F4

Question 1

Explain the difference between the net method and gross method of recording accounts payable

Answer 1

Gross Method - records a purchase wihtout regard to the discount. When invoices are paid within the discount period a purchase discount is credited.

Net Method - purchases and accounts payable are recorded net of the discount. If payment is made within the discount period, no adjustment is necessary. If payment is made after the discount period, a purchase discount lost account is debited.

Question 2

What types of costs are associated with exit and disposal activities?

Answer 2

• Involuntary employee termination benefits
• Costs to terminate a contract that is not a capital lease
• Costs to consolidate facilities
• Costs to relocate employees

Question 3

Define an asset retirement obligation (ARO).

Answer 3

A legal obligation associated with the retirement of a tangible long-lived asset that results from the aqcquisition, construction, development, and/or normal operation of a long-lived asset.

Question 4

How is an ARO initially measured?

Answer 4

At fair value (present value of the future obligation) as an asset (asset retirement cost) and a liability (asset retirement obligation).

Question 5

How is an ARO accounted for in periods after initial measurement?

Answer 5

The ARO liability is adjusted for accretion expense and the ARO asset is depreciated.

Question 6

What is the accounting treatment of gain contingencies?

Answer 6

Gain contingencies are not reflected on the balance sheet but are disclosed as to their nature and amount if liklihood is probable and to do so would not be misleading.

Question 7

Identify the three ranges of likelihood that a future event will confirm a contingent liability.

Answer 7

• Probable
• Reasonably possible
• Remote

Question 8

When are contingent liabilities accrued?

Answer 8

• When the loss is both probable and can be reasonably estimated, then record and disclose.
• Financial statement disclosure only for reasonably possible contingent losses.
• Remote contingent losses are not disclosed, unless they are “guarantee-type” contingent losses, which must be disclosed.

Question 9

Premiums, warranties, and service contracts are examples of estimated liabilities. When are the liabilities for these types of expenses recorded and why?

Answer 9

Estimated liabilities for premiums, warranties, and service contracts are recorded in the same period as the revenue associated with the various transactions in order to accomplish matching of costs and revenues.

Question 10

What is the equation to calculate the present value of $1?

Answer 10

PV = FV/(1+n)^n
where:
PV = present value
FV = future value
r = interest rate
n = number of years

Question 11

What is the difference between an ordinary annuity and an annuity due?

Answer 11

Timing of payments
* ordinary annuity - payments are at the end of each period
* annuity due - payments are at the beginning of each period

Question 12

How are notes payable recorded in the financial statements?

Answer 12

Notes payables must be recorded at present value at the date of issuance.

If a note is non-interest bearing or the interest rate is unreasonable (usually below market), the value of the note must be determined by imputing the market rate of the note and by using the effective interest method.

Question 13

What is the effective interest rate method?

Answer 13

The effective interest method is a method under which each payment on a note (or other loan) would be divided between an interest component and a principal component as though the note had a constant effective stated rate (or adequate rate) of interest.

Question 14

How are premiums or discounts resulting from recording notes payable and receivable at present value presented in the financial statements?

Answer 14

The premium or discount that arises from the use of present values on cash and noncash transactions is inseparable from the related asset or liability. Therefore, such premium or discount valuation accounts are added to (or deducted from) their related asset or liability on the balance sheet.

Question 15

Why do creditors use debt covenants in lending agreements, and how could this impact the issuer?

Answer 15

Debt covenants are stipulated in lending agreements to protect the creditors’ interests by limiting or prohibiting certain actions of the debtors that may be harmful to the creditors’ interests (i.e., issuing more debt).

Debt covenants are disadvantageous to the issuer (the debtor), as they may restrict certain management activities (i.e., selling assets)

Question 16

When is a bond issued at a discount? A premium?

Answer 16

A bond is issued at a discount when the coupon/stated interest rate is less than the market/effective rate of interest.

A bond is issued at a premium when the bond interest rate is greater than the market rate of interest.

Question 17

How is the bond selling price computed?

Answer 17

The price is the sum of the present value of the future principal payment plus the present value of the periodic interest payments discounted using the market/effective rate on the date the bonds are issued.

