Lease, Liabilities and Bonds

Question 1

What is a lease

Answer 1

A lease is a contractual agreement between a lessor, who conveys they right to use real or personal property (an asset) and a lessee, who agrees to pay periodic rents over a specific time

Question 2

Operating Lease

Answer 2

An operating lease includes a lessor, who collects rent, and a lessee, who uses the leased asset and pays periodic rent for such use. The lessee merely uses the asset; there is no transfer of ownership, or of any risk or benefit ownership

Question 3

Capitalize Leasehold Improvements

Answer 3

The value of leasehold improvements should be capitalized and added to the property, plant and equipment section or the intangible assets section of the B/S

Leasehold improvements should be depreciated over the lesser of

1. Lease life
2. Asset/ Improvement life

Question 4

Lessor Accounting ( Lease Bonus)

Answer 4

The lease bonus is deferred (unearned income ) and amortized over the life of the lease

Question 5

Temporary Difference

Answer 5

GAAP rule - Report prepaid rental income when earned

Tax rule - Report prepaid rental income when received

Question 6

Lessee Capital Lease Criteria

Answer 6

Must meet one condition to capitalize

1. Ownership transfer at end of lease
2. Written option for bargain purchase
3. Ninety percent of leased property FV less than PV of lease payment s
4. Seventy five percent or more of asset economic life is being committed lease term

MNEMONIC - OWNS

J/E
DR - F/A - leased property
CR. Liability - obligation under capital lease

Question 7

Capital (US GAAP)/ Finance Lease (IFRS)

Answer 7

Capital lease or fiance lease transfer substantially all of the benefit and risks inherent in ownership of property to the lessee

Situation that lead to Finance lease classification

MNEMONIC - OWES FACS

Question 8

Lessor- Sales Type/ Direct Financing type Criteria (US GAAP)

Answer 8

Under US GAAP, all of the below criteria meet it shall be classified by the lessor as a sales types or direct financing lease

1. Lesse “Owns” the leased property
2. Uncertainties do not exist regarding any un-reimbursable costs to be incurred by the lessor
3. Collectability of the lease payments is reasoably
   predictable

MNEMONIC -LUC

Question 9

Lease accounting

Answer 9

A simple way to remember the capitalized amount computation rules is to recall that leases are between a lessee and lessor. Therefore, always use the lessor of

1. Cost or Market
2. Implicit interest rate or incremental borrowing rate

Question 10

Recording a direct financing (Finance lease ) lease

Answer 10

Under IFRS, a direct financing lease is referred to as finance lease. Under both IFRS and US GAAP, no manufacture’s or dealer’s profit is realized in a direct financing lease because the FV of the leased property equals the cost or carrying value at the inception of the lease.

Question 11

Sale - Leaseback ( Accounting by seller/lessee)

Answer 11

The PV of the rent payments is equal or greater than 90% of the FV of the property, defer all the gain and amortized over the leased asset

If the rent payments less than 90% of FV but greater than 10%, defer gain up to the PV of minimum leaseback payments

If the rent payments less than 10% of the FV of the property, recognize gain or loss at the time of the transactions

Question 12

Convertible Bonds

Answer 12

Convertible bonds are convertible into common stock of the debtor (generally) at the option of the bondholder

1. Non-detachable Warrants - The convertible bond itself must be converted into capital stock
2. Detachable Warrants - The bond is not surrendered upon conversion. Only the warrants plus cash representing the exercise price of the warrants. The warrants can be bought and sold separately from bonds.

Question 13

Bond Selling price

Answer 13

When a bond is issued, the price is computed as the sum of the present value of the future principle payment plus the PV of the future periodic interest payment.

Question 14

Bond Issue cost

Answer 14

Bond issue cost include legal fees, accounting fees, underwriting commissions, and printing. These cost should be recorded as a deferred charge ( an asset) and amortized from the date of issuance using straight line method.

