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10-1 Notes
CHAPTER 10
NOTES, BONDS, AND LEASES
I. Learning Objectives
1. Develop the skills to compute the issue price, carrying value, and current
fair value of notes and bonds payable in an amount equal to the present
value of the future contractual cash flows by applying the appropriate
discount rate.
2. Understand the effective interest method, and apply it to debt amortization.
3. Understand the application of the fair value option to financial liabilities.
4. Develop an ability to distinguish between capital or finance leases and
operating leases based on their economic characteristics, accounting
criteria, and financial statement effects.
5. Develop the skills to account for capital or finance leases and operating
leases.
II. Organization of Class Sessions
This chapter discusses the accounting for long-term notes, bonds, and
leases. We emphasize two main topics in this chapter concerning the criteria
of accounting for these obligations in a firm:
(1) Amortized cost measurement, based on the historical market interest
rate. (2) Fair value measurement, based on the current market interest rate.
An idealistic approach would be to start with a brief introduction on
the sources of long-term finance and additional definitions concerning
accounting for notes and bonds (i.e., Historical Market Interest Rate and
Current Market Interest Rate) during the first session. Later three to four
session on accounting for Notes, Bonds. Bring out the various types of Bond
issues and the accounting treatments. Two sessions on the accounting for
leases and the effect of different leases on the financial statements. Also,
highlight on the U.S GAAP criteria for lease accounting and IFRS criteria
for lease accounting and the difference in-between these two.
III. Lecture Outline
Notes 10-2
1. Develop the skills to compute the issue price, carrying value, and
current fair value of notes and bonds payable in an amount equal to
the present value of the future contractual cash flows by applying the
appropriate discount rate.
We use the unifying principles of long-term liabilities from the text to
emphasize that
(1) A financial instrument, such as a bond, commits the firm to make
prescribed cash payments in the future, and
(2) The issue price equals the present value of those future cash flows
using a discount rate appropriate to the risk level appropriate for the issuer
and the instrument issued.
Various financial instruments have differing patterns and amounts of
the promised cash payments. The investor looks to the bond contract to
identify the cash flows of a particular investment. The terminology used for
bonds is new to most students and a source of confusion when they confront
this topic. Consider the following terms: par value, face value, book value,
current value, coupon (interest) rate, historical market interest rate, and
current market interest rate. As the text points out, much of the confusion
results from not keeping distinct the coupon rate and the historical market
interest rate. We think you will find it productive insisting that the
students not be allowed to think of the coupon payments as interest. Only in
the razor’s edge case where the historical market rate equals the coupon
rate, so the instrument issues exactly at face value will the coupon payment
amount equal the interest expense amount. We find the following helpful in
delineating these terms:
The par or face value and the coupon (interest) rate determine the
promised cash payments on a bond. (We show the word interest here only
because so many people use it in this context; we advise against it. Once the
students understand why the coupon payment amount is not the amount of
interest, then they can be free to be loose with the word.)
The promised cash payments on a bond and the historical market
interest rate determine the book value of the bond.
The promised cash payments on a bond and the current market
interest rate (or term structure of future rates, but out text does not explore
the term structure and its implications for fixed payment securities)
determine the current market value of the bond.
For example: Initial issue proceeds for a 12-percent, semiannual
coupon bond with a par or face value of $100,000 maturing in 10 years. The
10-3 Notes
issue price differs depending on the market required interest rate, or yield,
at the time of issue. The issue price equals the par or face value if the
market interest rate equals the coupon rate of 12 percent compounded
semiannually. The issue price exceeds the par or face value if the market
interest rate is less than the coupon rate. The issue price is less than the
par or face value if the market interest rate exceeds the coupon rate. The
entries that the accountant might logically make for these three possibilities
appear below (Schedule 10.1 in this instructor's manual shows the
supporting computations):
Time of Issue: Market Interest Rate at Time of Issue
12% 10% 14%
Even though these entries at the time of issue capture the economics of
the two promised types of future cash flows, accounting typically records
both in a single credit entry to bonds payable. Some textbooks use a bond
premium or bond discount account when the issue price differs from the par
or face value of the bonds. We find this approach confusing to students.