Question 18

What is the preferred method of accounting for bond issuance costs under U.S. GAAP?

Answer 18

Deducted from the carrying amount of the liability and amortized using the effective interest method.

Question 19

Name two methods of amortizing bond premium (discount).

Answer 19

• Straight-line method - Premium or discount / number of periods
• Effective interest method (GAAP) -
  Premium (or discount) amortized = (Carrying value X Effective rate) - (Face value X Stated rate)

Interest expense = (Face value X Stated rate) + Discount amortized - Premium amortized = Carrying value X Effective rate

Note: The straight-line method is permitted under U.S. GAAP if not materially different from the effective interest method.

Question 20

What are the major disclosures for long-term debt?

Answer 20

1. Maturity dates
2. Interest rates
3. Call and conversion privileges
4. Assets pledged as security
5. Borrower-imposed restrictions

Question 21

Name four types of restructurings involving debt.

Answer 21

1. Transfer of assets
2. Transfer of equity interest
3. Modification of terms
4. A combination of the above three

Question 22

How is the gain (loss) measured in a troubled debt restructuring involving a transfer of assets?

Answer 22

Restate the assets transferred to fair value and recognize a gain or loss in ordinary income.

Recognize a gain for the difference between the fair value of the assets transferred and the carrying amount of the debt forgiven.

Question 23

How is the gain (loss) measured in a troubled debt restructuring involving the modification of terms?

Answer 23

It is the difference between the carrying amount of the obligation prior to restructuring and undiscounted total future cash flows required after restructuring, if undiscounted future cash flows are less than the carrying amount.

Question 24

When is a loan considered impaired?

Answer 24

When it is probable that all amounts due under the original contract will not be received when due.

Question 25

How is the loss incurred as a result of a modification of terms of an impaired loan reported by the creditor?

Answer 25

The amount of the loss is the present value of the loan’s expected future cash flows discounted at the loan’s effective interest rate minus the carrying value of the loan before the modification of terms.

Debit Bad debt expense
—–Credit Allowance for credit losses

Question 26

When is a liability considered extinguished?

Answer 26

If either of the following conditions is met:
* If the debtor pays the creditor and is relieved of its obligations for the liability.
* If the debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor.

Question 27

Define in-substance defeasance.

Answer 27

An arrangement in which a company places purchased securities into an irrevocalbe trust and pledges them for the future principal and interest payments on its long-term debt.

The company remains the primary obligor; therefore, the liability is not considered extinguished.

Question 28

How is the gain or loss on early extinguishment of debt treated?

Answer 28

Gain or loss on the income statement, shown as a separate line item, if material, in income from continuing operations.

The gain or loss is the difference between net carrying value (including unamortized bond issuance costs and premium or discount) and the reacquisition price of the debt.

Question 29

Identify and define a lease and the parties to a lease.

Answer 29

Lease - A contract that identifies an asset, accounts for the lessor’s right of substitution of that asset, and conveys to the lessee the right to control the use and obtain economic benefits from the asset over the lease term.

Parties to a lease - a lessor conveys the right to use the asset (real or personal property) to the lessee, who agrees to pay consideration for this right over the lease term.

Question 30

Describe the two options that the lessee has for accounting for a contract that has lease and nonlease components

Answer 30

Option 1 - lease components are treated as separate units of account from nonlease components within the same contract.

Option 2 - a lease component of a contract may be combined with a related nonlease component wihtin the same contract to be treated as a single unit of account.

Question 31

Name the different types of lease classifications applicable to lessees.

Answer 31

Lessees will treat a lease as either an operating or finance lease.

Question 32

Name the criteria for determining whether a lease is a finance lease for the lessee.

Answer 32

If any of one of the five OWNES criteria is met, the lease will be classified as a finance lease by the lessee.

*OWNERSHIP of the underlying asset transfer from the lessor to the lessee by the end of the lease term.

*The lessee has the WRITTEN OPTION to purchase the underlying asset; the option is one that the lessee is “reasonably certain” to exercise.

*The NET PRESENT VALUE of the lease payments and any guaranteed residual value equals or exceeds substantially the underlying asset’s fair value.

