F6 OLD

Question 1

Identify and define a lease and the parties to a lease.

Answer 1

Lease
A contract that identifies an asset, accounts for the lessor’s right of substitution of that asset, and conveys to the lessee the right to control the sue and obtain economic benefits from the asset over the lease term.

Parties to a lease
A lessor conveys the right to use the asset (real or personal property) to the lessee, who agrees to pay consideration for this right over the lease term.

Question 2

Describe the two options that the lessee has for accounting for a contract that has lease and nonlease components.

Answer 2

Option 1
Lease components are treated as separate units of account from nonlease components within the same contract.

Option 2
A lease component of a contract may be combined with a related nonlease component within the same contract to be treated as a single unit of account.

Question 3

Name the different types of lease classifications applicable to lessees and lessors.

Answer 3

Lessees
Lessees will treat a lease as either an operating or a finance lease

Lessors
Lessors will treat a lease as either an operating, sales-type, or direct financing lease. Sales-type and direct financing leases are forms of finance leases.

Question 4

Name the criteria for determining whether a lease is a finance lease for the lessee and sales-type lease for the lessor.

Answer 4

If any one of five “OWNES” criteria are met, the lease will be classified as a sales-type lease by the lessor and a fianance lease by the lessee.

OWNERSHIP of the underlying asset transfers from the lessor to the lessee by the end of the lease term

the lessee has the WRITTEN OPTION to purchase the underlying asset; the option is one that the lessee is “reasonably certain” to exercise

the NPV of all lease payments and any guaranteed residual value equals or exceeds substantially the underlying asset’s fair value

the term of the lease represents the major part of the ECONOMIC LIFE remaining for the underlying asset

the asset is SPECIALIZED such that it will not have an expected, alternative use to the lessor when the lease term ends

Question 5

Describe the classification of a lease for a lessee and lessor if none of the “OWNES” criteria are met.

Answer 5

Lessee
If none of the 5 “OWNES” criteria are met, or if the lease is short-term, the lessee will treat the lease as an operating lease.

Lessor
If none of the 5 “OWNES” criteria are met, but both of the criteria below are met, the lessor will classify the lease as a direct financing lease. If only one or none of the criteria below are met, the lessor will treat the lease as an operating lease.

• Present Value of the sum of the lease payments, lessee guaranteed residual value not included in the lease payments, and any third-party guaranteed residual value, equals or exceeds substantially the underlying asset’s fair value.
• Collection of the lease payments and any amounts necessary to satisfy residual value guarantees is probable.

Question 6

How long is the period covered by a lease and how are options to extend or terminate a lease handled?

Answer 6

A lease begins on the commencement date (when the asset is available for use) and extends until the end of the noncancelable period.

The lease term will account for an:
* option to extend if the lessee is reasonably certain to exercise the option.
* option to terminate if the lessee is reasonably certain not to exercise.
* option to either extend or terminate if the decision is controlled by the lessor.

Question 7

What components will be included and excluded from lease payments?

Answer 7

Lessee lease payments will include:
* required contractual fixed payments
* exercise option (if reasonably assured)
* purchase price at the end of the lease
* only indexed or rate variable payments
* residual guarantees likely to be owed
* termination penalties (if reasonably assured)

Lessee lease may or may not include (at lessee’s option):
* nonlease components

Lessee lease payments specifically exclude:
* guarantees of lessor debt by lessee
* other variable lease payments

Question 8

Which rates should the lessor and lessee use to calculate th epresent value of the minimum lease payments?

Answer 8

The lessor should use the rate implicit in the lease.

The lessee should use the rate implicit in the lease. If the rate is not known, the lessee should use its incremental borrowing rate.

Question 9

Which initial direct costs are included/excluded in the valuation of the right-of-use (ROU) asset?

Answer 9

Include any initial direct costs that are incurred as a result of the execution of the leases.

Exclude any costs incurred prior to signing the lease (document preparation, credit checks, etc.).

Question 10

Describe a sale-leaseback transaction, the parties involved, and what happens when the criteria for a sale are not met.

Answer 10

A sale-leaseback transaction occurs when one party sells an asset to another party and then leases the asset back for a period of time.

The seller becomes the lessee and the buyer becomes the lessor.

In order to qualify as a sale, revenue recognition requirements must be met. If the criteria are not met, the transaction will be treated as a failed sale and classified as a financing transaction (the asset will remian on the “seller’s” books).

Question 11

List the initial and subsequent journal entries recorded by a lessee when the lease qualifies as an operating lease.

