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Appendix 9.1: A Closer Look at LIFO's Effects on Financial Statements

Appendix 9.1: A Closer Look at LIFO's Effects on Financial Statements

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Accounting for Bonds



Interest expense for the second six months (from January 1, Year 2, through June 30, Year

2) is $6,544 (= 0.07 × $93,484). It exceeds the $6,508 for the first six months because the

recorded book value of the liability at the beginning of the second six months has grown. The

journal entry on June 30, Year 2, to record interest expense follows:

6/30/Year 2

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To recognize interest expense for six months.



6,544

6,000

544



An amortization schedule for these bonds over their five-year life appears in Exhibit 11.3.

Column (3) shows the periodic interest expense, and column (6) shows the book value that

appears on the balance sheet at the end of each period.

The effective interest method of recognizing interest expense on a bond has the following

financial statement effects:

1. Interest expense equals a constant percentage of the recorded liability at the beginning of

each interest period. This percentage equals the market interest rate for these bonds when

the borrower issued them. When the borrower issues bonds for less than par value, the dollar amount of interest expense increases each period as the recorded carrying value amount

increases.

2. On the balance sheet at the end of each period, the bonds appear at the present value of

the remaining cash outflows discounted at the market interest rate measured when the borrower initially issued the bonds. For example, on July 1, Year 2, just after the borrower has

made a coupon payment, the remaining cash payments have present value computed as

follows:



(a) Present Value of $100,000 to Be Paid at the End of Four Years . . . . . . . . . . . . . . . . . . .

(Appendix Table 2 shows the present value of $1 to be paid at the end of eight

periods discounted at 7% to be $0.58201; $100,000 × 0.58201 = $58,201.)

(b) Present Value of Eight Remaining Semiannual Interest Payments Discounted

at 14% Compounded Semiannually . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(Appendix Table 4 shows the present value of an ordinary annuity of $1 per period for

eight periods discounted at 7% to be $5.97130; $6,000 × 5.97130 = $35,827.)

Total Present Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



$58,201



35,827



$94,028



The amount $94,028 appears in column (6) of Exhibit 11.3 for the liability at the end of the

second six-month period.



Bonds Issued at More Than Par The following discussion illustrates bonds issued

at more than par. Assume the data presented where the Macaulay Corporation issued 12%,

$100,000 par value, five-year bonds to yield approximately 10% compounded semiannually. The

issue price, derived previously, was $107,721. The journal entry at the time of issue follows:

7/1/Year 1

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



107,721

107,721



The firm borrows $107,721. The issuance of these bonds for $107,721, instead of the

$100,000 par value, indicates that 12% exceeds the interest rate investors (lenders) demand.

Their return comprises 10 coupon payments of $6,000 each over the next five years reduced by

the $7,721 (= $107,721 − $100,000) paid as part of initial amount transferred to the borrower

but not repaid at maturity.



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430



Chapter 11



Notes, Bonds, and Leases



For Macaulay Corporation, the total interest expense over the life of the bonds equals

$52,279 (= periodic payments totaling $60,000 less $7,721 received at the time of original

issue but not repaid at maturity). Following the next discussion will be easier if you refer to

Exhibit 11.4.



Interest Expense Under the Effective Interest Method Under the effective interest method, interest expense each period equals the market interest rate at the time the firm

initially issued the bonds (10% compounded semiannually, equals 5% per six months, in this

example), multiplied by the recorded book value of the liability at the beginning of the interest

period. For example, interest expense for the period from July 1, Year 1, to December 31, Year

1, the first six-month period, is $5,386 (= 0.05 × $107,721). The bond indenture requires the

borrower to pay $6,000 (= 0.06 × $100,000) on January 1, Year 2. This amount equals the coupon rate times the face value of the bonds. The difference between the payment of $6,000 and

the interest expense of $5,386 reduces the amount of the liability. The journal entry made on

December 31, Year 1, to recognize interest for the last six months of Year 1 follows:



EXHIBIT 11.4



Effective Interest Amortization Schedule for $100,000 of 12%,

Semiannual Coupon, Five-Year Bonds Issued for 107.721% of

Par to Yield 10%, Compounded Semiannually



Semiannual Journal Entry

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . .

