ment of cash flows. This is the same as a finance lease.

EXAMPLE 4

Lessor Accounting
Let’s examine Proton’s machine lease from Example 2 and Example 3 from the
perspective of the lessor. Assume that the carrying value of the asset immediately
prior to the lease is EUR350,000, accumulated depreciation is zero, and the lessor
elects to depreciate it on a straight-line basis over five years.

1. How are the lessor’s financial statements affected by the classification of the
lease as a finance or operating lease?
Solution:
The difference on the balance sheet is material, because a finance lease
requires the lessor to de-recognize the asset and recognize a lease receiv-
able, whereas an operating lease lessor continues to recognize the asset and
depreciate it over its useful life. In this case, where the present value of the
lease payments is well above the carrying value of the asset, the finance lease
classification results in a significant increase in assets.
​

Balance Sheet Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Lease receivable, net 316,987 248,685 173,554 90,909 0
256 Learning Module 8 Topics in Long-Term Liabilities and Equity

Balance Sheet Year 1 Year 2 Year 3 Year 4 Year 5

Operating lease:
Property, plant, and equip-
ment, net 280,000 210,000 140,000 70,000 0
​

The difference on the income statement is also material, because a finance

lease lessor recognizes interest revenue under the effective interest method
whereas the operating lease lessor recognizes straight-line lease revenue.
​

Income Statement Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Interest revenue 37,908 31,699 24,869 17,355 9,091
Operating lease:
Lease revenue 100,000 100,000 100,000 100,000 100,000
​

The statement of cash flows, however, is no different for the lessor under a
finance or operating lease: The entire cash inflow from the lease payment is
recognized under operating activities.
​

Statement of Cash
Flows Year 1 Year 2 Year 3 Year 4 Year 5

Finance lease:
Cash flows from operat-
ing activities 100,000 100,000 100,000 100,000 100,000
Operating lease:
Cash flows from operat-
ing activities 100,000 100,000 100,000 100,000 100,000
​

3 FINANCIAL REPORTING FOR POSTEMPLOYMENT AND

SHARE-BASED COMPENSATION PLANS

explain the financial reporting of defined contribution, defined

benefit, and stock-based compensation plans

Employee Compensation
Employee compensation packages are structured to achieve various objectives, includ-
ing satisfying employees’ needs for liquidity, retaining employees, and motivating
employees. Common components of employee compensation are salary, bonuses,
health and life insurance premiums, defined contribution and benefit pension plans,
and share-based compensation. The amount of compensation and its composition are
determined in labor markets, which vary significantly by the types of skills needed,
geography, the stage of the business cycle, and labor laws and customs.
Financial Reporting for Postemployment and Share-Based Compensation Plans 257

The salary component of compensation provides for the liquidity needs of an

employee. Bonuses, generally in the form of cash, motivate and reward employees
for short- or long-term performance or goal achievement by linking pay to perfor-
mance. Non-monetary benefits, such as health and life insurance premiums, housing,
and vehicles, may be provided to facilitate employees performing their jobs. Salary,
bonuses, and non-monetary benefits tend to vest (i.e., employee earns the right to
the consideration) immediately or shortly after their grant date. In terms of financial
reporting, a company reports compensation expense on the income statement in the
period in which compensation vests. Immediate or short-term vesting makes the
accounting for salary, most non-monetary benefits, and bonuses straightforward:
when the employee has earned the salary or bonus, an expense is recorded for the
fair value of the compensation, and a cash outflow or accrued compensation liability
(a current liability) is recognized. Expenses and cash outflows for short-term com-
pensation tend to be well matched.

