LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

LM08 Topics in Long-Term Liabilities and Equity

1. Introduction ...........................................................................................................................................................2
2. Leases .......................................................................................................................................................................2
3. Financial Reporting for Postemployment and Share-Based Compensation Plans ....................8
4. Presentation and Disclosure ........................................................................................................................ 12
Summary................................................................................................................................................................... 15

This document should be read in conjunction with the corresponding reading in the 2023 Level II
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

1. Introduction
The learning module covers:
• Financial reporting of leases from the perspective of lessors and lessees
• Financial reporting of defined contribution, defined benefit, and stock-based
compensation plans
• Presentation and disclosures relating to long-term liabilities and share-based
compensation
2. Leases
A lease is a contract in which a lessor grants the lessee the exclusive right to use a specific
underlying asset for a period of time in exchange for payments.
Below is a pictorial representation of what constitutes a lease. An asset’s owner is called a
lessor. The entity or person wishing to use the asset is called the lessee. The lessor allows the
lessee to use the asset for a pre-determined period. In return, the lessee makes periodic
payments to the lessor over the period for the right to use the asset. This period can be as
long as 20 years, or as short as a month.

Advantages of Leasing
Following are some of the advantages to leasing an asset compared to purchasing it.
• Less cash is needed upfront. Leases typically require little to no down payment.
• Since leases are a form of secured borrowing, they generally have low interest rates.
• Lower risks associated with ownership such as obsolescence.
Lease Classification as Finance or Operating
Leases are classified as finance or operating. A finance lease is similar to purchasing an asset
while an operating lease is similar to renting an asset.
A lease is classified as a finance lease if any of the following five criteria are met.
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.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

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 substantially all
of the fair value of the asset.
5. The underlying asset has no alternative use to the lessor.
If none of the criteria are met, then the lease is classified as an operating lease.
Financial Reporting of Leases
The financial reporting of leases depends on:
• Whether the party is the lessee or lessor
• Whether the party reports with IFRS or US GAAP
• Whether the lease is a finance or operating
US GAAP and IFRS share the same accounting treatment for lessors but differ for lessees.
IFRS has a single accounting model for both operating leases and finance lease lessees, while
US GAAP has different accounting models for each.
Lessee Accounting—IFRS
Under IFRS, there is a single accounting model for both finance and operating leases for
lessees.
• At inception, recognize a lease liability and corresponding right-of-use (ROU) asset on
the balance sheet, both equal to the present value of lease payments.
• The lease liability is subsequently reduced by each lease payment using the effective
interest method. Each lease payment is composed of:
o Interest expense = Lease liability x discount rate
o Principal repayment = Lease payment – Interest expense
• The right-of-use asset is amortized, often on a straight-line basis, over the lease term.
(Although the lease liability and ROU begin with the same carrying value, their balance
sheet values tend to diverge over time because of the differences in the calculation of
principal repayments that reduces the lease liability and the amortization expense
that reduces the ROU asset.)
The following list shows how the lease transaction affects the financial statements.
• Balance sheet: The lease liability is reported net of principal repayments and the ROU
asset is reported net of accumulated amortization
• Income statement: Interest expense and amortization expense are shown separately.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

• Cash flow statement: The principal repayment component is reported as cash outflow
under financing activities. The interest expense can be reported under either
operating or financing activities.
Example: Lessee Accounting - IFRS
(This is based on Example 2 from the curriculum.)
A company is offered the following terms to lease a machine: five-year lease with an implied
interest rate of 10% and an annual lease payment of EUR100,000 per year payable at the
end of each year. PV = EUR379,079. The asset will be amortized over the five-year lease term
on a straight-line basis. The company reports under IFRS.
What would be the impact of this lease on the company’s:
1. balance sheet at the beginning of the year?
2. income statement during the following year?
3. statement of cash flows during the following year?
Solution to 1:
The company will report a lease liability and a ROU asset of EUR379,079.
Solution to 2:
In Year 2, the company will report an interest expense of EUR31,699 and an amortization
expense of EUR 75,816.
The calculations are shown in the tables below:
Interest Expense
Lease (10% × Lease Principal Repayment
Payment Liability) (Payment – Interest) Lease 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