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Assets



=



© Cengage Learning 2014



−col(4)



Liabilities

−col(5)



Period

(6-Month

Intervals)

(1)



Liability

at Start

of Period

(2)



0

1

2

3

4

5

6

7

8

9

10



$107,721

107,107

106,462

105,785

105,074

104,328

103,544

102,721

101,857

100,950



.............

.............

.............

.............

.............

.............

.............

.............

.............

.............

.............

Total . . . . . . . . . .



+



Amount in Column (3)

Amount in Column (5)

Amount in Column (4)



Shareholders’

Equity



(Class.)



−col(3)



IncSt → RE



Effective

Interest:

5% per

Period

(3)



Coupon

Rate:

6% of Par

(4)



Decrease in

Recorded

Book Value

of Liability

(5)



$ 5,386

5,355

5,323

5,289

5,245

5,216

5,177

5,136

5,093

5,050

$52,279



$ 6,000

6,000

6,000

6,000

6,000

6,000

6,000

6,000

6,000

6,000

$60,000



$ 614

645

677

711

746

784

823

864

907

950

$7,721



Liability

at End of

Period

(6)

$107,721

107,107

106,462

105,785

105,074

104,328

103,544

102,721

101,857

100,950

100,000



Note: In preparing this table, we rounded calculations to the nearest dollar.

Column (2) = column (6) from previous period.

Column (3) = 0.05 × column (2), except for period 10, where it is a plug.

Column (4) is given.

Column (5) = column (4) − column (3), except for period 10, where it is a plug.

Column (6) = column (2) − column (5).



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Accounting for Bonds



12/31/Year 1

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To recognize interest expense for six months.



5,386

614

6,000



Interest Payable appears as a current liability on the balance sheet at the end of Year 1.

Debenture Bonds Payable has a new balance of $107,107 (= $107,721 − $614), which appears

as a noncurrent liability.

On January 1, Year 2, the borrower makes the first periodic cash payment and the following

entry:

1/1/Year 2

Interest Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record payment of interest for six months.



6,000

6,000



Interest expense for the second six months (from January 1, Year 2, through June 30, Year

2) equals $5,355 (= 0.05 × $107,107). Because the amount of the liability has declined from the

beginning of the preceding period to the beginning of the current period, interest expense for

the period declines from $5,386 for the first six months, and the borrower records it as follows:

6/30/Year 2

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To recognize interest expense for six months.



5,355

645

6,000



An amortization schedule for these bonds over their five-year life appears in Exhibit 11.4.

Column (3) shows the periodic interest expense, and column (6) shows the book value that

appears on the balance sheet at the end of the period.

The effective interest method of recognizing interest expense on a bond has the following

financial statement effects:

1. Interest expense on the income statement equals a constant percentage of the recorded

liability at the beginning of each interest period. This percentage equals the market interest

rate when the borrower first issued the bonds. When the borrower issues bonds for more

than par value, the dollar amount of interest expense will decrease each period as the

unpaid liability decreases to the amount to be paid at maturity.

2. On the balance sheet at the end of each period, the bonds will appear at the present value

of the remaining cash flows discounted at the market interest rate when the borrower initially issued the bonds.



PROBLEM 11.4 FOR SELF-STUDY

Preparing journal entries to account for bonds. Refer to Problem 11.3 for Self-Study.

Prepare the journal entries on January 1, June 30, and December 31, Year 1, to account

for the bonds, assuming each of the following market-required interest rates at the time

the firm issued the bonds:

a. 8% compounded semiannually.

b. 10% compounded semiannually.

c. 12% compounded semiannually.



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432



Chapter 11



Notes, Bonds, and Leases



RETIREMENT



OF



DEBT



Many bonds remain outstanding until the stated maturity date. Refer to Exhibit 11.3, where

Macaulay Corporation issued 12% coupon bonds to yield 14%. The company pays the final

coupon, $6,000, and the face amount, $100,000, on the stated maturity date. The entries are as

follows:

7/1/Year 6

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

See row for Period 10 of Exhibit 11.3.

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record retirement at maturity of bonds.