Deferred Compensation
Deferred compensation vests over time and can provide valuable retirement savings and
financial upside to employees and often serve as an effective retention and stakeholder
alignment tool for employers. The financial reporting for deferred compensation plans
is generally more complex than that for compensation that vests immediately because
of the difficulty in measurement and potential lags between employee service and
cash outflows. Employees may earn compensation in the current period but receive
consideration in future periods, and the amount of consideration can be based on
factors such as their future salary or the employer’s stock price. Management judgment
and assumptions are required.
Pensions and other postemployment benefit plans are a common type of deferred
compensation. Two common types of pension plans are defined contribution pen-
sion plans and defined benefit pension plans. Under a defined-contribution plan, a
company contributes an agreed-upon amount into the plan, which may be structured
as a match to employees’ contributions into the plan (e.g., 50 percent of 5 percent
of employees’ contribution up to a certain limit). The company contribution is the
pension expense and is reported as an operating cash outflow. The only impact on
assets and liabilities is a decrease in cash, although if some portion of the agreed-upon
amount has not been paid by fiscal year-end, an accrued compensation liability would
be recognized on the balance sheet. Because the amount of the contribution is defined
and the company has no further obligation once the contribution has been made,
accounting for a defined-contribution plan is straightforward.
Companies may also offer other types of postemployment benefit plans, such as
retiree healthcare plans. These plans also incur non-current liabilities for employers
but tend to be far smaller than pension plans and are typically not funded in advance;
thus, benefit payments are often expensed as incurred.

Defined-Benefit Pension Plans

Under a defined-benefit pension plan, a company makes promises of future benefits
to be paid to the employee during retirement. For example, a company could prom-
ise an employee annual pension payments equal to 70 percent of her final salary at
retirement until death. Measuring the obligation arising from that promise requires
the company to make many assumptions, such as the employee’s expected salary at
retirement and the number of years the employee is expected to live beyond retire-
ment. The company estimates the future amounts to be paid and discounts the future
estimated amounts to a present value (using a discount rate equal to the yield on a
258 Learning Module 8 Topics in Long-Term Liabilities and Equity

high-quality corporate bond) to determine the pension obligation today. The discount
rate and other assumptions used to determine the pension obligation significantly
affects the size of the pension obligation.
Most defined-benefit pension plans are funded through assets held in a separate
legal entity, typically a pension trust fund. A company makes payments into the pen-
sion fund and retirees are paid from the fund. The payments that a company makes
into the fund are invested until they are needed to pay the retirees. If the fair value of
the plan’s assets is higher than the present value of the estimated pension obligation,
the plan has a surplus and the company will report a net pension asset on its balance
sheet. Conversely, if the present value of the estimated pension obligation exceeds
the fair value of the fund’s assets, the plan has a deficit and the company will report
a net pension liability on its balance sheet.

Accounting for Defined-Benefit Plans under IFRS

Under IFRS, the change in the net pension asset or liability each period is viewed as
having three general components. Two of the components of this change are recognized
as pension expense on the income statement: (1) employees’ service costs, and (2) the
net interest expense or income accrued on the beginning net pension asset or liability.
The service cost during the period for an employee is the present value of the
increase in the pension benefit earned by the employee as a result of providing one
more year of service. The service cost also includes any effects from changes in the
plan, known as past service costs.
The net interest expense or income represents the change in the present value
of the net defined benefit pension asset or liability from the passage of time (i.e., a
liability would increase over time as payout dates near) and is calculated as the net
pension asset or liability multiplied by the discount rate.
The third component of the change in the net pension asset or liability during
a period (i.e., “remeasurements”) is recognized in other comprehensive income.
Remeasurements are not amortized into profit or loss over time. Remeasurements
include (1) actuarial gains and losses and (2) the actual return on plan assets less any
return included in the net interest expense or income. Actuarial gains and losses can
occur when changes are made to the assumptions on which a company bases its esti-
mated pension obligation (e.g., employee turnover, mortality rates, retirement ages,
compensation increases). The actual return on plan assets includes interest, dividends,
and other income derived from the plan assets, including realized and unrealized
gains or losses. The actual return typically differs from the amount included in the net
interest expense or income, which is calculated using a rate reflective of a high-quality
corporate bond yield; plan assets are typically allocated across various asset classes,
including equity as well as bonds.

Accounting for Defined-Benefit Plan under US GAAP

Under US GAAP, the change in net pension asset or liability each period is viewed
as having five components, some of which are recognized in profit and loss in the
period incurred and some of which are recognized in other comprehensive income
and amortized into profit and loss over time.
The three components recognized on the income statement in the period incurred
are as follows:
1. employees’ service costs for the period;
2. interest expense accrued on the beginning pension obligation; and
3. expected return on plan assets, which is a reduction in the amount of
expense recognized.
Financial Reporting for Postemployment and Share-Based Compensation Plans 259

