F5: Leases, Liabilities, and Bonds Flashcards
Ordinary Annuity
payment start end of year
- aka “in arrears”
- # of payments equal to # of interest periods
Annuity Due
payment start beg. of year
- subtract 1st payment to get ordinary annuity
- 1 less interest period than payment
Present Value of $1
amount that must be invested now at a specific interest rate so that $1 can be paid or received in the future
Future Value of $1
compound interest
- amt that would accumulated at a future point if $1 invested now
Operating Leases
lessee uses leased asset and pays periodic rent
- merely uses the asset
- no transfer of ownership or risk/benefit
- *operating lease expense must be recorded evenly over the life of the lease
Lessee Accounting
Operating Leases
Lease Rent Expense
- *operating lease expense must be recorded evenly over the life of the lease
- dr: rent expense, cr: cash/rent payable
- off balance sheet transaction bc doesn’t hit BS
Lease Bonus (prepayment)
- asset/deferred charge
- amortized using straight-line over life of lease
Leasehold Improvements
- permanently affixed to the property and reverts back to the lessor at the termination of the lease
- capitalize and add to PP+E or intangible assets
- depreciate over lessor of:
a) lease life
b) asset/improvement life
Rent Kicker
- period expense
Refundable Security Deposit
- reported as an asset (prepaid) until refunded by the lessor
Free or Reduced Rent Consideration
- take total rent expense to be paid for entire lease term and divide it evenly over each period
- matching principle
Lessor Accounting
Operating Lease
Fixed Asset
- cost of property is in PP+E
- depreciated over asset’s useful life
Rental Income
- dr: cash, cr: rental income
Security Deposits
- nonrefundable: deferred by lessor (unearned revenue) and capitalized by lessee (prepaid rent expense) until the lessor considers the deposit earned
- refundable: receivable by lessee and liability by lessor until deposit is refunded to the lessee
- revenue is only recognized when the earning process is complete
Temporary Difference
- GAAP: report prepaid rental income when earned
- tax: report prepaid rental income when received
Lease Bonus
- deferred (unearned income) and amortized (into income) over life of lease
Free or Reduced Rent Consideration
- take total rental income over entire time and divide evenly
Capital/Finance Lease
capital: US
finance: IFRS
transfers substantially all benefits and risks of ownership
- in substance, an installment purchase in the form of a lease arrangement
- lessee accounts as acquisition of both an asset (leased asset under capital lease) and a related liability (obligation under capital lease)
- lessor accounts as a sales-type or direct financing lease
+ for IFRS: sales-type and direct financing are referred to as finance leases
+ for GAAP: sales type results in dealer’s or manufacturer’s profit or loss to the lessor
+ for GAAP: direct financing does not result in ^
Lessee Capital Lease Criteria (GAAP)*
Capital/Finance Lease
just meet 1 condition to capitalize “OWNS”
- Ownership transfers at end of lease (upon final payment or required buyout)
- Written option for bargain purchase
- Ninety percent of leased property FV <= PV of lease payments
- Seventy-five percent or more of asset economic life is being committed in lease term
- N and S can’t be used if lease begins w/i last 25% of original estimated economic life of the leased property
- OWNS is in order of capitalized cost
Lessee Finance Lease Criteria (IFRS)
Capital/Finance Lease
Situations that lead to Finance Lease Classification “OWESFACS”
- lease transfers Ownership to lessee by end of lease
- lease has Written Bargain Purchase Option
- lease term is for major part of Economic Life, even if title doesn’t transfer
- PV of min. lease payments Substantially all of FV of leased asset
+ OWES similar to OWNS
- gains and losses from Fluctuation in FV of residual accrue to the lessee
- lessee has Ability to Continue the Lease for a secondary period at rent substantially lower than market
- lessee can Cancel the lease and lessor’s losses associated w cancellation are borne by lessee
- leased assets are of such Specialized Nature that only lessee can use them w/o modification
Lessor Sales-type/Direct Financing Type Criteria (GAAP)
Capital/Finance Lease
lease, at inception, meets all 3:
- Lessee owns the leased property (meets 1/4 lesee’s criteria)