6,936

6,000

936

100,000

100,000



Retirement Before Maturity A firm sometimes repurchases its own bonds from investors before maturity. Because of changes in market interest rates, the purchase price (that is, the

fair value of the bonds when they are repurchased) will seldom equal the balance sheet carrying

value of the bonds. Assume that Macaulay Corporation originally issued its 12% coupon bonds

to yield 14% compounded semiannually. Assume that three years later, on June 30, Year 4, market interest rates have increased so that the market currently requires Macaulay Corporation to

pay a 15% interest rate. We compute, but do not show the computations here, that the fair value

of 12% bonds with two years until maturity is 94.9760% of par when the current interest rate is

15% compounded semiannually.

Accounting principles and practices do not constrain the pricing of bonds in the marketplace. Even though Macaulay Corporation shows Debenture Bonds Payable on the balance

sheet at $96,612 (see row for Period 6 of Exhibit 11.3), the marketplace puts a price of only

$94,976 on the bond issue. From the point of view of investors, these bonds are the same as

two-year bonds issued on June 30, Year 4, at an effective yield of 15%, so they carry a discount

of $5,024 (= $100,000 – $94,976).

If on June 30, Year 4, Macaulay Corporation purchased $10,000 of par value of its own

bonds, it would pay $9,498 (= 0.94976 × $10,000) for those bonds, which have a book value of

$9,661. Macaulay would make the following journal entries at the time of purchase:

6/30/Year 4

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

See row for Period 6 of Exhibit 11.3.

Interest Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record payment of coupons, as usual.

Debenture Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Gain on Retirement of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record purchase of bonds for less than the balance sheet carrying value.

The gain is the difference between the purchase price and the balance sheet

carrying value.



6,713

6,000

713

6,000

6,000

9,661

9,498

163



The gain on bond retirement arises because the firm can extinguish a liability recorded at

$9,661, by paying a smaller amount, $9,498. The borrower enjoyed this gain as interest rates

increased between Year 1 and Year 4. Historical cost accounting reports the gain as earned

in the period when the borrower realizes it—that is, in the period when the borrower retires

the bonds. This phenomenon parallels the economic events that occur when a firm invests in

land, holds the land as its value increases, sells the land in a subsequent year, and reports all the



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Fair Value Option



gain in the year of sale. The phenomenon results from the accounting convention of recording

amounts at historical cost and not recording changes in the fair values until the firm realizes

those changes in arm’s-length transactions with outsiders.



DISCLOSURES OF CARRYING



AND



FAIR VALUES



OF



DEBT



Authoritative guidance requires firms that account for notes and bonds using the historical

market interest rate to report the carrying values, or book values, on the balance sheet and to

disclose the fair values of these notes and bonds in notes to the financial statements.7 The fair

value of long-term debt is the amount the firm would have to pay to repurchase the debt in an

orderly market transaction on the measurement date, typically the balance sheet date. The fair

value of bonds traded in an active market is the market price of the bonds on that date. The

fair value of bonds not actively traded is the present value of the contractual cash payments

discounted at the interest rate a lender would require on the measurement date.



FAIR VALUE OPTION

An earlier section indicated 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.8 Chapter 3 introduced fair

value measurement. This section introduces certain implications of measuring financial assets

and financial liabilities at their fair values on the balance sheet and recognizing the unrealized

changes in fair values (often referred to as “unrealized gains and losses”) on the income statement. This discussion of the fair value option applies to other items discussed in later chapters

as well, including investments in debt and equity securities and derivatives in Chapter 13.

Authoritative guidance has taken the position that measurements of financial assets and

financial liabilities at fair value provide more relevant and reliable information than cost-based

measurements. Accounting for notes and bonds using the historical market interest rate under

the amortized cost approach is a cost-based approach. U.S. GAAP and IFRS require firms to

report certain financial instruments related to hedging activities at fair value,9 a topic discussed

in Chapter 13. U. S. GAAP and IFRS permit but do not require fair value measurement for

qualifying financial assets and financial liabilities, perhaps as an interim step toward reporting

all financial instruments at fair value.

Firms can choose between fair value measurement and the amortized cost approach based

on historical market interest rates on a case-by-case (instrument-by-instrument) basis for qualifying financial instruments. Firms make this choice when they first adopt the FASB Statement

No. 159 or IAS 39 or when they subsequently acquire a financial asset or incur a financial liability. The choice to use the fair value option is generally irrevocable.

