F6 - Leases, Derivatives, Foreign Currency Accounting, and Income Taxes Flashcards
M1 - Leases: Part 1
For a lessee to account for a lease as a finance lease under U.S. GAAP, the terms of the lease must meet at least one of the finance lease criteria:
- Title transfer at end of lease
- Bargain purchase option (reasonably certain to exercise)
- PV = 90% of FV of asset
- Economic life = 75% of estimated useful life
- Specialized use
M1 - Leases: Part 1
When should a lessee begin recognition of expenses?
- The lessee should begin the recognition of lease expenses on the commencement date.
- The commencement date is the date the underlying asset is made available to the lesee for use.
Lease expense is recorded over the lease term.
M1 - Leases: Part 1
Assuming no direct costs are involved, what are the components of the lease receivable for a lessor involved in a direct-financing lease?
The minimum lease payments plus residual value.
- Lessors recording a lease receivable for a direct-financing lease should include the minimum lease payments PLUS any residual value.
- The reason for this is because the lessor can also expect to collect this residual value from the lessee at the culmination of the lease.
M1 - Leases: Part 1
How should lessee recognize lease payments?
The lessee calculates lease payments at commencement of the lease based on the present value of the following items:
- fixed payments
- variable payments
- exercise price of purchase option
- termination penalties
- probable amount owed of the guaranteed residual
M1 - Leases: Part 1
If the underlying lease in a sale-leaseback is a finance lease..
it is considered equivalent to a repurchase and will therefore be considered a “failed sale”.
M1 - Leases: Part 1
If Sale-leaseback is less than FV of property at the time of sale
GAAP requires that a loss to be recognized immediately in a sales-leaseback transaction when the fair value of the property at the time of the sale-leaseback is less than book value.
FV < BV
M2 - Leases: Part 2
Amortization of leasehold improvements
should be over the life of the improvements or the remaining life of the lease, whichever is shorter.
M2 - Leases: Part 2
What rate should the Lessee use?
Lessee should use the rate implicit in the lease (if known by the lessee) to discount cash flows.
M2 - Leases: Part 2
How should Finance leases be recorded?
Finance leases should be recorded as both an asset and liability at the present value of the minimum lease payments.
- The asset is depreciated.
- The liability is amortized using the interest method.
Each payment is allocated between principal and interest.
The liability is reduced by the amount of principal reduction.
The lease liability should be segregated between current (due within one year) and non-current (due beyond one year).
Accordingly, the reduction in lease liability each year is equal to the current liability at the end of the previous year.
M2 - Leases: Part 2
How should a LESSEE amortize a finance lease?
- over the economic life of the asset when there is a written purchase option or when the lessee takes ownership of the asset at the end of the lease term.
M2 - Leases: Part 2
the liability for a finance lease would be reduced periodically by?
- A minimum lease payment less the portion of the minimum lease payment allocable to interest.
Minimum lease payments less the portion of the minimum lease payment allocated to interest represents the liability for a finance lease.
- For a finance lease, the minimum lease payment is allocated between principal and interest using the interest rate inherent in the lease.
- The portion allocated to principal reduces the remaining lease liability.
M2 - Leases: Part 2
Amortization of Leasehold improvements
should be over the life of the improvements or the remaining life of the lease, whichever is shorter.
M2 - Leases: Part 2
Variable lease payments not included in the lease liability
are treated as cash outflows from operations and will therefore have a negative impact on bottom-line cash flow from operations.
M3 - Derivatives and Hedge Accounting
Derivative
A derivative is a financial instrument that derives its value from the value of some other instrument and has three characteristics:
1. it has one or more underlyings, and one or more notional amounts or payment provisions, or both;
2. it requires no initial net investment or one that is smaller than would be required for other types of similar contracts; and
3. its terms require or permit a net settlement, or it can readily be settled net outside the contract or by delivery of an asset that gives substantially the same results.
M3 - Derivatives and Hedge Accounting
What is considered a derivative financial instrument?
- futures
- forwards
- options
- swaps
A bank certificate of deposit is not a derivative financial instrument.
M3 - Derivatives and Hedge Accounting
In order for a financial instrument to be a derivative for accounting purposes, the financial instrument must:
- Have one or more underlyings.
- NOT requiring an initial investment
M3 - Derivatives and Hedge Accounting
The determination of the value or settlement amount of a derivative involves a calculation which uses:
- An underlying
- A notional amount
M3 - Derivatives and Hedge Accounting
Put options
Put options on stock lock in the sale price of the stock;
- if the stock decreases in value, the put option holder will have locked in the now higher price.
