122. What are the general principles for measuring financial instruments.
MEASUREMENT OF FINANCIAL INSTRUMENTS: GENERAL PRINCIPLES
The term financial instrument refers to a financial arrangement in which a firm contracts to receive or make
specified payments in the future in return for cash or other resources paid or received currently. Notes, bonds,
and leases are financial instruments. Derivatives are also financial instruments. A characteristic of financial
instruments is that they specify the means of calculating the amounts that firms will receive or pay at specified
times in the future.
The accounting measurement of notes and bonds payable follows two general principles:
To understand the accounting for notes and bonds, we need two additional definitions:
U.S. GAAP and IFRS permit firms to account for notes and bonds under one of two approaches:
123. How are notes valued and accounted for under the authoritative guidance?.
ACCOUNTING FOR NOTES
Firms typically borrow from banks, insurance companies, and other financial institutions by signing a note,
which specifies the terms of the borrowing arrangement.
The carrying value of the loan on subsequent accounting periods equals the present value of the remaining cash
flows discounted at the initial yield required by the lender at issuance
An amortization schedule shows the amount of interest expense and cash payments each payment period and
the resulting reduction in the carrying value of the loan during the periods. The interest expense equals the
required yield times the unpaid balance of the loan at the beginning of each payment period. Common
terminology refers to the calculations for amortizing a financial instrument to its maturity value over time as the
effective interest method. The effective interest method has the following features:
124. What are the cash flows patterns related to bonds?
ACCOUNTING FOR BONDS
Firms typically issue bonds on the market to large numbers of debt investors to obtain cash for long-term
purposes. The provisions of bond issues vary widely, depending on the firm’s cash needs over time and the
preferences of investors in the bonds. Investment bankers often advise corporate borrowers on the sorts of
financial instruments the lending market appears to prefer at the time the firm wants to borrow.
The bond contract specifies the basis for computing all future cash flows for that bond issue. Identifying those
cash flows is the starting point to account for the bond both initially and at each subsequent measurement date.
CASH FLOW PATTERNS FOR BONDS
embedded in the maturity value.
125. How are bonds measured at issuance?
INITIAL MEASUREMENT OF BONDS
The initial issue price of a bond depends on two factors:
126. What are the requirements for the disclosure of the carrying and fair values of debt?
DISCLOSURES OF CARRYING AND FAIR VALUES OF DEBT
Authoritative guidance requires firms that account for notes and bonds using the historical market interest rate
127. Discuss the fair value option in accounting for certain assets and liabilities.
FAIR VALUE OPTION
U.S. GAAP and IFRS allow firms to account for certain financial assets and certain financial liabilities,
including notes and bonds, using either (1) amortized cost, with measurements based on the historical market
interest rate, or (2) fair value, with measurements based on current market conditions, including the current
market interest rate. Authoritative guidance has taken the position that measurements of financial assets and
UNDERLYING CONCEPTS FOR FAIR VALUE OPTION
Fair value is the amount a firm would receive if it sold an asset or would pay if it transferred, or settled, a
liability in an orderly transaction at the measurement date. Determining fair value
Measuring fair value also rests on the assumption that the market participants in the principal (or most
advantageous) market are independent of the reporting entity, knowledgeable about the asset or liability, and
willing and able to engage in a transaction with the reporting entity. Fair value must reflect assumptions that
market participants, as opposed to the reporting entity, would make about the best use of a financial asset or the
best terms for settling a financial liability. The best use for a financial asset might be to combine it with other
assets, as when an automobile manufacturer uses customer financing, which generates receivables, to enhance
sales of its automobiles. The best use for a financial asset might be as a stand-alone asset, as when an
investment bank purchases and sells automotive receivables for profit.
Inputs to measuring fair value fall into three categories:
128. Describe the various methodologies in accounting for leases.
ACCOUNTING FOR LEASES
An alternative to borrowing cash to purchase buildings, equipment, and certain other assets is signing a contract
to lease the property from its owner, called the lessor. Leases vary in their characteristics but all convey to the
lessee the right to use an asset. In some cases the lessor enjoys the rewards and bears most of the risks of
ownership, whereas in other cases the lessee, or user of the property, enjoys the rewards and bears most of these
risks. U.S. GAAP and IFRS provide for two methods of accounting for long-term leases: the operating lease
method and the capital or finance lease method. The operating lease method is appropriate when the lessor
enjoys most of the rewards and bears most of the risks of ownership. The leased property is an asset on the
129. Describe the effect of the operating and capital lease methods on the financial statements of the lessee.
EFFECT OF THE OPERATING AND CAPITAL LEASE METHODS ON THE FINANCIAL STATEMENTS
OF THE LESSEE
130. Define the following terminology with respect to bonds:
REVIEW OF BOND TERMINOLOGY
1. The bond contract specifies the basis for computing all future cash flows for that bond issue. Identifying
those cash flows is the starting point to account for the bond both initially and at each subsequent measurement
date.
2. Terminology with respect to bonds includes the following:
131. What factors enter into choosing the accounting method for leases under U.S. GAAP and IFRS?
CHOOSING THE ACCOUNTING METHOD FOR LEASES
The capital lease method results in larger long-term debt and debt-equity ratios during the life of a lease than the
operating lease method. A larger debt ratio makes a firm appear more risky. Thus, given a choice, lessees tend
1. The lease transfers ownership of the leased asset to the lessee at the end of the lease term.
2. Transfer of ownership at the end of the lease term seems likely because the lessee has a bargain purchase
option. A bargain purchase option gives the lessee the right to purchase the leased asset at a specified future
time for a price less than the currently predicted fair value of the property at that future time.
fourth criterion has presented the most difficulties in practice because small changes in the amount or timing of
lease payments can shift the present value of the lease payments to just below or just above the 90% threshold.
IFRS Criteria for Lease Accounting
IFRS uses the same general criterion for classifying leases: Which party to the lease enjoys the rewards and
bears the risk in a leasing arrangement? Unlike U.S. GAAP, IFRS does not specify strict percentages, such as
the 75% useful life criterion or the 90% present value criterion. Instead, IFRS identifies several indicators about
which entity enjoys the rewards and bears the risk in the leasing arrangement and permits firms and their
independent accountants to apply their professional judgment to classify a lease as an operating lease versus a
capital lease. The criteria are similar to those of U.S. GAAP but not as specific:
132. How does a lessor account for leases?
ACCOUNTING BY THE LESSOR
The entries to account for operating leases and capital leases for the lessor mirror those for the lessee, but there
are some important differences.
Lessor Accounting for Operating Leases
133. What disclosures are required for leases?
LEASE DISCLOSURES
134. What are the effect of the operating and capital lease methods on the financial statements of the lessor?
EFFECT OF THE OPERATING AND CAPITAL LEASE METHODS ON THE FINANCIAL STATEMENTS
OF THE LESSOR
135. When a company issues bonds, it must sometimes issue them at a discount, while at other times it will
issue them at a premium.
Required:
Discuss the economic circumstances that surround the situations where bonds are issued at discounts or
premiums. Use examples where appropriate.
136. Consider a firm that recently issued bonds. Further, consider that the firm also set up a bond sinking fund.
Required:
a.
Why would a firm create a long-term liability?
b.
Why would a firm set up a bond sinking fund?
c.
If a firm paid $10,000 into its bond sinking fund at the end of the year, how would this transaction be
journalized?
b.
A firm would set up a sinking fund to accumulate funds to eventually retire the bonds. The existence
of the fund would mitigate the need for a large, lump sum payment when the bonds are due to retire.
c.
Debit to bond sinking fund (noncurrent asset) and credit to cash.