1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

2. Chapter 7

3. Investing Decisions (Investing in Other Firms’ Debt) Topics –Securities Long-term bonds Notes Receivable Lease Receivables (lessor accounting) –SFAS No. 115 Mark-to-Market Accounting –Impairments, Troubled Debt

4. Characteristics of Debt Securities (e.g., Bonds Owned) Owner has claims to future cash inflows: –Principal –Interest Current market price equals present value of future cash flows; thus, calculations use the current market rate of interest.

5. May be marked-to-market under SFAS No. 115: –Bond investments are marked-to-market if classified as Trading or Available-for-Sale (but not if classified as Held-to-Maturity). Loans (notes) receivable and lease receivables (similar to notes receivable) are EXCLUDED by SFAS No. 115.

6. Trading Securities Owned Recorded at cost (price paid to purchase securities, including transaction costs). Interest income equals amount received; there is no premium/discount amortization. Trading securities are marked-to-market! Unrealized gains (losses) are recognized and reported in the Income Statement (other income section).

7. Available-for-Sale Securities Owned Recorded at cost (price paid to purchase securities, including transaction costs) Interest income is computed using the effective interest method. –Premium/discount is amortized if... Original maturity > 1 year

8. Available-for-sale securities are marked-to- market! Unrealized gains (losses) are reported as a component of other comprehensive income section –income is not affected Cumulative unrealized holding gains and losses are reported in owners’ equity

9. Held-to-Maturity Securities Owned Recorded at cost (price paid to purchase securities, including transaction costs). Interest income is computed using the effective interest method; premium/discount is amortized. Held-to-Maturity securities are NOT marked-to-market; thus, NO unrealized gains/losses are reported! –Reported in the balance sheet at amortized cost (i.e., face  premium/discount).

10. Effective Interest Method Calculated on a per period basis (i.e., per n), where n equals the number of compounding periods during the life of the debt security. Computation: Beginning of the Period Carrying (Book) Value ×Effective interest rate at purchase time =Interest income  Interest received (or receivable) =Premium/Discount

11. Example: Compute Historical, Effective Interest Rate Facts: On January 1, 2004, the Faulconer Co. purchased the following bond investment for $4,550,000, plus $75,000 in transactions costs: $4,000,000 in 8% bonds due January 1, 2011, with interest paid semiannually on July 1 and January 1 of each year.

12. The purchase price reflects a 2.65% semiannual effective interest rate, or 5.3% per year: n = 14 (7-year bonds, with interest paid semiannually) interest collection per period = $160,000 ($4,000,000 × 8% × ½ year) PV = purchase price = $4,550,000 + $75,000 = $4,625,000 [bought at a premium] Maturity value = $4,000,000 (face value) i = ? = 2.65% per period

13. Comprehensive Example Facts: On July 1, 2004, the Beane Co. purchased the following investment for $2,760,000, including transactions costs: $3,000,000 in 7% bonds due July 1, 2009, with interest paid semiannually on July 1 and January 1. Illustrations follow displaying the effective rate method for investment securities under three cases: Available-for-sale securities, Held-to- maturity securities, and Trading securities.

14. Beane Co.: Calculation of Effective Interest Rate The purchase price reflects a 4.51% semiannual effective interest rate: n = 5 × 2 = 10 interest payment (ordinary annuity) = $210,000  2 = $105,000 PV = $2,760,000 [bought at a discount] Maturity value = $3,000,000 i = ? = 4.51% per period

15. Beane Co.: Application of the Effective Interest Method 2004 Interest income = $124,476 ($2,760,000 x 4.51%) Dec. 31, 2004 Interest receivable = $105,000 (½ year’s cash interest receivable: $3,000,000 × 7% × ½) 2004 Bond discount amortization = $124,476 - $105,000 = $19,476

16. Dec. 31, 2004 Amortized cost = $2,779,476 ($2,760,000 + $19,476) –July 1, 2004 bond discount = $3,000,000 - $2,760,000 = $240,000 –December 31, 2004 bond discount = $240,000 - $19,476 = $220,524

17. Beane Co. Financial Statement Effects if Classified as a Long-Term Available- for-Sale Security Assume the facts from the initial Beane example and that the year-end FMV for the bonds is $2,900,000: 2004 interest income = $124,476 Dec. 31, 2004 interest receivable = $105,000 2004 bond discount amortization = $19,476 Dec. 31, 2004 amortized cost = $2,779,476

18. Therefore, at December 31, 2004, Beane’s investment has a $120,524 unrealized gain: FMV = $2,900,000 Amortized cost = 2,779,476 Unrealized gain = $ 120,524 Is it to be reported? If so, where?

