FAR SEC 11

Question 1

How are noncurrent liabilities measured?

Answer 1

Unless the fair value option (outlined in Study Unit 5, Subunit 2) is elected, they are measured and accounted for in accordance with the guidance for interest on receivables and payables. The topics in this study unit are frequently tested.

Question 2

What is a bond?

Answer 2

A bond is a formal contract to pay an amount of money (face amount) at the maturity date plus interest at the stated rate at specific intervals.

Question 3

What is an indenture?

Answer 3

All of the terms of the agreement are stated in an indenture.

Question 4

How are bonds classified in terms of nature of security? (4 elements)

Answer 4

Nature of security
1) Mortgage bonds are backed by specific assets, usually real estate.
2) Debentures are backed only by the borrower’s general credit.
3) Collateral trust bonds are backed by specific securities.
4) Guaranty bonds are guaranteed by a third party, e.g., the parent of the subsidiary that issued the bonds.

Question 5

How are bonds classified by maturity pattern? (2 elements)

Answer 5

1) A term bond has a single maturity date at the end of its term.
2) A serial bond matures in stated amounts at regular intervals.

Question 6

How are bonds classified in terms of ownership? (2 elements)

Answer 6

1) Registered bonds are issued in the name of the owner, who receives interest payments directly.
-When the owner sells the bonds, the certificates must be surrendered and new certificates must be issued.
2) Bearer bonds (coupon bonds) are bearer instruments.
-Whoever presents the interest coupons is entitled to payment.

Question 7

How are bonds classified in terms of priority? (2 elements)

Answer 7

(1) Subordinated debentures and second mortgage bonds are junior securities with claims inferior to those of (2) senior bonds.

Question 8

How are bonds classified in terms of repayment provisions? (3 elements)

Answer 8

1) Income bonds pay interest contingent on the debtor’s profitability.
2) Revenue bonds are issued by governments and are payable from specific revenue sources.
3) Participating bonds share in excess earnings of the debtor.

Question 9

How are bonds classified in terms of valuation? (3 elements)

Answer 9

1) Variable rate bonds pay interest that is dependent on market conditions.
2) Zero-coupon or deep-discount bonds are noninterest-bearing.
-Because they are sold at less than their face amount, an interest rate is imputed.
3) Commodity-backed bonds are payable at prices related to a commodity, such as gold.

Question 10

How are bonds classified in terms of redemption provisions? (2 elements)

Answer 10

Redemption provisions
1) Callable bonds may be repurchased by the issuer at a specified price before maturity.
i) During a period of falling interest rates, the call provision allows the issuer to replace old high-interest debt with new low-interest debt.
ii) Because only the issuer can benefit from the call provision, callable bonds generally have a higher yield than comparable noncallable bonds.
2) Convertible bonds may be converted into equity securities of the issuer at the option of the holder (buyer) under specified conditions.

Question 11

What item is linked to a bond indenture?

Answer 11

A bond indenture may require a bond sinking fund (a long-term investment).
-Payments into the fund plus the revenue earned on its investments provide the assets to settle bond liabilities.

Question 12

Why are time value of money concepts important?

Answer 12

Time value of money concepts are important in financial accounting. They affect the accounting for noncurrent receivables and payables (bonds and notes), leases, and certain employee benefits.

Question 13

What is the basic principle of time value of money?

Answer 13

A quantity of money to be received or paid in the future is worth less than the same amount now. The difference is measured in terms of interest calculated using the appropriate discount rate. Interest is the payment received by an owner of money from the current consumer to forgo current consumption.

Question 14

How do standard time value of money tables work?

Answer 14

Standard tables have been developed to facilitate the calculation of present and future values. Each entry in one of these tables represents the factor by which any monetary amount can be modified to obtain its present or future value.

Question 15

How is present value of a single amount calculated? (2 elements)

Answer 15

1) The present value of a single amount is the value today of some future payment.
2) It equals the future payment times the present value of 1 (a factor found in a standard table) for the given number of periods and interest rate.

Question 16

How is future value of a single amount calculated? (2 elements)

Answer 16

1) The future value of a single amount is the amount available at a specified time in the future based on a single investment (deposit) today. The FV is the amount to be computed if one knows the present value and the appropriate discount rate.
2) It equals the current payment times the future value of 1 (a factor found in a standard table) for the given number of periods and interest rate.

