CMA Part 1 Chapter 3

Amortization of Bond Premiums/Discounts

Bond premium or discount must be fully amortized over the life of the bonds using the effective-interest method (the market interest rate on the date the bond was sold). Under this method, interest expense changes every period and equals the following: Annual interest expense=Carrying amount of the bond (at the beginning of the period)× Effective interest rate (Market/Coupon Rate) J/E of amortization of premium Int Exp xx Premium xx Cash xx

Depreciation

Depreciation is the process of systematically and rationally allocating the depreciable base of a tangible capital asset over its expected useful life. The periodic depreciation expense is recognized in the income statement. Accumulated depreciation is a contra-asset account. J/E to record depreciation Depreciation Expense Accumulated Depreciation The asset's depreciable base (the amount to be allocated) is calculated as follows: Depreciable base = Historical cost - Salvage value - Recognized impairment loss Estimated useful life is an estimated period over which services or economic benefits are expected to be obtained from the use of the asset. Salvage value (residual value) is the amount that the entity expects to obtain from disposal of the asset at the end of the asset's useful life. Land has an indefinite useful life and therefore must not be depreciated. Thus, the depreciable base of property that consists of land or a building is the depreciable base of the building only.

Net Operating Losses Carryforward

Entities that incurr net operating losses can obtain the tax benefit of the loss by carryingforward the loss indefinitely. We can reduce taxable income of future periods by the amount of our loss. This does not affect the total amt of income tax exp recognized. Initial Recognition Deferred Tax Asset xx Income Tax Benefit from Loss Carryforward XX Realization (cannot be greater than 80% of that years taxable inc) Ex. A NOL of 100k in year one will reduce taxable income by 100k once realized in year 2. Income Tax Exp- current xx Income Tax exp- deferred xx Inc Tax Pay xx DTA xx

Lessee accounting for Finance leases and operating leases

General Rule: A lessee must recognize a lease liability and a right-of-use asset at the lease commencment date. Finance and operating leases result in the same accounting for 1. Initial recognition of the lease liability 2.Initial recognition of the right-of-use asset 3.Subsequent measurement of the lease liability. It is different for: 1.The accounting for subsequent measurement of a right-of-use asset (amortization of asset) differs under finance and operating leases. 2.The Income statement presentation of interest expense and amortization of right-of-use asset 3. Statement of cash flow classification of lease pmts

3. Goodwill

Goodwill is recognized only in a business combination. It is "an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized." The calculation of goodwill and its presentation in the financial statements are described in Study Unit 2, Subunit 8. Impairment Test: Goodwill is tested for impairment at the reporting-unit level. All goodwill is assigned to the reporting units that will benefit from the business combination. It is tested for impairment each year at the same time. We perform a qualitative assessment and if that indicates potential impairment, we perform a 2 step quantitave test. 1. If Carrying amount of reporting unit (including goodwill) > its fair value - move to step 2 2. We must estimate implied fair value of reporting unit goodwill= fair value of reporting unit - fair value of reporting unit net assets. 3. If the carrying amount of reporting unit goodwill is > its implied fair value, we report a loss for the difference.

What equation do we use to measure PPE on the B/S?

Historical cost- accumulated depreciation - impairment loss= carrying amount of PPE

Differences for presentation on Financial Statements, Operating Vs Financing Leases

Income Statement: Financing Leases: interest expense and amortization expense are reported seperately Operating Leases: Interest +amortization are included in one single pertiodic lease expense. B/S: Finance/Operating liabilities and right-of-use assets must be presented separately from one another. Under Statement of Cash Flows: FInancing: Interest is an operating activity and principal pmt is a financing activity. Interest Expense (Operating) xx Lease Liability (financing) xx Cash x Payments for operating leases and short-term leases are operating activites

Repayment Provisions: Income Bond? Revenue Bond?

Income bonds pay interest contingent on the issuing firm's profitability. Revenue bonds are issued by governments and are payable from specific revenue sources.

