FAR - Notes Chapter 5

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Present Value and Annuities
Ordinary Annuity – start at end of period (also called arrears)
Annuity Due – payments start at beginning of year

On the present value table: Annuity due – 1 = ordinary annuity

On the PV table: Ordinary annuity + 1 = annuity due

Present value of $1 – used for capital lease buyout at end of lease (bargain purchase buyout); bond principle
payoff at end
Future value of $1 – used bank savings account

Present value of an Ordinary annuity – used for periodic lease payments, periodic bond interest payments
Future Value of an Ordinary annuity – investment an in IRA

PV and FV of annuity due

Accounting for Leases

Operating lease – Rental agreement
Lessee accounting – the renter
The lessee records rent expense over the lease term, usually straight line
Rent Exp xx
Cash/rent payable xx

Lease bonus (prepayment) for future expenses (real estate agent cost) is a deferred asset and amortized over the
life of the lease

Leasehold improvement – one permanently affixed to the property and reverts back to the lessor at end of lease
- Should be capitalized as added to PPE
- Should be depreciated/amortized over the lesser of:
- Lease life
- Asset/improvement life

Premium rent payments required for specific events are a period expense
- renter has to pay additional amount if sales exceed a certain threshold

Non-refundable security deposit – capitalized by the lessee as prepaid rent expense

Refundable security deposit – reported as a receivable until refunded by the lessor

Free or reduced rent – free months must be allocated evenly over lease term

Lessor accounting – the owner

The cost of the property is included on the lessors books, PPE
Depreciate over the assets useful life
Cash/rent receivable xx
Rental income xx

Non-refundable security – booked as unearned revenue until the lessor considers the deposit earned
Refundable security – treat as a liability by the lessor until the deposit is refunded

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The CPA exam tries to trick you into recognizing security deposits as revenue in advance of being earned by
giving information in the question about the historical percentage of security deposits earned. Don’t be fooled
into recognizing it early

Capital Lease – purchase/ownership

Lessee capital lease criteria – must meet one condition to capitalize (consider a capital lease)
O Ownership transfers at end of lease (upon final payment or required buyout)
W Written option for bargain purchase
N Ninety % (90%) of leased property FMV is less than or equal to P.V of lease payments
S Seventy-five (75%) or more of asset economic life is being committed in lease term

If the lessee OWNS the asset in one aspect they need to capitalize it

Lessor – seller; sales type/direct financing criteria; must meet all 3

L Lessee OWNS the leased property
U Uncertainties do not exist regarding any unreimbursable costs to be incurred by the lessor
C Collectability of the lease payments is reasonably predictable

Sales type lease – has 2 profit streams

- gain on sale
- interest income

Direct financing lease – has 1 profit stream

- interest income

Lessee capital lease accounting

Fixed asset – capital lease xx
Liability – capital lease xx

The lessee records the capitalized lease amount at the lower (lessor) of:
- Fair market value of the asset at the inception of the lease
- Cost = present value of the minimum lease payments
Costs includes
- required payments (beginning = PV of annuity due; ending = PV of annuity (ordinary annuity)
- bargain purchase option (PV of $1)
- guaranteed residual value back to lessor (PV of $1)
Exclude executory costs (insurance, maintenance, and taxes paid) and optional buyout

For the interest rate use the lower/lessor of:

- Rate implicit in the lease (if known)
- Rate available in market to lessee (not prime)

Depreciation rules for the capitalized lease on the lessee’s books

OW – depreciate over the asset life (OW you will actually own the asset at the end of lease term)
NS – depreciate over lease life (NS will give it back to lessor at end of lease term; substance over form acctg)

Asset retirement obligation (FASB 143)

Expanded to other similar closure or removal type costs in other industries (such as oil and mining)
ARO qualifies for recognition when it meets the definition of a liability
- duty or responsibility
- little or no discretion to avoid
- obligating event
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B/S
Asset retirement cost xx (FMV)
Asset retirement obligation xx
I/S
Depreciation exp – ARC xx
Accretion exp – ARO xx

Period to period changes in the ARO liability will result from

- Passage of time (accretion expense)
- Revisions in the timing and amount of cash flows

Disclose everything
- minimum future lease payments in total and for each of the next 5 years

Lessor accounting sales type lease (2 profit streams)

• Gross investment = (Lease payment * # of yrs) + unguarenteed residual value [estimated FMV at end]
Gross investment recorded as lease receivable
• PV of minimum lease payments = lease payment * PV of annuity due
Recorded as sales
• Net investment = (lease payment * PV of annuity due) + (Unguaranteed residual value * PV of $1)
• Unearned interest revenue = gross investment – net investment
Recorded as unearned interest revenue which is a contra lease-receivable
• COGS = (Lessors cost of leased asset + initial direct costs) – PV of unguarenteed residual value
JE
Lease payments receivable xx (gross investment)
COGS xx
Sales xx (PV of minimum lease payments)
Equipment xx (Lessors cost of leased asset)
Unearned interest revenue xx

Lessor accounting direct financing lease (1 profit streams)

• Gross investment = (Lease payment * # of yrs) + unguarenteed residual value [estimated FMV at end]
Gross investment recorded as lease receivable
• Net investment = gross investment * PV
• Unearned interest revenue = gross investment – net investment
JE
Lease payments receivable xx (gross investment)
Unearned interest revenue xx
Asset xx (lower of cost or FMV)

PV = carrying amount of receivable = cost of asset sold

Sale-leaseback
Operating Lease
Sale price
- Asset NBV
- PV of minimum lease payments
= Excess Gain
Capital Lease
Sale price
- Asset NBV
- leaseback asset
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= Excess Gain

In "major" sale-leasebacks (capital lease), all gain is deferred.