*The term of the lease represents the major part of the ECONOMIC LIFE remaining for the underlying asset

*The asset is SPECIALIZED such that it will not have an expected, alternative use to the lessor when the lease term ends.

Question 33

Describe the classification of a lease for a lessee if none of the OWNES criteria are met.

Answer 33

If non of the five OWNES criteria is met, or if the lease is short-term, the lessee will treat the lease as an operating lease.

Question 34

How long is the period covered by a lease and how are options to extend or terminate a lease handled?

Answer 34

A lease begins on the commencement date (when the asset is available for use) and extends until the end of the noncancelable period.

The lease term will account for an:
* Option to extend if the lessee is reasonably certain to exercise the option
* Option to terminate if the lessee is reasonably certain not to exercise.
*Option to either extend or terminate if the decision is controlled by the lessor.

Question 35

What components will be included and excluded from lease payments?

Answer 35

Lessee lease payments will include:
* Required contractual fixed payments
* Exercise option (if reasonably assured)
* Purchase price at the end of the lease
* Only indexed or rate variable payments
* Residual guarantees likely to be owed
* Termination penalties (if reasonably assured)

Lessee lease may or may not include (at lessee’s option):
* Nonlease components

Lessee lease payments specifically exclude:
* Guarantees of lessor debt by lessee
* Other variable lease payments

Question 36

What rates should the lessee use to calculate the present value of the minimum lease payments?

Answer 36

The lessee should use the rate implicit in the lease. If the rate is not known, the lessee should use its incremental borrowing rate.

Question 37

Which initial direct costs are included/excluded in the valuation of the right-of-use (ROU) asset?

Answer 37

Include any initial direct costs that are incurred as a result of the execution of the leases.

Exclude any costs incurred prior to signing the lease (document preparation, credit checks, etc.).

Question 38

How does a lessee account for an operating lease?

Answer 38

With an operating lease, the lessee will record a right-of-use (ROU) asset and a lease liability on the balance sheet. The ROU asset will be amortized as the lease liability is paid down over the life of the lease. On the income statement, lease expense will be recognized over the lease term.

Question 39

List the initial and subsequent journal entries recorded by a lessee when the lease qualifies as an operating lease.

Answer 39

Initial Entry:
Dr ROU asset
Cr Lease liability

Subsequent Entries:
Dr Lease expense
Cr Cash/lease liability

Dr Lease liability
Cr Accumulated amortization—ROU asset

Question 40

How does a lessee account for a finance lease?

Answer 40

With a finance lease, the lessee will record both an ROU asset and a lease liability on its balance sheet. Each lease payment will consist of interest and principal pay down. Interest expense will be shown on the income statement and the reduction of the liability will be reflected on the balance sheet.

Question 41

List the initial and subsequent journal entries recorded by a lessee when the lease qualifies as a finance lease.

Answer 41

Initial Entry:
Dr ROU Asset
Cr Lease Liability

Subsequent Entries:
Dr Interest Expense
Dr Lease Liability
Cr Cash/lease payable

Dr Amortization Expense
Cr Accumulated amortization - ROU Asset

Question 42

Over what period will the lessee depreciate the leased asset under a finance lease?

Answer 42

Asset’s use life: (O or W) if ownership transfers to the lessee or if the lessee is reasonably certain to exercise an option to purchase the asset.

Shorter of lease term or asset’s useful life: (N, E, or S) if any of the other criteria are met.

Question 43

Describe the accounting policy election that lessees can make regarding the balance sheet treatment of leases.

Answer 43

For leases with terms of 12 months or less, a lessee can make an accounting policy election and choose to not recognize ROU assets or lease liabilities. The election must be made by class of underlying asset, and leases falling into this category cannot include purchase options for the asset that the lessee would be reasonably certain to exercise.

Question 44

For finance and operating leases, which cash flows are treated as operating cash flows?

Answer 44

For finance leases, the interest payments and any variable and short-term lease payments not included in the lease liability are treated as cash flows from operations (principal payments are cash flows from financing).

For operating leases, lease payments, variable lease payments, and short-term lease payments are all treated as cash flows from operations.