CPA - FAR - 10 & 11 - Bonds, PV, Leases
For a finance lease, which life should the lessee use to amortize the right-of-use asset? 1. Useful life, or 2 Lease term
Normally, the useful life, if there is a purchase option that is reasonably certain to be exercised, or title transfers to the lessee at the end of the lease term. This makes sense because if the lessee will end up with the equipment, it would be depreciated over its useful life. If there is no purchase option and title does not transfer, then use the shorter of the useful life or lease term. This follows the principle of conservatism.
On January 3, 20X4, Salas Company leased a piece of equipment that cost Salas $23,500, to Merlin's Haberdashery over a 6-year period, which is equal to the useful life of the equipment. The lease calls for annual payments of $6,000, beginning on January 3, 20X4. The rate implicit in the lease, which is not known to the lessee, is 7%. The lessee's incremental borrowing rate is 8%. The present value of an annuity in advance of $1 per period for 6 periods is: - 5.100 at 7% - 4.993 at 8% How much will Salas recognize on its 20X4 income statement as gain on sale of equipment and as interest income?
PV of lease = $6,000 x PVAD, 5.100 (7%, because lessor always uses the implicit rate) = $30,600 Less: Cost of equipment, $23,500 = Gain on sale, $7,100 PV of lease = $30,600 Less: First interest payment at inception, $6k = $24,600 to apply for interest payments for first year x 7% interest rate = $1,722 interest for whole first year
On December 31, 20X1, Wright Corp. placed cash of $875,000 in an irrevocable trust that meets the necessary defeasance requirements. The trust's assets are to be used solely for satisfying obligations on Wright's 6%, $1,100,000, 30-year bond payable. Wright has not been legally released from its obligations under the bond agreement, but any additional liability is considered remote. On December 31, 20X1, the bond's carrying amount was $1,050,000, and its present value was $800,000. Disregarding income taxes, what amount of gain (loss) should Wright report in its 20X1 income statement?
Placing $875,000 in trust to satisfy the remaining bond obligation essentially measures the company's remaining liability with only a remote possibility that the liability will be greater. This is referred to as an in substance defeasance and is treated like a retirement of debt. Comparing the $875,000 paid to the carrying value of $1,050,000 indicates a gain, before tax, of $175,000.
Treatment of items like property taxes or insurance when considering lease accounting
Property taxes and insurance are not considered components of a contract and, therefore, do not receive any allocation of the consideration in the contract. Administrative costs of setting up a contract or initiating a lease, and direct payment or reimbursement to the lessor of costs associated with ownership (property taxes or insurance), don't convey a good or service to the lessee that is separate from the benefit associated with the right to the property. Therefore, no portion of the lease payments is allocated to them.
How to account for leasehold improvements
Report with PP&E and amortize over the shorter of: 1. Remaining lease term 2. Useful life
IFRS vs. GAAP on reporting/recording B/P
SL amortization may not be used under IFRS; may be used under GAAP if results do not differ materially. IFRS: bonds may be recognized at FVTPL when it will result in more relevant info.
Dixon Co. incurred costs of $3,300 when it issued, on August 31, Year 1, 5-year debenture bonds dated April 1, Year 1. What amount of bond issue expense should Dixon report in its income statement for the year ended December 31, Year 1?
$240. Total bond issue costs = $3,300 Divide by: months from ISSUE date to maturity date (five years, less five months from 4/1 - 8/31, = 55 months) = $60/month x Months elapsed since ISSUE date (4) = $240. Remember: Bond ISSUE costs are divided by total months from ISSUE date to maturity date. Then multiply by months elapsed since ISSUE date.
Five criteria of finance leases
Special POT 75/90: 1. Specialized in nature 2. Purchase Option that's reasonably expected to be exercised 3. Transfer title 4. Major part or benefit transfers to the lessee (at least 75% of asset's life) 5. Substantially all of the value (at least 90% of FMV) If you meet any ONE of these five criteria, it's a finance lease. If not, it's an operating lease.
SL vs effective interest amortization
- Using the SL method creates higher discount amortization for the earlier years of the bond. - Because the SL amortized discount is overstated, the unamortized discount is understated, which results in an overstated carrying value. - At maturity, the bond discount is fully amortized and carrying value is the same for both methods.