- Uncertainties do not exist regarding any unreimbursable costs to be incurred by the lessor
- Collectability of the lease payments is reasonably predictable
- since UC is add. criteria to lessee owning, lessee can classify as capital lease while lessor classifies same lease as operating*
Sales-Type vs Direct Financing Lease for Lessors
Capital/Finance Lease
Sales-Type
- 2 profits:
1) gain on sale: diff b/w FV of leased property (PV of min payments) and NBV to lessor at inception of lease
2) interest income
(manufacturer’s or dealer’s profit or loss)
Direct Financing
- 1 profit: interest income
- FV same as NBV so no manuf./dealer profit or loss
- both transfer substantially all of the benefits and risks of ownership
Lessor Finance Lease Criteria (IFRS)
Capital/Finance Lease
if lease transfers subs. all risks and rewards inherent in ownership to lessee
- lessee and lessor use same criteria
- thus under IFRS, lessee and lessor will usually classify lease consistently as finance or operating
IFRS doesn’t specifically use terms sales-type and direct financing
- manufacturer or dealer lessors may recognize profit/loss at inception of lease like Sales-Type for GAAP
CPA focuses on 3 issues:
Capital/Finance Lease
- Capitalized Lease Criteria
- Asset Capitalized Amt and Depreciation
- Liability Amortization
Recording the Lease
Lessee Capital (Finance) Lease Accounting
Capitalized Amount Include: - required payments - PV of BPO - PV of Guaranteed Residual Value Exclude: - Executory Costs - Optional Buyout (not required and not a bargain)
GAAP vs IFRS
- IFRS, initial direct costs of lease paid by lessee are added to the amt recognized as a finance lease asset
- thus, at inception, the amt of the lease asset and lease obligation may differ
Executory Costs: insurance, maintenance, and taxes that can be paid by lessor or lessee
- if lessor pays them, a portion of each lease payment representing the costs is excluded from calc. of minimum lease payments
- if lessee pays, they are not included in min. lease payments
Interest Rate
Lessee Capital (Finance) Lease Accounting
when calculating PV of min. lease payments, lessee uses lesser of:
- rate implicit in the lease (if known)
- lessee’s incremental borrowing rate (rate available in the market to the lessee, not prime)
Computing Depreciation of the Assset
Lessee Capital (Finance) Lease Accounting
Depreciation Method
- straight line method
- (capitalized lease asset - salvage value)/periods of benefit = depreciation expense
Period of Benefit (depreciable life)- GAAP
- O+W: estimated economic life of the asset (keeping it, legal form)
- N+S: lease term (not keeping it, substance over form)
Period of Benefit (depreciable life)- IFRS
- lesser of lease term and useful life of the asset
- if reasonable certainty lessee will own after lease term, use useful life
Lessee’s FS Disclosure of Leases
Lessee Capital (Finance) Lease Accounting
F5-19
GR: disclose everything, the more the better
- minimum future payments for the next 5 years
Good Summary
Lessee Capital (Finance) Lease Accounting
F5-20
Recording a Sales-Type (Finance) Lease
Lessor Accounting
seller with all the “LUC”
Gross Investment (lease receivable) - gross min. lease payments + any unguaranteed residual value (est. FV at end) is recorded as Lease Payment Receivable on lessor's books
Net Investment
- gross investment * PV = net investment
- net principal
- PV of min. lease payments + PV of unguaranteed RV
Unearned Interest Revenue
- gross investment - net investment = Unearned Interest Revenue
- interest
- recognized over life of lease using effective interest method
- contra-lease receivable, deduction from gross investment
COGS
- cost of leased asset plus any initial direct costs (such as legal fees or commissions to the lessor) minus PV of unguaranteed RV
Sales Revenue
- PV of min. lease payments is sales rev
- doesn’t include PV of unguaranteed RV
- when sales price not given, cost + profit = PV = selling price = FV*
Sale-Leaseback Conservatism
if at a loss, recognize immediately
if at a gain, defer gain bc sale not complete
- defer up to amt you have to give back in lease payments
(conservatism)
Sale-Leaseback
owner of a property sells property and simultaneously leases it back from the purchaser-lessor
- usually no visible interruption in use of property
- treated as single financing transactions where profit may be deferred and amoritzed
GAAP, asks 2 questions for treatment of profits:
- is lease a capital or operating lease?