M3 - Derivatives and Hedge Accounting
What is an interest swap agreement?
An interest swap agreement is a financial instrument that is both a contractual right and a contractual obligation to both parties.
Such agreement has an off-balance-sheet risk of accounting loss resulting from both credit and market risk.
- Credit risk results from the risk of nonperformance by the counter-party to the agreement.
- Market risk is the risk of exchaning a lower interest rate for a higher interest rate.
M3 - Derivatives and Hedge Accounting
What is a fair value hedge?
A fair value hedge is an instrument designed to hedge the exposure from changes in the fair value of a recognized asset or liability.
- Gains and losses on both the fair value hedge itself and the hedged item are recognized in earnings in the same accounting period
M3 - Derivatives and Hedge Accounting
What is a perfect hedge?
A perfect hedge results in neither gains or losses.
- In a perfet hedge, the gain or loss on the derivative instrument exactly offsets the loss or gain on the item or transaction being hedged.
M3 - Derivatives and Hedge Accounting
How should gains or losses from fair value hedges be recognized?
Gains or losses on fair value hedges as well as the offsetting gains or losses on the hedged item are recognized in earnings in the same accounting period.
M3 - Derivatives and Hedge Accounting
Fair value hedge gains and losses
are recorded on the income statement
M3 - Derivatives and Hedge Accounting
Cash flow hedge gains and losses
are recorded as a component of other comprehensive income (part of the U in the PUFI mnemonic).
M3 - Derivatives and Hedge Accounting
A derivative designated as a fair value hedge must
A derivative may be designated and qualify as a fair value hedge if a set of criteria relating to the derivative and the hedged item are met.
The most significant criteria are:
1. There is formal documentation of the hedging relationship between the derivative and the hedged item.
2. The hedge must be expected to be highly effective in offsetting changes in the fair value of the hedged item and the effectiveness is assessed at least every three months
3. The hedged item is specifically identified.
4. The hedged item presents exposure to changes in fair value that could affect income.
M3 - Derivatives and Hedge Accounting
Qualified derivatives
A qualified derivative may be used (designated) to hedge exposure to variabillity in cash flow associated with an:
- asset,
- liability or a
- forecasted transaction (but not a firm commitment, which would be a fair value hedge).
M4 - Foreign Currency Accounting
functional currency
The functional currency is the currency of the primary economic environment in which the entity operates, usually the local currency or the reporting currency.
The foreign subsidiary itself should measure its assets, liabilities, and operations using the currency of its primary economic environment.
M4 - Foreign Currency Accounting
Capital accounts
are translated into the functional currency using the historical exchange gaps.
M4 - Foreign Currency Accounting
foreign subsidiary’s funcional currency
is the currency of the environment in which the subsidiary primarily generates and expends cash.
M4 - Foreign Currency Accounting
The functional currency of a company may be:
- A foreign entity’s local currency, which is typically the one in which the entity keeps its books;
- The currency in which the financial statements will be presented, which is the currency of the parent company; or
- A foreign currency other than the one in which the foreign entity maintains its books.
- The functional currency of an entity generally depends upon the environment in which the entity generates and expends cash (unless there is a requirement by law to use another currency), which may be any of the above three.
- However, the functional currency cannot be the local currency if the foreign entity operates in a highly inflationary environment (i.e., approximately 100% over three years).
M4 - Foreign Currency Accounting
translation (current) method
all income statement items, including salaries expense and sales to external customers, are translated using the weighted-average exchange rate for the current year.
M4 - Foreign Currency Accounting
If an entity’s books are not maintained in its functional currency
RULE:
If an entity’s books are not maintained in its functional currency, remeasurement into the functional currency is required.
- Any gains or losses are included in determinig net income and are classified as part of continuing operations.
M4 - Foreign Currency Accounting
Remeasurement method
used to convert the financial statements of a subsidiary from the foreign (local) currency to the functional currency.
- The starting point is the balance sheet and any gain/loss is recorded on the income statement.
M4 - Foreign Currency Accounting
Translation method
used to convert the financial statements of a subsidiary from the functional currency to the reporting currency.
- The starting point is the income statement and any gain/loss is recorded in OCI.
M4 - Foreign Currency Accounting
Under the translation method
- all assets and liabilities are translated to the reporting currency using the current (year-end) exchange rate
- common stock and APIC are translated using historical exchange rates.