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

Year 2 75,816 227,447

Year 3 75,816 151,631
Year 4 75,816 75,816
Year 5 75,816 0
Total 379,079
Solution to 3:
In Year 2, principal repayment of EUR68,301 will be reported as a cash outflow under
financing activities. The interest expense of EUR31,699 may be reported under operating or
financing activities depending on the company’s reporting policies.
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 the same as the lease accounting model for IFRS.
The operating lease accounting model is different:
• At inception, recognize a lease liability and corresponding right-of-use asset on the
balance sheet, both equal to the present value of lease payments.
• As with the previous method, the lease liability is subsequently reduced by each lease
payment using the effective interest method
• But the amortization of the right-of-use asset is different, it is calculated as the lease
payment less the interest expense.
(Since the principal repayment and amortization are calculated in the same way, the
lease liability and the ROU asset will always equal each other.)
The following list shows how the lease transaction affects the financial statements.
• Balance sheet: The lease liability is reported net of principal repayments and the ROU
asset is reported net of accumulated amortization
• Income statement: Interest expense and amortization expense are shown together as
a single operating expense on the income statement. They are not reported separately.
• Cash flow statement: The entire lease payment is reported as cash outflow under
operating activities. The interest and principal components are not reported
separately.
For a US GAAP company classifying a lease as an operating lease instead of a finance lease
affects the financial ratios as shown below:

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

Impact of Using an Operating Lease Instead of a

Ratio Formula Finance Lease
EBITDA EBITDA Lower: Lease expense is classified as an operating
margin Total revenues expense rather than interest and amortization.
Asset Total revenues Lower: Total assets are higher under an operating lease
turnover Total assets because the ROU asset is amortized at a slower pace in
initial years.
Cash Cash flow from operations Lower: Cash flow from operations is lower because the
flow per Shares outstanding entire lease payment is included in operating activities
share versus solely interest expense for a finance lease.
Lessor Accounting
The accounting for lessors is identical under IFRS and US GAAP. However, the accounting
differs based on whether the lease is a finance lease or an operating lease.
Finance lease lessors (IFRS and US GAAP)
• At inception, recognize a lease receivable asset equal to the present value of future
lease payments and de-recognize the leased asset, simultaneously recognizing any
difference as a gain or loss.
• The lease receivable is subsequently reduced by each lease payment using the
effective interest method.
The following list shows how the lease transaction affects the financial statements.
• Balance sheet: Lease receivable net of principal proceeds is reported on the balance
sheet.
• Income statement: Interest income is reported on the income statement, typically as
revenue.
• Cash flow statement: The entire cash receipt is reported under operating activities.
Operating lease lessors (IFRS and US GAAP)
• The lease contract is treated as a rental agreement.
The following list shows how the lease transaction affects the financial statements.
• Balance sheet: The balance sheet is not affected. The lessor continues to recognize the
underlying asset and depreciate it.
• Income statement: Lease revenue is recognized on a straight-line basis on the income
statement. The depreciation expense continues to be recognized.
• Cash flow statement: The entire cash receipt is reported under operating activities.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

Example: Lessor Accounting

(This is based on Example 4 from the curriculum.)
Let’s examine the previous example 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.
How would the lessor’s financial statements be affected by the classification of the lease as a
finance or operating lease?
Solution:
Balance sheet: The difference on the balance sheet is material. The present value of lease
payments is well above the carrying value of the asset. The finance lease classification
therefore 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
Operating lease:
Property, plant, and 280,000 210,000 140,000 70,000 0
equipment, net

Income statement: The difference on the income statement is also material.

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

Cash flow statement: The cash flow statement is the same under both options.
Statement of Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5
Finance lease:
Cash flows from operating
activities 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