- what portion of the rights to the leaseback property is retained?
IFRS, treatment of an profits determined by whether operating lease or finance lease
Excess Profit on Sale-Leaseback (GAAP only)
Sale-Leaseback
Operating Lease Excess Profit
- rent-back
- sale price - asset NBV = tentative gain - PV min. lease payment = excess gain
Capital Lease Excess Profit
- “OWNS”-back
- sale price - asset NBV = tentative gain - leaseback asset = excess gain
- leaseback asset is lesser of:
a) FV of leased property or
b) PV of min. lease payments
Amount of Deferred Gain
Accounting by Seller/Lessee (GAAP)
Sale-Leaseback
use PV of rent payments paid by seller-lessee compared to FV of property: 90%+ - defer all gain and amortize w leased asset - capital leases 10% - 90%: - defer gain up to PV of min. leaseback payments (operating lease) or capitalized asset (capital lease) - gain in excess recognized immediately - capital or operating leases =< 10% - recognize gain or loss at time of sale - gains not deferred - operating leases
Losses
- Real Economic Loss: recognized immediately (when FV < BV)
- Artificial Loss: sales price < FV, loss is deferred and amortized over leaseback period
Amortization of Deferred Gain
Capital Leaseback
- any deferred gain or loss is amortized in proportion to the amortization of the leased asset
- “Unearned Profit (or Loss) on Sale-Leaseback” treated as valuation account of leased (back) asset
Operating Leaseback
- any deferred gain or loss is amortized in proportion to the gross rental expense over the life of the lease
- “Unearned Profit (or Loss) on Sale-Leaseback” treated as deferred credit in BS
Accounting by Seller/Lessee (IFRS)
Sale-Leaseback
Finance Lease
- any profit deferred and amortized over the lease term (sales price (not pv of payments) - carrying value)
Operating Lease
- profit/loss recognized immediately if sales price at FV
- if sales price > FV, profit deferred and amortized over the period the asset is expected to be used
- if sales price < FV, profit/loss recognized immediately, unless the loss is compensated for by future lease payments at below market price, then loss should be deferred and amortized over period that the asset is expected to be used
Subleases
Sale-Leaseback
Original Lessor
- if original lessee enters into a sublease, accounting will not change
Sublease Classification by Original Lessee and Sublessee
- Original Lease = Operating Lease
- operating lease - Original Lease = Capital Lease
- O+W: capital lease
- N+S: operating lease
Accounting by Purchaser-Lessor
Sale-Leaseback
acquisition of the asset is accounted for as a purchase
- if operating lease, accounted for as such
- if capital lease, accounted for as direct financing lease
Bond Indenture
Bond Definitions
document that describes contract b/w issuer (borrower) and bond-holder (lenders)
Face (Par) Value
Bond Definitions
total dollar amt of the bond and the basis on which periodic interest is paid
- bonds are issued at face (par) when the stated rate = the market rate
borrower:
dr: cash
cr: bond payable
investor:
dr: investment in bonds
cr: cash
Stated (Nominal or Coupon) Interest Rate
Bond Definitions
interest to be paid to the investors, calculated by applying to face amt of bond
- specified in bond contract
- typically printed on the bond and included in the bond indenture before the bond is brought to market
- will not change, regardless of market rate
- *if stated interest rate =/= market rate at date of issuance, you have a premium or discount
Market (Effective) Interest Rate
Bond Definitions
rate of interest actually earned by the bondholder and is the rate of return for comparable contracts on the date the bonds are issued
- caused by premium/discount, adjusted coupon rate
bc amt of cash to be received in the future is fixed at the time bond is sold, market will automatically adjust the issue price of the bond so the purchaser receivs the market rate of interest for comparable risk bonds
Discount
Bond Definitions
if market rate > stated rate
- bonds sell for less than face to make up for lower return
Unamortized Discount
- contra account to bonds payable, presented on BS as reduction from face of bonds to arrive at carrying value
Amortization of the Discount
- discount amortized over life of bond
- increases interest expense each period
- amortization is added to amt of cash paid at stated rate to obtain GAAP interest expense (remember any cash paid could be zero if bond is a zero coupon bond)
borrower:
dr: cash, dr: discount on bond payable, cr: bond payable
investor:
dr: investment in bonds, cr: cash
Premium
Bond Definitions