What is the name of the interest rate printed on the bond representing the basis for calculating the amount of cash the investor will receive at every payment?
Stated, Face, Coupon, or Nominal Rate
Lessor accounting: After commencement date, how are fixed lease payments received and initial direct costs accounted for?
Straight line basis over the lease term. - Fixed lease payments received: Include in income. Total lease payments / years in lease term = Annual rent revenue. - Initial direct costs: expensed.
Lessee accounting: How to recognize: 1. The difference between the total lease expense and accreted interest for each period 2. Lease payments
1. Difference between the total lease expense and accreted interest for each period: Amortize unevenly over the term of the lease. This is because the journal entry needs to balance, and the net amortization/decrease to lease liability in the JE's is affected by cash payments. See the journal entries. 2. Lease payments: Expense evenly using SL over the lease term. Ex: payments are $5k, $10k, $10k, $10k, and $10k, then periodic expense = $9k (average).
What interest rate should the lessee use to determine the PV of the lease payments?
1. If it is known, use the rate implicit in the lease (this is determined by the lessor). 2. If the implicit rate is unknown to the lessee, use the incremental borrowing rate, which is the rate that the lessee would otherwise pay to borrow the same amount of money over the same amount of time in a similar economic environment.
Bond Sinking Fund
A fund set up for the retirement of bonds. The balance is treated as a noncurrent asset until the bonds mature. Any interest or dividends earned are added to the sinking fund balance and reported as income.
At the inception of a finance lease, amounts likely to be owed under a residual value guarantee: A. Are included as part of lease payments at PV B. Are included as part of lease payments at FV C. Are included as part of lease payments only to the extent that estimated residual value is expected to exceed guaranteed residual value D. Are excluded from lease payments
A. Are included as part of lease payments at PV. An amount likely to be owed under a residual value guarantee is considered one component of minimum lease payments. It represents a future liability. As a result, it is included in calculating the capitalized amount of the asset and obligation under the lease. The amount will be the present value of the payment to be made in a lump sum at the end of the lease term.
"Component" of a lease
An item in a contract is considered a component if it conveys some benefit, transferring a good or service, to the lessee. These costs are considered associated with ownership.
The following information relates to noncurrent investments that Fall Corp. placed in trust as required by the underwriter of its bonds: Bond sinking fund balance, 12/31/X1 $450,000 20X2 additional investment $90,000 Dividends on investments $15,000 Interest revenue $30,000 Administration costs $5,000 Carrying amount of bonds payable $1,025,000 What amount should Fall report in its December 31, 20X2, balance sheet related to its noncurrent investment for bond sinking fund requirements?
Bond sinking fund balance, 12/31/X1 $450,000 + 20X2 additional investment $90,000 + Dividends on investments $15,000 + Interest revenue $30,000 - Administration costs $5,000
What interest rate should the lessor use to determine the PV of the lease payments?
The lessor always uses the implicit rate.
On January 1 of the current year, Lean Co. made an investment of $10,000. The Present value of $1.00 discounted at 10% for 2 periods is .826. What amount of cash will Lean accumulate in two years?
The present value of an amount to be received in the future is equal to the future amount times the appropriate present value factor or Present Value = Future Amount x Factor. In this case, the present amount is given as $10,000 and the factor for two years is .826 resulting in $10,000 = Future Amount x .826 or Future Amount = $10,000/.826 = $12,107.
On November 1, Year 1, Mason Corp. issued $800,000 of its 10-year, 8% term bonds dated October 1, Year 1. The bonds were sold to yield 10%, with total proceeds of $700,000 plus accrued interest. Interest is paid every April 1 and October 1. What amount should Mason report for interest payable in its December 31, Year 1, balance sheet?
The purchaser of the bonds prepays interest, so the issuer pays the same amount of interest at each interest payment date. Therefore, the interest should accrue from October 1, Year 1. $800,000 x 8% interest payment = $5,333/month x 3 months = $16k interest payable.
