MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

1
MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING
REPORTS
Baginski Hassell
Electronic presentation adaptation by Dr.
Barbara L. Hassell Dr. Harold O. Wilson
2
Chapter 7
INVESTING DECISIONS Investing in Other Firms'
Debt
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 are
  using 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 gt 1 year

8

• Available-for-sale securities are
  marked-to-market!
• Unrealized gains (losses) are reported in the
  Statement of Comprehensive Income (other
  comprehensive income section).
• Therefore, income is not affected.

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. 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 Computation
Beginning of the Period Carrying (Book) Value
x Historical 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, 2001, 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, 2008, 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 a 5.3 stated rate
  per year
• n 14 (7-year bonds, with interest paid
  semiannually)
• interest collection per period 160,000
  4,000,000 x 8 x 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, 2001, the Beane Co. purchased
  the following investment for 2,760,000,
  including transactions costs 3,000,000 in 7
  bonds due July 1, 2006, 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.
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Beane Co. Calculation of Effective Interest
Rate

• The purchase price reflects a 4.51 semiannual
  effective interest rate
• n 5 x 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

• 2001 Interest income 124,476
  (2,760,000 x 4.51
• Dec. 31, 2001 Interest receivable 105,000
  (1/2 years cash interest receivable
  3,000,000 x 7 x ½)
• 2001 Bond discount amortization
  124,476 - 105,000 19,476

16

• Dec. 31, 2001 Amortized cost 2,779,476
  (2,760,000 19,476)
• July 1, 2001 bond discount
  3,000,000 - 2,760,000 240,000
• December 31, 2001 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

2001 interest income
124,476 Dec. 31, 2001 interest receivable
105,000 2001 bond discount amortization
19,476 Dec. 31, 2001 amortized cost
2,779,476
18

• Therefore, at December 31, 2001, Beanes
  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?
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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
Statement of Comprehensive Income
Net income effect (ignoring income taxes)
Effect of interest income 124,476
Other comprehensive income
Unrealized gains (losses) on available-for-sale securities 120,524
22
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

2001 interest income
124,476 Dec. 31, 2001 interest receivable
105,000 2001 bond discount amortization
19,476 Dec. 31, 2001 amortized cost
2,779,476
23

• Therefore, at Dec. 31, 2001, Beanes
  investment has a 120,524 unrealized gain
• FMV 2,900,000
• Amortized cost 2,779,476
• Unrealized gain 120,524
  

Under Held-to-Maturity classification, the
unrealized gain is NOT recognized!
24
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
25
Balance Sheet
Non-current assets
Investments in bonds 2,900,000
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
26
Statement of Comprehensive Income
Net income effect (ignoring income taxes)
Effect of interest income 124,476
Other comprehensive income
Unrealized gains (losses) on held-to-maturity securities No effect
27
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.

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• Prior facts and computations
• 2001 interest income 124,467
  Dec. 31, 2001 interest receivable
  105,000
• Adjusted information
• 2001 bond discount amortization 0
  Dec. 31, 2001 cost 2,760,000
• Therefore, at Dec. 31, 2001, Beanes investment
  has a 140,000 unrealized gain
• 2,900,000 (FMV) versus 2,760,000 (cost)

29
Beane Co. Financial Statements Trading
Classification
Statement of Cash Flows Statement of Cash Flows
Operating activities Operating activities
Interest payment received Interest payment received 0
Investing activities Investing activities
Purchase bonds (2,760,000) (2,760,000)
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Income Statement
Other revenues, (expenses), gains, (losses)
Interest income 105,000
Unrealized gains (losses) on trading securities) 140,000
245,000
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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
32
Statement of Comprehensive Income
Net income effect (ignoring income taxes)
Effect of interest income and unrealized gain on net income 245,000
Other comprehensive income
Unrealized gains (losses) on trading securities No effect
33
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 gt 1 year
  at date of execution)

34
Note Receivable Example (General Rule,
Stated Interest Rate Market Rate at Date of
Execution)

• Facts On January 1, 2001, the Simpson Co.
  loaned 2,000,000 to a key supplier under the
  following terms Principal due on December 31,
  2002 interest paid annually on December 31, 2001
  and 2002 stated interest rate is 8. The
  appropriate market rate of interest for this type
  of loan on January 1, 2001 is 8.

35
Simpson Co. Note Receivable Financial
Statement Effects
Statement of Cash Flows 2001 2002
Operating Activities
Interest received 160,000 160,000
Investing Activities
Loans to suppliers (2,000,000)
Collections on Notes Receivable 2,000,000
36
Income Statement 2001 2002
Other revenues (expenses), gains, (losses)
Interest income 160,000 160,000
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Balance Sheet (12/31) 2001 2002
Current assets
Notes receivable 2,000,000 0
Stockholders Equity
Retained earnings
Effect on net income, ignoring income taxes 160,000 320,000
38
Statement of Comprehensive Income 2001 2002
Net income effect, ignoring income taxes
Effect of interest income on net income 160,000 160,000
Other comprehensive income 0 0
39
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.