The other two components are past service costs and actuarial gains and losses. Past
service costs are recognized in other comprehensive income in the period in which they
arise and then subsequently amortized into pension expense over the future service
period of the employees covered by the plan. Actuarial gains and losses are typically
also recognized in other comprehensive income in the period in which they occur
and then amortized into pension expense over time. In effect, this treatment allows
companies to “smooth” the effects on pension expense over time for these latter two
components. US GAAP does permit companies to immediately recognize actuarial
gains and losses in profit and loss.
Pension expense on the income statement is classified on a functional basis like
other employee compensation expenses. For a manufacturing company, pension
expense related to production employees is added to inventory and expensed through
cost of sales (cost of goods sold). For other employees, the pension expense is included
in selling, general, and administrative expenses. Therefore, pension expense is typi-
cally not directly reported on the income statement. Rather, extensive disclosures are
included in the notes to the financial statements.
Exhibit 3 presents excerpts from the balance sheet and pension-related disclosures
in BT Group plc’s Annual Report for the year ended 31 March 2018. BT reports
under IFRS.

Exhibit 3: BT Group plc: Excerpts from Balance Sheet and Pension-Related

Disclosures

Non-current liabilities, GBP

millions Mar. 31, 2018 Mar. 31, 2017 Mar. 31, 2016

Loans and other borrowings 11,994 10,081 11,025

Derivative financial instruments 787 869 863
Retirement benefit obligations 6,371 9,088 6,382
Other payables 1,326 1,298 1,106
Deferred tax liabilities 1,340 1,240 1,262
Provisions 452 536 565
Non-current liabilities 22,270 23,112 21,203

Pension-Related Disclosures
The following are excerpts of pension-related disclosures from BT Group plc’s 2018
Annual Report.

Extract from Note 3 “Summary of Significant Accounting Policies”

Retirement benefits
The group’s net obligation in respect of defined benefit pension plans
is the present value of the defined benefit obligation less the fair value of
the plan assets.
The calculation of the obligation is performed by a qualified actuary
using the projected unit credit method and key actuarial assumptions at
the balance sheet date.
The income statement expense is allocated between an operating charge
and net finance income or expense. The operating charge reflects the
increase in the defined benefit obligation resulting from the pension benefit
earned by active employees in the current period, the costs of administering
260 Learning Module 8 Topics in Long-Term Liabilities and Equity

the plans and any past service costs/credits such as those arising from cur-
tailments or settlements. The net finance income or expense reflects the
interest on the net retirement benefit obligations recognised in the group
balance sheet, based on the discount rate at the start of the year. Actuarial
gains and losses are recognised in full in the period in which they occur
and are presented in the group statement of comprehensive income.
The group also operates defined contribution pension plans and the
income statement expense represents the contributions payable for the year.

Extract from Note 20 “Retirement Benefit Plans Information on Defined

Benefit Pension Plans”

GBP millions 2018 2017 2016

Present value of liabilities 57,327 60,200 50,350

Fair value of plan assets 50,956 51,112 43,968

EXAMPLE 5

BT Group’s Pension Plan

Use information in the excerpts in Exhibit 3 to answer the following questions:

1. What type(s) of pension plans does BT have?

Solution:
Note 3 “Summary of Significant Accounting Policies” indicates that the
company has both defined contribution and defined benefit pension plans.

2. What proportion of BT’s total non-current liabilities are related to its retire-
ment benefit obligations?
Solution:
Retirement benefit obligations represent 29 percent, 39 percent, and 30 per-
cent of BT’s total non-current liabilities for the years 2018, 2017, and 2016.
Using 2018 to illustrate, GBP6,371/GBP22,270 = 29%. (GBP million)

3. Describe how BT’s retirement benefit obligation is calculated.

Solution:
Note 3 “Summary of Significant Accounting Policies” indicates that BT’s Re-
tirement benefit obligation is calculated as the present value of the defined
benefit obligation minus the fair value of the plan assets.
Using data from Note 20 “Retirement Benefit Plans” the retirement ben-
efit obligation for each year can be calculated. Using 2018 to illustrate,
GBP57,327 − GBP50,956 = GBP6,371 (GBP million).