Statement No. 15710 (Codification Topic 820) and IFRS 13 set forth the requirements for

measuring fair values, when authoritative guidance permits or requires items to be measured at

fair value. Regardless of whether a firm uses fair value or amortized cost (historical cost) to measure bonds on its balance sheet, and regardless of the methods the firm uses to record expense,

gain, and loss, the total effect on income over the life of a bond issue depends solely on the cash



7



FASB, Statement of Financial Accounting Standards No. 107, “Disclosures about Fair Value of Financial

Instruments,” 1991 (Codification Topic 825); Statement of Financial Accounting Standards No. 157, “Fair Value

Measurements,” 2006 (Codification Topic 820); IASB, International Financial Reporting Standard 7, “Financial

Instruments: Disclosures,” 2005.

8

FASB, Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and

Financial Liabilities,” 2007 (Codification Topic 825); IASB, International Accounting Standard 39, “Financial

Instruments: Recognition and Measurement,” 1999, revised 2003.

9

FASB, Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and

Hedging Activities,” 1998 (Codification Topic 815); IASB, International Accounting Standard 39, “Financial

Instruments: Recognition and Measurement.”

10

FASB, Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” 2006 (Codification

Topic 820); IASB, International Financial Reporting Standard 13, “Fair Value Measurement,” 2011. IFRS 13 is

effective starting January 1, 2013. The guidance in these two standards is similar.



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434



Chapter 11



Notes, Bonds, and Leases



flows related to the bond issue. The firm issuing the bonds will collect cash from the lenders. It

will, over time, make payments for periodic obligations, for example, coupon payments and a

final payment at maturity or when it buys back the bonds via repurchase. Total expense over the

life of the bond issue will be the difference between the cash paid out for debt service payments

and the cash collected from the lenders. If the cash received from the lenders exceeds the total

debt service payments, then the borrowing firm will have a gain from issuing the bonds. One of

the questions at the end of the chapter asks you to think about how this can happen.



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 with a market participant at the measurement

date. Measuring fair value rests on the assumption that the transaction would occur in the

principal market for the asset or liability or, in the absence of a principal market, in the most

advantageous market from the viewpoint of the reporting entity. Thus, a firm that normally

obtains and repays long-term debt in public capital markets would measure fair value based on

the amount it would pay to repay bonds in those markets.

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 in financial reporting reflects 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.

Inputs to measuring fair value fall into three categories:

1. Level 1: Observable market prices in active markets for identical assets or liabilities that the

reporting entity is able to access at the measurement date.

2. Level 2: Observable inputs other than market prices within Level 1. This category might

include prices for similar assets or liabilities in active markets or market prices for identical

assets or liability in markets that are not active. This category also includes observable factors that would be of particular relevance in using present values of cash flows to measure

fair value, including interest rates, yield curves, foreign exchange rates, credit ratings, and

default rates.

3. Level 3: Unobservable inputs reflecting the reporting entity’s own assumptions about the

assumptions market participants would use in pricing an asset or settling a liability.

Firms should use Level 1 inputs if available to measure fair value, then Level 2 inputs, and

finally Level 3 inputs.11

Because the fair value option offers a free choice between measurement at fair value and

measurement at amortized cost for qualifying instruments, firms could report some financial

instruments using historical market interest rates (amortized cost measurement) and some

using fair values. 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.

A firm must identify the financial assets and financial liabilities on the balance sheet for

which it used the fair value option and disclose the reasons for choosing to measure those items

at fair value.



ACCOUNTING FOR LEASES

Authors’ Note. As this book goes to press, the FASB and IASB have proposed changes to the

authoritative guidance for accounting for leases, including both lessor and lessee accounting.

This textbook does not consider lessor accounting.



11



For a discussion of the difficulties firms encounter in measuring fair values using Level 2 and Level 3 inputs,

see Securities and Exchange Commission, “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting.”



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Accounting for Leases



The current authoritative guidance for accounting for leases distinguishes between operating leases and capital leases (the IFRS term is finance leases). This textbook describes the

accounting for both operating leases and capital (finance) leases. The FASB and IASB proposals would eliminate this distinction and would require that lessees account for most leases using

an approach that is similar to the currently required accounting for capital leases. In this section, we refer to the old rules, to mean those in effect as we write and, where appropriate, the

proposed rules to refer to those proposed by the IASB and FASB.