Answer 11

Initial entry
dr ROU asset
cr Lease liability

Subsequent entries
dr Lease expense
cr Cash/lease liability

dr Lease liability
cr Accumulated amortization - ROU asset

Question 12

List the initial and subsequent journal entries recorded by a lessee when the lease qualifies as a finance lease.

Answer 12

Initial entry
dr ROU asset
cr Lease liability

Subsequent entries
dr Interest expense
dr Lease liability
cr Cash/lease payable

dr Amortization expense
cr Accumulated amortization -ROU asset

Question 13

Describe the accounting policy election that lessees can make regarding the balance sheet treatment of leases.

Answer 13

For leases with terms of 12 months or less, a lessee can make an accounitng policy election and choose to not recognize ROU assets or lease liabilities. The election must be made by class of underlying asset, and leases falling into this category cannot include purchase options for the asset that the lessee would be reasonably certain to exercise.

Question 14

Identify the ways in which sales-type leases differ from direct financing leases.

Answer 14

In sales-type leases, the lessee gains control of the asset. The lessor will remove the asset from its books and recognize a profit or loss.

In direct financing leases, the lessee does not gain control of the asset. The lessor will remove the asset from its books and recognize a net investment in the lease.

Question 15

List the journal entries recorded by a lessor when the lease qualifies as an operating lease.

Answer 15

dr Cash
cr Rental income

dr Depreciation expense
cr Accumulated depreciation

Question 16

Over what period will the lessee depreciate the leased asset under a finance lease?

Answer 16

Asset’s useful life: (O or W) if ownership transfers to the lessee or if the lessee is reasonably certain to exercise an option to purchase the asset.

Shorter of lease term or asset’s useful life: (N, E, or S) if any of the other criteria are met.

Question 17

For finance and operating leases, which cash flows are treated as operating cash flows?

Answer 17

For financing leases, the interest payments and any variable and short-term lease payments not included in the lease liability are treated as cash flows from operations (principal payments are cash flows from financing).

For operating leases, lease payments, variable lease payments, and short-term lease payments are all treated as cash flows from operations.

Question 18

How are gains and losses on financial instruments that hedge trading securities reported?

Answer 18

Reported in earnings, consistent with reporting unrealized gains and losses on trading securities.

Question 19

Define derivative instrument.

Answer 19

A “derivative instrument” is a financial instrument (or other contract) that “derives” its value from the value of some other instrument and has all three of the following characteristics:

1) One or more underlyings and one or more notional amounts or payment provisions (or both);

2) Requires no initial net investment; and

3) Its terms require or permit net settlement.

Question 20

Define underlying and notional amount as they relate to a derivative financial instrument.

Answer 20

underlying: a specified price, rate, or other variable (e.g., interest rate, security price, foreign exchange rate, index of prices or rates, etc.).

notional amount: a specified unit of measure (e.g., currency units, shares, bushels, pounds, etc.).

Question 21

Name four common derivative instruments.

Answer 21

• option contracts
• futures contracts
• forward contracts
• swap contracts

Question 22

Identify the three types of hedge designations.

Answer 22

• fair value hedge
• cash flow hedge
• foreign currency hedge

Question 23

Describe the accounting for changes in fair value associated with each type of hedge
designation.

Answer 23

Fair value hedge:
Included in current earnings with gain or loss from change in value of offsetting asset/liability

Cash flow hedge:
Included in other comprehensive income until the hedged transaction impacts earnings

Foreign currency hedge:
Fair value hedge—included in current earnings with gain or loss from change in value of offsetting asset/liability

Cash flow hedge—included in other comprehensive income
Net investment hedge—included in other comprehensive income, as cumulative translation adjustment

Question 24

What are monetary items?

Answer 24

• Assets and liabilities that are fixed in amount by contract or in terms of number of dollars.
• Examples include cash, accounts and notes receivable, and accounts and notes payable.
• These items are already stated in constant dollars.

Question 25

What are nonmonetary items?

Answer 25

• Assets and liabilities that fluctuate in value with inflation/ deflation.
• Examples are inventories; property, plant, and equipment; and capital stock. These items need to be restated to constant dollars.

Question 26

Identify the two foreign currency activities.

Answer 26

• Foreign currency translations
• Foreign currency transactions

Question 27

What is an entity’s functional currency under U.S. GAAP?