Share-Based Compensation
Share-based compensation is intended to align employees’ interests with those of
the shareholders and is another common type of deferred compensation. Unlike
pension plans, share-based compensation tends to be highly concentrated among
more senior-level employees such as executives as well as directors. Both IFRS and
Financial Reporting for Postemployment and Share-Based Compensation Plans 261

US GAAP require a company to disclose in their annual report key elements of man-
agement compensation. Regulators may require additional disclosure. The disclosures
enable analysts to understand the nature and extent of compensation, including the
share-based payment arrangements that existed during the reporting period. In the
United States, these disclosures are typically provided in a company’s proxy statement
that is filed with the SEC. Exhibit 4 shows the disclosure of Apple Inc.’s 2021 Named
Executive Officer Compensation:

Exhibit 4: Apple Inc.’s 2021 Named Executive Officer Compensation

Our executive compensation program is designed to motivate and reward out-

standing performance in a straightforward, consistent, and effective way, com-
mensurate with Apple’s size, performance, and profitability. The compensation
of our named executive officers has three basic components: annual base salary,
annual cash incentive, and long-term equity awards.

Annual Base Salary

Base salary is a customary, fixed element of compensation intended to attract and
retain executives. When setting the annual base salaries of our named executive
officers, the Compensation Committee considers market data provided by its
independent compensation consultant, internal pay equity, and Apple’s financial
performance and size relative to peer companies. The annual base salaries for
our named executive officers did not change for 2021.

Annual Cash Incentive

Our annual cash incentive program is a performance-based, at-risk component
of our named executive officers’ compensation. Variable payouts are designed to
motivate our named executive officers to deliver strong annual financial results,
while advancing Apple values and key community initiatives. The financial per-
formance measures and payout opportunities under the annual incentive program
did not change for 2021, although the design of the program was enhanced to
include a modifier based on Apple values and key community initiatives (“ESG
Modifier”), as described below.

Long-Term Equity Awards

We pay for performance and manage Apple for the long-term. Consistent with
this approach and our guiding compensation principles, the majority of our
named executive officers’ annual compensation is provided in the form of long-
term equity incentives that emphasize long-term shareholder value creation and
the retention of a strong executive leadership team through a balanced mix of
performance-based and time-based RSU awards.

Performance-Based RSUs
RSU awards with performance-based vesting are a substantial, at-risk component
of our named executive officers’ compensation tied to Apple’s long-term perfor-
mance. The number of performance-based RSUs that vest depends entirely on
Apple’s total shareholder return relative to the other companies in the S&P 500
(“Relative TSR”) for the applicable performance period. To earn a target award,
Apple must achieve performance at the 55th percentile of the S&P 500. The
Compensation Committee chose Relative TSR as it continues to be an objective
and meaningful metric to evaluate our performance against the performance of
other large companies and to align the interests of our named executive officers
with the interests of our shareholders in creating long-term value.
262 Learning Module 8 Topics in Long-Term Liabilities and Equity

We measure Relative TSR for the applicable performance period based on

the change in each company’s stock price during that period, taking into account
any dividends paid during that period, which are assumed to be reinvested in
the stock. A 20-trading-day averaging period is used to determine the beginning
and ending stock price values used to calculate the total shareholder return of
Apple and the other companies in the S&P 500. This averaging period mitigates
the impact on the long-term Relative TSR results of one-day or short-term stock
price fluctuations at the beginning or end of the performance period. The change
in stock price value from the beginning to the end of the period is divided by
the beginning stock price value to determine TSR.

Time-Based RSUs
RSU awards with time-based vesting align the interests of our named executive
officers with the interests of our shareholders by promoting the stability and
retention of a high-performing executive team over the longer term. Vesting
schedules for time-based awards are generally longer than typical peer company
practices, as described below.

Dividend Equivalents
All RSUs granted to our employees in 2021, including our named executive
officers, have dividend equivalent rights. The dividend equivalents will only pay
out if the time-based vesting and performance conditions have been met for the
RSUs to which the dividend equivalents relate.
Source: Apple Inc’s 2022 Proxy Statement Form DEF14A, filed 6 January 2022, p. 43.

