3. Measurement, Valuation and Disclosures - Long Term Items (Assets, Leases, Income tax..)

Question 1

PPE

Answer 1

• Fixed assets that are expected to benefit more than 1 year, they are NOT held for investment
• Measured at historical cost which includes net purchase price + cost to bring asset to the location and ready for use + Interest borrowing cost attributable to the acquisition, construction or production of PPE for internal use ( Borrowing cost AFTER asset is prepared is expensed
• Capital expenses conditions:
  1) Improve the quality
  2) Extend useful life
  3) Increase output
• Salvage value ( Residual value ) is the amount the entity expect to obtain from the disposal of the asset at the end of the asset useful life
• Types of Depreciation methods:
  1) Straight line method - Appropriate when asset service potential decline with passage of time
  2) Units of output method - Appropriate when asset service potential decline with use
  3) Sum of years digit - Appropriate when asset service potential decline with use
  4) Accelerated depreciation method - Appropriate when asset service potential is subject to rapid obsolescence. Salvage value is ignored using this method
• Under IFRS the entity may choose either Cost or Reevaluation modes for asset evaluation. An revaluation increase must be recognized in OCI as revaluation surplus but it must be recognized in IS to the extent it reverses a loss on asset. Revaluation loss must be recognized in IS but the decrease must be recognized in OCI to the extent revaluation surplus
• Under IFRS investment property (Land, building or both) held by owner or lessee under finance lease agreement or for capital appreciation is accounted for Cost or FV model. Gain/loss arise for the change in FV must be recognized in IS. Investment property accounted for according FV model is NOT DEPRECIATED.

Question 2

Impairment and Disposal of Long Lived assets

Answer 2

• Testing for impairment occurs when event or
  changes in circumstances indicate that the carrying amount may not be recoverable when market price reduce significantly OR the use or physical condition of the asset has changed.
• Under GAAP Impairment test have 2 steps - Reversal is prohibited:
  1) Recoverability test when Undiscounted future value (also called expected future cash flow) minus carrying amount = negative amount
  2) Carrying value minus FV
• Under IFRS impairment has 1 step - Reversal MAY BE ACCEPTABLE and it will only impact increase on income:
  1) Carrying amount - Recoverable amount ( The greater of NRV and Value in use
  Value in use is the present value of its expected cash flows

Question 3

Intangible Assets

Answer 3

• Under GAAP Externally acquired intangible assets are recorded at cost plus any additional costs.
• Under GAAP Internally developed intangible assets are NOT capitalized except for their additional costs - Research and Development are EXPENSED.
• If an asset is purchased for Research and Development only it must be Expenses. If other purposes are used asset must be capitalized.
• Under IFRS intangible assets are accounted for using Cost or Revaluation methods (if there is an active market exists for the intangible asset)
• Under IFRS Research is expensed, Development is capitalized.
• Intangible assets with FINITE useful life is amortized over the USEFUL LIFE. Subject to impairment similar to long lived assets
• Intangible assets with INDEFINITE useful life is NOT amortized. Must be reviewed for impairment at least ANNUALLY.
• Goodwill is recognized ONLY in business combinations. They are tested for impairment at REPORTING UNIT each year at the same time. NOT amortized.
• Under IFRS reversal of impairment loss is acceptable EXCEPT FOR GOODWILL
• Under IFRS reversal of impairment loss will INCREASE INCOME ONLY
• Two steps for Goodwill impairment:
  1) Compare FV of the reporting unit with carrying value including goodwill
  2) Compare the implied FV of the reporting unit goodwill with carrying amount of that goodwill.
• Patent is amortized over the SHORTER of:
  1) Useful life
  2) Legal life remaining after acquisition
• Successful litigation are capitalized, the cost of unsuccessful litigation cost is expensed.