Question 17

What is an annuity?

Answer 17

An annuity is a series of equal payments at equal intervals of time, e.g., $1,000 at the end of every year for 10 years. The two types of annuities are ordinary annuities (annuity in arrears) and annuities due (annuity in advance).
-An ordinary annuity (annuity in arrears) is a series of payments occurring at the end of each period. In an annuity due (annuity in advance), the payments are made (received) at the beginning of each period.

Question 18

What is an ordinary annuity?

Answer 18

An ordinary annuity (annuity in arrears) is a series of payments occurring at the end of each period. In an annuity due (annuity in advance), the payments are made (received) at the beginning of each period.

Question 19

What is the present value of an annuity? (3 elements)

Answer 19

1) The present value of an annuity is the value today of a series of future equal payments at equal intervals discounted at a given rate.
2) The first payment of an ordinary annuity is discounted, but the first payment of an annuity due is not discounted (since it was received today, it is worth its exact face amount, regardless of the discount rate).
3) A typical present value table is for an ordinary annuity, but the present value factor for an annuity due can be easily derived. The present value factor of an annuity due is equal to the present value factor of an ordinary annuity multiplied by (1 + i).

Question 20

What is the future value of an annuity? (3 elements)

Answer 20

1) The future value of an annuity is the value that a series of equal payments will have at a certain moment in the future if the interest is earned at a given rate.
2) Interest is not earned for the first period of an ordinary annuity. Interest is earned on the first payment of an annuity due.
3) A typical future value table is for an ordinary annuity, but the future value factor for an annuity due can be easily derived. The future value factor of annuity due is equal to the future value factor of an ordinary annuity multiplied by (1 + i).

Question 21

How are bond proceeds calculated? (2 elements)

Answer 21

1) Of primary concern to an entity issuing bonds is the amount of cash that it will receive from investors on the day the bonds are sold.
2) This amount is equal to the sum of the present value of the cash flows associated with the bonds discounted at the interest rate prevailing in the market at the time (called the market rate or effective rate).

Question 22

What are the cash flows associated with bonds? (2 elements)

Answer 22

The cash flows associated with bonds are
1) Face amount (present value of a single amount)
2) Interest payments (present value of an annuity)

Question 23

Why is the effective rate used as the discount rate for bonds payable?

Answer 23

Using the effective rate as the discount rate ensures that the bonds’ yield to maturity (that is, their ultimate rate of return to the investor) is equal to the rate of return prevailing in the market at the time of the sale.

Question 24

How does the present value calculation relate to cash proceeds for bonds payable?

Answer 24

This present value calculation can result in cash proceeds equal to, less than, or greater than the face amount of the bonds, depending on the relationship of the bonds’ stated rate of interest to the market rate.

Question 25

What does it mean for a bond to be sold at par?

Answer 25

If the bonds’ stated rate equals the market rate at the time of sale, the present value of the bonds will exactly equal their face amount, and the bonds are said to be sold at par.

Question 26

What happens when a bond is issued at a premium? (3 elements)

Answer 26

1) If the bonds’ stated rate is greater than the current market rate, the cash proceeds are greater than the face amount, and the bonds are sold at a premium.

Premium on bonds = Cash proceeds – Bonds’ face amount

2) Sometimes the issue price is an exact percentage of the face amount. In these cases, the bonds are said to be sold, for example, “at 101” or “at 102.”

3) Bonds issued “at 101” are issued at a price equal to 101% of the face amount.

Question 27

What is the formula for calculating premium on bonds?

Answer 27

Premium on bonds = Cash proceeds – Bonds’ face amount

Question 28

What happens for bond issuance at a discount?

Answer 28

1) If the bonds’ stated rate is less than the current market rate, the cash proceeds are less than the face amount, and the bonds are sold at a discount.

Discount on bonds = Bonds’ face amount – Cash proceeds

2) Sometimes the issue price is an exact percentage of the face amount. In these cases, the bonds are said to be sold, for example, “at 97” or “at 98.”

3) Bonds issued “at 99” are issued at a price equal to 99% of the face amount.

Question 29

What happens when bonds are sold between interest dates?

Answer 29

When bonds are sold between interest payment dates, the buyer pays the issuer the amount of interest that has accrued since the last payment date.

Question 30

How are bonds payable reported on the balance sheet?

