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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

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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  1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

  2. Chapter 7 INVESTING DECISIONS: Investing in Other Firms' Debt

  3. 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

  4. 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.

  5. 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.

  6. 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).

  7. 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

  8. 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

  9. 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).

  10. Effective Interest Method

  11. 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.

  12. 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

  13. 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.

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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?

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

  20. 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

  21. 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!

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

  23. 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.

  24. 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)

  25. Beane Co. Financial Statements: Trading Classification

  26. 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)

  27. 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%.

  28. Simpson Co. Note Receivable Financial Statement Effects

  29. 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.

  30. Receivables [Loan] Impairment “Impairment” recognition criteria: Carrying value of the receivable PV of any “new” estimated future cash collections(*) (*) Using historical, effective interest rate.

  31. 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

  32. 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.

  33. 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

  34. 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.

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

  36. 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.

  37. 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

  38. Financial Statement Effects of Debt Settlement

  39. 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%

  40. 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%.

  41. Financial Statement Effects of the Modification of Terms

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