market rate < stated rate
- investor will pay more due to higher return
Unamortized Premium
- presented on BS as direct addition to face value of bonds to arrive at carrying value
Amortization of the Premium
- amortized over life of bond
- decreases interest expense each period
- subtracted from amt of cash paid at stated rate to obtain GAAP interest expense
borrower:
dr: cash, cr: premium on bond payable, cr: bond payable
investor:
dr: investment in bonds, cr: cash
Bonds Payable
represent a contractual promise by the issuing corporation to pay investors (bondholders) a specific sum of money at a designated maturity date plus periodic, fixed interest payments (usually made semi-annually) based on a % of the face
Types of Bonds
Debentures
- unsecured bonds
Mortgage Bonds
- bonds secured by real property
Collateral Trust Bonds
- secured bonds
Convertible Bonds*
- convertible into CS at the option of the bondholder
1. Nondetachable Warrants - convertible bond itself must be converted into capital stock
2. Detachable Warrants - bond is not surrendered upon conversion, only the warrants + cash representing the exercise price of the warrants
- warrants can be bought and sold separately from the bonds
Participating Bonds
- bonds that not only have a stated rate of interest but participate in income if certain earnings levels are obtained
Term Bonds*
- bonds that have a single fixed maturity date
- entire principal is paid at the end of this term/period
Serial Bonds*
- pre-numbered bonds that the issuer my call and redeem a portion by serial number
- often redeemed pro rata annually/in a series of annual installments
Income Bonds
- bonds that only pay interest if certain income objectives are met
Zero Coupon Bonds
- aka deep discount bonds
- bonds sold w no stated interest, but rather at a discount and redeemed at face w/o interest payments
Commodity-backed Bonds
- aka asset-linked bonds
- redeemable either in cash or a stated volume of a commodity, whichever is greater
Overview of Bond Terms**
bonds payable should be recorded as a long-term liability at face value and adjusted to the PV by either subtracted unamortized discounts or adding unamortized premiums
- recorded at true present value at date of issuance based on market (effective) interest rate at that date
- *
1. usually in denominations of $1,000
2. price is always quoted in 100’s (% of par value)
3. indenture is a contract for purchase of bond
4. coupon rate = stated interest rate on bond
5. bond interest (check amount) = coupon rate * face - bonds generally pay interest semi-annually in the US and annually in other countries
6. principal payoff is always the full face amount
7. premium/discount is the result of buyer and seller “adjusting” the coupon rate to the prevailing market rate of interest
Bond Selling Price
price is sum of PV of future principal payment + PV of future periodic interest payments
- both cash flows are discounted at market rate of interest
Carrying Value
Bonds
as bonds approach maturity, their carrying values approach face value so they = at maturity
- carrying value = face + unamortized premium or - unamortized discount
- discount or premium will go towards face
Bond Issuance Costs
transaction costs incurred when bonds are issued
- legal fees, accounting fees, underwriting commissions, and printing
- under both GAAP and IFRS:
a. bond issuance costs are presented on BS as direct reduction to carrying amt of the bond, like bond discounts
b. when bonds are issued, bond proceeds are recorded net of bond issuance costs
c. bond issuance costs are amortized as interest expense over the life of the bond using effective interest method
Effective Interest Rate
- used to determine the interest expense for the period as the bond discount/premium and issuance costs are amortized
- effective interest rate must be disclosed in the footnotes
Deferred Bond Issuance Costs
- bond issuance costs incurred before the issuance of the bonds are deferred on BS until bond liability is recorded
- dr: deferred bond issuance costs, cr: cash
- reversed at issue (F5-28)
Discount, Premium, and Bond Issuance Cost Amortization**
Amortization Period
- under GAAP: time period outstanding/ contractual life of the bond
- IFRS: expected life of the bond, not the contractual
Straight-Line Method
- constant dollar amt of interest each period
- not GAAP, but allowed under GAAP if results not materially different from effective interest method
- (premium/discount and bond issuance cost / # of periods bond is outstanding) = periodic amortization