Answer 30

Bonds payable are reported in the balance sheet at their face amount (1) minus (plus) any unamortized discount (premium) and (2) minus any unamortized debt issuance costs.

Carrying amount of bonds payable = Face amount ± Unamortized premium (discount) – Unamortized debt issuance costs

Question 31

What is the formula to calculate carrying amount of bonds payable?

Answer 31

Carrying amount of bonds payable = Face amount ± Unamortized premium (discount) – Unamortized debt issuance costs

Question 32

How does the effective interest method of amortization work? (4 elements)

Answer 32

1) Bond discount or premium must be amortized using the effective interest method (unless the results of another method are not materially different).
2) Under this method, interest expense changes every period, but the effective interest rate remains constant.

Annual interest expense = Carrying amount × Effective interest rate

3) The cash paid for periodic interest also remains constant over the life of the bonds.

Cash interest paid = Face amount × Stated rate

4)The difference between interest expense and cash interest paid is the discount or premium amortization.
-At the maturity date, the discount or premium is fully amortized, and the carrying amount of the bonds equals the face amount.

Question 33

According to the effective interest method of amortization, how is annual interest expense calculated?

Answer 33

Annual interest expense = Carrying amount × Effective interest rate

Question 34

According to the effective interest method of amortization, how is cash interest paid calculated?

Answer 34

Cash interest paid = Face amount × Stated rate

Question 35

What is the amortization schedule for premium amortized of bonds payable?

Answer 35

Premium amortized, total interest expense, and the carrying amount of the bonds decrease each period when amortizing a premium. The entry is
Interest expense $XXX
Premium on bonds payable $XXX
Cash $XXX

Question 36

What is the amortization schedule for discount amortized of bonds payable/

Answer 36

Discount amortized, total interest expense, and the carrying amount of the bonds increase each period when amortizing a discount. The entry is
Interest expense $XXX
Discount on bonds payable $XXX
Cash $XXX

Question 37

How does interest on bonds paid more often than annually work? (2 elements)

Answer 37

1) Some bonds may pay interest more often than annually, e.g., semiannually. The accounting for these bonds is based on the number of periods in which interest is paid.
2) The interest rates on bonds are provided on an annual basis. For the sake of simplicity, the stated rate and the market (effective) interest rate that apply to each period can be calculated as follows:

(Interest rate on an annual basis)/(Number of times interest is paid per year)

Question 38

What issue costs are incurred to bring debt to market? (6 elements)

Answer 38

Issue costs are incurred to bring debt to market. They include
1) Printing and engraving costs,
2) Legal fees,
3) Accountants’ fees,
4) Underwriters’ commissions,
5) Registration fees, and
6) Promotion costs.

Question 39

What is the accounting treatment for issuance costs of bonds payable? (2 elements)

Answer 39

1) Costs to issue debt securities must be reported in the balance sheet as a direct deduction from the face amount of the debt.
2) Debt issue costs should be amortized over the term of the debt using the effective interest method. But the straight-line amortization method may be applied if the results are not materially different.

Question 40

What causes a liability?

Answer 40

A liability results from a current obligation to transfer assets or provide services.

Question 41

What is equity?

Answer 41

Equity is the residual interest in the assets of an entity after subtraction of liabilities.

Question 42

How is common stock or preferred stock that is not redeemable treated? (2 elements)

Answer 42

1) Common stock or preferred stock that is not redeemable is treated as equity.
2) Each confers a residual interest in entity assets, and no obligation exists to pay dividends or redeem the stock.

Question 43

Are bonds assets or liabilities?

Answer 43

Bonds are treated as liabilities.
-They represent an obligation to make [EARN?] interest and principal payments, with no residual interest in entity assets.

Question 44

What factors determine how a financial instrument is classified as either a liability or equity? (3 elements)

Answer 44

1) The classification of a financial instrument as liability or equity is based on its specific characteristics, such as the way it is settled.
2) A financial instrument that is settled by transferring cash is classified as a liability.
3) A financial instrument that is settled by issuing a fixed number of shares is classified as equity. It is reported in the additional paid-in capital (APIC) account.

Question 45

What two factors apply for a financial instrument that is settled by issuing a variable number of shares to be classified as a liability? (2 elements)

Answer 45

A financial instrument that is settled by issuing a variable number of shares is classified as a liability if
1) The number of shares to be issued is based on a fixed monetary amount known at inception.
2) The number of shares to be issued is inversely related to changes in the fair value of the issuer’s shares. For example, the greater the issuer’s market price per share, the lower the number of shares to be issued, and vice versa.