Calculating Tax Expense (or benefit) See notes for journal Entries

Income tax expense or benefit reported on the income statement is the sum of the 1. current component and the 2. deferred component. 1. Current Tax Expense (refundable): Is the amount of taxes payable or (refundable) for the year based on the tax law. Current Tax Expense (beneift)= Taxable Income * Tax Rate 2. Deferred Tax Expense (benefit): Is the net change during the year in an entity's deferred tax amounts. Changes in DTL Balances +/- Changes in DTA Balances

Securitization: Mortgage Bonds? Debentures? Guaranty Bond? Collaterial Trust BonD? Equipment Trust Bond?

Mortgage bonds are backed by specific assets, usually real estate. Debentures are not secured by specific collateral. Instead, they are secured by the full faith and credit of the issuing firm. Guaranty bonds are guaranteed by a third party, e.g., the parent of the subsidiary that issued the bonds. Collateral trust bonds are secured by a financial asset, such as stock or other bonds. Equipment trust bonds are secured by a mortgage on movable equipment, such as airplanes or railroad cars.

Net Operating Loss carryback

NOL's can also be carreid back to prior periods that refunds some of prior years tax expenes. A tax return must be filed and the journal entry is Income Tax refund receivable xx Income tax benefit from loss carryback xx

Lessor Accounting for Sales-Type Lease, Initial Measurement

On the lease agreement date, the lessor must 1.deregoznie the leased asset and Recognize: 2. Net investment in the lease 3. Selling Profit/Loss Journal Entry: Net Investment in the lease xxx COGS (PV of asset-PV of unguaranteed RV)xxx Revenue (Lease receivable-COGS) xxx Lease Asset (carrying amt of asset) xxx

Lessor Accounting for Operating and Direct Financing Leases

Operating Leases: (These did not meat any of the 5 criteria) Lease payments are recognized as rental income by the lessor on a straight-line basis even if rental payments vary. 1. Rental Income recognzied each period= Total Lease payments to be received/ Years on lease term J/E Cash/Lease Receivable xx Rental Income xx 2. The leased asset continues to be reported on the lessors B/S. ( No net investment is recognized, the lessor will continue to depreciate their asset following their normal procedures) 3. Intial direct costs, such as realtor fees, are deferred, they are expensed over the lease term on a straight-line basis.

Taxable Income vs Pretax Income

Pretax Income is the income calculated under GAAP prior to being taxed. Taxable Income is the income calculated under the tax code. Taxable income takes pretax income and adjusts for permanent and temporary tax differences between GAAP and Tax Code.

Lessor Accounting for Sales-Type Leases (lessee will own asset at end of lease or use most of the remaining economic life)

The Lease Receivable= the PV of the lease pmts + PV of the residual value guaranteed by lessee/3rd party (this is the value of the asset at end of lease that is responsible to be paid by the lessee) Unguaranteed Residual Value is the value of the asset @ end of term that is responsible by lessor Net Investments in the Lease (fair value of the leased asset)= PV of lease pmts+PV of guaranteed/unguaranteed residual value or Lease Receivable + PV of unguarnteed RV= Net Investments in the Lease Profit must be determined at lease commencment date. How to calculate profit or loss at the lease agreement date (assuming no initial direct costs) Fair value of the asset or lease receivable, if lower + PV of unguaranteed Residual Value - Carrying amount of the leased asset = Gross profit/loss

Capital expenditures vs Revenue Expenditures

The accounting issue related to PPE is to dermine if 1. Capitalized at cost and depreciated in future periods (a capital expenditure) 2.Recognized as an expense as incurred (a revenue expenditure). Capital Expenditure: Prodivde additional benefits to the asset by imporving the quality of service, extending its useful life or increasing output. These will be capitalzed at cost and depreciated (added to the carrying amount of the asset) All related expenses that help improve quality/useful life should be capitalized. Ex. Upgrading a LAN system cost 81300, work spaces had to be rearranged due to the wiring of the LAN sys costing 31000 and we had to install computers for 102,700 for the LAN. Revenue Expenditure: (expenses) These are routine expenses that maintain an assets normal service capacity. These costs are recurring and do not benefit the future of the asset. These will be expensed as incurred.