Question 4

Leases

Answer 4

• Lessee may prefer operating lease to avoid recognition of the following in his FS:
  1) Liability of future lease payment
  2) Interest expense
  3) Depreciation of the leased asset
• One of the following criteria must be met to account for as capital lease:
  1) Transfer of Ownership of the leased property
  2) Lease contains bargain Purchase option - the right to purchase the leased property at a price LOWER than its expected FV at the date BPO is exercised.
  3) Lease term is 75% or more of property economic life
  4) The PV of minimum lease payment is at least 90% of the fair value of the leased property.
• At inception of capital lease, the lessee recognizes leased asset (debit), leased liability (credit)
• Capital Lease have 2 types:
  1) Direct financing - the lessor economic interest is in financing the purchase not promoting the sale
  2) Sales type lease
• Minimum lease payment must be discounted (measured at present value) at LOWER of:
  1) Lessor implicit rate
  2) Lessee borrowing rate
• Each periodic lease payment the LESSEE must recognize:
  1) Interest expense
  2) Reduction of lease liability
• Each periodic lease payment the LESSOR must recognize:
  1) Interest income
  2) Reduction of lease receivable
• Depreciation expense under capital lease:
  1) Over economic life of asset leased if it follows condition 1 and 2
  2) Over term of leave if it follows condition 3 and 4
• Under GAAP if a lease involves land and a building contains transfer of ownership Or BPO, land and building elements are treated separately. If it does not contain both elements are treated as single unit unlss the Land is 25% or more of the FV of leased property
• Under IFRS if a lease involves land and a building both elements are treated separately. The land element is classified as operating lease unless title passes to the lessee. The building is classified either as finance or operating lease based on regular criteria

Question 5

Income Taxes

Answer 5

• Income tax expense or benefit is the sum of Current tax expense/benefit + deferred tax expense/benefit
• Deferred tax expense/benefit is the net change of deferred tax during the year.If deferred tax asset increased it will be deducted from current tax expense, If deferred tax liability increased it will be added to current tax expense.
• Deferred tax asset/liability arises from temporary differences
• IntrAperiod tax allocation is required because items included in the determination of taxable income may be presented in different section of FS, such as continuous operations, discontinued operations and OCI
• IntErperiod tax allocation arises from temporary difference when expenses are deductible for tax purposes before/after being recognized in financial income.
• Temporary differences arises from:
  1) Different depreciation method
  2) Expense for Warranty liability
  3) Bad debt expense
• Permanent difference is an event that recognized either in pretax financial income Or taxable income BUT NEVER IN BOTH, such as:
  1) Payments of fines or penalties are not deductible for taxable income
  2) Interest on state municipal bonds are not deductible for taxable income
• Deferred taxes are accumulated difference between income tax expense and the income tax actually paid
• Deferred tax liability arises when Income under GAAP > Taxable income - higher taxes to be paid in the future. Example; the company uses for tax purposes accelerated depreciation method and for GAAP straight line method
• Deferred tax assets arises when Income under GAAP < Taxable income - lower taxes to be paid in the future. Example; Bad debt expenses under allowance method recognized in financial income, bad debt expense recognized under taxable income when it is written off
• Deferred tax amounts should be netted in the BS, current assets with current liabilities and Vice Versa. If there is beginning and ending balances, they should be subtracted then net current and non current
• Deferred tax amounts are classified as Noncurrent
• A valuation allowance reduces deferred tax ASSET. It is recognized if probability > 50%.
• Entities that incur net operating losses have two options:
  1) Carry the loss back 2 years AND forward 20 years - both BS and IS are affected
  2) Carry the loss forward 20 years.
• When an entity incur loss it means that it have deferred tax asset. Upon realization, the deferred tax asset reduces the amount of income tax payable in future periods but DOESN’T affect income tax expense.
• The journal entry for NOLs deferred tax asset recognition is Deferred Tax Asset (Debit), Income tax benefit from loss carry forward/carry backward.
• Review P.18, 19

