This topic covers the accounting and reporting standards under IFRS and U.S. GAAP for key non-current (long-term) liabilities and equity components. We will explore the details of leases, postemployment benefits like pension plans, and share-based compensation.
Learning Objectives: Understanding the complex accounting treatments for long-term liabilities and equity components that significantly impact financial statement analysis and company valuation.
A lease is a contract where an asset owner (the lessor) gives another party (the lessee) the right to use an asset for a specific period in exchange for periodic payments.
Advantages of Leasing: Leases are a popular form of financing. For the lessee, it provides access to an asset without the large initial cash outlay of a purchase. For the lessor, it's an investment that generates income and can be an effective way to facilitate sales of their products.
2.1 Lease Classification
Leases are generally classified as either finance leases or operating leases. A lease is classified as a finance lease if it effectively transfers the risks and rewards of owning the asset to the lessee.
Key Classification Criteria:
- Ownership Transfer: The lease transfers ownership of the asset to the lessee by the end of the lease term.
- Purchase Option: The lessee has an option to purchase the asset at a price that is substantially lower than its expected fair value (a "bargain purchase option").
- Lease Term: The lease term covers a major part of the asset's economic life.
- Present Value: The present value of the lease payments is substantially all of the asset's fair value.
- 🔧 Asset Specialization: The asset is so specialized that only the lessee can use it without major modifications.
2.2 Financial Reporting for Leases
The accounting treatment for leases differs significantly for the lessee and lessor, with notable differences between IFRS and U.S. GAAP.
Lessee Accounting
This is where we see the most significant difference between the two accounting standards.
| Standard |
Treatment |
| IFRS |
Under IFRS, there is a single model for lessee accounting. For both finance and operating leases, the lessee must:
- At the start of the lease, recognize a Right-of-Use (ROU) asset and a corresponding Lease Liability on the balance sheet.
- In subsequent periods, recognize amortization expense on the ROU asset (typically straight-line) and interest expense on the lease liability on the income statement.
|
| U.S. GAAP |
U.S. GAAP also requires lessees to recognize an ROU asset and a lease liability for both lease types at inception. However, the income statement recognition differs:
- Finance Leases: The treatment is the same as under IFRS, with separate amortization and interest expenses reported.
- Operating Leases: The lessee recognizes a single, straight-line total lease expense on the income statement.
|
Lessor Accounting
For lessors, the classification of the lease as either operating or finance determines the accounting treatment.
Finance Leases:
- Remove leased asset from balance sheet
- Recognize lease receivable asset
- Allocate payments between receivable reduction and interest income
Operating Leases:
- Keep asset on balance sheet
- Continue to depreciate the asset
- Recognize lease payments as lease revenue
Employee Compensation Overview
Companies offer various forms of compensation to attract, retain, and motivate employees. Key components include salary, bonuses, and deferred compensation plans. The accounting principle of matching requires that compensation expense be recognized in the period it is earned by the employee, which is tied to the vesting period.
Postemployment Benefit Plans
These are forms of deferred compensation designed to provide for employees' retirement.
| Plan Type |
Description |
| Defined Contribution (DC) Plans |
The employer contributes a specified amount to an employee's individual retirement account. The employer's obligation ends once the contribution is made. The employee bears the investment risk. Accounting is simple: the employer expenses the contribution when it is made. |
| Defined Benefit (DB) Plans |
The employer guarantees a specific retirement benefit to the employee, often based on a formula involving salary and years of service. The employer bears the investment risk. Accounting is complex because the future obligation must be estimated. |
Defined Benefit (DB) Pension Plans in Detail
Net Pension Asset/Liability: A company with a DB plan reports this on its balance sheet as the difference between the plan's assets and the estimated pension obligation. A surplus results in an asset; a deficit results in a liability.
Periodic Pension Cost Components:
- Service Cost: The present value of benefits earned by employees in the current period.
- Interest Expense: The increase in the pension obligation due to the passage of time.
- Expected Return on Plan Assets: The expected earnings on the plan's investments, which reduces the total pension cost.
- Past Service Cost: The cost of retroactive benefits from plan amendments.
- Actuarial Gains and Losses: Changes in the pension obligation resulting from changes in actuarial assumptions.
3.1 Share-Based Compensation
This type of compensation aligns the interests of employees with those of shareholders. It motivates employees without requiring immediate cash outlays from the company.
Disadvantages: Employee influence on market value is limited, it can encourage excessive risk-aversion, and it can dilute the ownership of existing shareholders.