M4 - Foreign Currency Accounting
Cumulative foreign exchange translation loss
Cumulative foreign exchange translation loss should be reported as a component of APIC. A cumulative foreign exchange translation loss would be a debit to APIC; therefore, contra to shareholders’ equity.
“Translation” adjustments are not included in determining net income for the period but are disclosed and accumulated as a component of OCI in consolidated equity until sale or until liquidation of the investment takes place.
M4 - Foreign Currency Accounting
Balance sheet accounts
Balance sheet accounts are generally included at the current exchange rate, except for:
1. A self contained subsidiary with a 3 year inflation rate of 100% or more (hyperinflationary economy).
2. A foreign entity which does not maintain its accounts in a foreign functional currency.
In these circumstances, the remeasurement method is used and the historical rates should be used only for those balance sheet accounts carried at “cost” (most non-monetary items). Otherwise dollow the general rule and use the “current” rate.
M5 - Income Taxes: Part 1
Operating income
GAAP does not require intraperiod income tax allocation to operating income.
Only select items on the income statement are shown “net of income tax”, and operating income is not one of them.
M5 - Income Taxes: Part 1
What is the objective of inter-period tax allocation?
to recognize the amount of current and future tax related to events that have been recognized in financial accounting income.
M5 - Income Taxes: Part 1
What is the approach used in GAAP to determine income tax expense?
the asset and liability approach
(sometimes referred to as the balance sheet approach).
M5 - Income Taxes: Part 1
The justification for the method of determining periodic deferred tax expense is based on:
recognition of assets and liabilities
M5 - Income Taxes: Part 1
Deferred tax expense
arises due to temporary differences between GAAP and tax accounting.
Deferred tax expense = Increase in DTL - Increase in DTA
The tax-exempt interest revenue is an item that is always included in accounting income and never in taxable income, so it is a permanent difference between GAAP and tax accounting that will not result in deferred taxes.
M5 - Income Taxes: Part 1
The current portion of income tax expense is the amount payable to IRS.
M5 - Income Taxes: Part 1
permanent difference
is a difference that affects taxable income or book income but never both.
Tax penalties paid to tax authorities are recorded as expenses in book income, but these penalties cannot be used as a deduction to reduce taxable income in calculating the tax liability.
M5 - Income Taxes: Part 1
Income tax expense
Income tax expense = Taxable income x Tax rate
M5 - Income Taxes: Part 1
Effective tax rate
Effective tax rate = Income tax expense / Pretax income
M5 - Income Taxes: Part 1
RULE:
Whenever income is reconigzed in the financial statement before it is reported as taxable income, a deferred tax liability should be reported.
M5 - Income Taxes: Part 1
Accrued warranty costs
Accrued warranty costs are expensed for GAAP purposes before they are deductible for tax purposes.
M5 - Income Taxes: Part 1
Valuation allowances in accounting for income taxes
The effect of a change in the opening balance of a valuation allowance that results from a change of circumstances ordinarily is included in income from operations.
A change in circumstances that results in a change in judgement concerning the potential realization of a deferred tax asset should be recognized in income from continuing operations in the period of change.
M6 - Income Taxes: Part 2
Recorded amount
Recognize the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the taxing authority.
M6 - Income Taxes: Part 2
The premium on an officer’s life insurance as well as interest on municipal bonds are permanent diffferences.
Deferred taxes are not affected by either.
M6 - Income Taxes: Part 2
The deferred tax liability is non-current because..
under U.S. GAAP, all deferred tax assets and deferred tax liabilities are reported as non-current.
M6 - Income Taxes: Part 2
Deferred taxes
should be computed based upon the enacted tax rates when the difference will reverse.
M6 - Income Taxes: Part 2
When preparing interim financial statements
income tax expense is estimated each quarter using the effective tax rate expected to apply to the entire
M6 - Income Taxes: Part 2
Under U.S. GAAP, deferred tax liabilities and assets should be classified and reported as a non-current amount on the BS.
All deferred tax liabilities and assets must be offset (netted) and presented as one amount (a net non-current asset or a net non-current liability), unless the deferred tax liabilities and assets are attributable to different tax-paying components of the entity or to different tax jurisdictions.
M6 - Income Taxes: Part 2
All deferred tax assets and deferred tax liabilities are reported as non-current
NOT as both current and non-current, ONLY as NON-CURRENT
M6 - Income Taxes: Part 2
All deferred tax assets and deferred tax liabilities are reported on the BS NET, and are classified as non-current.
