Learning Module 8 Topics in Long-Term Liabilities and Equity
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This chapter explains accounting for leases, pensions, and share-based compensation under IFRS and US GAAP and the required disclosures and financial-statement presentation. It emphasizes the economic impact of classification choices and accounting estimates on the balance sheet, income statement, and statement of cash flows.
Leases: definition, classification, and lessee/lessor accounting
A lease is a contract conveying the right to use an identified asset for a period of time in exchange for consideration. To be a lease a contract must (1) identify an underlying asset, (2) give the customer the right to obtain substantially all of the economic benefits of use, and (3) give the customer the ability to direct the use of the asset. Leases are classified as finance (capital) leases when they transfer substantially all the risks and rewards of ownership and as operating leases otherwise. Five common finance-lease tests include transfer of ownership, a purchase option reasonably certain to be exercised, lease term as a major part of useful life, present value of payments substantially all of fair value, and underlying asset having no alternative use to the lessor.
Lessor accounting is substantially the same under IFRS and US GAAP. For finance leases lessors derecognize the underlying asset and recognize a lease receivable equal to the present value of lease payments; interest income is recognized using the effective interest method, and cash receipts are operating cash inflows. For operating leases lessors keep the asset on the books, recognize straight-line lease income, continue to depreciate the asset, and report lease receipts as operating cash inflows.
Lessee accounting differs modestly. Under IFRS a single model requires recognition at lease commencement of a lease liability and a right-of-use (ROU) asset both measured at the present value of lease payments (with certain exemptions for short-term and low-value leases). Lease liabilities are reduced with principal repayments (financing cash outflow) and interest (finance or operating classification depending on policy) and the ROU asset is amortized (usually straight line). Under US GAAP lessees use one model for finance leases (same as IFRS) and a different model for operating leases: operating leases also recognize an ROU asset and lease liability but present a single lease expense in operating income; all lease payments are operating cash outflows.
Disclosures and presentation
Both IFRS and US GAAP require extensive lessee and lessor disclosures: carrying amounts of ROU assets by class, lease liabilities' maturity analysis, cash outflows, interest on lease liabilities, depreciation on ROU assets, and qualitative descriptions of lease activities and significant judgments (discount rates, lease terms, options). Lessors disclose selling profit, finance income, and operating lease revenue by class and maturity schedules.
Key Points
- A lease must identify an asset and convey substantive control and economic benefits.
- Finance leases transfer substantially all risks/rewards; operating leases do not.
- Lessee accounting under IFRS uses a single model; US GAAP uses two models.
- Lessors apply similar finance/operating distinctions under both frameworks.
- Extensive quantitative and qualitative disclosures are required.
Two primary pension-plan types are defined contribution and defined benefit. In a defined-contribution plan the employer’s obligation is the contribution amount; the employer recognizes the cash contribution as pension expense and has no further obligation. In a defined-benefit plan the employer promises a specified future benefit; accounting requires measuring the present value of the defined benefit obligation (discounted using high-quality corporate bond yields) and comparing it with the fair value of plan assets. The net of obligation and plan assets is recognized on the balance sheet.
Under IFRS the change in the net defined-benefit asset/liability each period is analyzed into service cost (including past service cost), net interest (net pension asset/liability multiplied by the discount rate), and remeasurements (actual return on plan assets less the amount included in net interest and actuarial gains/losses). Service cost and net interest are recognized in profit or loss; remeasurements are reported in other comprehensive income (OCI) and are not recycled to profit or loss. Under US GAAP the components include service cost, interest cost on the obligation, expected return on plan assets (reducing expense), and actuarial gains/losses/past service costs which are often recognized in OCI and amortized into pension expense subject to smoothing rules. Recognition timing, amortization, and valuation allowance considerations differ modestly between standards.
Companies disclose plan funding status, actuarial assumptions (discount rate, inflation, salary growth, mortality), sensitivity analysis, categories of plan assets, employer contribution expectations, and expected benefit payments.
Share-based compensation
Share-based compensation aligns employee and shareholder interests and includes stock grants (including restricted stock units and performance shares) and stock options. Under both IFRS and US GAAP share-based awards are measured at fair value at grant date and expensed over the vesting/service period. Grants settled in equity increase paid-in capital and decrease compensation expense recognition upon vesting; cash-settled awards (stock appreciation rights, phantom stock) create liabilities that are remeasured each reporting period at fair value through profit or loss.