4. Patents

The amortization period for a patent is the shorter of 1. Its useful life or 2.The legal life remaining after acquisition or the moment the application was filed. The accounting treatment of the costs of the legal defense of a patent depends upon the outcome of the litigation. 1.. The costs of successful litigation are capitalized to the cost of the patent because they will benefit future periods. They are amortized over the shorter of: A. The remaining legal life or B. The estimated useful life of the patent. The costs of unsuccessful litigation (damages, attorneys' fees, etc.) are expensed as incurred. -An unsuccessful suit also may indicate that the unamortized cost of the patent has no value, or lower value, and impairment loss might be recognized.

What is the objective of accounting for income taxes and which approach do we use?

The objectives of accounting for income taxes are to recognize the following: 1. The amount of taxes currently payable or refundable 2.Deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns To achieve these objectives, an entity uses the asset-and-liability approach to account for (1) income taxes currently payable or deductible and (2) deferred taxes.

Group and Composite Depreciation Methods

These methods apply straight line depreciation to a collection of assets as if they were one single asset. Group Method: Applies to similiar assets Composite Method: Applies to assets that are not similiar wit varrying useful lives.

Deferred Tax Assets

These result from temporary differences and not permanent. 1. DTAs result when revenues or gains are included in taxable income before they are recognized under GAAP. (When Income Under GAAP<Taxable Income) Examples are unearned revenues such as rent and subscriptions received in advance. 2. DTAs also result when expenses or losses are recognized under GAAP before they are deductible for tax purposes. Examples are bad debt expense recognized under the allowance method and warranty costs.

Deferred Tax Liabilities

These result from temporary differences and not permanent. 1. Deferred Tax Liabilities arise when revenues or gains are recognized under GAAP before they are included in taxable income under tax code If Income under GAAP>Taxable Income, there is a Deferred Tax Liability 2. Deferred Tax Liabilitees also arise when expenses or losses are deductible for tax purposes before they are recognized under GAAP Ex. Accelerated tax depreciation of a property but S/L for the Fin Statements.

Valuation: Variable (floating) Bonds? Zero-Coupon Bond? Commodity-Backed Bond? Redemption Provisions: Callable Bond? Convertible Bond?

Variable (or floating) rate bonds pay interest that is dependent on market conditions. Zero-coupon or deep-discount bonds bear no stated rate of interest and thus involve no periodic cash payments. The interest component consists entirely of the bond's discount. The discount is amortized annually on a straight-line basis, but no periodic interest payments are required. The cash outflow for interest does not occur until the bond itself is retired. Commodity-backed bonds are payable at prices related to a commodity such as gold. Callable bonds (also called redeemable bonds) may be repurchased (redeemed) by the issuer at a specified price before maturity.During a period of failing interest rates, the issuer can replace high-interest debt with low-interest debt. Convertible bonds may be converted into equity securities of the issuer at the option of the holder (buyer) under specified conditions. Convertible bonds generally pay a lower yield than comparable nonconvertible bonds.

Two-Step Impairment Test

We apply this to fixed assets and to intangible assets with finite useful lives. We test for impairment when we believe that the carrying amount of the asset may not be recoverable under certain circumstances such as 1. The market price has decreased a lot 2. The use or physical condition of the asset has changed significantly There are two steps when testing for impariment: 1. Recoverability Test: The carrying amount of a fixed asset is not recoverable if Carrying Amount is > sum of undiscounted future cash flows 2. If the carrying amount is not recoverable, we must recognize an impairment loss. Impairment loss is the excess of the carrying amount over its fair value. Impairment Loss Accumulated depreciation - The new carrying amount of the asset is adjusted for the impairment loss and an impairment loss cannot be reversed.