Types of Share-Based Compensation
| Type |
Description |
Accounting Treatment |
| Stock Grants |
Outright grants of company stock. These can be unrestricted, restricted (requiring conditions to be met), or performance-based. |
The compensation expense is the fair value of the stock at the grant date. This total expense is recognized over the service period. |
| Stock Options |
Gives employees the right to purchase company stock at a predetermined price (the exercise price) for a specific period. |
Compensation expense is based on the fair value of the options at the grant date, estimated using a valuation model like Black-Scholes. This expense is recognized over the vesting period. |
| Stock Appreciation Rights (SARs) |
Cash-settled compensation based on the increase in the company's share price over a predetermined period. No shares are issued, so there is no ownership dilution. |
Compensation expense is tied to the change in the stock price. |
| Phantom Shares |
Cash-settled compensation based on the performance of hypothetical stock. Similar to SARs, it provides the economic benefits of share ownership without issuing actual shares. |
Compensation expense is tied to the performance of the hypothetical shares. |
Key Dates for Stock Options
- Grant Date: The date the options are granted to the employee.
- Service Period: The period between the grant date and the vesting date.
- Vesting Date: The date when the employee is first able to exercise the options.
- Exercise Date: The date when the employee exercises the options and converts them into stock.
The objective of disclosures is to provide financial statement users with information about the amount, timing, and uncertainty of cash flows related to these long-term items.
Lease Disclosures
Lessee Disclosures
Quantitative Data:
- Carrying amount of ROU assets by class
- Depreciation charges for ROU assets
- Interest expense on lease liabilities
- Total cash outflow for leases
- Maturity analysis of lease liabilities
Qualitative Data:
- Nature of leasing activities
- Future cash outflows not yet reflected
- Restrictions or covenants from leases
Lessor Disclosures
Finance Leases:
- Selling profit or loss at inception
- Finance income on net investment
- Maturity analysis of receivables
Operating Leases:
- Lease income recognized
- Maturity analysis of payments
- Risk management information
Postemployment Plan Disclosures
DC Plans:
The amount recognized as an expense on the income statement must be disclosed.
DB Plans (IAS 19):
- Plan characteristics and risks
- Reconciliation of net pension asset/liability
- Sensitivity analysis of assumptions
- Breakdown of plan assets by category
- Effect on future cash flows
Share-Based Compensation Disclosures
Required Disclosures:
- Plan Description: Terms, vesting requirements, maximum option term, and settlement methods
- Stock Options:
- Reconciliation of options outstanding
- Number and weighted-average exercise price
- Non-Option Instruments:
- Number and weighted-average fair value
- Fair value determination method
Key Exam Areas
Long-term liabilities and equity topics are heavily tested. Master these areas:
- Finance lease vs. operating lease classification and financial statement impacts
- Defined benefit vs. defined contribution pension plans
- Bond accounting (issuance at premium/discount, effective interest method)
- Stock-based compensation (options valuation, expense recognition)
- IFRS vs. US GAAP differences in lease and pension accounting
ESSENTIAL FORMULAS
Lease Liability (Initial Recognition):
Lease Liability = PV of Lease Payments
Right-of-Use Asset (Initial Recognition):
ROU Asset = Lease Liability + Initial Direct Costs
Finance Lease Interest Expense:
Interest Expense = Lease Liability Ă— Discount Rate
Finance Lease Amortization:
Amortization Expense = ROU Asset / Lease Term
Bond Interest Expense (Effective Interest Method):
Interest Expense = Carrying Value Ă— Market Rate
Bond Amortization:
Amortization = Interest Paid - Interest Expense
Stock Option Total Compensation:
Total Compensation = Fair Value at Grant Date Ă— Options Granted
Stock Option Annual Expense:
Annual Expense = Total Compensation / Vesting Period
Net Pension Asset/Liability
Net Pension Asset/(Liability) = Plan Assets - PBO
where:
PBO = Projected Benefit Obligation
Pension Expense:
Pension Expense = Service Cost + Interest Cost - Expected Return on Plan Assets ± Other
COMMON PITFALLS
Finance vs. Operating Lease Reporting: Both types now require ROU asset and liability recognition on the balance sheet. The key difference is income statement presentation: finance leases show separate interest and amortization expenses, while operating leases (US GAAP) show a single straight-line lease expense.
Lease Discount Rate: Use the rate implicit in the lease if known; otherwise, use the lessee's incremental borrowing rate. Do not use the company's WACC or risk-free rate.
Defined Contribution vs. Defined Benefit Plans: DC plans have simple accounting—expense equals contribution amount. DB plans are complex, involving actuarial assumptions, plan assets, and PBO. The employer bears investment risk in DB plans.
Bond Premium/Discount Mechanics: Bonds issued at premium (price > face value) have amortization that reduces interest expense and carrying value over time. Bonds at discount (price < face value) have amortization that increases interest expense and carrying value, converging to face value at maturity.
Stock Option Expense Recognition: Compensation expense is recognized over the vesting period (not the exercise period). Fair value is determined at grant date and does not change, even if stock price fluctuates.
Pension Actuarial Gains/Losses: Under IFRS, actuarial gains and losses go to OCI, not pension expense on the income statement. Under US GAAP, they may be amortized to pension expense using the corridor approach.