An alternative to borrowing cash to purchase buildings, equipment, and certain other assets

is signing a contract to lease (that is rent) the property from its owner, the lessor. Leases vary in

their characteristics but all convey to the lessee the right to use an asset. 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.12 Under the capital lease method, the lessee records both the

right to use leased asset and a lease liability, much the same as if it had borrowed to purchase

the asset.

To understand these two methods, suppose that 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.13 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, 2013.



OPERATING LEASE METHOD—OLD RULES

The accounting designation of a lease as an operating lease is based on the idea that the owner,

or lessor, retains all or most of the rewards and risks of ownership. The lessee merely pays

for the right to use the asset for a specified period. A common example of an operating lease

occurs when you rent a car from Hertz or Avis for a few days. If the lease specifies that the lessee must return the leased asset to the lessor at the end of the lease term, which the asset can

still provide substantial future benefits, 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 and

rewards of ownership, the old rules the lease as an operating lease, that does not result in an

asset or a liability on the lessee’s balance sheet. Food Barn would make no entry on January 1,

2013, when it signs the lease, if the lease is classified as an operating lease. It makes the following entry on December 31 of each year:

December 31 of Each Year

Rent Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record annual expense of leasing computer under the operating lease

method.



17,461.51

17,461.51



CAPITAL LEASE METHOD—OLD RULES

The accounting designation of a lease as a capital lease results from the idea that the lessee has

all or most of the rewards and risks of owning the leased asset. If, in the example, the lease

period approximately equals the useful life of the leased computer, 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 and rewards of ownership, the old rules classify the lease as a

capital lease. This treatment recognizes the signing of the lease as the simultaneous acquisition



12



FASB, Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” 1975 (reissued and interpreted 1980) (Codification Topic 840); IASB, International Accounting Standard 17, “Leases” 1982, revised 1997

and 2003. U.S. GAAP uses the term capital lease method and IFRS uses the term finance lease method. We use

the term capital lease method throughout this section on leases.

13

The present value of an annuity of $17,461.51 for three years at a discount rate of 8% is $45,000.



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of a long-term asset (the right to use the leased asset) and the incurring of a long-term liability

for lease payments. At the time Food Barn signs the lease, it records both an asset and a liability

at the present value of the required cash payments, $45,000 in this example. The entry at the

time Food Barn signs the three-year lease is as follows:

January 1, 2013

Leased Assets—Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record lease asset and lease liability under the capital lease method.



45,000

45,000



At the end of each year, Food Barn must account for the lease asset and the lease liability.

In practice, many firms treat the right to use the leased asset similarly to the asset itself and

recognize depreciation expense. Under this treatment and assuming straight-line depreciation

method and zero salvage value, Food Barn makes the following entry at the end of each year:

December 31 of Each Year

Depreciation Expense (on Computer). . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accumulated Depreciation—Computer. . . . . . . . . . . . . . . . . . . . . .

To record depreciation expense on leased asset under the capital lease

method.



15,000

15,000



The second entry made by Food Barn at the end of each year recognizes that each contractually specified lease payment both pays interest and reduces the lease liability. Separating

the portion of the lease payment that represents interest from the portion reducing the liability

follows the effective interest method illustrated for notes and bonds earlier in this chapter. The

amortization schedule for this lease appears in Exhibit 11.5.

The entries made for the lease payments at the end of each year are as follows:

December 31, 2013

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To recognize lease payment, interest on the lease liability for the first

year of $3,600.00 (= 0.08 × $45,000), and the reduction in the liability,

equal to the difference between the lease payment and Interest Expense.

The present value of the lease liability after this entry is $31,138.49

(= $45,000 – $13,861.51).

December 31, 2014

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



3,600.00

13,861.51

17,461.51



2,491.08

14,970.43

(continued)



© Cengage Learning 2014



EXHIBIT 11.5



Amortization Schedule for $45,000 Lease Liability, Accounted

for as a Capital Lease, Repaid in Three Annual Installments of

$17,461.51 Each, Interest Rate 8%, Compounded Annually



Period

(1)



Balance at

Beginning

of Period

(2)



Interest

Expense

for Period

(3)



1 ............