Stock-option valuation requires option-pricing models (Black-Scholes, binomial) and key inputs: exercise price, share price volatility, expected term, dividend yield, risk-free rate, and expected forfeitures. Small changes to inputs materially affect estimated compensation expense. Companies must disclose the nature of awards, terms and conditions, numbers of options outstanding, weighted-average exercise prices, and aggregate unrecognized compensation cost and expected recognition periods.
Key Points
- Defined-contribution plans record employer contributions as expense when paid.
- Defined-benefit plans measure a present-value obligation and separate service cost, net interest and remeasurements.
- IFRS reports remeasurements in OCI; US GAAP has different smoothing/amortization rules.
- Share-based awards are measured at fair value at grant and expensed over vesting.
- Option valuation assumptions materially affect compensation expense.
Lease classification affects EBITDA, operating cash flow, asset turnover, and leverage ratios. Pension accounting affects balance sheet leverage and profit volatility; deferred tax and valuation allowances require scrutiny. Share-based compensation affects reported earnings and shareholders’ equity and is a potential source of dilution. Analysts should study accounting policy notes, sensitivity disclosures, discount rates and assumptions, and reconciliations for non-GAAP metrics. Key red flags include inconsistent or unexplained changes in accounting estimates, unusually large or increasing valuation allowances, frequent use of non-GAAP exclusions that omit recurring costs, large and unexplained lease finance vs operating reclassifications, and unexplained changes in pension assumptions or in the realizability of deferred tax assets. Understanding the economics behind disclosures and the judgment areas helps analysts adjust reported amounts and build informed forecasts.
Presentation choices and non-GAAP measures
Companies commonly present non-GAAP (non-IFRS) metrics—adjusted EBIT, EBITDA, adjusted EPS, or adjusted cash flow. Regulators and standards require reconciliations to the most comparable GAAP/IFRS measures and explanations of relevance. Analysts should check that excluded items are truly non-recurring and not routine operating costs. Common manipulative presentation choices include excluding recurring marketing or employee-related costs, reclassifying operating cash outflows as investing or financing, and highlighting adjusted metrics more prominently than GAAP metrics.
Cash flow statement classification
Choices permitted by IAS 7 and US GAAP allow interest and dividends to be classified as operating, investing, or financing in some cases, and classification choices can materially change operating cash flow presentation. Analysts should reconcile cash flow from operations with accrual income and examine working capital changes to identify unusual timing or classification choices that inflate operating cash flow.
Disclosures and audit considerations
Disclosure of assumptions—discount rates, useful lives, volatility, expected term, pension demographics, and sensitivity analyses—are critical for analyst adjustments. Auditors and market regulators provide discipline, but limitations exist: audit sampling, expectation gaps, and the possibility of management override of controls. Private contracting (covenants) and regulatory enforcement add further checks on reporting quality.
Key Points
- Assess how lease classification affects key ratios and cash flow presentation.
- Carefully review actuarial and valuation assumptions for pensions and deferred taxes.
- Scrutinize non-GAAP adjustments—ensure exclusions are non-recurring and justified.
- Reconcile operating cash flow with accrual income and analyze working capital changes.
- Use disclosures, audit reports, and regulatory filings to detect potential manipulation.
Questions
Which of the following is required for a contract to be accounted for as a lease?
View answer and explanationWhich of the following is one of the five common criteria indicating a finance lease under IFRS and US GAAP?
View answer and explanationUnder IFRS, how does a lessee initially measure the right-of-use asset and lease liability for a qualifying lease?
View answer and explanationWhich statement correctly contrasts lessee accounting under US GAAP for a finance lease versus an operating lease?
View answer and explanationWhich of the following is a required lessee disclosure under IFRS 16?
View answer and explanationWhich of these best describes a defined-contribution pension plan?
View answer and explanationUnder IFRS, where are actuarial gains and losses on defined-benefit pension plans reported?
View answer and explanationWhich of the following is TRUE about share-based compensation accounting under both IFRS and US GAAP?
View answer and explanationWhich input to an option-pricing model will, all else equal, increase the estimated fair value of a stock option grant?
View answer and explanationWhen a lessee qualifies for the short-term lease exemption (lease term of 12 months or less and no purchase option), what accounting alternative is permitted?
View answer and explanationWhich of the following statements about remeasurement of pension plan assets and liabilities is correct under IFRS?
View answer and explanationA company grants restricted stock units (RSUs) that vest in three years if the employee remains employed. How should the company account for this grant?
View answer and explanationWhich of the following best describes the primary accounting recognition for employer contributions to a defined-contribution pension plan?
View answer and explanationA company issues stock options to employees with a weighted-average fair value at grant of USD10 per option, a three-year vesting period, and 100,000 options granted. If the company expects no forfeitures, what annual compensation expense should be recognized?