19. Beane Co. Financial Statements: Available-for-Sale Classification Statement of Cash Flows Operating activities Interest payment received$0 Investing activities Purchase bonds($2,760,000) Income Statement Other revenues, (expenses), gains, (losses) Interest income$124,476

20. Balance Sheet Non-current assets Investments in bonds$2,900,000 Stockholders’ Equity (ignoring income taxes) Retained earnings Effect of interest income$124,476 Accumulated Other Comprehensive Income Unrealized gains (losses) on available-for-sale securities $120,524

21. Beane Co. Financial Statement Effects if Classified as a Long-term Held-to-Maturity Security Assume the facts from the initial Beane example and that the year-end FMV for the bonds is $2,900,000: 2004 interest income = $124,476 Dec. 31, 2004 interest receivable = $105,000 2004 bond discount amortization = $19,476 Dec. 31, 2004 amortized cost = $2,779,476

22. Therefore, at Dec. 31, 2004, Beane’s investment has a $120,524 unrealized gain: FMV = $2,900,000 Amortized cost = 2,779,476 Unrealized gain = $ 120,524 BUT … under Held-to-Maturity classification, the unrealized gain is NOT recognized!

23. Beane Co. Financial Statements: Held-to-Maturity Classification Statement of Cash Flows Operating activities Interest payment received$0 Investing activities Purchase bonds($2,760,000) Income Statement Other revenues, (expenses), gains, (losses) Interest income$124,476

24. Balance Sheet Non-current assets Investments in bonds (amortized cost)$2,779,476 Stockholders’ Equity (ignoring income taxes) Retained earnings Income statement effect$124,476 Accumulated Other Comprehensive Income Unrealized gains (losses) on held-to- maturity securities No effect

25. Beane Co. Example: Financial Statement Effects if Classified as a Short-term Trading Security Assume the facts from the initial Beane Co. example and that the year-end market value for the bonds is $2,900,000. One computation must change, and... As a short-term investment, bond discount is not amortized.

26. Prior facts and computations: 2004 interest income = $124,467 Dec. 31, 2004 interest receivable = $105,000 Adjusted information: 2004 bond discount amortization = $0 Dec. 31, 2004 cost = $2,760,000 Therefore, at Dec. 31, 2004, Beane’s investment has a $140,000 unrealized gain: $2,900,000 (FMV) versus $2,760,000 (cost)

27. Beane Co. Financial Statements: Trading Classification Statement of Cash Flows Operating activities Interest payment received$0 Purchase bonds($2,760,000)

28. Income Statement Other revenues, (expenses), gains, (losses) Interest income$105,000 Unrealized gains (losses) on trading securities) 140,000 $245,000

29. Balance Sheet Current assets Investments in bonds$2,900,000 Stockholders’ Equity (ignoring income taxes) Retained earnings Income statement effect$245,000 Accumulated Other Comprehensive Income Unrealized gains (losses) on trading securities No effect

30. Notes (Loans) Receivable Normally, notes receivable are recorded at face value. –No premium/discount (the stated rate on the note equals the market rate) –Notes with an unreasonable stated rate (i.e., 0%) at the date of execution do have a premium/discount. The effective interest method is used to compute interest income if the note receivable is classified as long-term (i.e., maturity > 1 year at date of execution)

31. Note Receivable Example (General Rule, Stated Interest Rate = Market Rate at Date of Execution) Facts: On January 1, 2004, the Simpson Co. loaned $2,000,000 to a key supplier under the following terms: Principal due on December 31, 2005; interest paid annually on December 31, 2004 and 2005; stated interest rate is 8%. The appropriate market rate of interest for this type of loan on January 1, 2004 is 8%.

32. Simpson Co. Note Receivable Financial Statement Effects Statement of Cash Flows20042005 Operating Activities Interest received$160,000 Investing Activities Loans to suppliers($2,000,000) Collections on Notes Receivable $2,000,000

33. Income Statement20042005 Other revenues (expenses), gains, (losses) Interest income$160,000

34. Balance Sheet (12/31)20042005 Current assets Notes receivable$2,000,0000 Stockholders’ Equity Retained earnings Effect on net income, ignoring income taxes $160,000$320,000

35. Receivables [Loan] Impairment Receivable [Loan] is written down to the present value of “the new” estimated future cash flows. The “impairment loss” is treated as a bad debt write-off.