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

3. Financial Reporting for Postemployment and Share-Based

Compensation Plans
Employee Compensation
Employee compensation packages are designed to achieve a variety of goals, including
meeting employees' liquidity needs, retaining employees, and motivating employees.
Common components of employee compensation are:
• Salary: Provides for the liquidity needs of an employee.
• Bonuses: Generally provided in the form of cash. They can motivate and reward
employees for short-or-long term performance.
• Non-monetary benefits such as health and life insurance premiums: Provided to
facilitate employees performing their jobs.
• Defined contribution/benefit pension plan: Provides cash flow to employees in
retirement.
• Share-based compensation: Aligns employee’s interest with those of shareholders.
Pension Plans
Instructor’s Note: Pensions are discussed in great detail at Level II.
One common post-employment benefit offered by companies to their employees is pension.
Pensions and other post-employment benefits give rise to non-current liabilities reported by
many companies. When companies promise its employees certain benefits after a certain
period of time, they are obligated to fulfill that promise.
The accounting treatment of pensions depends on the type of pension plan. There are
primarily two types of pension plans:
1. Defined contribution plan: Under this plan, a company contributes an agreed-upon
amount to the plan. This contribution is recognized as a pension expense on the income
statement and an operating cash outflow. Since there is no future payout or obligation, no
liability is reported on the balance sheet. A liability is recognized on the balance sheet if
some prior agreed-upon amount is not paid by the end of the fiscal year.
2. Defined benefit plan: Under this plan, a company promises to pay a certain amount in the
future to the employees. The amount of future obligation is based on a lot of assumptions
such as retirement age of its employees, last drawn salary before retirement, mortality
rate, etc. For example, a company may promise an employee an annual pension payment
equal to 60% of his last salary at retirement, until death. The pension obligation is the
present value of future payments the company expects to make. A company fulfills this
obligation by setting up a pension fund (also known as plan assets) and making

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

payments to this fund. The ongoing pension obligations are paid from this fund. The
amount in the fund remains invested until it has to be paid to the retirees.
Accounting for Defined-Benefit Plans
Since the future obligation of defined benefit pension fund cannot be determined with
certainty, accounting is more complicated than the defined contribution plan. Listed below
are a few rules for you to remember for a defined benefit plan:
• If the fair value of plan assets > present value of estimated pension obligation, the plan
is overfunded (has a surplus). It is called net pension asset.
• If the present value of estimated pension obligation > fair value of plan assets, the plan
is underfunded. It is called net pension liability.
Under both IFRS and US GAAP, the net pension asset or liability is reported on the balance
sheet. An underfunded defined benefit pension plan is reported as a non-current liability on
the balance sheet.
For each period, the change in net pension asset or liability is recognized either in profit or
loss or in other comprehensive income.
Under IFRS, the change in net pension asset or liability has three components:
• Employee service costs and past service costs: Recognized as pension expense in the
income statement.
• Service cost is the present value of the benefit earned by an employee for one additional
year of service. It is the sum of past service costs and present value of the increase in
pension benefit earned by working for one more year.
• Net interest expense or income accrued on the beginning net pension asset or liability
represents the change in value of the net defined benefit pension asset or liability:
Recognized as pension expense in the income statement.
• Net interest expense = net pension asset or liability x discount rate used to estimate the
present value of the pension obligation.
• Remeasurements: Recognized in other comprehensive income on the balance sheet.
• Remeasurements = actuarial gains and losses and the actual return on plan assets minus
the net interest expense or income.
The actual return on plan assets includes interest, dividends and other income derived from
the plan assets, including realized and unrealized gains or losses.
Under US GAAP, the change in net pension asset or liability has five components:
• Employees’ service costs for the period.
• Interest expense accrued on the beginning pension obligation.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

• Expected return on plan assets. It isa reduction in the amount of expense recognized.
• Past service costs.
• Actuarial gains or losses.
The first three are recognized in profit and loss during the period incurred. Past service costs
and actuarial gains and losses are recognized in other comprehensive income in the period
they occur and later amortized into pension expense. Under US GAAP, companies are also
allowed to immediately recognize actuarial gains and losses in profit and loss.
Example
On 31 Dec. 2012, a company has a pension obligation of 100 and pension assets are 90. What
will the company report on the balance sheet under IFRS and US GAAP?
Solution:
Funded status = pension assets – pension obligation = 90 – 100.
The company will report a net pension liability of 10.
Share-Based Compensation
Share-based compensation is intended to align incentives of management and owners. From
an accounting perspective, share-based compensation is treated as an expense even though
no cash changes hands when stock options/grants are issued. Both IFRS and US GAAP
require us to come up with a fair value to measure the share-based compensation. Also, the
nature and extent of share-based compensation and its effect on financial statements need to
be disclosed.
There are several disadvantages of share-based compensation:
• Employees may have limited influence over the company’s market value. Hence, it
does not necessarily provide the desired incentives.
• Increased ownership may lead managers to be more risk averse or less risk averse
than they should be, depending on whether the current stock price is above or below
the exercise price of the stock options.
• When shares are granted to employees, the existing shareholder’s ownership is
diluted.
The common forms of share-based compensation are discussed below.
Stock Grants
There are three types of stock grants:
Outright grants
• Compensation expense is reported on the basis of fair value of the stock on the grant
date.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

• Compensation expense is allocated over the service period.