- interest expense = (face value * stated interest rate) - premium amortization (or + discount and bond issuance cost amortization)
- IFRS: not permitted
Effective Interest Method**
- aka constant yield method
- required by both GAAP and IFRS
- constant rate of interest each period based on effective interest rate
- IS (net carrying value * effective interest rate = interest expense) - BS (bond face * coupon rate = interest paid) = amortization
Bonds Issued Between Interest Dates
requires additional entries for accrued interest at the time of sale
- amt of interest that has accrued since last interest payment is added to price of the bond
- purchaser pays the accrued interest and is reimbursed at the ext payment date upon receipt of a full period’s interest
sale:
dr: cash, dr: discount on bonds payable, cr: bonds payable, cr: bond interest expense (or payable)
first interest payment:
dr: bond interest expense (or payable), cr: cash
- reverses the bond interest paid
Year-End Bond Interest Accrual
when date of scheduled interest payment and issuer’s year end do not agree
- must accrue interest by an adjusting entry on issuer’s books at year-end
- accrual must take into account pro-rated share of discount or premium amortization
year-end
dr: interest expense, cr: interest payable
dr: interest expense, cr: discount on bond payable
Bond Sinking Funds
trustee fund (restricted cash) that company contributes money to each year so that at maturity, there is a sum available to repay the entire liability
- *generally non-current (restricted) asset, current asset only to the extent that it offsets a current liability
- earns interest or dividends over time and pays it’s own expenses*
- a bond sinking fund reserve is merely an appropriation of retained earnings to indicate to the shareholders that certain RE are being accum. for bond sinking fund purposes
- amt of current maturities of LT debt does not include the annual sinking fund requirement, but the amt would be included as a footnote
Determination of Periodic Sinking Fund Payments
- FV of annuity = face value
dr: bond sinking fund, cr: cash
dr: bond sinking fund, cr: interest revenue
Serial Bonds
an alternative to using sinking funds
- principals mature in installments*
- allow issuer to match maturity dates w the organization’s cash flow requirements
Accounting for Serial Bonds
PV of each maturity should be separately calculated
- since ST and LT interest rates often differ, there could be a diff discount or premium related to each maturity
- Unamortized Bond Discount or Unamortized Bond Premium is used to accumulate all discounts or premiums for each maturity
- PV of periodic interest payments for each maturity is calculated separately, based on diff yield rates, just as w separate term bonds
- when underwriters bid on an entire serial bond issue at one average interest rate, an average yield can be used for all maturities in that series to calculate interest expense
- * Amortization methods on serial bonds are:
a) Effective Interest Method
b) Bonds Outstanding Method
- not GAAP, but has been tested on CPA
- like sum of year’s digits
- fraction of total bonds outstanding used to calculate related amt of premium or discount on the bonds
- F5-48
Convertible Bonds
often issued at more than face value bc of the value of the conversion feature
- under GAAP, issuance price is allocated to bonds w no recognition of conversion feature bc difficult to assign specific value to it
- under IFRS, conversion feature should be recognized when convertible bonds are issued. diff b/w actual proceeds received and FV of bond liability. similar to acct for bonds w detachable warrants
- nondetachable warrants
- interest rate on convertible debt is generally lower than nonconvertible debt bc of the value of the conversion feature
Book Value Method (GAAP)
- no gain or loss is recognized (no IS impact)
- by carryving value
- CS and APIC impact only
- at conversion, bond payable and related premium or discount is written off and CS and APIC are credited
Market Value Method
- non-GAAP, but tested
- recognize gain or loss (IS impact)
- at conversion, the BP and related premium are written off, and CS and APIC are credited, diff b/w market value of the stock and book value of the bonds is recognized gain or loss
Premium
- since convertible bonds are issued at more than face, difference b/w proceeds and face value is recorded as a premium on BP
- when conversion is exercised, any unamortized premium attributable to that portion must be written off
Bonds Sold With Detachable Stock Purchase Warrants
warrants are option contracts that are issued with, and detachable from, bonds (and notes)
