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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS. Baginski & Hassell. Chapter 7. INVESTING DECISIONS: Investing in Other Firms' Debt. Investing Decisions (Investing in Other Firms’ Debt). Topics Securities Long-term bonds Notes Receivable Lease Receivables (lessor accounting)

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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

Baginski & Hassell


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Chapter 7

INVESTING DECISIONS:

Investing in Other Firms' Debt


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Investing Decisions (Investing in Other Firms’ Debt)

  • Topics

    • Securities

      • Long-term bonds

      • Notes Receivable

      • Lease Receivables (lessor accounting)

    • SFAS No. 115 Mark-to-Market Accounting

    • Impairments, Troubled Debt


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Characteristics of Debt Securities (e.g., Bonds Owned)

  • Owner has claims to future cash inflows:

    • Principal

    • Interest

  • Current market priceequalspresent value of future cash flows; thus,calculations usethe current market rateof interest.


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  • May be marked-to-market under SFAS No. 115:

    • Bond investments are marked-to-market if classified asTrading or Available-for-Sale (but not if classified as Held-to-Maturity).

Loans (notes) receivable and lease receivables (similar to notes receivable) are EXCLUDED by SFAS No. 115.


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Trading Securities Owned

  • Recorded at cost (price paid to purchase securities, including transaction costs).

  • Interest income equals amount received; there is no premium/discount amortization.

  • Trading securities are marked-to-market!

  • Unrealized gains (losses) are recognized and reported in the Income Statement (other income section).


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Available-for-Sale Securities Owned

  • Recorded at cost (price paid to purchase securities, including transaction costs)

  • Interest income is computed using theeffective interest method.

    • Premium/discount is amortized if ...

      Original maturity > 1 year


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  • Available-for-sale securities are marked-to-market!

  • Unrealized gains (losses) are reported as a component of other comprehensive income section

    • income is not affected

  • Cumulative unrealized holding gains and losses are reported in owners’ equity


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Held-to-Maturity Securities Owned

  • Recorded at cost (price paid to purchase securities, including transaction costs).

  • Interest income is computed using theeffective interest method; premium/discount is amortized.

  • Held-to-Maturity securities are NOT marked-to-market; thus, NO unrealized gains/losses are reported!

    • Reported in the balance sheet at amortized cost (i.e., face  premium/discount).


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Effective Interest Method


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Example: Compute Historical, Effective Interest Rate

Facts: On January 1, 2004, the Faulconer Co. purchased the following bond investment for $4,550,000, plus $75,000 in transactions costs: $4,000,000 in 8% bonds due January 1, 2011, with interest paid semiannually on July 1 and January 1 of each year.


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  • The purchase price reflects a 2.65% semiannual effective interest rate, or 5.3% per year:

    • n = 14 (7-year bonds, with interest paid semiannually)

    • interest collection per period = $160,000 ($4,000,000 × 8% × ½ year)

    • PV = purchase price = $4,550,000 + $75,000 = $4,625,000 [bought at a premium]

    • Maturity value = $4,000,000 (face value)

    • i = ? = 2.65% per period


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Comprehensive Example

Facts: On July 1, 2004, the Beane Co. purchased the following investment for $2,760,000, including transactions costs: $3,000,000 in 7% bonds due July 1, 2009, with interest paid semiannually on July 1 and January 1.

Illustrations follow displaying the effective rate method for investment securities under three cases: Available-for-sale securities, Held-to-maturity securities, and Trading securities.


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Beane Co.: Calculation of Effective Interest Rate

  • The purchase price reflects a 4.51% semiannual effective interest rate:

    • n = 5 × 2 = 10

    • interest payment (ordinary annuity) = $210,000  2 = $105,000

    • PV = $2,760,000 [bought at a discount]

    • Maturity value = $3,000,000

    • i = ? = 4.51% per period


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Beane Co.: Application of the Effective Interest Method

  • 2004 Interest income = $124,476 ($2,760,000 x 4.51%)

  • Dec. 31, 2004 Interest receivable = $105,000 (½ year’s cash interest receivable: $3,000,000 × 7% × ½)

  • 2004 Bond discount amortization = $124,476 - $105,000 = $19,476


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  • Dec. 31, 2004 Amortized cost = $2,779,476 ($2,760,000 + $19,476)

    • July 1, 2004 bond discount = $3,000,000 - $2,760,000 = $240,000

    • December 31, 2004 bond discount = $240,000 - $19,476 = $220,524


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Beane Co. Financial Statement Effects if Classified as a Long-Term Available-for-Sale Security

Assume the facts from the initial Beane example and that the year-end FMV for the bonds is $2,900,000:

  • 2004 interest income = $124,476

  • Dec. 31, 2004 interest receivable = $105,000

  • 2004 bond discount amortization = $19,476

  • Dec. 31, 2004 amortized cost = $2,779,476


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Therefore, at December 31, 2004, Beane’s investment has a $120,524 unrealized gain:

FMV = $2,900,000

Amortized cost = 2,779,476

Unrealized gain = $ 120,524

Is it to be reported? If so, where?