40
Receivables Loan Impairment

• Impairment recognition criteria
• Carrying value
• of the receivable

PV of any new estimated future cash
collections()
() Using historical, effective interest rate.
41
Example of a Receivable Debt Impairment and
Settlement

• Facts On Dec. 31, 2001, the Schmenner Co. had
  the following accounts related to its Jan. 1,
  2000 note receivable from the James Co., which is
  due Jan. 1, 2004
• Principal 4,000,000
• Interest receivable 280,000
• Stated and historical effective rate 7
• Annual interest payments Jan. 1

42
Schmenner Co. Example Impairment

• Schmenners 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,
  2002, 2003, and 2004 interest payments, and
  collect 3,600,000 principal on January 1, 2004.

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Solution

• Carrying value of the Jones 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, 2002 interest payment
  200,000, plus
• - Present value of January 1, 2003 and 2004
  interest payments plus principal 3,505,983
• n 2, i 7, payments 200,000, future value
  3,600,000
• Present value 3,505,983

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• Schmenners 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 bed debts expense, impairment losses are
  charged to the allowance for doubtful accounts.

45
Schmenner Co. 2001 Financial Statement Effects of
Loan Impairment
Statement of Cash Flows 2001
Operating activities
Interest Received (for 2000) 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)
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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)
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Statement of Comprehensive Income
Net income effect (ignoring income taxes)
Effect of interest income and impairment loss on net income (294,017)
Other comprehensive income 0
48
Trouble Debt Settlement

• Use the previous Schmenner example.
• On December 31, 2001, the Schmenner Co. had the
  following accounts related to its January 1, 2000
  note receivable from the James Co., which is due
  January 1, 2004
• Principal 4,000,000
• Interest receivable 280,000
• Stated and historical effective rate 7
• Annual interest payments, due on Jan. 1.

49
Negotiation ...

• Assume that to settle James debt on December
  31, 2001, Schmenner accepted from James
• land with a FMV of 2,000,000, and
• James common stock with a FMV of 1,600,000.
• Schmenners gain
• 4,280,000 - 3,600,000 680,000

50
Financial Statement Effects of Debt Settlement
Statement of Cash Flows
Operating activities
Interest received (for 2000) 280,000
Significant non-cash financing and investing activities
Acquired land and common stock in debt settlement 3,600,000
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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)
52
Balance Sheet (December 31)
Non-current assets
Investments in common stock 1,600,000
Land 2,000,000

Stockholders Equity
Retained Earnings
Effect on net income, ignoring income taxes (400,000)
53
Statement of Comprehensive Income
Net income effect, ignoring income taxes
Effect of interest income and debt settlement on net income (400,000)
Other comprehensive income 0
54
Troubled Debt Modification of Terms

• Assume that on December 31, 2001, the Hendricks
  Co. had the following accounts related to its
  note receivable from the Shane Co.
• Principal 500,000
• Interest receivable 75,000
• 2001 interest income 75,000
• Historical effective interest rate 9

55
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.

56
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)
57
Balance Sheet (December 31)
Non-current assets
Notes receivable 400,000
Stockholders Equity
Retained Earnings
Effect on net income, ignoring income taxes (100,000)
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Statement of Comprehensive Income
Net income effect (ignoring income taxes)
Effect on net income (100,000)
Other comprehensive income 0
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Lease Receivables

• Determination of capital lease classification
  (as versus an operating lease)
• Must capitalize by recognizing a lease
  receivable if the contract meets at least one
  of four specific criteria.

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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 items FMV?

In operating leases the assets stay on the
lessors books, where rent revenue is accrued!
61
Lease Receivable and
Lessors 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.

62

• Sales-type (dealer or manufacturer, where FMV
  gt 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

63
Lessor Example Operating Lease

• Facts The Lee Co. (lessor) and a lessee signed
  a lease agreement on January 1, 2001. 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, 2001, 2002, and 2003 Lease
termination December 31, 2003
64

• There are no transfer of title nor purchase
  option clauses.
• Lee anticipates the asset will be worth
  1,500,000 on December 31, 2003.
• Lees 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.
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Notes ...

• PV of MLP 100,000 down payment 509,252
  (see computation following) 609,252.
• This is not ? 90 of the assets 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

66
Lessor Example Capital Lease (Direct Financing)

• Facts On Jan. 1, 2001, 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 2001 2006 (i.e., no January 1, 2007
  payment)

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• 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.
• Lockhearts implicit interest rate 8.
• On Lockhearts balance sheet, the leased asset
  has a book value (and an estimated FMV
  1,900,000.

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Determination of Lease Classification

• The lease is capitalized because the lease term
  of 6 years is ? 75 of the assets estimated
  useful life of 6 years!
• The lease is a direct financing lease because the
  assets book value equals its FMV.

69
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 2001, Lockheart recognizes interest income of
  121,556 (1,900,000 -
  380,555) x 8 121,556

70
Lessor Example Capital Lease (Sales-type lease)

• Consider the previous example. The facts are the
  same except that the leased assets book value on
  January 1, 2001 1,500,000.
• On January 1, 2001, 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.

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Determination of Lease Classification

• The lease is capitalized because the lease term
  of 6 years is ? 75 of the assets 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
  2001, 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.
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End of Chapter 7