Share-based compensation, in addition to theoretically aligning the interests of

employees with shareholders, has the advantage of potentially requiring no cash outlay.
However, share-based compensation is treated as an expense and thus as a reduction
of earnings even when no cash changes hands. In addition to decreasing earnings
through compensation expense, share-based compensation has the potential to dilute
earnings per share. Share-based compensation arrangements can also be cash-settled,
which can result in the accrual of a liability.
Although share-based compensation is generally viewed positively as it aligns
managers’ interests with those of the shareholders, there are several disadvantages.
First is that issuing shares to employees dilutes existing shareholders. Second, the
recipient may have limited influence over the company’s market value (especially with
respect to the performance of the broad stock market), so share-based compensation
does not necessarily provide the desired incentives and may improperly reward or
punish employee performance. Another disadvantage is that the increased ownership
may lead managers to be risk averse. Fearing a large market value decline (and loss
in individual wealth), shareholder managers may seek less risky (and less profitable)
projects. An opposite effect, excessive risk taking, can also occur with the awarding of
stock options. Options have skewed payouts that reward the upside while the downside
is limited to zero; as a result, managers may seek high-risk, high-reward investments.
For financial reporting of share-based compensation plans, under both IFRS and
US GAAP, companies generally estimate the fair value of the share-based compen-
sation at the grant date and recognize it as compensation expense ratably over the
plan’s vesting schedule. Any changes in the employee’s stock price after the grant date
does not affect the financial reporting. Specifically, the financial reporting depends
on the type of plan. Two common forms of equity-settled share-based compensation
are stock grants and stock options.
Financial Reporting for Postemployment and Share-Based Compensation Plans 263

Stock Grants
A company can grant stock to employees outright, with restrictions, or contingent
on performance. For an outright stock grant, compensation expense is reported on
the basis of the fair value of the stock on the grant date—generally the market value
at grant date. Compensation expense is allocated over the period benefited by the
employee’s service, referred to as the service period. The employee service period
is presumed to be the current period unless there are some specific requirements,
such as three years of future service, before the employee is vested (has the right to
receive the compensation).
Another type of stock award is a restricted stock grant, which requires the employee
to return ownership of those shares to the company if certain conditions are not met.
Common restrictions include the requirements that employees remain with the com-
pany for a specified period or that certain performance goals are met. Compensation
expense for restricted stock grants is measured as the fair value (usually market value)
of the shares issued at the grant date. This compensation expense is allocated over
the employee’s service period.
Shares granted contingent on meeting performance goals are called performance
shares. The amount of the grant is usually determined by performance measures other
than the change in stock price, such as accounting earnings or return on assets. Basing
the grant on accounting performance addresses employees’ potential concerns that
the stock price is beyond their control and thus should not form the basis for com-
pensation. However, performance shares can potentially have the unintended impact
of providing incentives to manipulate accounting numbers. Compensation expense
is equal to the fair value (usually market value) of the shares issued at the grant date.
This compensation expense is allocated over the employee service period.
Generally, companies have increased their use of stock grants, particularly restricted
stock grants in the form of restricted stock units (RSUs), and have decreased their use
of stock options to compensate employees over time. Stock grants benefit employees
as they are valuable so long as the employer’s stock price is greater than zero, while
stock options can expire worthless if the employer’s stock price does not exceed the
exercise price.

Stock Options
Like stock grants, compensation expense related to option grants is reported at fair
value under both IFRS and US GAAP. Both require that fair value be estimated using
an appropriate valuation model.
Whereas the fair value of stock grants is usually the market value at the date of
the grant (adjusted for dividends prior to vesting), the fair value of option grants must
be estimated. Companies cannot rely on market prices of options to measure the fair
value of employee stock options because features of employee stock options typically
differ from traded options. The choice of valuation or option pricing model is one of
the critical elements in estimating fair value. Several models are commonly used, such
as the Black–Scholes option pricing model or a binomial model. Accounting standards
do not prescribe a particular model. Generally, though, the valuation method should
(1) be consistent with fair value measurement, (2) be based on established principles of
financial economic theory, and (3) reflect all substantive characteristics of the award.
Once a valuation model is selected, a company must determine the inputs to
the model, typically including exercise price, stock price volatility, estimated life of
each award, estimated number of options that will be forfeited, dividend yield, and
the risk-free rate of interest. Some inputs, such as the exercise price, are known at
the time of the grant. Other critical inputs are highly subjective—such as stock price
volatility or the estimated life of stock options—and can greatly change the estimated
264 Learning Module 8 Topics in Long-Term Liabilities and Equity

fair value and thus compensation expense. Higher volatility, a longer estimated life,
and a higher risk-free interest rate increase the estimated fair value, whereas a higher
assumed dividend yield decreases the estimated fair value. Combining different
assumptions with alternative valuation models can significantly affect the fair value
of employee stock options.
In Exhibit 5, an excerpt from GlaxoSmithKline, plc’s 2021 Annual Report explains
the assumptions and model used in valuing its stock options.