Showing a single amount in the bonds payable account permits the
generalization that the book value of a bond always equals the present value
of the bond's promised future cash flows discounted at the historical market
interest rate.
We assign one or two problems that require students to compute the
issue price of bonds (Exercises 10.16 and 10.17) before introducing the
calculation of periodic interest expense. We find that this sequencing
hammers home the concept that the initial book value is a present value
calculation. We also introduce the use of bond tables at this point (Problem
10.31).
2. Understand the effective interest method, and apply it to debt
amortization.
We find it helpful to begin by having students construct an
amortization table for the full length of a financial instrument (Exercises
10.15 and 10.18). This step demonstrates how the initial issue price of the
bond decreases to zero over the life of the bond. We emphasize two concepts
Notes 10-4
once we have a full amortization table on the board or an overhead
transparency:
(1) The passage of time causes interest to accrue and the book value of the
bond to increase, but cash payments cause the book value of the bond to
decrease, and
(2) The book value of the bond at the end of any period equals the present
value of the remaining cash flows discounted at the historical market
interest rate.
The final step in the conceptual development shows that interest
We work several bond problems to illustrate the calculations and
journal entries for bonds while they are outstanding. (Exercises 10.19,
10.23, and 10.24)
3. Understand the application of the fair value option to financial
liabilities.
We start stating that 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, as illustrated in previous sections of this chapter, or
(2) Fair value, with measurements based on current market conditions,
including the current market interest rate.
Determining fair value rests on the assumption that the transaction
would occur in the principal market for the asset or liability or, in the
10-5 Notes
absence of a principal market, in the most advantageous market from the
viewpoint of the reporting entity. 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.
Because the fair value option offers a free choice between measurement
at fair value and measurement at amortized cost, firms will likely report
some financial instruments using historical market interest rates (amortized
cost measurement) and some using fair values. The disclosure requirements
attempt to provide sufficient information to enable the user of the financial
statements to understand the effect of this mixture of accounting
measurements. Refer Problem 32 which narrates to find out the net income
before taxes assuming fair value option of FASB Statement No. 159.
4. Develop an ability to distinguish between capital or finance leases
and operating leases based on their economic characteristics,
accounting criteria, and financial statement effects.
We pose the following situations and ask whether the lessor or lessee
appears to be assuming most of the risk in the leasing transaction.
A. An airline leases a Boeing 767 for a ten-year period. At the end of the ten
years, the aircraft reverts to the lessor. The lessor expects to sell the
aircraft on the open market at that time.
B. Same as the situation in 1. above except that the lease runs for a 20-year
period. Because of changes in technology and the unknown condition of
the aircraft at the end of 20 years, the lessor cannot accurately predict
the salvage value at the end of the lease period.
C. Same as 2. above except that the lease period runs for 30 years and the
airline can purchase the aircraft for $1 at the end of the lease period.
It seems clear that the lessor bears most of the risk in the first
situation above whereas the lessee bears most of the risk in the third
situation. Not all agree about the second. If the airplane becomes
technologically obsolete during the first 20 years, the lessee is still liable for
the payments. This puts the lessee at risk. If the lease payments have
present value approximately equal to the outright-sales price, then the
lessee has the risk. If, on the other hand, participants think airplanes likely
Notes 10-6
have useful lives substantially beyond 20 years, then the lessor bears the
risks. These three situations help to motivate the four criteria for classifying
a lease as an operating lease and a capital lease under GAAP. List the four
criteria on the board or an overhead transparency and discuss how each of
the criteria attempts to identify the party bearing most of the risk.