Disposal of Long Lived Assets

When PPE is sold, the gain/loss on disposal is the difference between Net Proceeds - carrying amount of the asset. The journal entry is a follows (we must close out the PPE's historical cost since this is what is on B/S and reverse accumulated depreciation) If we sell a machine for a gain, this is the J/E Cash Acc dep Machine Gain

Amortization of an 1. intangible asset with Finite useful lifes

1. Amortization is just like depreciation (PPE) but for intangible assets (patents, copyrights). The J/E is: Amortization Expense xx Intangible asset xx A. The amortizable Amount= Historical (initial cost) - Residual Value (value expected at end of useful life) B. The carrying amount of an intangible asset= Historical Cost- accumulated amortization-any impairment losses C. The impairment test and amortization methods are the same as for depreciation.

Depreciation Methods

1. Straight line: The simplest method, an equal amount of depreciation is charged to each period of the assets useful life. Periodic Depreciation Expense= Depreciable base/Useful life 2. Units of Output Method: Allocates cost based on production, as production varies so will depreciation. Periodoic Dep Exp= Depreciable base * (Units produced during current period/estimated total lifetime units) 3. Accelerated Depreciation Methods: These are time based. They result in decreasing depreciation over the life of the asset (higher expenses in earlier years) 1. Declining Balance Method: determines depreciation expense by multiplying the carrying amount (not the depreciable base equal to cost minus salvage value) at the beginning of each period by some percentage (e.g., 200% or 150%) of the straight-line rate of depreciation. Periodic depreciation expense = Carrying amount × Declining-balance percentage A. The carrying amount decreases by the depreciation recognized. The result is the use of a constant rate against a declining balance. B. Salvage value is ignored in determining the carrying amount, but the asset is not depreciated below salvage value. 2. Sum of the years digits (SYD) method: This depreciation method multiplies not the carrying amount but the constant depreciable base (cost minus salvage value) by a declining fraction. It is a declining rate, declining-charge method. Periodic Dep Exp = Depreciable base * (Remaining years in useful life/Sum of all years in useful life)

Bond

A bond is a formal contract to pay an amount of moeny (face amount) at the maturity date plus interest at the stated rate at intervals. The proceeds received from the investors on the day the bonds are sold equal the present value of the sum of the future cash flows expected to be received from the bonds. These proceeds equal 1. The present value of the face amount + 2. The present value of the annuity of interest payments. Bond Issuance J/E @ premium Cash (PV of int and PV @ end) 103435 Premium (3435) Bond Payable (Face Value) 100,000 (Opposite for Discount)

Leases Lease classification test

A lease is a long-term contract in which the owner of property (lessor) allows another party (lessee) to use the property for a stated period for a stated payment. -The primary issue is whether the lease agreement transfers substantially all the benefits and risks of ownership of the asset to the lessee. Lease Classification Test: A lease is classified as a finance lease by the lessee and as a sales-type lease by the lessor if at least one of following 5 criteria is met: 1. The lease transfers ownership to the lessee by the end of the lease term. 2. The lease includes an option to purchase 3. The lease term is for the major part of the remaining economic life of the leased asset (75% of economic life) 4. The present value of the sum of The lease payments + any residual value guaranteed equals or is >90% of the fair value of the asset. 5. The leased asset is so specialized that is expected to have no alternatie use to the lessor @ end of the lease - If none of the 5 criteria are met, the lease is classifed as an operating lease by the lessee and operating lease or direct financing lease by the lessor -When the lease is an operating lease, the lessor reports a direct financing lease only when: 1. The present value of the sum of (a) the lease payments and (b) any residual value guaranteed by the lessee or any other third party equals or exceeds substantially all of the fair value of the leased asset, and 2.It is probable that the lease payments and any residual value guarantee will be collected.

Lessee accounting for Finance Leases- Subsequent measurement of Right-of-use assets.

A lessee amortizes the right of use asset on a straight line basis. The short of : 1. Its useful life 2. or its lease term -However, if, at the end of the lease term, (1) the ownership of the leased asset is transferred to the lessee, or (2) the lessee is reasonably certain to exercise the purchase option, the amortization period is the useful life of the leased asset. The amortization expense = PV of lease payments (rental payments+purchase option)/# of years. Amortization expense xx Right-of-use asset xx

Lessor Accounting for Sales-Type Lease, Subsequent Measurement

A periodic lease payment made to the lessor 1. Interest Income Cash Int Income 2. Reduction of Net investment in the leased asset Cash Net investment in the leased asset Interest Inc= Net investment in the lease x Discount Rate

Short-term leases What are they, recognized as and journal entries?