- gives bondholder right to buy stock at a fixed price w/i a specific time period
- bc they are detachable, warrants are traded separately and considered to be a separate financial instrument
- accounted for differently than convertible bonds under GAAP
Account for Separately
- value assigned to a separate conversion feature is it’s relative FV at time of issue
- credited to APIC- warrants*
- value is assigned to a conversion feature only if it is detachable and has its own market value*
Accounting Treatment (2 methods)
- warrants only method
- used if only FV of warrants is known - market value method (warrants and bonds method)
- if FV of both warrants and bonds are known
- allocate cost based on FV
- diff b/w amt allocated to bonds and FV of bonds should be debited or credited to discount or premium on BP
- at exercise of detachable warrants, no bond impact
- dr: cash, dr: APIC-warrants, cr: CS, cr: APIC
Extinguishment of Debt
corps issuing bonds may call or retire them prior to maturity
- callable bonds can be retired after certain date at a stated price
- refundable bonds allow an existing issue to be retired and replaced w a new issue at a lower interest rate
Liability considered Extinguished if either condition is met:
- Debtor Pays
- bond extinguishment at maturity: no gain or loss
- bond extinguishment before: usually gain or loss - Debtor Legally Released
In-Substance Defeasance Not Extinguishment
- when they set aside securities into an irrevocable trust and pledges them for future principal and interest payments on LT debt
*Gain or Loss on Bond Extinguishment Before Maturity
Adjustments in any bond reacquisition
- any related unamortized bond issuance costs
- any related unamortized discount or premium and
- diff b/w bond’s FV and reacquisition price
- Calculation of Gain or Loss
- = reacquisition price - net carrying amt
- net carrying amt: face value + unamortized premium - unamortized discount - unamortized bond issuance costs
- goes to income from continuing ops in IS*
Disclosure Requirements
- comps w large amt of debt issues report only 1 BS supported by comments and schedules in accompanying notes
- notes show liability maturity dates, interest rates, call and conversion privileges, assets pledged as security, and borrower imposed restrictions
- part of the disclosure should include any future sinking fund payments and maturities for each of next 5 years, reported in aggregate
Leases Classification
IFRS vs GAAP
GAAP
- lessees classify leases as operating or capital
- lessors classify as operating, sales-type, or direct financing
IFRS
- leases classified as operating or finance, by both lessee and lessor
Capital (finance) Lease Criteria
IFRS vs GAAP
GAAP
- lessee: at least 1 “OWNS”
- lessor: classified as sales-type or direct financing if all “LUC”
IFRS
- both lessee and lessor classify lease as financial if it transfers substantially all risks and rewards of ownership to lessee
Initial Direct Cost of Lease
IFRS vs GAAP
GAAP
- paid by lessee are expensed when incurred
IFRS
- paid by lessee are added to amt recognized as finance lease asset
Sale-leaseback Transactions
IFRS vs GAAP
GAAP
- recognition of gain depends on rights to leased property retained by seller-lessee
IFRS
- recognition of gain depends on classification of lease as operating or finance
Bond discount/premium amortization
IFRS vs GAAP
GAAP
- effective interest method required
- straight line can be used if not materially different
- amortization over contractual life of bond
IFRS
- effective interest method required
- straight line method prohibited
- amortization over expected life of bond
Convertible Bonds
IFRS vs GAAP
GAAP
- no separate recognition given to conversion feature
- bonds recorded in same manner as non-convertible
IFRS
- liability (bond) AND equity component (conversion feature) recognized
- bond liability recorded at FV
- diff b/w actual proceeds received and FV of bond recorded as equity component
IFRS Defined Benefit Cost (equivalent of net periodic pension cost/pension expense)
- service cost = current service cost + past service cost
- net interest on defined benefit liability = net defined benefit liability/asset * discount rate
- the net interest on .. includes interest cost on DBO and interest income on plan assets
- net defined benefit/asset = FV of plan assets - DBO
- gains and losses = remeasurement of net defined benefit liability/asset + diff b/w actual return on plan assets and interest income included in net interest on DBL/A (reported in OCI and not amortized)
DBO calculated similarly to PBO