Question 6

Bonds and Noncurrent Notes Payable

Answer 6

• Bonds is a formal contract to pay an amount of money at maturity plus interest at stated rate.
• Bonds are recorded as debt on ISSUER and investment on INVESTOR
• Stated rate is the rate on face amount of bond, effective interest rate is the market rate.
• Conditions if bond is issued on premium or discount:
  1) Stated = market rate then bonds sold at par
  2) Stated > market rate then bond sold at premium - premium is a non current liability
  3) Stated < market rate then bond sold at discount - discount is non current liability in negative sign to reduce bond value
• Bonds are amortized over the LIFE of the bond using market rate.
• At maturity date, the discount or premium is fully amortized and the carrying amount of the bond equals the face amount.
• Examples on P.20, 21
• Types of bonds:
  1) Term bond - have single maturity date
  2) Serial bond - matures at regular intervals
  3) Income bond - contingent on issuer profitability
  4) Revenue bond - issued by governments and are payable from specific revenue sources
  5) Mortgage bond - backed by specific real state
  6) Debentures - backed by borrower general credit, unsecured bonds
  7) Guaranty bond - Guaranteed by a third party
  8) Collateral trust bond - secured by finance assets such as stocks
  9) Equipment bond - backed up by movable equipment
  10) Variable (floating) bond - pay interest that is dependent on market condition
  11) Zero Coupon (deep discount) bond - No stated interest rate, interest can be amortized annually on a straight line basis but is noncash outlay
  12) Commodity backed bond - Payable at prices related to commodity like gold
  13) callable bond - maybe be repurchased by issuer before maturity
  14) Convertible bond - may be converted to equity securities
• Noncurrent notes payable examples P.22, 23

Question 7

Rules for Calculations

Answer 7

• Asset carrying value = NO SALVAGE VALUE
  Historical cost
• Accumulated depreciation
• Impairment loss
• Asset selling price = Carrying amount + Gain OR Carrying amount - loss
• PPE purchases during the year =
  Carrying value current PPE
  + Depreciation expense
  + Increase in PPE

* How to calculate disposal in Year 2=
Beg carrying value
\+ 2nd year purchased PPE
- 2nd year depreciation expense
- Ending carrying value

• Depreciable base for fixed assets = Historical cost - salvage value - impairment loss
• Straight line method = Depreciable base * (1/estimated useful life)
• Double Declining method = Carrying amount * declining balance % (1/estimated useful life *2 )

Units of output method = Depreciable base * (Units produced during current period/estimated total lifetime units)

• Sum of years digit method = Depreciable base * (Remaining years in useful life/Sum of all years in useful life)
• Impairment loss GAAP = Carrying amount - FV
• Impairment loss IFRS = Carrying amount - recoverbale amount
• Disposal value = Net proceeds - carrying amount\
• In calculation of operating lease, if the lessor gives 1 month free; example if annual rent is 33,000 what shall the entries be
  33,000/12 = 2,750 , First month entry would be Rent Expense 2,750 (debit) Rent Payable 2,750 (credit)
  Second month entry Rent expense 2,750(debit) Rent payable 250 (debit) Cash 3,000 (credit)
• Annual minimum lease payment = Annual payment - executory cost
• PV of annual minimum lease payment = (Annual minimum lease payment * present value factor) + (PV of residual value guaranteed by lessee + PV of nonrenewal penalty) OR PV of BPO
• Interest Expense at capital lease = PV of minimum lease payment * stated interest rate
• Depreciation Expense at capital lease = PV of minimum lease payment / depreciation method used
• Deferred tax asset when NOLs exists = NOLs * tax rate - in the following year this amount will be used o reduce income tax payable. Following year tax expense = (Current year income - previous year NOLs) * tax rate.
• Interest expense for bonds = Carrying amount (Face amount * PV factor + Interest * PV factor) * market rate
• Cash Interest paid for bonds = Face amount * Stated rate
• Journal entry to purchase bond: Dr Bond type (@ present value amount), Cr Cash (@ present value amount)
• Journal entry of interest bond: Example hold to maturity
  Cash (debit) amount of interest received on stated rate, Interest revenue (credit) amount of carrying value * market rate, Hold to maturity (credit) difference between debit and credit side to amortize premium
• Premium/discount amortized = Interest expense - Cash interest paid
• PV value of 1 is used for face amount, PV of ordinary annuity is used for interests
• Face amount and the amount of stated interest must be discounted (to present value) using market rate to see premium or discount value of the bond