FAR-F5-M3-Long Term Liabilities

Question 1

What are the several different computations of the present value and future value of money?

Answer 1

Computations for questions involving a single lump sum
1. Present value of $1
2. Future value of $2

Computations for questions involving multiple equal cash flows
1. Present value of an ordinary annuity
2. Future value of an ordinary annuity
3. Present value of an annuity due
4. Future value of an annuity due.

Question 2

What does the present value of $1 represent and how is the present value of $1 calculated?

Answer 2

The present value of $1 is the amount that must be invested now at a specific interest rate so that $1 can be paid or received in the future.

present value = future value * “Present value of $1 for appropriate n and r” where n = number of periods and r = periodic interest rate

or in formulaic form
present value = future value / (1+r)^n

Question 3

what does the future value of $1 represent and how is the future value of $1 calculated?

Answer 3

The future value of $1 is the amount that would accumulate at a future point in time if $1 were invested now.

future value = present value * “future value of $1 for appropriate n and r” where n = number of periods and r = periodic interest rate

or in formulaic for
future value = present value * (1+r)^n

Question 4

If PV = 1 / FV factor then…

Answer 4

FV = 1 / PV FACTOR

Question 5

What does the present value of an ordinary annuity represent and how is it calculated?

Answer 5

Important to remember that with an ordinary annuity, the periodic payments are made AT THE END OF THE PERIOD.

The present value of an ordinary annuity is the current worth of a series of identical, periodic payments to be made in the future.

Present Value of ordinary annuity = annuity payment * “present value of ordinary annuity of $1 for appropriate n and r” aka Present value of ordinary annuity factor aka PVFOA

Question 6

What does the present value of an annuity due represent and how is it calculated?

Answer 6

The only difference in the calculations of an annuity due and an ordinary annuity is the timing of payments. For an annuity due, the payment occurs AT THE BEGINNING OF THE PERIOD.

PV of an annuity due = annuity payment * PVFAD

Question 7

If you have the present value of an ordinary annuity of $1 for “n” periods AKA the PVFOA for appropriate n and r, and need the present value of an annuity due of $1 for “n” periods aka the PVFAD for appropriate n and r, then…

Answer 7

PVFAD = PVFOA * (1+r)

Question 8

How can the present value of an annuity due of $1 for “n+1” periods aka the PVFAD be found if you only have the present value of ordinary annuity for “n” periods aka the PVFOA?

Answer 8

PVFAD for n+1 periods = PVFOA for n periods +1

Question 9

What does the future value of an ordinary represent and how is it calculated?

Answer 9

The future value of an ordinary annuity is the value at a future date of a series of identical, periodic payments.

Future value of an ordinary annuity = Periodic payment * “Future value of an ordinary annuity of $1 for appropriate n and r” aka the FVFOA

Question 10

Are long term liabilities recorded at present value?

Answer 10

Yes, long term liabilities are recorded at present value.

Question 11

Is the following statement true or false. Notes payable must be recorded at the present value at the date of issuance.

Answer 11

True. Notes payable must be recorded at present value at the date of issuance.

Question 12

Is the following statement true or false? If a note is non-interest bearing or the interest rate is unreasonable (below market) the value of the note is determined by IMPUTING the market rate of the note and by using the effective interest method.

Answer 12

True. If a note is non-interest bearing or the interest rate is unreasonable (below market) the value of the note is determined by IMPUTING the market rate of the note and by using the effective interest method.

Question 13

If no rights or privileges are attached to the note and the interest rate on the note reflects prevailing interest rates, then should the note payable be recorded at face value without any present value considerations?

Answer 13

Yes, if no rights or privileges are attached to the note and the interest rate on the note reflects prevailing interest rates, record the note payable at face value without any present value considerations.

Question 14

When is the present value calculation at the market rate of interest (imputing interest) not required for certain payables with low or no interest?

Answer 14

The present value calculation at the market rate of interest is not required for certain payables with low or no interest when those payables are
1. Short term
2. are paid in property or services (NOT CASH)
3. Bear an interest rate determined by a government entity.
4. Arise from transactions between a parent and subsidiary.

Question 15

What is the effective interest method?

Answer 15

The effective interest method is a method under which each payment on a note (or other loan) is allocated to interest and principal as though the note had a constant effective stated rate.