(Questions 10.4 and Exercise 10.26)
We next ask students to give the journal entries a lessee would make
under an operating lease and a capital lease, both at the time of signing and
in each subsequent period. We indicate that the journal entries under the
capital lease method are similar to the entries a firm would make if it
purchased the asset and gave the seller an installment note payable. We
contrast the different effects of the operating and capital lease method on
the balance sheet and the income statement. We tend not to emphasize
accounting by the lessor at this time. (Questions 10.5, 10.6, and 10.7,
Exercise 10.28 and Problem 10.33)
Students tend to experience greater difficulty with the lessor's
accounting. We ask students to give the lessor's journal entries for an
operating and a capital lease, both at the time of signing and in subsequent
periods. We indicate that the journal entries under the capital lease method
are similar to the entries a firm would make if it sold the asset and received
an installment note receivable from the buyer. (Exercise 10.27 and Problem
10.33)
We suspect that the issues of disaggregating a lease payment into its
various components for the asset, the financing, the service, and the
maintenance will become significant during the life of this edition of the
textbook.
The issue arises as follows, when the FASB, in 1976, first issued its
leasing rules, most leases were for the use of the asset. Think about a
copier. Now, the customer/lessee wants a full service package, including
copier, toner, service, regular maintenance, and emergency service. The
lessor accommodates the customer by packaging all these together and
quoting a single monthly price. GAAP requires that the lessor disaggregate
that single monthly receipt into components using as a basis the prices the
lessor charges for the components when it sells or leases them separately.
The problem is that many lessors do not sell the components separately.
Xerox, for example, rarely leases or sells a copier without financing or toner
or maintenance or emergency service. You can introduce these issues and
leave the details to a second accounting course.
10-7 Notes
5. Develop the skills to account for capital or finance leases and
operating leases.
Start of with the two methods of accounting for long-term leases,
namely operating lease method and the capital or finance lease method. To
understand with the concept of this illustrate the below example.
Food Barn wants to acquire a computer that has a three-year life and a
purchase price of $45,000. Assume that Food Barn must pay 8% per year to
borrow funds for three years. The computer manufacturer will sell the
computer to Food Barn for $45,000 or lease it for three years for $17,461.51
per year, payable at the end of each year. In practice, lessees usually make
payments in advance, but assuming the payments occur at year-end
simplifies the computations. Food Barn must pay for property taxes,
maintenance, and repairs of the computer whether it purchases or leases.
Food Barn signs the lease on January 1, 2008.
If the lease specifies that the lessee must return the leased asset to the
lessor at the end of the lease term, the lessor must then re-lease or sell the
asset. The lessor bears the risk of technological change and other factors
that would affect its ability to lease or sell the asset. If the computer
manufacturer, and not Food Barn, bears most of the risks of ownership,
accounting considers the lease to be an executory contract and treats it as an
operating lease. Food Barn would make no entry on January 1, 2008, when
it signs the lease. Illustrate with Exercise 25, and Problem 33.
If the periodic rental payments vary with changes in interest rates,
then Food Barn, not the computer manufacturer, bears interest rate risk. If
the lease period approximately equals the useful life of the leased asset, then
Food Barn bears the risk of factors that affect the market value of the asset.
If Food Barn—not the computer manufacturer—bears most of the risks of
ownership, accounting views the arrangement as a form of borrowing to
purchase the computer Food Barn must account for it as a capital lease. This
treatment recognizes the signing of the lease as the simultaneous acquisition
of a long-term asset and the incurring of a long-term liability for lease
payments. At the time Food Barn signs the lease, it records both the leased
asset and the lease liability at the present value of the required cash
payments, $45,000 in this example. At the end of each year, Food Barn must
account for the leased asset and the lease liability. Illustrate the same with
the exercise 26, 27, 28
Elucidate that the leased asset and the lease liability appear on the
lessee’s balance sheet under the capital lease method, whereas neither
appears on the lessee’s balance sheet under the operating lease method. The
Notes 10-8
operating lease method classifies all of the lease payment each period as an
operating use of cash on the statement of cash flows. The capital lease
method classifies the portion of the lease payment related to interest
expense as an operating use of cash and the portion related to a reduction in
the lease liability as a financing use of cash. In addition, the lessee adds
depreciation expense to net income or net loss to compute cash flow from
operations. Illustrate the same with Problem 35, 36. Bring out the U.S.
GAAP Criteria and IFRS Criteria for Lease Accounting.
