FAR M4

• An asset retirement obligation exists when an asset is constructed and there are legal requirements to incur removal-type costs related to the constructed asset
• The increase in an ARO liability due to the passage of time is known as accretion expense
• Beginning ARO

  Times: Credit-adjusted risk-free interest rate

  Equals: ARO accretion expense
• For an ARO, the reported liability is the present value of the future obligation, which is the estimated fair value of the liability.
• Gain contingencies should be disclosed in the notes unless the likelihood of the gain being realized is remote.
• A contingent liability that is probable and estimable must be recognized. If all amounts within a range of values are equally likely, then the lowest amount in the range is the measurement amount. 
• If a loss is reasonably possible, how much loss should be accrued?

  NONE (only footnote disclosure is required if the loss is not probable)
• In a business combination, the investment is valued at the fair value of the consideration given or the fair value of the consideration received, whichever is more clearly evident.
• Paxton Co. signed contracts for the purchase of raw materials to be executed the following year at a firm price of $5 million. The market price of the materials dropped below that price on December 31.

  
  

  The estimated liability on purchase commitments as of December 31 would be the amount committed for purchase LESS the new market value
• Pie Co. uses the installment sales method to recognize revenue. Customers pay the installment notes in 24 equal monthly amounts, which include 12% interest.

  An installment note's receivable balance six months after the sale would be the present value of the remaining monthly payments discounted at 12%.
• Noninterest bearing notes payable are reported at the present value of future cash flows.
• Normally interest is imputed when no, or an unreasonably low, rate is stated. An exception exists for receivables and payables arising from transactions with customers or suppliers in the normal course of business when the trade terms do not exceed one year.
• According to GAAP, financial instruments in the form of shares that meet the following criteria are presented as liabilities and not equity:

  • mandatorily redeemable
  • represent an unconditional obligation of the issuer which must be satisfied by transferring assets at a specified date
• The discount on a note payable should be reported on the balance sheet as a direct reduction from the face amount of the note.
• A discount on a note payable is calculated using the imputed interest rate.
• Total note payable payments

  Less: Principal paid at present value

  Equals: Total interest revenue earned over life of note
• EBIT (earnings before interest and tax) formula:

  Income before taxes plus interest expense
• EBITDA (earnings before interest, taxes, depreciation, + amortization) formula:

  Income before taxes

  Plus: interest expense

  Plus: depreciation/amortization
• A gain or loss on bond retirements is reported in:

  
  

  a)income from continuing operations

  b) other comprehensive income

  
  

  Answer: income from continuing operations
• When assets are transferred in a troubled debt restructuring, the asset is adjusted to fair value and a gain or loss is recorded.
• If a bond was originally issued at a discount (96% of par) and was redeemed at a price above par (102%), the result is a loss, which will be booked in income from continuing operations.
• Criteria for classification as a finance lease (OWNES)

  • O - ownership transfers to the lessee at the end of the lease
  • W - Written purchase option the lessee is reasonably certain to exercise
  • N - Net PV of minimum lease payments = Fair value of the leased asset (approximately 90%)
  • E - Lease term = Major part (75%) of asset's economic (useful) life
  • S - Asset is specialized such that it has no alternative use to the lessor
• Upon entering into an operating lease, when should the recognition of lease expense occur?

  commencement date, or the date the underlying asset is made available to the lessee for use.
• A lessee calculates lease payments at commencement of the lease based on the present value of the following items:

  • fixed payments
  • variable payments
  • exercise price of purchase option
  • termination penalties
  • the probable amount owed of the guaranteed residual.
• Lease expense must be reported on a straight-line basis. When lease rates fluctuate and when reduced costs are given, the average lease rate must be computed.
• With a finance lease, the lessee should amortize the leased property over the

  • ECONOMIC life of the asset when there is a written purchase option, or
  • when the lessee takes ownership of the asset at the end of the lease term
• If a lease does not meet the Ownership Transfer or Written Purchase Option criteria of OWNES, the leased asset will be depreciated over the term of the lease, not the life of the asset.
• A company issued bonds with detachable common stock warrants. The issue price exceeded the sum of the warrants' fair value and face value of the bonds. The fair value of the bonds cannot be determined.

  
  

  What value, if any, should be assigned to the warrants?

  The fair value of the warrants; the remainder of the issuance price not allocated to the warrants would then be allocated to the bonds.
• • Debentures are unsecured corporate bonds
  • Serial bonds mature in installments
  • Term bonds have a single fixed maturity date
• For par value bonds, the market rate at issuance will equal the coupon rate on the bond.
• How is a par value bond amortized?

  a)at a discount

  b)at a premium

  c)None of the above; no premium or discount to amortize

  ANSWER: c
• A 15-year bond was issued in Year 1 at a discount. During Year 11, a 10-year bond was issued at face amount with the proceeds used to retire the 15-year bond at its face amount.

  
  

  The long-term liabilities will increase by the difference between the carrying amount of the old 15-year bond and the face amount (issuing price) of the new 10-year bond.
• Bond issuance costs are:

  • deducted from the carrying value of the bond liability
  • amortized over the life of the bond (as a part of the discount/premium)using the effective interest method
• When calculating the present value of the principal payment, use the effective (market) rate on the date the bond was issued.
• Formula for interest expense:

  Carrying value of the bond at the beginning of the period

  Times: effective (market) interest rate
• Formula for interest payable:

  Face value of the bonds at the beginning of the period

  Times: contractual (stated) interest rate.
• When a discount on a bond/note is amortized, the discount amortization increases interest expense for the period.
• Interest expense is recognized for the ENTIRE period from bond issuance all the way thru the fiscal year end.

  
  

  The time period from the most recent interest payment date through the fiscal year end would represent the interest accrual.
• The higher the Times Interest Earned ratio, the better it is for a company paying interest on the debt.

  Times Interest Earned ratio formula: EBIT/interest expense
• When purchasing a bond, the PV of the bond's expected net future cash inflows discounted at the market rate of interest provides the bond's:

  
  

  a)Interest

  b)Yield

  c)Price

  d)Par

  
  

  Answer: c)Price