A shipping company sells a boat and leases it from the buyer in a sale-leaseback transaction. At the end of the 10-year lease, ownership of the boat does not revert to the shipping company. The fair value of the boat, at the time of the transaction, was less than its undepreciated cost. Which of the following outcomes most likely will result from the sale-leaseback transaction? A. The boat will be classified in property, plant and equipment of the shipping company. B. The shipping company will recognize the total profit on the sale of the boat ratably over the lease term. C. The shipping company will treat the transaction like a loan to raise cash. D. The shipping company will recognize in the current year a loss on the sale of the boat.
D. The shipping company will recognize in the current year a loss on the sale of the boat. Profits or losses are recognized immediately in a sales-leaseback transaction. When the shipping company sold the boat, its fair value was below its undepreciated cost, and the loss is recognized immediately. A sale-leaseback where one of the five criteria for a finance lease is met is treated like a loan to raise cash. Here, none of the five criteria is met, so it is treated like a sale + operating lease.
What is the name of the interest rate at which an investor expects to earn the interest?
Effective, Yield, or Market Interest Rate
In general, IFRS requires a financial liability to be reported at: a. amortized cost b. fair value through P&L
Either Amortized cost or Fair value through profit or loss. IFRS normally requires a financial liability to be reported at amortized cost. Only certain financial liabilities, such as derivatives, are recognized at fair value. IFRS does, however, allow an entity to make an irrevocable election to report financial liabilities at fair value through profit or loss (FVTPL). As a result, a bond may be reported at either amortized cost or fair value through profit and loss.
Converting from PV of a stream of interest payments (ordinary annuity) to PV of annuity due
Either: 1. Use the factor for one less period (ex: 3 vs 4 periods) and add 1.0, or 2. Use the factor for the same period and interest rate, and multiply by 1.0 plus the interest rate
Converting from PV of annuity due to PV of a stream of interest payments (ordinary annuity) Note: This might be required when a CPA question is asking for an amount related to PV of an ordinary annuity, but the only table available is for an annuity due.
Either: 1. Use the factor for one more period (ex: 4 vs 3 periods) and subtract 1.0, or 2. Use the factor for the same period and interest rate, and divide by 1.0 plus the interest rate
In an operating lease, how does the lessor or lessee determine rental revenue or expense?
In an operating lease, the lessor recognizes rental revenue and the lessee recognizes rental expense uniformly over the term of the lease regardless of the pattern of payments.
Finance lease journal entries for lessee
Initial JE: DR Right of Use Asset (PV) CR Lease Liability (PV) Periodic interest payments: DR Amortization Expense (of asset; SL over life of lease) CR Right of Use Asset (of asset; SL over life of lease) DR Interest Expense DR Lease Liability CR Cash This JE is straightforward b/c the Interest Expense, Lease Liability, and Cash portion come straight from the effective interest table.
Operating lease journal entries for lessee
Initial JE: DR Right of Use Asset (PV) CR Lease Liability (PV) Periodic interest payments: DR Lease Exp (SL of average of payments) CR Cash DR Lease Liability (effective interest table) CR Right of Use Asset (plug) The Right of Use Asset credit is a plug. The DR to interest expense includes amortization of the Right of Use Asset, and some accreted interest. The lessor also depreciates the actual asset, not the lessee.
True or false: Under IFRS, any lease with a purchase option generally cannot be classified as a S/T lease, even if the purchase option is not considered likely to be exercised. "Low-value leases" worth $5k or less may be classified as S/T, even if there is a purchase option.
True.
True or false: IFRS requires remeasurement of the lease liability or lease receivable if the index rate tied to variable lease payments changes, resulting in a change in cash flows. GAAP does not require remeasurement.
True.
Lessor accounting: How to recognize uneven rental payments (like free rent)
Uneven rental payments are recognized uniformly over the lease term.
When bonds are issued at a discount, and the discount is amortized, the interest expense (decreases or increases) year-over-year, and the amortization (decreases or increases) year-over year.
When bonds are issued at a discount, and the discount is amortized, the interest expense INCREASES year-over-year, and the amortization DECREASES year-over year.
When bonds are issued at a premium, and the premium is amortized, the interest expense (decreases or increases) year-over-year, and the amortization (decreases or increases) year-over year.
When bonds are issued at a premium, and the premium is amortized, the interest expense DECREASES year-over-year, and the amortization INCREASES year-over year.
