MANAGEMENT DECISIONS
AND FINANCIAL
ACCOUNTING REPORTS
Baginski & Hassell
Chapter 7
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
Characteristics of Debt Securities
(e.g., Bonds Owned)
• Owner has claims to future cash inflows:
– Principal
– Interest
• Current market price equals
present value of future cash
flows; thus, calculations use
the current market rate
of interest.
• May be marked-to-market under
No. 115:
SFAS
– Bond investments are marked-to-market if
classified as Trading 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.
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).
Available-for-Sale Securities
Owned
• Recorded at cost (price paid to purchase
securities, including transaction costs)
• Interest income is computed using the
effective interest method.
– Premium/discount is amortized if ...
Original maturity > 1 year
• Available-for-sale securities are marked-tomarket!
• 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
Held-to-Maturity Securities Owned
• Recorded at cost (price paid to purchase
securities, including transaction costs).
• Interest income is computed using the
effective 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).
Effective Interest Method
Calculated on a per period basis (i.e., per n), where n
equals the number of compounding periods during
the life of the debt security.
Computation:
Beginning of the Period Carrying (Book) Value
× Effective interest rate at purchase time
= Interest income
 Interest received (or receivable)
= Premium/Discount
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.
• 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
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-tomaturity securities, and Trading securities.
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
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
• 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
Beane Co. Financial Statement Effects
if Classified as a Long-Term Availablefor-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
Therefore, at December 31, 2004, Beane’s
investment has a $120,524 unrealized gain:
FMV =
Amortized cost =
Unrealized gain =
$2,900,000
2,779,476
$ 120,524
Is it to be reported? If so, where?
Beane Co. Financial Statements:
Available-for-Sale Classification
Statement of Cash Flows
Operating activities
Interest payment received
Investing activities
Purchase bonds
Income Statement
Other revenues, (expenses), gains,
(losses)
Interest income
$0
($2,760,000)
$124,476
Balance Sheet
Non-current assets
Investments in bonds
Stockholders’ Equity (ignoring income
taxes)
Retained earnings
Effect of interest income
Accumulated Other Comprehensive
Income
Unrealized gains (losses) on
available-for-sale securities
$2,900,000
$124,476
$120,524
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
Therefore, at Dec. 31, 2004, Beane’s
investment has a $120,524 unrealized gain:
FMV =
Amortized cost =
Unrealized gain =
$2,900,000
2,779,476
$ 120,524
BUT … under Held-to-Maturity
classification, the unrealized gain is
NOT recognized!
Beane Co. Financial Statements:
Held-to-Maturity Classification
Statement of Cash Flows
Operating activities
Interest payment received
Investing activities
Purchase bonds
Income Statement
Other revenues, (expenses), gains,
(losses)
Interest income
$0
($2,760,000)
$124,476
Balance Sheet
Non-current assets
Investments in bonds (amortized cost) $2,779,476
Stockholders’ Equity (ignoring income
taxes)
Retained earnings
Income statement effect
$124,476
Accumulated Other Comprehensive
Income
Unrealized gains (losses) on held-toNo effect
maturity securities
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.
• 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)
Beane Co. Financial Statements:
Trading Classification
Statement of Cash Flows
Operating activities
Interest payment received
Purchase bonds
$0
($2,760,000)
Income Statement
Other revenues, (expenses), gains,
(losses)
Interest income
Unrealized gains (losses) on trading
securities)
$105,000
140,000
$245,000
Balance Sheet
Current assets
Investments in bonds
Stockholders’ Equity (ignoring income
taxes)
Retained earnings
Income statement effect
Accumulated Other Comprehensive
Income
Unrealized gains (losses) on trading
securities
$2,900,000
$245,000
No effect
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)
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%.
Simpson Co. Note Receivable
Financial Statement Effects
Statement of Cash Flows
2004
2005
$160,000
$160,000
Operating Activities
Interest received
Investing Activities
Loans to suppliers
Collections on Notes
Receivable
($2,000,000)
$2,000,000
Income Statement
Other revenues (expenses),
gains, (losses)
Interest income
2004
2005
$160,000
$160,000
Balance Sheet (12/31)
2004
2005
$2,000,000
0
$160,000
$320,000
Current assets
Notes receivable
Stockholders’ Equity
Retained earnings
Effect on net income,
ignoring income taxes
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.
Receivables [Loan] Impairment
“Impairment” recognition criteria:
Carrying value
of the receivable
PV of any “new”
estimated future
cash collections(*)
(*) Using historical, effective interest rate.
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
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.
Solution:
• Carrying value of the James debt: $4,280,000
• The loan is impaired because 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
• 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.
Schmenner Co. 2001 Financial Statement
Effects of [Loan] Impairment
Statement of Cash Flows
Operating activities
Interest Received (for 2003)
Income Statement
Other revenues, (expenses), gains, (losses)
Interest income
Impairment loss (assume no previous
accruals of bad debt expense)
2004
$280,000
$280,000
574,017
($294,017)
Balance Sheet (December 31)
Current assets
Interest receivable
Noncurrent Assets
Notes receivable (1)
Stockholders’ Equity
Retained Earnings
Effect on net income, ignoring
income taxes
(1)
$3,705,983 - $200,000 interest
receivable)
$200,000
$3,505,983
($294,017)
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.
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
Financial Statement Effects
of Debt Settlement
Statement of Cash Flows
Operating activities
Interest received (for 2003)
Significant non-cash financing and
investing activities
Acquired land and common stock in
debt settlement
$280,000
$3,600,000
Income Statement
Other revenues, (expenses), gains,
(losses)
Interest income
Bad debts expense (assume no
previous accruals of bad debts
expense)
$280,000
( 680,000)
($400,000)
Balance Sheet (December 31)
Non-current assets
Investments in common stock
Land
$1,600,000
2,000,000
Stockholders’ Equity
Retained Earnings
Effect on net income, ignoring
income taxes
($400,000)
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%
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 value below original principal!
• The $175,000 loss is recognized.
• The “new effective interest rate” is 0%.
Financial Statement Effects of the
Modification of Terms
Statement of Cash Flows
Operating activities
No effect
Income Statement
Bad debts expense (assume no
previous accruals of bad debts
expense)
Interest Income
Net Effect
$0
$(175,000)
75,000
$(100,000)
Balance Sheet (December 31)
Non-current assets
Notes receivable
Stockholders’ Equity
Retained Earnings
Effect on net income, ignoring
income taxes
$400,000
$(100,000)
“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.
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!
“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.
– 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
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
• 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.
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
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)
• 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
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.
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
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.
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.
End of Chapter 7