Restricted grants
• Shares have to be returned if certain conditions not met. Conditions might include
staying with the company for a specified period, or meeting certain performance goals.
• Compensation expense is reported on the basis of fair value of the stock on the grant
date.
• Compensation expense is allocated over the service period.
Performance shares
• Determined by performance measures other than change in share price. For example,
accounting earnings or return on assets.
• It addresses employees’ concern that share price is beyond their control and should
not be used for assessment.
• Compensation expense is reported on the basis of fair value of the stock on the grant
date.
• Compensation expense is allocated over the service period.
Stock Options
Like stock grants, compensation expense related to stock options is reported at fair value.
The fair value has to be estimated using an appropriate valuation model. Commonly used
models are the Black–Scholes option pricing model and the binomial model. The value of a
stock option is sensitive to model inputs and assumptions. The table below shows the impact
of an increase in an input value or assumption:
Input or Assumption Impact if there is an increase in input value or
assumption
Exercise price Higher exercise price leads to a lower option value
Stock price volatility Higher stock price volatility leads to higher option value
Estimated life of each Higher time to expiration leads to higher option value
award
Estimated dividend yield Higher dividend yield leads to a lower option value
Risk free rate Higher risk-free rate leads to a higher option value
In accounting for stock options, there are several important dates, 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 vesting date is the date that employees can first
exercise the stock options. The exercise date is the date when employees actually exercise
the options and convert them to stock. If the options go unexercised, they may expire at
some pre-determined future date, commonly 5 or 10 years from the grant date. The
compensation expense is allocated over the service period.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

Example: Stock options

A company awards 1,000,000 stock options to its executives on 1 July 2015. The estimated
cost of each option is $0.50. The options require a service period of 4 years after the grant
date before vesting. What is the stock option expense for 2015?
Solution:
The expense for the year = 1,000,000 x $0.50/4 x ½ = $62,500
Note: We divide by 4 because the options have a service period of 4 years. Since the options
are granted in the middle of 2015, we multiply by ½ to allocate the expense to the second
half of 2015.
Other Types of Share-Based Compensation
Both stock grants and stock options have the potential to dilute EPS. To avoid this, options
such as Stock Appreciation Rights (SARs) are available. They compensate an employee on
the basis of changes in the value of shares without requiring the employee to hold the shares.
Like other forms of share-based compensation, SARs align employee’s interests with
shareholders.
They have the following additional advantages:
• The potential for risk aversion is limited because employees have limited downside
risk and unlimited upside potential similar to employee stock options, and
• Shareholder ownership is not diluted.
A disadvantage is that SARs require a current-period cash outflow.
Similar to other share-based compensation, SARs are valued at fair value and compensation
expense is allocated over the service period of the employee.

4. Presentation and Disclosure

Instructor’s Note: Relevant excerpts from the curriculum are reproduced below. Read
through this section once or twice. It is not very testable.
Presentation and Disclosure of Leases
The objective of lease disclosure is to provide the user of financial statements 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 liabilities section will typically show the lease liability.
Lessee Disclosure
Lessee disclosures should include the following:

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

• 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 and additional
quantitative and qualitative information about leasing activity.
Lessor Disclosure
At a minimum, lessors should disclose:
• for finance leases, the amount of selling profit or loss; and finance income on the net
investment in the lease; and income relating to variable lease payments not included
in the measurement of the lease;
• for operating leases, lease income with separate disclosure for income relating to
variable lease payments based on an index or rate.
Presentation and Disclosure of Postemployment Plans
Companies are required to make disclosures such as:
• the nature of benefits provided, the regulatory framework in which the plan operates,
governance of the plan, and risks to which the plan exposes the entity;
• a reconciliation from the opening balance to the closing balance of the net pension
asset or liability, with separate reconciliations for plan assets and the present value of
the defined benefit obligation, showing service costs, interest income or expense,
remeasurements, past service costs, contributions to the plan, and other components
of the change;
• a sensitivity analysis showing how changes in significant assumptions (such as the
discount rate used to measure the defined benefit pension obligation) would affect the
amounts reported on the financial statements;
• the composition of plan assets by category, such as equity securities, fixed-income
securities, and real estate; and
• indications of the effect of the defined benefit pension plans on the entity’s future cash
flows
Presentation and Disclosure of Share-Based Compensation
Companies are required to make disclosures such as:
• A description of each type of share-based payment arrangement, including its general
terms and conditions, such as vesting requirements, the maximum term of options
granted and the method of settlement (i.e., cash or equity)