Question 46

What is the impact of a security having both asset and liability attributes?

Answer 46

However, the classification of the securities covered in the following outline is more complex because they have liability and equity components.

Question 47

What is convertible debt? (2 elements)

Answer 47

1) Convertible debt may be exchanged for common stock of the issuer.
2) The debt and equity elements of convertible debt are treated as inseparable. The entire proceeds, typically cash, should be accounted for and reported as a liability until conversion.

Question 48

What are detachable vs. nondetachable warrants? (4 elements)

Answer 48

1) Like convertible debt, warrants allow a debtholder to obtain common shares.
-Unlike convertible debt, warrants require the debtholder to pay an additional amount to receive the shares.
2) When warrants are nondetachable, their conversion feature is considered to be inseparable from the underlying debt, and the entire proceeds are attributed to debt.
3) When debt is issued with detachable warrants, the proceeds must be allocated between the underlying debt and the warrants pro rata based on their relative fair values at the time of issuance.
i) Allocate the proceeds pro rata to the debt.
Cash proceeds received × (FV of debt)/(FV of debt + Warrants)

ii) Record the issuance of the debt.
Cash (see formula above) $XXX
Discount on bonds payable $XXX
Bonds payable $XXX

iii) Allocate the proceeds pro rata to the warrants.

Cash proceeds received × (FV of warrants)/(FV of debt + Warrants)

iv) Record the issuance of the warrants.

Cash (see formula above) $XXX
Paid-in capital – warrants $XXX

v) When the fair value of the warrants but not the debt is known, paid-in capital from warrants should be credited (increased) for the fair value of the warrants.
-The remainder is credited to the debt.
4) When the warrants are exercised, the journal entry is
Cash $XXX
Paid-in capital – warrants $XXX
Common stock $XXX
Additional paid-in capital $XXX

Question 49

What occurs for early extinguishment of debt? (4 elements)

Answer 49

1) Issuers sometimes retire debt before maturity, for example, to eliminate high-interest debt when rates are declining or to improve debt ratios.
2) All extinguishments of debt before scheduled maturities are fundamentally alike and should be accounted for similarly.
The carrying amount is the amount due at maturity, adjusted for unamortized premium or discount and unamortized issue costs.
3) The reacquisition price is the amount paid on extinguishment, including any call premium and miscellaneous costs of reacquisition.
-An extinguishment may be done by exchanging new securities for the old (a refunding). The reacquisition price equals the total present value of the new securities.

Question 50

How are gains or losses on early extinguishment of debt recognized? (2 elements)

Answer 50

1) Gains or losses are recognized in earnings in the period of extinguishment.
2) The gain or loss is measured by the difference between the reacquisition price and the carrying amount of the debt, which includes any unamortized debt issue cost.

Question 51

When does derecognition of a debt occur? (3 elements)

Answer 51

1) A debtor derecognizes a liability only if it has been extinguished. Extinguishment results only if the debtor
2) Pays the creditor and is relieved of its obligation with respect to the liability or
3) Is legally released from being the primary obligor, either judicially or by the creditor.

Question 52

How does the accounting for notes payable differ from the accounting for bonds payable? (3 elements)

Answer 52

Notes payable are essentially accounted for the same as bonds. However,
1) A note is payable to a single creditor, while bonds are payable to many creditors.
2) Notes are usually of shorter duration than bonds.
3) A loan agreement may require the debtor to pay principal and interest at specified intervals.

Question 53

For noncurrent notes payable, how is premium or discount amortized? (4 elements)

Answer 53

1) Any material premium or discount is amortized using the effective-interest method, as described in Subunit 11.4.
2) Discount or premium, loan origination fees, etc., are amortized in accordance with the effective-interest method.
3) Discount or premium is not an asset or liability separable from the related note.
4) A discount or premium is therefore reported in the balance sheet as a direct subtraction from, or addition to, the face amount of the note.

Question 54

What portion of noncurrent notes payable is considered current? (2 elements)

Answer 54

1) Noncurrent notes that are payable in installments are classified as current to the extent of any principal payments due in the coming year.
2) Payments not due in the current year are classified as noncurrent.