Exhibit 5: GlaxoSmithKline, plc’s Assumptions and Model Used in Valuing Its

Stock Option

Share options and savings-related options

For the purposes of valuing savings-related options to arrive at the share-based
payment charge, a Black-Scholes option pricing model has been used. The
assumptions used in the model are as follows:

2021 Grant 2020 Grant 2019 Grant

Risk-free interest rate 0.74% (0.07%) 0.44%

Dividend yield 3.8% 6.2% 4.5%
Volatility 27% 27% 22%
Expected life 3 years 3 years 3 years
Savings-related options grant price
(including 20% discount) £12.07 £10.34 £14.15

Options outstanding

Savings-related share options scheme

Number Weighted exercise price

At 31 December 2021 7,165 £11.58

Range of exercise prices on options
outstanding at year end £10.34–14.15
Weighted average market price on exer-
cise during year £13.30
Weighted average remaining contrac-
tual life 2.1 years

Options over 1.9 million shares were granted during the year under the sav-
ings-related share option scheme at a weighted average fair value of £3.22. At
31 December 2021, 5.3 million of the savings-related share options were not
exercisable.
There has been no change in the effective exercise price of any outstanding
options during the year.
Source: GSK, 2021 Annual Report, p. 246.
Financial Reporting for Postemployment and Share-Based Compensation Plans 265

Accounting for Stock Options

In accounting for stock options, the basic requirement is that the value of options
granted to employees as compensation must be expensed ratably over the period
that services are provided. Several important dates affect the accounting, including
the grant date, the vesting date, the exercise date, and the expiration date. The grant
date is the day that options are granted to employees. The service period is usually
the period between the grant date and the vesting date.
The vesting date is the date that employees can first exercise the stock options.
The vesting can be immediate or over a future period. If the share-based payments
vest immediately (i.e., no further period of service is required), then expense is rec-
ognized on the grant date. If the share-based awards do not vest until a specified
service period is completed, compensation expense is recognized and allocated over
the service period. If the share-based awards are conditional upon the achievement
of a performance condition or a market condition (i.e., a target share price), then
compensation expense is recognized over the estimated service period. The exercise
date is the date when employees exercise the options and convert them to stock.
If the options go unexercised, they may expire at some predetermined future date,
commonly 5 or 10 years from the grant date.
The grant date is also the date that compensation expense is measured if both
the number of shares and the option price are known. If facts affecting the value of
options granted depend on events after the grant date, then compensation expense
is measured when those facts are known.

EXAMPLE 6

Disclosure of Stock Options’ Current Compensation

Expense, Vesting, and Future Compensation Expense

Exhibit 6: Excerpts from Note 12—Stock Compensation Plans in the

Notes to Financial Statements of Coca Cola, Inc.

Our Company grants long-term equity awards under its stock-based

compensation plans to certain employees of the Company.
Total stock-based compensation expense was $337 million, $141 million
and $201 million in 2021, 2020 and 2019, respectively. In 2020, for certain
employees who accepted voluntary separation from the Company as a
result of our strategic realignment initiatives, the Company modified their
outstanding equity awards granted prior to 2020 so that the employees
As of December 31, 2021, we had $335 million of total unrecognized
compensation cost related to nonvested stock-based compensation awards
granted under our plans, which we expect to recognize over a weight-
ed-average period of 1.9 years as stock‑based compensation expense.
This expected cost does not include the impact of any future stockbased
compensation awards.
Source: Coca Cola, Inc. Form 10-K, filed 22 February 2022.

Using the information in Exhibit 6, from Coca Cola, Inc.’s Notes to Financial
Statements, determine the following:
266 Learning Module 8 Topics in Long-Term Liabilities and Equity

1. Total compensation expense relating to options already granted that will be

recognized in future years as options vest.
Solution:
Coca Cola, Inc. discloses that unrecognized compensation expense relating
to stock options already granted, but not yet vested, totals USD335 million.