36. Receivables [Loan] Impairment “Impairment” recognition criteria: Carrying value of the receivable PV of any “new” estimated future cash collections(*) (*) Using historical, effective interest rate.

37. Example of a Receivable [Debt] Impairment and Settlement Facts: On Dec. 31, 2004, the Schmenner Co. had the following accounts related to its Jan. 1, 2003 note receivable from the James Co., which is due Jan. 1, 2007: Principal = $4,000,000 Interest receivable = $280,000 Stated and historical effective rate = 7% Annual interest payments: Jan. 1

38. Schmenner Co. Example: Impairment Schmenner’s accounting staff estimates that the company will not be able to collect all contractually due principal and interest. The best estimate: Schmenner will collect $200,000 in interest payments for the January 1, 2005, 2006, and 2007 interest payments, and collect $3,600,000 principal on January 1, 2007.

39. Solution: Carrying value of the James debt: $4,280,000 The loan is impaired because the present value of the new estimated cash flows using the historic effective interest rate = $3,705,983. - PV of January 1, 2005 interest payment = $200,000, plus … - Present value of January 1, 2006 and 2007 interest payments plus principal = $3,505,983 n = 2, i = 7%, payments = $200,000, future value = $3,600,000 Present value: $3,505,983

40. Schmenner’s receivable [James’ note] is written down from $4,280,000 to $3,705,983; a $574,017 impairment loss! –Assuming Schmenner had been recording accruals for bad debts expense, impairment losses are charged to the allowance for doubtful accounts.

41. Schmenner Co. 2001 Financial Statement Effects of [Loan] Impairment Statement of Cash Flows2004 Operating activities Interest Received (for 2003)$280,000 Income Statement Other revenues, (expenses), gains, (losses) Interest income$280,000 Impairment loss (assume no previous accruals of bad debt expense) 574,017 ($294,017)

42. Balance Sheet (December 31) Current assets Interest receivable$200,000 Noncurrent Assets Notes receivable (1) $3,505,983 Stockholders’ Equity Retained Earnings Effect on net income, ignoring income taxes ($294,017) (1) $3,705,983 - $200,000 interest receivable)

43. Troubled Debt: Settlement Use the previous Schmenner example. On December 31, 2004, the Schmenner Co. had the following accounts related to its January 1, 2003 note receivable from the James Co., which is due January 1, 2007: Principal = $4,000,000 Interest receivable = $280,000 Stated and historical effective rate = 7% Annual interest payments, due on Jan. 1.

44. Negotiation... Assume that to settle James’ debt on December 31, 2004, Schmenner accepted from James: – land with a FMV of $2,000,000, and –James common stock with a FMV of $1,600,000. Schmenner’s write-off: $4,280,000 - $3,600,000 = $680,000

45. Financial Statement Effects of Debt Settlement Statement of Cash Flows Operating activities Interest received (for 2003)$280,000 Significant non-cash financing and investing activities Acquired land and common stock in debt settlement $3,600,000

46. Income Statement Other revenues, (expenses), gains, (losses) Interest income$280,000 Bad debts expense (assume no previous accruals of bad debts expense) ( 680,000) ($400,000)

47. Balance Sheet (December 31) Non-current assets Investments in common stock$1,600,000 Land2,000,000 Stockholders’ Equity Retained Earnings Effect on net income, ignoring income taxes ($400,000)

48. Troubled Debt: Modification of Terms Assume that on December 31, 2004, the Hendricks Co. had the following accounts related to its note receivable from the Shane Co.: Principal = $500,000 Interest receivable = $75,000 2004 interest income = $75,000 Historical effective interest rate = 9%

49. Negotiation and results... Carrying value = $575,000. Hendricks agrees to modify the Shane note such that the present value of the new cash inflows (using the 9% historical effective interest rate) = $400,000. Impairment has occurred, via modification to a present value below original principal! The $175,000 loss is recognized. The “new effective interest rate” is 0%.