A short-term lease is a lease that at commencment date has a lease term of 12 months or less and does not include a purchase option. A lessee has the option to not elect to recognize the right-of-use asset and Liabilit. These are treated like rent to the lessee (dont have to recognize a liability) Rent Expense xx Cash/Rent payable xx This is a form of off-balance sheet financing for the lessee.

Maturity Pattern: What is a term bond? Serial bond?

A term bond has a single maturity date at the end of its term. The examples in this study unit are regarding a regular term bond. A serial bond matures in stated amounts at regular intervals. Investors can choose the maturity that suits their financial needs.

PPE what is the definition and how is it measured

AKA fixed assets. are tangible property expected to benefit the entity >1 year PPE is measured at historical cost which consists of all the cost inccured to bring the asset to the condition and location for its intended use. This includes: 1. Net purchase price (less discounts, rebates, taxes) 2. The direct costs to bring the asset to the location bring the condition to its intended use (enginnering fees, delivery, testing, installation) 3. The interest (borrowing costs) Ex. In the case of constructing a building, the costs for site preparation such as clearing the land, draining and leveling the land are not part of the buildings historical costs but the lands.

Lessee Accounting for Lease Liability (initial recognigtion) (Finance and Operating Leases)

Accounting for Lease Liability (initial recognigtion): A lease liability is measured at the present value of the lease payments to be made over the lease term. These are seperated on the balance sheet into current and noncurrent liabilities based on what is due this year and the following years. 1.. They are discounted using a discount rate. 2.. If the lease includes a purchase option that is reasonably certain to be met, the lease payments includes the following: A. Rental Payments B. Exercise price of the purchase option If it does not include a purchase option, the lease payments includes the following: A. Rental payments B. Nonrenewal penalities C. Amounts probable of being owed by the lessee under residual value guarantees

Lessee Accounting for Right-of-Use Asset (initial recognition) (Finance and Operating leases)

Accounting for Right-of-Use Asset (initial recognition): This is measured at the amount at which the lease liability was recognized + initial direct costed incurred by lessee When no direct costs were incurred, the right-of-use asset equals the lease liability Right-of-use asset xx Lease liability xx

Amortization of an 2. intangible asset with Indefinite useful lifes

An intangible asset with an indefinite useful life is not amortized but is tested for impairment. The carrying amount= historical cost minus any impairment losses. Goodwill is an intangible asset with an indefinite useful life. However, the accounting treatment of goodwill differs from that for other intangible assets. Impairment test. An intangible asset with an indefinite useful life (a nonamortized intangible asset) must be reviewed for impairment at least annually. It is tested more often if events or changes in circumstances suggest that the asset may be impaired.An entity may elect to perform a qualitative assessment to determine whether a quantitative impairment test is needed. The entity also may directly perform the quantitative test. Qualitative assessment. After the assessment of qualitative factors, the entity may determine that it is more likely than not (probability > 50%) that an indefinite-lived intangible asset is not impaired.In this case, the quantitative impairment test is not required.If potential impairment is found, the quantitative impairment test must be performed. Quantitative impairment test. The carrying amount of an asset is compared with its fair value. If the carrying amount exceeds the fair value, the asset is impaired, and the excess is the recognized impairment loss. Determination of an Impairment Loss 1. Review for impairment 2. Impairment loss = Carrying amount - Fair value This impairment loss is nonreversible, so the adjusted carrying amount is the new accounting basis.

Intraperiod Tax Allocation

An intraperiod tax allocation is the allocation of income taxes to different parts of the results appearing in the income statement of a business, so that some line items are stated net of tax. The following must have tax expenses or benefits allocated: 1. Continuing Operations 2. Discontinued Operations 3. Other Comprehensive Income 4. Items debited or credit directly to equity Intraperiod tax allocation is needed because items included in determining taxable income may be presented in different sections of the income statement. A tax on tax benefit should be shown in the same section as the related income or expense.