View answer and explanationWhich of the following is a typical disclosure requirement for share-based compensation under IFRS 2?
View answer and explanationHow does an operating lease (lessee) under US GAAP affect EBITDA compared with a finance lease, all else equal in early years?
View answer and explanationWhich of the following is most likely to create a deferred tax asset?
View answer and explanationA company reports a large gross deferred tax asset but maintains a substantial valuation allowance. What is the likely implication?
View answer and explanationWhen an employee stock option is exercised, which of the following best describes the accounting entries?
View answer and explanationWhich of the following statements about lessor accounting is correct under both IFRS and US GAAP?
View answer and explanationA company has a defined-benefit obligation of USD80 million and plan assets with fair value USD60 million at year end. How should the net position generally be presented on the balance sheet?
View answer and explanationWhich of the following items would an analyst most likely consider a non-GAAP adjustment when evaluating a company's operating performance?
View answer and explanationWhich of the following best describes how an increase in the discount rate used to measure a defined-benefit obligation will typically affect that obligation's present value?
View answer and explanationWhich of the following statements about cash-settled share-based payments (e.g., stock appreciation rights) is true?
View answer and explanationUnder IFRS, which of the following best describes the presentation of depreciation and amortization for property, plant, and equipment and intangible assets in the income statement?
View answer and explanationA lessee under IFRS recognizes a lease liability and ROU asset for a 5-year lease with annual payments of EUR100,000 and discount rate 10%. Which statement about subsequent accounting is correct?
View answer and explanationA company reports net income of USD50 million and cash from operations of USD30 million for the year. Which inference is most supported by this single-year observation?
View answer and explanationWhich of the following is a required element of lessee disclosures under IFRS 16 for the reporting period?
View answer and explanationWhich of the following best explains why companies might prefer to report non-GAAP (adjusted) earnings to investors?
View answer and explanationIf a company under US GAAP recognizes an impairment of a long-lived asset held for use, what is the general rule about reversing that impairment in later periods?
View answer and explanationWhen allocating purchase consideration in a business combination, which of the following statements is correct under IFRS?
View answer and explanationWhich of the following is the most important reason analysts examine pension plan discount rates and sensitivity disclosures?
View answer and explanationUnder IFRS 16, how are lease payments generally allocated in the lessee's statement of cash flows for a finance lease?
View answer and explanationWhich of these items would most likely be classified as part of an entity's defined-benefit plan remeasurements under IFRS?
View answer and explanationHow should a company treat preparatory (research) costs for internally developed intangible assets under IFRS?
View answer and explanationWhich of the following is most likely a conservative accounting choice?
View answer and explanationWhich of the following best describes the typical analyst reaction when a company consistently excludes recurring operating expenses from its adjusted EBITDA and emphasizes the adjusted measure in press releases?
View answer and explanationA company has an ROU asset and corresponding lease liability for a major equipment lease recorded at lease inception. Over the first two years, the ROU asset net balance declines faster than the lease liability. Which explanation is most consistent with typical accounting?
View answer and explanationWhich disclosure would most help an analyst assess the sensitivity of a company’s goodwill impairment to key assumptions?
View answer and explanationIf a company capitalizes development costs for internally developed software rather than expensing them immediately, what is the likely immediate effect on current-period operating profit and on investing cash flow?
View answer and explanationWhich of the following disclosure items about leases would enable analysts to assess the timing of future cash outflows?
View answer and explanationAn analyst notices that a company significantly increased its estimate of useful lives for its property plant and equipment during the current year. What is the most likely immediate effect on current-year depreciation expense and on future-year depreciation expense?
View answer and explanationWhich of the following is most likely a red flag indicating potential earnings management related to accounts receivable?
View answer and explanationWhich of the following is an appropriate reason to capitalize development costs under IFRS IAS 38?
View answer and explanationIn the context of auditing and regulatory oversight, which statement accurately reflects a limitation of audits in preventing financial reporting fraud?
View answer and explanationWhich of the following cash flow classification choices can materially increase reported operating cash flow under IAS 7?
View answer and explanationWhich of the following is a required disclosure relating to intangible assets under IFRS?
View answer and explanationWhich action related to deferred tax assets should an analyst consider a potential sign of management optimism or earnings management if there is little other evidence of future taxable profits?
View answer and explanationWhich of the following best explains why analysts reconcile cash tax paid to income tax expense reported on the income statement?
View answer and explanationWhich of the following is NOT a common reason management might be motivated to report adjusted non-GAAP earnings?
View answer and explanation