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

• Details about the number and weighted average exercises price of options, including:
o the number outstanding at the beginning of the period,
o granted during the period,
o forfeited during the period,
o exercised during the period,
o expired during the period,
o outstanding at the end of the period, and
o exercisable at the end of the period.
• For other equity instruments granted during the period (i.e., other than share
options), the number and weighted average fair value of those equity instruments at
the measurement date, and information on how that fair value was measured.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

Summary
LO: Explain the financial reporting of leases from the perspectives of lessors and
lessees.
Lessee’s perspective:
Under IFRS, there is a single accounting model for both finance and operating leases for
lessees.
• Recognize a lease liability and corresponding right-of-use asset on the balance sheet,
both equal to the present value of lease payments.
• The liability is subsequently reduced using the effective interest method
• The right-of-use asset is amortized, often on a straight-line basis over the lease term.
• Interest expense and amortization expense are shown separately on the income
statement.
• The principal repayment component is reported as cash outflow under financing
activities. The interest expense can be reported under either operating or financing
activities.
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 the same as the lease accounting model for IFRS.
The operating lease accounting model is different:
• Recognize a lease liability and corresponding right-of-use asset on the balance sheet,
both equal to the present value of lease payments.
• The liability is subsequently reduced using the effective interest method
• But the amortization of the right-of-use asset is the lease payment less the interest
expense.
• Interest expense and amortization expense are shown together as a single operating
expense on the income statement.
• The entire lease payment is reported as cash outflow under operating activities.
Lessor’s perspective:
Finance lease lessors (IFRS and US GAAP)
• Recognize a lease receivable asset equal to the present value of future lease payments
and de-recognize the leased asset, simultaneously recognizing any difference as a gain
or loss.
• The lease receivable is subsequently reduced by each lease payment using the
effective interest method.
• Interest income is reported on the income statement, typically as revenue.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

• The entire cash receipt is reported under operating activities on the statement of cash
flows.
Operating lease lessors (IFRS and US GAAP)
• The balance sheet is not affected: the lessor continues to recognize the underlying
asset and depreciate it.
• Lease revenue is recognized on a straight-line basis on the income statement.
• The entire cash receipt is reported under operating activities on the statement of cash
flows.
LO: Explain the financial reporting of defined contribution, defined benefit, and stock-
based compensation plans.
Defined Contribution Plans
• The amount of contribution into the plan is specified. However, the amount of pension
that is ultimately paid by the plan is not defined and it depends on the performance of
the plan’s assets.
• The cash payment made into the plan is recognized as pension expense on the income
statement.
Defined Benefit Plans
• The amount of pension that is ultimately paid by the plan is defined, usually according
to a benefit formula.
• Under both IFRS and US GAAP, companies must report the difference between the
defined benefit pension obligation and the pension assets as an asset or liability on the
balance sheet. An underfunded defined benefit pension plan is reported as a non-
current liability on the balance sheet.
• Under IFRS, the change in the defined benefit plan net asset or liability is recognized
as a cost of the period. Two components of the change (service cost and net interest
expense or income) are recognized in the income statement and one component (re-
measurements) is recognized in other comprehensive income.
• Under US GAAP, the change in the defined benefit plan net asset or liability is also
recognized as a cost of the period. Three components of the change (current service
costs, interest expense on the beginning pension obligation, and expected return on
plan assets) are recognized in the income statement and two components (past
service costs and actuarial gains and losses) are recognized in other comprehensive
income. Under US GAAP, companies are also allowed to immediately recognize
actuarial gains and losses in profit and loss.
Stock Based Compensation Plans
• Share-based compensation is treated as an expense even though no cash changes
hands when stock options/grants are issued.

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LM08 Topics in Long-Term Liabilities and Equity 2024 Level I Notes

• Both IFRS and US GAAP require us to come up with a fair value to measure the share-
based compensation. Also, the nature and extent of share-based compensation and its
effect on financial statements need to be disclosed.
LO: Describe the financial statement presentation of and disclosures relating to long-
term liabilities and share-based compensation.
Refer to Section 4 of the notes.

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