Carryforwards

Are deductions or credits that may be carried forward to recude taxable income or taxes payable in a future year. A carryforward results in a future deductible amt requiring recognition of a DTA.

Amortization of an intangible asset with Indefinite useful lifes

Intangible assets with indefinite useful lifes are not amortized. The Carrying Amount= Historical Cost-any impairment losses. Goodwill is an intangible asset with an indefinite useful life. However, the accounting treatment of goodwill differs from that for other intangible assets. Impairment test. An intangible asset with an indefinite useful life (a nonamortized intangible asset) must be reviewed for impairment at least annually. It is tested more often if events or changes in circumstances suggest that the asset may be impaired. An entity may elect to perform a qualitative assessment to determine whether a quantitative impairment test is needed. The entity also may directly perform the quantitative test. Qualitative assessment. After the assessment of qualitative factors, the entity may determine that it is more likely than not (probability > 50%) that an indefinite-lived intangible asset is not impaired.In this case, the quantitative impairment test is not required.If potential impairment is found, the quantitative impairment test must be performed. Quantitative impairment test. The carrying amount of an asset is compared with its fair value. If the carrying amount exceeds the fair value, the asset is impaired, and the excess is the recognized impairment loss. Determination of an Impairment Loss 1. Review for impairment 2. Impairment loss = Carrying amount - Fair value This impairment loss is nonreversible, so the adjusted carrying amount is the new accounting basis.

Lessee accounting for Finance leases- Subsequent measurement of lease liability

Interest expense and lease liability amortization. Each periodic lease payment made by the lessee has two components: interest expense and the reduction of the lease liability. Interest Expense: Calculated using the effective intertest meothod. Int exp= lease liability at beginning of the period * Discount rate Lease liability=difference between cash and int exp Interest Expense xx Lease Liability ( ) Cash xx

What is an intangible asset? How are externally/internally aquired intangible assets recorded?

Is an identifiable, nonmonetary asset that lacks physical substance. (Licenses, patents, copyrights, franchises) Externally acquired intangible assets (other than goodwill) are initially recorded at acquisition cost plus any additional costs such as legal fees. Internally acquired intangible assets (other than goodwill) are initially recorded at the amount of the additional costs (legal fees) other than those for R&D. R&D costs must be expensed as incurred (not capitalized, capitalized: recorded as an asset on (b/s) not an expense(i/s)) until technological feasbility is established.

Interperiod Tax Allocation

Items in an entity's tax return for a year include the tax consequences of most items but not all. There are temporary differences that result when items of income and expenses are recognized in different periods between GAAP and the tax code. The effect is that a taxable or deductible amount will occur in future years when the asset is recovered or the liability is settled. Examples: 1. Different depreciation methods may be used on the same asset for tax purposes vs financial statements. (One asset may be using accelerated depreciation for tax but Straight line for the Fin Statements) 2. BDE is recognized in the Fin Statements under the allowance method (I/S or B/S approach) but for tax purpose BDE is recognized when the debts are determined to be uncollectible using the direct write-off method. 3. Warranty liabilities are recognized at different times. F/S (@ date of sale), Tax (When actual payments are made) A permanent difference is an event that is recognized either in pretax financial income or in taxable income but never in both. It does not result in a deferred tax amount. The following are examples: 1. Payments of fines or penalties are recognized as an expense in the financial statements but are never deducted in the tax return. 2. Interest on state or municipal bonds is recognized as income in the financial statements but not in taxable income for tax purposes. When tax consequences and financial-statement effects differ, income taxes currently payable or refundable also may differ from income tax expense or benefit. The accounting for these differences is interperiod tax allocation.

Lessee accounting for Operating Leases- Subsequent measurement of Right-of-use assets (amortization of asset).

Lease expenses in operating leases are recorded each period on a straight-line basis. Lease Expense= Total undiscounted lease pmts (includes initial direct costs)/lease term years Interest and amortization expenses are not reported separetly like Financing leases, they are included in one single periodic lease expense Lease expense (includes int + amortization) xx cash/ xx