2. Approximate compensation expense in 2022 and 2023 relating to options

already granted.
Solution:
The options already granted will vest over the next 1.9 years. Compensation
expense related to stock options already granted will be USD176 million
(USD335/1.9 years) in 2022 and USD159 million in 2023 (USD335 total less
USD176 expensed in 2022). New options granted in the future will likely
raise the total reported compensation expense.

When an option is exercised, the market price of the option at the time of exercise
is not relevant. The amount of expense is determined based on the fair value of the
option at the grant date. The fair value amount is recognized as compensation expense
over the vesting period.
The exercise of an option is accounted for in a similar way to the issuance of stock.
Upon exercise, the company increases its cash for the exercise price of the option (paid
by the option holder) and credits common stock for the par value of the stock issued.
Additional paid-in capital is increased by the difference between the par value of the
stock and the sum of the fair value of the option at the grant date and the cash received.
In sum, the key accounting requirements are as follows:
1. Recognize compensation expense based on the fair value of the award. Since
no cash is exchanged upon the grant, the offsetting account for the compen-
sation expense is additional paid in capital.
2. The grant date fair value is recognized as compensation expense over the
vesting period.
3. Upon exercise, the company increases equity by the fair value of the options
on the grant date plus the cash provided by the employee upon exercise.
As the option expense is recognized over the relevant vesting period, the impact
on the financial statements is to ultimately reduce retained earnings (as with any other
expense). The offsetting entry is an increase in paid-in capital. Thus, the recognition
of option expense has no net impact on total equity.

Other Types of Share-Based Compensation

Both stock grants and stock options allow the employee to obtain ownership in the
company. Other types of share-based compensation, such as stock appreciation
rights (SARs) or phantom stock, compensate an employee on the basis of changes
in the value of shares without requiring the employee to hold the shares. These are
referred to as cash-settled share-based compensation. With SARs, an employee’s
compensation is based on increases in a company’s share price. Like other forms of
share-based compensation, SARs serve to motivate employees and align their interests
with shareholders. The following are two additional advantages of SARs:
■ The potential for risk aversion is limited because employees have limited
downside risk and unlimited upside potential similar to employee stock
options.
■ Shareholder ownership is not diluted.
Presentation and Disclosure 267

Similar to other share-based compensation, SARs are valued at fair value and
compensation expense is allocated over the service period of the employee. While
phantom share plans are similar to other types of share-based compensation, they
differ somewhat because compensation is based on the performance of hypothetical
stock rather than the company’s actual stock. Unlike SARs, phantom shares can be
used by private companies or business units within a company that are not publicly
traded or by highly illiquid companies.

PRESENTATION AND DISCLOSURE

4
describe the financial statement presentation of and disclosures
relating to long-term liabilities and share-based compensation

This lesson examines the presentation and disclosure requirements for leases, post-
retirement benefits, and share-based compensation. These disclosures are typically
included as notes to the financial statements.

Presentation and Disclosure of Leases

Both IFRS and US GAAP indicate that the objective of lease disclosure is to provide
the user of the financial statement with information to assess the amount, timing and
uncertainty of cash flows associated with leases.
The non-current portion of the balance sheet will typically contain a “right of use”
asset and the non-current (long-term) liabilities section will typically show the lease
liability. However, depending on the size of leased assets and lease obligations, some
companies may not have discrete lease line items on the balance sheet and instead will
report leases in “Other assets” or “Other liabilities.” In addition to amounts reported
on the balance sheet, both lessees and lessors must disclose quantitative and quali-
tative information about its leases, significant judgments made to comply with lease
accounting requirements and the amounts recognized in the financial statements
relating to those leases and their location on the statements.

Lessee Disclosure
Specifically, as indicated in IFRS 16, lessee disclosures must include the following
amounts for the current reporting period:
■ the carrying amount of right of use assets and the end of the reporting
period by class of underlying asset;
■ total cash outflow for leases;
■ interest expense on lease liabilities;
■ depreciation charges for right-of-use assets by class of underlying asset; and
■ additions to right of use assets.
In addition, lessees should disclose a maturity analysis of lease liabilities (sepa-
rately from the maturity analysis of other financial liabilities like bonds and loans) and
additional quantitative and qualitative information about leasing activity to enable
users of financial statements to assess the nature of the lessee’s leasing activities and
future cash outflows. This analysis should include the following:
■ the nature of the lessee’s leasing activities;