Beginning carrying value of note payable * market effective rate = interest expense

Allocate payment
Less interest expense
EQUALS principle (plug)

Question 16

What should be disclosed in the financial statements in relation to note payables?

Answer 16

A full description of the payable, the effective interest rate and the face amount of the note should be disclosed in the financial statement.

Question 17

How do you distinguish between a liability and equity instrument?

Answer 17

A liability has a maturity date and are considered an obligation. Equity instruments do not have a maturity date.

Question 18

When imputing interest on a note payable, should interest expense be recorded even though no cash payment has been made?

Answer 18

Yes, interest expense must be recorded whether cash payment is made or not.

Question 19

When a note contains no interest or an unreasonable rate of interest, then should interest be imputed and if so, what are the steps to record the transaction?

Answer 19

When a note contains no interest or an unreasonable rate of interest, then the value of the note is determined by imputing the marker rate of the note and by using the effective interest method.

First, we must determine the present value of the obligation at the appropriate market interest rate and

Step 1: record the payable at its face amount.
# of payments * payment amount = gross

Step 2: record the item received in exchange for the note at the present value of the obligation AND

Step 3: Record any difference between the face amount of the note and its present value as a discount that must be amortized over the life of the note.

Example of JE:
Dr. Machine A (recorded at PV of note) $6,210
Dr. Discount on Notes Payable (plug) $3,790
Cr. Notes Payable (recorded at face amount) ($10,000)

Question 20

The effective interest method is generally solved using a table. What is the general format of this table?

Answer 20

Period / Beginning Carrying Value of Note Payable / Interest Expense / Cash Payment / Amortization / Ending Carrying Value

When using imputed interest and the effective interest method, a discount on the note payable is created. The discount must amortized over the life of the note. Every period the discount is amortized, the discount is lowered and the carrying value of the note payable increases until it reaches the maturity value of the note aka the face amount.

JE to record issuance of note payable
Dr. Machine A (recorded at PV of note) $6,210
Dr. Discount on Notes Payable (plug) $3,790
Cr. Notes Payable (recorded at face amount) ($10,000)

JE to record amortization of the discount using the table previously mentioned at the top:
Dr. Interest Expense $621
Cr. Discount on Notes Payable ($621)

Question 21

What is the nature of the discount on notes payable?

Answer 21

Discounted notes use the discount on notes payable account to record the discount and keep track of it once the note is repaid. The discount account is a contra liability account with a debit balance that reduces the recorded face value of the note to the actual amount received.

Question 22

Consider a transaction where a company lends money to a major supplier in exchange for a non interest bearing note and a contract to purchase a fixed amount of supplies at a 10 discount over the next few years. The market rate for a note of this type is 10%. Should interest be imputed on a note receivable and if so, what is the accounting treatment for this transaction?

Answer 22

Interest must be imputed on the non-interest bearing note which will result in the recognition of a discount on the note receivable and the purchase commitment must be recognized which will result in the recognition of a deferred charge.

Ex. JE to record the note receivable:
Dr. Note Receivable (recorded at face amount) $10,000
Dr. Deferred Charge ($2,500)
Cr. Cash ($10,000)
Cr. Discount on Note Receivable (difference b/w face amount and PV of NR) ($7,500)

Question 23

Are deposits into a bond sinking fund included as a current maturity of long term debt?

Answer 23

No. Deposits such as sinking fund requirements would be disclosed in a footnote but is not included as a current maturity of long term debt.

Question 24

Should loan origination fees be deferred and recognized over the life of the loan as an adjustment of interest income?

Answer 24

Yes. Loan origination fees should be deferred and recognized over the life of the loan as an adjustment of interest income.

Face amount of the loan
Less loan origination fees
EQUALS net amount of loan subject to effective interest method.

Basically means that loan origination fees will be part of the discount on note payable that is subject to amortization (making it a deferred charge), at which point when it is amortized each period, amortization expense will be recognized over the life of the loan as an adjustment

Question 25

What are debt covenants?

Answer 25

Debt covenants are when a creditor gives a debtor specific covenants that they have to meet. These are usually financial ratios . If the debtor falls out of covenant, there are penalties such as the debt being due immediately.

Most of the concessions are negotiated and real default as opposed to technical default is avoided.

Concessions can result in the violated covenant being waved temporarily or permanently.