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Beane Co. Financial Statements: Available-for-Sale Classification


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Beane Co. Financial Statement Effects if Classified as a Long-term Held-to-Maturity Security

Assume the facts from the initial Beane example and that the year-end FMV for the bonds is $2,900,000:

  • 2004 interest income = $124,476

  • Dec. 31, 2004 interest receivable = $105,000

  • 2004 bond discount amortization = $19,476

  • Dec. 31, 2004 amortized cost = $2,779,476


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Therefore, at Dec. 31, 2004, Beane’s investment has a $120,524 unrealized gain:

FMV = $2,900,000

Amortized cost = 2,779,476

Unrealized gain = $ 120,524

  • BUT … under Held-to-Maturity classification, the unrealized gain is NOT recognized!


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Beane Co. Financial Statements: Held-to-Maturity Classification


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Beane Co. Example: Financial Statement Effects if Classified as a Short-term Trading Security

  • Assume the facts from the initial Beane Co. example and that the year-end market value for the bonds is $2,900,000.

  • One computation must change, and ...

  • As a short-term investment, bond discount is not amortized.


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  • Prior facts and computations:

    2004 interest income = $124,467 Dec. 31, 2004 interest receivable = $105,000

  • Adjusted information:

    2004 bond discount amortization = $0 Dec. 31, 2004 cost = $2,760,000

  • Therefore, at Dec. 31, 2004, Beane’s investment has a $140,000 unrealized gain:

    $2,900,000 (FMV) versus $2,760,000 (cost)


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Beane Co. Financial Statements: Trading Classification


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Notes (Loans) Receivable

  • Normally, notes receivable are recorded at face value.

    • No premium/discount (the stated rate on the note equals the market rate)

    • Notes with an unreasonable stated rate (i.e., 0%) at the date of execution do have a premium/discount.

  • The effective interest method is used to compute interest income if the note receivable is classified as long-term (i.e., maturity > 1 year at date of execution)


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Note Receivable Example (General Rule, Stated Interest Rate = Market Rate at Date of Execution)

  • Facts: On January 1, 2004, the Simpson Co. loaned $2,000,000 to a key supplier under the following terms: Principal due on December 31, 2005; interest paid annually on December 31, 2004 and 2005; stated interest rate is 8%. The appropriate market rate of interest for this type of loan on January 1, 2004 is 8%.


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Simpson Co. Note Receivable Financial Statement Effects


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Receivables [Loan] Impairment

  • Receivable [Loan] is written down to the present value of “the new” estimated future cash flows.

  • The “impairment loss” is treated as a bad debt write-off.


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Receivables [Loan] Impairment

“Impairment” recognition criteria:

Carrying value

of the receivable

PV of any “new” estimated future cash collections(*)

(*) Using historical, effective interest rate.


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Example of a Receivable [Debt] Impairment and Settlement

  • Facts: On Dec. 31, 2004, the Schmenner Co. had the following accounts related to its Jan. 1, 2003 note receivable from the James Co., which is due Jan. 1, 2007:

  • Principal = $4,000,000

  • Interest receivable = $280,000

  • Stated and historical effective rate = 7%

  • Annual interest payments: Jan. 1


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Schmenner Co. Example: Impairment

  • Schmenner’s accounting staff estimates that the company will not be able to collect all contractually due principal and interest.

  • The best estimate: Schmenner will collect $200,000 in interest payments for the January 1, 2005, 2006, and 2007 interest payments, and collect $3,600,000 principal on January 1, 2007.


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Solution:

  • Carrying value of the James debt: $4,280,000

  • The loan is impairedbecause the present value of the new estimated cash flows using the historic effective interest rate = $3,705,983.

    - PV of January 1, 2005 interest payment = $200,000, plus …

    - Present value of January 1, 2006 and 2007 interest payments plus principal = $3,505,983

    • n = 2, i = 7%, payments = $200,000, future value = $3,600,000

    • Present value: $3,505,983


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  • Schmenner’s receivable [James’ note] is written down from $4,280,000 to $3,705,983; a $574,017 impairment loss!

    • Assuming Schmenner had been recording accruals for bad debts expense, impairment losses are charged to the allowance for doubtful accounts.


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Schmenner Co. 2001 Financial Statement Effects of [Loan] Impairment


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Troubled Debt: Settlement

  • Use the previous Schmenner example.

  • On December 31, 2004, the Schmenner Co. had the following accounts related to its January 1, 2003 note receivable from the James Co., which is due January 1, 2007:

  • Principal = $4,000,000

  • Interest receivable = $280,000

  • Stated and historical effective rate = 7%

  • Annual interest payments, due on Jan. 1.


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Negotiation ...

  • Assume that to settle James’ debt on December 31, 2004, Schmenner accepted from James:

    • land with a FMV of $2,000,000, and

    • James common stock with a FMV of $1,600,000.

  • Schmenner’s write-off:

    $4,280,000 - $3,600,000 = $680,000


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Financial Statement Effects of Debt Settlement


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Troubled Debt: Modification of Terms

  • Assume that on December 31, 2004, the Hendricks Co. had the following accounts related to its note receivable from the Shane Co.:

  • Principal = $500,000

  • Interest receivable = $75,000

  • 2004 interest income = $75,000

  • Historical effective interest rate = 9%


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Negotiation and results ...