2 ............

3 ............



$45,000.00

31,138.49

16,168.06



$3,600.00

2,491.08

1,293.45



Cash

Payment

(4)



Portion of

Payment

Reducing

Principal

(5)



Balance at End

of Period

(6)



$17,461.51

17,461.51

17,461.51



($13,861.51)

(14,970.43)

(16,168.06)



$31,138.49

16,168.06

0



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Accounting for Leases



Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To recognize lease payment, interest on the lease liability for the second

year of $2,491.08 (= 0.08 × $31,138.49), and the reduction in the

liability, equal to the difference between the lease payment and Interest

Expense. The present value of the lease liability after this entry is

$16,168.06 (= $31,138.49 – $14,970.43).

December 31, 2015

Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Lease Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To recognize lease payment, interest on the lease liability for the third

year of $1,293.45, which differs slightly due to rounding from $1,293.44

(= 0.08 × $16,168.06), and the reduction in the liability. The present value

of the lease liability after this entry is zero (= $16,168.06 – $16,168.06).



EFFECT

ON THE



OF THE OPERATING AND C APITAL LEASE

FINANCIAL STATEMENTS OF THE LESSEE



17,461.51



1,293.45

16,168.06

17,461.51



METHODS



Both the lease 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.

Exhibit 11.6 summarizes the nature and amount of expenses under the operating and capital lease methods for the Food Barn computer lease example. Total rent expense under the

operating lease method equals $52,384.53 (= $17,461.51 × 3). Total depreciation expense of

$45,000 (= $15,000 × 3) plus total interest expense of $7,384.53 (= $3,600.00 + $2,491.08 +

$1,293.45) also equals $52,384.53. Total expenses under the operating lease method and the

capital lease method are the same and equal the total cash expenditures. The operating lease

method and the capital lease method differ in the timing, but not in the total amount, of

expense. For the lessee, the capital lease method recognizes expenses earlier than the operating

lease method.

The 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.



THE ACCOUNTING DISTINCTION BETWEEN OPERATING

LEASES AND CAPITAL LEASES—OLD RULES

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 to prefer the operating lease method to the capital lease

method. The operating lease method also recognizes expense more slowly over the life of the



EXHIBIT 11.6



Comparison of Expense Recognized Under Operating

and Capital Lease Methods for Lessee

Expense Recognized Each Year Under:



© Cengage Learning 2014



Year

1 .................

2 .................

3 .................

Total . . . . . . . . . . . . .



Operating Lease Method

$17,461.51

17,461.51

17,461.51

$52,384.53



Capital Lease Method

$18,600.00

17,491.08

16,293.45

$52,384.53



(= $15,000.00 + $3,600.00)

(= 15,000.00 + 2,491.08)

(= 15,000.00 + 1,293.45)

(= $45,000.00 + $7,384.53)



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Chapter 11



Notes, Bonds, and Leases



lease than the capital lease method. These financial statement effects often lead lessees to structure leases so that under the old rules they qualify for as operating leases.



U.S. GAAP Criteria for Lease Accounting—Old Rules U.S. GAAP specifies criteria for a lease to qualify as a capital lease on the financial statement of the lessee. If the lease

meets none of the following four conditions, the lessee treats the lease as an operating lease.

1. The lease transfers ownership of the leased asset to the lessee at the end of the lease term.

2. The lease provides the lessee with a bargain purchase option, 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.

3. The lease extends for at least 75% of the asset’s expected useful life.

4. The present value of the contractual minimum lease payments equals or exceeds 90% of

the fair value of the asset at the time the lessee signs the lease. The present value computation uses a discount rate appropriate for the creditworthiness of the lessee.

These criteria attempt to identify who enjoys the benefits and bears the economic risks of the

leased property. If the leased asset, either automatically or for a bargain price, becomes the

property of the lessee at the end of the lease period, then the lessee enjoys of the economic benefits of the asset and incurs all risks of ownership. If the life of the lease extends for most of

the expected useful life of the asset (U.S. GAAP specifies 75% or more), then the lessee enjoys

most of the benefits, particularly when we measure them in present values, and incurs most of

the risk of technological obsolescence.