Under IFRS, bond issue cost are not recorded as a separate asset. Bond issue cost are deducted from the carrying of the liability and amortized using the effective interest method.

Question 15

Bond Amortization Period

Answer 15

Under US GAAP, Amortization is done over the contractual life of the bond

Under IFRS, Amortization is done over the expected life of the bond, not the contractual life of the bond.

Question 16

Straight line Method Amortization of Bond’s discount or premium

Answer 16

The S/L method is not GAAP but allowed under US GAAP if the results are not materially different from the effective interest method. Interest expenses are calculated as follows

Premium or discount divided by Number of periods bond is outstanding = Periodic amortization

The S/L method is not permitted under IFRS

Question 17

Effective Interest Method

Answer 17

It’s required by both US GAAP and IFRS. It is calculated by multiplying the carrying value of the bond at the beginning of period by effective interest rate

Interest expense = CV at the beginning period X effective interest rate

Question 18

Convertible Bonds

Answer 18

The conversion of the bonds to stock may be recorded under either the book value method or the market value method.

Under the Book value method, no gain or loss is recognized. At conversion, the bonds payable and related premium or discount are written off and common stock is credited ( at par). No Income statement impact , C/S and APIC only

Question 19

Convertible Bonds ( Market value method)

Answer 19

The market value method views the conversion as culmination of the earnings process, thereby resulting in a recognizing gain or loss. Income statement impact. The difference between the market value of the stock and the book value of the bonds is a recognized gain or loss.

Since the conversion feature cannot be assigned a value, the difference between the proceeds and the face value of the bonds is recorded as a premium on bonds payable.

Question 20

Bonds sold with detachable stock purchase warrants

Answer 20

Warrants are option contract that are issued with, and detachable from, bonds. The warrants gives the bondholder the right ti buy stock at a fixed price within a specific time period. Because they detachable, the warrants are traded separately and are considered to be a separate financial instruments.

Question 21

Bonds sold with detachable stock purchase warrants ( Accounting Treatment)

Answer 21

Bonds with detachable stock purchase warrants may be recorded at issuance using two different method. The warrants only method is used if only the fair value of warrants is known. The market value method (warrants and bonds method) is used if the FV of both the warrants and bonds are known.

In Both method, APIC is a plug

Question 22

Extinguishment of Debt

Answer 22

Callable bonds can be retired after a certain date at a stated price. Refundable bonds allow an existing issue to be retired and replace with a new issue at a lower interest rate.

If a bond extinguished before maturity, a gain or loss is generally recorded.

Question 23

Definition of Extinguishment

Answer 23

A liability cannot be de-recongnized in the F/S until it has been extinguished. A liability is consider extinguished if either if the condition is met

1. Debtor pays
2. Bond Extinguishment at Maturity
3. Debtor legally released by either judicially or by the creditor

Question 24

Gain or Loss on Bond Extinguishment before Maturity

Answer 24

Adjust item in F/S, in any bond reacquisition, the following items must be accounted for and adjusted in the F/S

A. Bond issue costs reported as an asset under US GAAP.
B. Any related unamortized discount or premium and
C. The difference between the bond’s face value and the requisition proceeds.

Question 25

Convertible Bonds

Answer 25

Under GAAP, the issuance price is allocated to the bonds with no recognition of the conversion feature because it is difficult to assign a specific value to the conversion feature

Under IFRS, both a liability (bond) and an equity component (conversion feature) should be recognized when convertible bonds are issued. The bond liability should be valued at FV, with the difference between the acutal proceeds recevied and the FV of the bond liability recorded as a component of equity.

Question 26

Period of Benefits ( depreciable life ) -IFRS

Answer 26

The depreciation period is the shorter of the lease term and the useful life of the assets. If there is a reasonable certainty that the lessee will own the leases asset after the term then the lease should be depreciated over it’s useful life.

US GAAP Rule -

Ownership - Depreciate over asset life
Written - Depreciate over asset life
Ninety % FV = Depreciate over lease life
75% life - Depreciate over lease life