50. Financial Statement Effects of the Modification of Terms Statement of Cash Flows Operating activities No effect$0 Income Statement Bad debts expense (assume no previous accruals of bad debts expense)$(175,000) Interest Income 75,000 Net Effect$(100,000)

51. Balance Sheet (December 31) Non-current assets Notes receivable$400,000 Stockholders’ Equity Retained Earnings Effect on net income, ignoring income taxes $(100,000)

52. “Lease Receivables” Determination of capital lease classification (versus an operating lease): Must capitalize by recognizing a “lease receivable” if the contract meets at least one of four specific criteria.

53. Capitalize if “Yes” to any query! Does the “lease contract”... contain a transfer of title clause? contain a BPO clause? cover 75% or more of the remaining useful life of the item? support that the present value of the MLP terms is 90% or more of the item’s FMV? In “operating leases” the assets stay on the lessor’s books, where rent revenue is accrued!

54. “Lease Receivable” and Lessor’s Accounting Treatment Capital Leases: –Direct Financing (finance type company, fair value of asset = book value of asset) Leased asset written off the balance sheet and a “lease receivable” is recorded Interest income is recognized using effective interest method No gross profit recognized at the point of execution of the lease contract.

55. –Sales-type (dealer or manufacturer, where FMV > book value of asset) Leased asset written off the balance sheet and a lease receivable recorded Interest income recognized using effective interest method Gross profit on the asset is recognized when lease is signed; GP = FMV – BV

56. Lessor Example: Operating Lease Facts: The Lee Co. (lessor) and a lessee signed a lease agreement on January 1, 2004. Lee agrees to lease machinery with an estimated useful life of 8 years, a book value of $1,800,000, and an estimated FMV of $1,800,000, under the following terms: Down payment: $100,000 Lease payments: $197,607 at December 31, 2004, 2005, and 2006 Lease termination: December 31, 2006

57. There are no transfer of title nor purchase option clauses. Lee anticipates the asset will “be worth” $1,500,000 on December 31, 2006. Lee’s implicit interest rate on the transaction is 8%. The lease is an operating lease because it does not meet even 1 of the 4 criteria.

58. Notes... –PV of MLP = $100,000 down payment + $509,252 (see computation following) = $609,252. –This is not  90% of the asset’s estimated FMV of $1,800,000. ($609,252  $1,800,000 = 33.84%) Present value of annual lease payments: n = 3; i = 8%; payments = $197,607; future value = $0 (the lessee is not obligated to make any payment). PV = $509,252

59. Lessor Example: Capital Lease (Direct Financing) Facts: On Jan. 1, 2004, Lockheart (lessor) and Ohh (lessee) signed a lease contract whereby Ohh agrees to lease an asset with an estimated useful life of 6 years, and a $0 estimated salvage at the end of 6 years. Terms follow. No separate down payment. Lease payments of $380,555 due on January 1 of the years 2004 – 2009 (i.e., no January 1, 2010 payment)

60. Ohh does not guarantee any residual price at the end of 6 years; GRV = $0. The lease contains no transfer of title nor purchase option clauses. Lockheart’s implicit interest rate = 8%. On Lockheart’s balance sheet, the leased asset has a book value of $1,900,000 The asset’s estimated FMV is $1,900,000

61. Determination of Lease Classification The “lease” is capitalized because the lease term of 6 years is  75% of the asset’s estimated useful life of 6 years! The lease is a direct financing lease because the asset’s book value equals its FMV.

62. Direct financing lease... The “lease receivable” is initially recorded at $1,900,000: n = 6; i = 8%; payments = $380,555 (annuity due); future value = $0; PV = ? = $1,900,000. –The first payment of $380,555 immediately reduces the lease receivable. In 2004, Lockheart recognizes interest income of $121,556: ($1,900,000 - $380,555) × 8% = $121,556

63. Lessor Example: Capital Lease (Sales-type lease) Consider the previous example. The facts are the same except that the leased asset’s book value on January 1, 2004 = $1,500,000. On January 1, 2004, Lockheart (lessor) and Ohh (lessee) signed a lease agreement. Ohh agrees to lease an asset with an estimated useful life of 6 years and an estimated salvage at the end of 6 years of $0; and, all other terms of the lease are identical.

64. Determination of Lease Classification The lease is capitalized because the lease term of 6 years is  75% of the asset’s estimated useful life of 6 years. The lease is a sales-type lease because the book value of the asset is less than its FMV. In 2004, Lockheart recognizes sales of $1,900,000, cost of sales of $1,500,000 and gross profit of $400,000. The receivable and interest income details will be identical to the Direct Financing case.

65. End of Chapter 7