Lessors and lessees can usually structure leasing contracts to avoid the first three conditions and thereby qualify for operating lease treatment. Avoiding the fourth condition is more

difficult. That condition compares the present value of the lessee’s contractual minimum lease

payments with the fair value of the leased asset at the time the lessee signs the lease. The lessor presumably could either sell the asset for its fair value or lease it to the lessee. The present

value of the minimum lease payments has the economic character of a loan in that the lessee

has committed to make payments just as it would commit to make payments on a bank loan.

When the present value of the contractual minimum lease payments equals at least 90% of the

amount that the lessor would receive if it sold the asset instead of leasing it, then the lessor

receives most of its return from the leasing arrangement. That is, 90% of the fair value of the

asset is not at risk, and the lessor need receive only 10% of the asset’s fair value from selling or

re-leasing the asset at the end of the lease term.

If, on the other hand, the lessor has more than 10% of the asset’s initial fair value at risk,

then the accounting criterion views the lessor as enjoying most of the benefits and bearing most

of the risks of ownership and would classify the lease as an operating lease. 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—Old Rules 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 to determine 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:

Does ownership transfer from the lessor to the lessee at the end of the lease?

Is there a bargain purchase option?

Does the lease extend for the major part of the asset’s economic life?

Does the present value of the minimum lease payments equal substantially all of the asset’s

fair value?

5. Is the leased asset specialized for use by the lessee?

1.

2.

3.

4.



A lease for which the present value of the minimum lease payments was 89% of the fair value

of the leased asset at inception of the lease could escape capital lease treatment under U.S.

GAAP but might not under IFRS.



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Lessee Accounting—Proposed Rules In a joint project, the IASB and FASB have proposed that lessees should use the capital lease method for most leases. That is, the lessee computes the present value of its expected cash payments under the lease and recognizes both a

right-of-use asset and a lease liability for that amount. It then uses methods similar to those

described for capital leases for expense recognition.



ACCOUNTING



BY THE



LESSOR—OLD RULES



Under the old rules, the entries to account for operating leases and capital leases for the lessor

mirror those for the lessee with important differences.



Lessor Accounting for Operating Leases—Old Rules The leased asset appears

on the books of the lessor in an operating lease. If the lessor also manufactured the leased

property, the leased asset will appear at the cost of manufacturing the item. If the lessor is a

financial institution that purchased the property that it subsequently leases, the leased asset will

appear at the acquisition cost to the financial institution. Assume that the lessor’s manufacturing cost of the computer it leased to Food Barn is $39,000. The first entry made by the lessor

reclassifies the leased asset from inventory, a current asset, to equipment, a noncurrent asset.

January 1, 2013

Equipment (Computer Leased to Customers) . . . . . . . . . . . . . . . . . . . . . . .

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To reclassify computer from inventory to equipment at its manufacturing

cost of $39,000.



39,000

39,000



Each year the lessor records the cash received as Rent Revenue, mirroring the lessee’s entries

for Rent Expense.

December 31 of Each Year

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record annual revenue of leasing computer under the operating lease

method.



17,461.51

17,461.51



The lessor must also recognize depreciation expense on the leased asset. The lessor uses its

acquisition cost of $39,000 to compute depreciation (analogous to the lessee using its acquisition cost of $45,000 to compute depreciation under the capital lease method illustrated previously). The lessor also uses the expected useful life of the leased asset, which might exceed the

lease period. We assume the computer has a three-year useful life with zero salvage value and

the lessor uses the straight-line depreciation method.

December 31 of Each Year

Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Accumulated Depreciation—Computer. . . . . . . . . . . . . . . . . . . . . .

To record depreciation expense on rented computer of $13,000 (=

$39,000/3).



13,000

13,000



Lessor Accounting for Capital Leases—Old Rules The lessor initially records a

capital lease as if it had sold the leasehold asset to the lessee. (Recall that the lessee records a

capital lease as if it had purchased the leased asset with financing provided by the lessor.) The

lessor receives a promise by the lessee to make future lease payments, which gives rise to a Lease

Receivable. Continuing with the assumption that the lessor manufactured the computer leased

to Food Barn, the lessor makes the following two entries at the time of signing the lease contract on January 1, 2013:



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Appendix 9.1: A Closer Look at LIFO's Effects on Financial Statements

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