In "minor" sale-leasebacks (operating), there is no deferral [pv of leaseback is 10% or less of fmv of the asset
sold]
An “in-betweener” sale leasebacks, realize profit in excess of the pv of minimum lease payments, the "excess
portion" of the profit should be recognized immediately and the balance should be deferred

Right to remaining use of property retained by Seller-Lessee:

• Substantially all rights retained (major) – PV of minimum lease payments > 90%
- defer all gain and amortize over the leases asset
• Rights retained less than substntial, more than minor (middle) – PV of min lease payments btwn 10% - 90%
- defer gain up to PV of minimum lease payments, gain in excess is recognized immediately
• Minor portion of rights retained (minor) – PV of minimum lease payments < 10%
- no deferred gain, recognize all gain/loss immediately

• Real economic loss – when the fair value of the asset is less than book value at the time of sale-leaseback
loss recognized immediately
• Artificial loss – sales price is below the fair value, loss is deferred and amortized over the leaseback term

Sublease
• The lessor classifies the sublease in the same category as the original lease
• For the lessee
- If the original lease was an operating lease, then the sublease is an operating lease
- If the original lease was a capital lease due to OW, then the sublease is a capital lease
- If the original lease was a capital lease due to NS, then the sublease is a operating lease

Investment in Debt securities (bonds held as assets)

SFAS No 115 – investments in debt securities classified as held to maturity are measured at amortized cost
(carrying amount) on the balance sheet

Stated (nominal) rate = coupon rate

Discount = market rate > stated rate
Premium = market rate < stated rate

Total interest revenue = (principal + total coupon payments) – PV of the note

Long Term Liabilities and Bonds Payable

Nondetachable warrants – the convertible bond itself must be converted into capital stock
Detachable warrants – the bond is not surrendered upon conversion, the warrants can be sold bought and sold
separately from the bonds

The unamortized discount on bonds payable is contra account to bonds payable

The unamortized premium on bonds payable is presented on the B/S as a direct addition to the face (par) value

Bond issue costs should be recorded as a deferred asset and amortized from the bond issuance date
- examples: legal fees, accounting fees, underwriting commissions

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2 methods to bond amortization methods: Straight line and effective interest method
Straight line:
Periodic amortization = Premium or discount ÷ number of periods bond is outstanding
Interest expense = (Face value * stated interest rate) – premium amortization or + discount amortization

Effective interest method – required by GAAP

I/S
Interest expense/earned = Net carrying value * effective interest rate [market rate]
B/S
Interest paid/receivable = Bond face value * coupon rate
Amortization = interest expense – interest paid
Unamortized discount = Face value - net carrying value

If bond issued at discount add amortization to carrying value, if premium subtract from carrying value
The bonds' book value equals the bond face value less the unamortized discount

Bonds sold or issued between interest dates requires additional entries for accrued interest at time of sale
Total cash received = selling price + accrued interest [face * stated rate * (months of interest owed ÷ 12)

Bond sinking fund – built up restricted cash to repay bond principal when due
- non-current restricted asset

Serial bonds – have principals that mature in instalments

2 amortization methods:
- Effective interest method (already explained)
- Bonds outstanding method (not GAAP)
- review F5-52, its has been tested before

Convertible bonds – nondetachable warrants

Issued at more than face value due to value of conversion feature
 However, the conversion feature cannot be assigned a specific value so issuance price allocated to the
bonds with no recognition of the conversion feature

The conversion is recorded under 2 methods:

Book value method
• No gain or loss is recognized (no I/S impact)
• Common stock is credited (par), APIC is credited (bond carrying value – stock par value – conversion cost)
Market Value Method
• Recognize gain or loss
• g/l = market value of the stock – book value of the bonds

Convertible bonds – detachable warrants

• at issue date allocate bond account for proceeds separately; part goes to bond; part goes to warrant
Recording JE at issue date
Cash xx
Bonds Payable xx
APIC Warrants xx (FMV at issuance date)
Recorded under 2 methods:
Warrants only method – used if only the fair market value of the warrants is known

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Market value method (warrants and bonds method) – used is the FMV of both the bonds and warrants are
available
- FMV of warrants / (FMV of bonds + FMV of Warrants ) = % yield
- % yield * bonds face value = bond discount and APIC warrants
- Bond face value – bond discount or + bond premium = bond payable

Extinguishment of debt
Gain or loss = reacquisition price [face* % paid] – net carrying amount [Face+ unamortized prem or – disc]
- included in income from continuing operations, may be considered extraordinary if its unusual and infrequent
Bond settlement/retirement price is > than the book value = loss would be recognized

Troubled Debt Restructurings (impaired loans)

A troubled debt restructuring is when the creditor allows the debtor certain concessions to improve the
likelihood of collection.
- examples: reduced interest rates, extension of maturity dates, reduction of the face amount
Ordinary gain/loss = FMV debt discharged – NBV debt discharged
Possible extraordinary gain/loss = (Face of payable + accrued interest) – FMV of debt discharged

When total future cash payments are less than the carrying amount, the debtor should reduce the carrying
amount accordingly and recognize the difference as a gain

When a creditor receives either assets or equity as full settlement of a receivable, these are accounted for at the
fair value at the time of restructuring.
Ordinary loss = recorded receivable – FMV of asset received
As a general rule, Large write downs and write offs of assets are not considered extraordinary

Impairment is recorded by creating a valuation allowance with a corresponding charge to bad debt expense
Bad debt expense xx
Allowance for credit losses xx

Beg accrued int payable + interest expense – interest paid = end interest payable