Question 55

What are the three main patterns of repayments for noncurrent notes payable? (3 elements)

Answer 55

1) Some notes require one principal payment at the end of the note’s term plus periodic interest payments during the note’s term (like a term bond).
2) Other notes require equal periodic principal payments plus interest. Each periodic payment includes an equal amount of return of principal and an amount of interest accrued on the beginning carrying amount.
3) A third type of note requires equal periodic cash payments. Each payment includes a principal component (i.e., return of principal) and an interest component.

Question 56

What is a troubled debt restructuring (TDR)? (2 elements)

Answer 56

1) A troubled debt restructuring (TDR) occurs when the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.
2) A TDR can consist of either a settlement of the debt in full or a continuation of the debt with a modification in terms.

Question 57

What is a troubled debt restructuring (TDR)? (2 elements)

Answer 57

1) A troubled debt restructuring (TDR) occurs when the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.
2) A TDR can consist of either a settlement of the debt in full or a continuation of the debt with a modification in terms.

Question 58

For troubled debt restructuring, what is settlement in full with a transfer of assets? (3 elements)

Answer 58

1) A gain on restructuring is recognized by the debtor when the carrying amount of the debt exceeds the fair value of the asset(s) given.
The debtor also recognizes a gain or loss on disposition of the asset equal to the difference between the fair value of the assets given and their carrying amount.
The total gain (loss) on the restructuring transaction is recognized by the debtor when the carrying amount of the debt is greater (lower) than the carrying amount of the assets given.

Question 59

For troubled debt restructuring, what is settlement in full with a transfer of equity interest? (2 elements)

Answer 59

1) A debtor issues an equity interest to a creditor to fully settle the debt.
2) The debtor recognizes a gain on the restructuring for the excess of the carrying amount of the debt over the fair value of the equity interest granted.

Question 60

For troubled debts restructuring, how is modification of terms done? (4 elements)

Answer 60

1) Three changes in the terms of the debt are common:
i) A reduction in the principal
ii) An extension of the maturity date
iii) A lowering of the interest rate
2) The debtor accounts for the modification of terms based on the undiscounted cash flows (UCF) associated with the modified terms.
3) When the UCF associated with the modified terms are greater than the carrying amount of the troubled debt:

UCF > Carrying amount of the debt

i) No gain is recognized by the debtor.
ii) The carrying amount of the debt is unchanged.
4) When the UCF associated with the modified terms are less than the carrying amount of the troubled debt:

UCF < Carrying amount of the debt

i) A gain is recognized by the debtor for the difference.
ii) The carrying amount of the debt is reduced to the undiscounted cash flows specified by the new term.

Question 61

What is an asset retirement obligation (ARO)? (3 elements)

Answer 61

1) Certain long-lived tangible assets, such as mines or nuclear power plants, incur significant costs after the end of their productive lives.
2) An asset retirement obligation (ARO) reflects a legal obligation arising from acquisition, construction, development, or normal operation of an asset.
3) A legal obligation is one arising from an existing or enacted law, statute, ordinance, or contract.

Question 62

What are the rules & procedures for initial recognition of asset retirement obligations? (3 elements)

Answer 62

1) An entity must recognize the fair value of a liability for an ARO. Upon initial recognition of such a liability, an entity must capitalize an asset retirement cost (ARC) by increasing the carrying amount of the related asset by the same amount as the liability recognized.

The journal entry is
Asset $XXX
Liability for asset retirement obligation $XXX

2) If an item of property, plant, and equipment with an existing ARO is acquired, the entity credits a liability for that obligation and debits the carrying amount of the item for the same amount (the ARC) at the acquisition date. The effect is the same as if that obligation were incurred on that date.
3) The fair value of the liability is initially measured by using an expected present value technique. The liability recognized equals the present value of the future cash flows expected to be paid to settle the obligation discounted at the credit-adjusted risk-free rate.

Question 63

For asset retirement obligations, what is the accounting subsequent to initial recognition? (3 elements)

Answer 63

1) After initial recognition, the ARC should be depreciated over the asset’s useful life.
2) In addition, the liability recognized must be adjusted periodically for (1) the passage of time (accretion expense) and (2) revisions in the original estimate.
3) At the end of the asset’s useful life, the actual costs incurred to settle the liability may differ from the carrying amount of the liability on that date. The difference between the amount paid and the carrying amount of the liability for an ARO is recognized as a gain or loss on settlement of the ARO.