978-0324651140 Chapter 10 Lecture Note

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.