  • Carrying value = $575,000.

  • Hendricks agrees to modify the Shane note such that the present value of the new cash inflows (using the 9% historical effective interest rate) = $400,000.

  • Impairment has occurred, via modification to a present valuebelow original principal!

  • The $175,000 loss is recognized.

  • The “new effective interest rate” is 0%.


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Financial Statement Effects of the Modification of Terms


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“Lease Receivables”

Determination of capital lease classification (versus an operating lease):

Must capitalize by recognizing a “lease receivable” if the contract meets at least one of four specific criteria.


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Capitalize if “Yes” to any query!

Does the “lease contract” ...

  • contain a transfer of title clause?

  • contain a BPO clause?

  • cover 75% or more of the remaining useful life of the item?

  • support that the present value of the MLP terms is 90% or more of the item’s FMV?

In “operating leases” the assets stay on the lessor’s books, where rent revenue is accrued!


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“Lease Receivable” and Lessor’s Accounting Treatment

  • Capital Leases:

    • Direct Financing (finance type company, fair value of asset = book value of asset)

      • Leased asset written off the balance sheet and a “lease receivable” is recorded

      • Interest income is recognized using effective interest method

      • No gross profit recognized at the point of execution of the lease contract.


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  • Sales-type (dealer or manufacturer, where FMV > book value of asset)

    • Leased asset written off the balance sheet and a lease receivable recorded

    • Interest income recognized using effective interest method

    • Gross profit on the asset is recognized when lease is signed; GP = FMV – BV


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Lessor Example: Operating Lease

  • Facts:The Lee Co. (lessor) and a lessee signed a lease agreement on January 1, 2004. Lee agrees to lease machinery with an estimated useful life of 8 years, a book value of $1,800,000, and an estimated FMV of $1,800,000, under the following terms:

  • Down payment: $100,000

  • Lease payments: $197,607 at December 31, 2004, 2005, and 2006

  • Lease termination: December 31, 2006


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  • There are no transfer of title nor purchase option clauses.

  • Lee anticipates the asset will “be worth” $1,500,000 on December 31, 2006.

  • Lee’s implicit interest rate on the transaction is 8%.

The lease is an operating lease because it does not meet even 1 of the 4 criteria.


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Notes ...

  • PV of MLP = $100,000 down payment + $509,252 (see computation following) = $609,252.

  • This is not  90% of the asset’s estimated FMV of $1,800,000.

    ($609,252  $1,800,000 = 33.84%)

    • Present value of annual lease payments: n = 3; i = 8%; payments = $197,607; future value = $0 (the lessee is not obligated to make any payment).

    • PV = $509,252


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Lessor Example: Capital Lease (Direct Financing)

  • Facts: On Jan. 1, 2004, Lockheart (lessor) and Ohh (lessee) signed a lease contract whereby Ohh agrees to lease an asset with an estimated useful life of 6 years, and a $0 estimated salvage at the end of 6 years. Terms follow.

  • No separate down payment.

  • Lease payments of $380,555 due on January 1 of the years 2004 – 2009 (i.e., no January 1, 2010 payment)


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  • Ohh does not guarantee any residual price at the end of 6 years; GRV = $0.

  • The lease contains no transfer of title nor purchase option clauses.

  • Lockheart’s implicit interest rate = 8%.

  • On Lockheart’s balance sheet, the leased asset has a book value of $1,900,000

  • The asset’s estimated FMV is $1,900,000


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Determination of Lease Classification

  • The “lease” is capitalized because the lease term of 6 years is  75% of the asset’s estimated useful life of 6 years!

  • The lease is a direct financing lease because the asset’s book value equals its FMV.


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Direct financing lease ...

  • The “lease receivable” is initially recorded at $1,900,000: n = 6; i = 8%; payments = $380,555 (annuity due); future value = $0; PV = ? = $1,900,000.

    • The first payment of $380,555 immediately reduces the lease receivable.

  • In 2004, Lockheart recognizes interest income of $121,556: ($1,900,000 - $380,555) × 8% = $121,556


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Lessor Example: Capital Lease (Sales-type lease)

  • Consider the previous example. The facts are the same except that the leased asset’s book value on January 1, 2004 = $1,500,000.

  • On January 1, 2004, Lockheart (lessor) and Ohh (lessee) signed a lease agreement. Ohh agrees to lease an asset with an estimated useful life of 6 years and an estimated salvage at the end of 6 years of $0; and, all other terms of the lease are identical.


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Determination of Lease Classification

  • The lease is capitalized because the lease term of 6 years is  75% of the asset’s estimated useful life of 6 years.

  • The lease is a sales-type lease because the book value of the asset is less than its FMV. In 2004, Lockheart recognizes sales of $1,900,000, cost of sales of $1,500,000 and gross profit of $400,000.

The receivable and interest income details will be identical to the Direct Financing case.


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End of Chapter 7


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