Answer 27

The functional currency is the currency of the primary economic environment in which the entity operates. All of the following conditions must be met:

• The foreign operations are relatively self-contained and integrated within the country.
• The day-to-day operations do not depend on the parent’s or investor’s functional currency.
• The local economy of the foreign entity is not highly inflationary.

Question 28

When is the translation method used?

Answer 28

Translation is used to restate financial statements denominated in the functional currency to the reporting currency.

Question 29

When is the remeasurement method used?

Answer 29

Remeasurement is used to restate financial statements from the foreign currency to the entity’s functional currency when:

• The reporting currency is the functional currency.
• The financial statements must be restated in the entity’s functional currency prior to translating from the functional currency to the reporting currency.

Question 30

Identify the exchange rate to be used when remeasuring different components of the
balance sheet and income statement.

Answer 30

Balance Sheet
* Monetary—current exchange rate
* Nonmonetary—historical rate

Income Statement
* Balance sheet related—historical rate
* Non-balance-sheet related—weighted average

Question 31

Identify the exchange rate to be used when translating different components of the
balance sheet and income statement.

Answer 31

Assets and Liabilities
= Current exchange rate

Common Stock and APIC
= Historical rate

Revenue and Expenses
= Weighted average exchange rate for the period

Question 32

Where are remeasurement gains/losses reported in the financial statements?

Answer 32

Remeasurement gains or losses are recognized on the income statement.

Question 33

Where are translation adjustments reported in the financial statements?

Answer 33

Translation gains or losses are reported in other comprehensive income. They are treated as unrealized gains and losses.

Question 34

State two types of foreign currency transactions.

Answer 34

• Operating transactions, such as importing, exporting, borrowing, lending, and investing transactions.
• Forward exchange contracts, which are agreements to exchange two different currencies at a specific future date and at a specific rate.

Question 35

Where are foreign currency transaction gains or losses reported in the financial
statements?

Answer 35

Foreign currency transaction gains or losses are included in determining net income for
the period.

Question 36

For operating transactions in foreign currency, detail the recording process.

Answer 36

• Record original transaction at exchange or spot rate on date of transaction.
• At balance sheet date, compute gain/loss on the transaction by recalculating using the current exchange or spot rate.
• On payment date, compute gain/loss on the transaction by using the exchange rate on payment date.

Question 37

Define permanent differences and list examples.

Answer 37

Permanent differences are transactions that affect either taxable income or financial income, but not both, and only in the period in which they occur. They do not affect future financial or taxable income.

• Premium on key-officer life insurance policy when entity is owner and beneficiary
• Proceeds from key-officer life insurance
• Tax-exempt interest on state and municipal bonds
• Nondeductible portion of meals and entertainment
• Fines and expenses in violation of law
• Dividends-received deduction

Question 38

Define temporary differences and list examples.

Answer 38

Temporary differences are differences between taxable income and financial income that result in taxable or deductible amounts in future years and necessitate the recognition of deferred tax assets or liabilities.

• Depreciation (financial vs. MACRS)
• Gross profit on long-term construction contracts (percentage completion vs. completed contract)
• Estimated warranty costs
• Gross profit on installment sales (accrual vs. cash)
• Bad debt expense using the allowance method vs. actual bad debt expense

Question 39

Define deferred tax liability.

Answer 39

Anticipated future tax liabilities derived from situations in which future taxable income will be greater than future financial income due to temporary differences.

A deferred tax liability is measured by applying the applicable enacted tax rate and provisions of the enacted tax law to temporary differences in the periods in which they are expected to reverse.

Question 40

Define deferred tax asset.

Answer 40

Anticipated future taxable income will be less than future financial income due to temporary differences.

A deferred tax asset is recognized for all deductible temporary differences, operating losses, and tax credit carryforwards by applying the applicable enacted tax rate and provisions of the enacted tax law to temporary differences in the period in which they
are expected to reverse. Deferred tax assets are also subject to recording a valuation allowance to reduce the asset to its net realizable value if it is more likely than not that its full value will not be recognized.

Question 41

What is the valuation allowance?

Answer 41

If it is more likely than not (>50 percent) that some portion or all of the deferred tax asset will not be realized, a valuation allowance needs to be created to recognize the reduction in the carrying amount of the deferred tax asset (DTA).

Question 42

Identify the tax rate used to measure deferred tax assets and liabilities under U.S. GAAP.

Answer 42

The enacted tax rate expected to apply to taxable items (temporary differences) in the periods the taxable item is expected to be paid (liability) or realized (asset).

Do not allow the examiners to trick you into using the anticipated, proposed, or unsigned tax rate.