FAR - Leases, Derivatives, Foreign Currency Accounting, Income Taxes

Question 1

How to calculate the deferred income tax expense?

Answer 1

it is the sum of net changes in DTAs and DTLs

Question 2

How does the lessee account for leases? what about the lessor

Answer 2

lessee - either operating or finance lease (both get capitalized)
lessor - operating, sales type lease, or direct financing lease

Question 3

What are the 5 criteria to determine whether a lease should be an operating or finance lease?

Answer 3

1. transfer of asset
2. purchase option at end of lease (lessee likely to exercise)
3. NPV of all lease payments (and guaranteed residual) is 90% or more of FV of asset
4. 75% or more of economic life
5. asset is specialized, there is no alternate use or value at end of lease

*if any of these criteria are met then it is a financing lease

Question 4

For the lessor, if none of the five criteria are met then the classification will depend on the following:

Answer 4

1. the sum of the lease payments, lessee guaranteed residual value and any third party guaranteed residual value is equal or exceeds the asset’s fair value
2. collection of lease payments and residual value guarantees are probable
   * if both are met, then it is recorded as a direct financing lease
   * if only one is met, then operating lease classification

Question 5

What would be the December 31 carrying amount of a finance lease with the following:

• entered into lease at Jan 1
• FV of truck is $90
• PV of lease pmts on truck is $50K
• will purchase truck at end of lease for $30K, PV is $20K
• lease term is 5 years, truck useful life is 10 years
• straight-line depreciation

Answer 5

The carrying value of the leased truck will be:

PV of Truck $50K + PV of BPO $20K = $70K.

At the end of the year the asset will be $63K ($70K - $7K in depreciation)

Question 6

Under a finance lease, how is the carrying value of the asset recorded?

Answer 6

the carrying value is the cost of the asset minus the depreciation.

Depreciation is the only transaction that reduces the asset value.

Question 7

In a sale type finance lease, how does the lessor record profit?

Answer 7

the profit is recorded at inception of lease. it is the PV of the lease payments plus PV of residual over the cost of the sale (carrying amount)

Question 8

Are leases eligible for the fair value option?

Answer 8

no they are not eligible

Question 9

What are the criteria for qualifying for the fair value hedge?

Answer 9

1. formal documentation of the hedging relationship between the derivative and the hedged item
2. expected to be highly effective
3. must be specifically identified
4. exposure to changes in fair value that could affect income

Question 10

how is the value or settlement of a derivative determined?

Answer 10

by the multiplication of a notional and underlying amount

i.e. the number of stock shares (notional amount) times a price per share (underlying)

Question 11

What are the three unique characteristics of a derivative instrument?

Answer 11

1. one or more underlyings and one or more notional amounts
2. small, if any, initial investment
3. requires a net settlement

Question 12

How are gains and losses reported for:

1. fair value hedge
2. cash flow hedge

Answer 12

1. all gains and losses go to earnings

2. effective portion goes to OCI and ineffective goes to earnings

Question 13

When using the translation method, how are the following accounts translated:

1. Assets and Liabilities Accounts
2. Income Statement Accounts
3. Common stock and additional paid in capital (capital accounts)

Answer 13

1. year end exchange rates
2. weighted average exchange rates
3. historical exchange rates

Question 14

How are the gains and losses foreign currency transactions vs foreign exchange translations reported?

Answer 14

foreign currency transactions are reported in earnings, while the translations are reported in OCI

Question 15

What is the relationship between re-measurement method and the translation method?

Answer 15

The remeasurement method is used to convert the financials of a sub from the local currency to the functional currency. gain/loss goes to income

The translation method is used to convert the financials from the functional currency to the reporting currency. gain/loss goes to OIC

Question 16

Under GAAP, what approach is used to determine income tax?

Answer 16

Asset and liability approach (aka balance sheet approach)

Question 17

What is a DTA?

Answer 17

A deferred tax asset occurs when a temporary difference results in more taxes paid now and less taxes owed in the future. Income appears on a tax return before the income statement; expenses appear on an income statement before they appear on a tax return

Question 18

What are the journal entries for DTA and DTL

Answer 18

DTA - debit: DTA, credit: Income tax benefit -deferred

DTL - debit: Income tax expense - deferred, credit: DTL

Question 19

How do you calculate the current portion of income tax expense?

Answer 19

taxable income multiplied by the tax rate

Question 20

Does it create a DTA or DTL?

1. Depreciation Expense
2. Accruing Warranty Expense for financial reporting
3. Installment Sales method
4. prepaid insurance

Answer 20

1. Depreciation expense creates a DTL
2. Accruing warranty costs are expensed in GAAP before they are deductible for tax purposes. As such this creates a DTA
3. Installment Sales method is DTL
4. Prepaid insurance creates a DTL, it is deducted for tax purposes in the year it was paid.

Question 21

How are DTLs and DTAs reported on the balance sheet?

Answer 21

They are reported as a net either as a NON current asset or liability. The amounts must be netted unless the DTLs or DTAs are attributable to different tax paying components or tax jurisdictions

Question 22

What tax rate should be used at the quarterly reporting dates?

Answer 22

The income tax rate should be the effective tax rate expected to apply to the entire year

Question 23

What should be reported as a supplemental disclosure on the statement of cash flows (indirect)?

Answer 23

income taxes paid and interest payments

Question 24

how and where should a gain and loss of PPE be reported on the cash flow statement?

Answer 24

the gain should be subtracted from net income and the loss should be added to net income in the operating section

Question 25

What are the required disclosures for the statement of cash flows (direct)?

Answer 25

major classes of gross cash receipts and gross cash payments, amount of income taxes paid, and a reconciliation of net income to net cash flow from operations

Question 26

What discount rate should the lessee use when calculating the PV of the lease?

Answer 26

They should use the implicit rate of the lease (if known), if not use the lessee’s incremental borrowing rate

Question 27

In a sales type lease, how does the lessee calculate the financing liability component of the sale?

Answer 27

This is the difference between the sale price and the fair value

Question 28

What initial direct costs are capitalized in a leasing transaction?

Answer 28

Commissions paid, legal, and consulting fees. Document preparation and credit checks are not included

Question 29

How should long should the lessee depreciate the asset?

Answer 29

If the ownership or written option criteria is met then depreciate over the useful life. If the net present value, specialized asset, or economic life are met then the shorter of the lease term or useful life

Question 30

How do lease payments impact the statement of cash flows for financing and operating leases? From the lessee’s perspective..

Answer 30

Operating leases - all payments go to operating activities Financing leases - the interest component goes to operating but the remaining amount of the payment goes to financing..paying down the lease asset

Question 31

For operating leases for the lessor: 1. How is interest income recorded? 2. How do you determine the lease receivable and liability? 3. How does the journal entries change from lease payment to lease payment.

Answer 31

1. No interest income 2. To calculate the receivable and liability (unearned income) you take the lease payment and multiply it by the number of payments. You do not discount the payments. 3. They do not change. They are exactly the same each period.

Question 32

What is the difference between a long and short hedge?

Answer 32

Long hedge offsets the risk that cost of asset you will buy in the future goes up in value (outflows go up) Short hedge offsets risk that asset you sell in the future will go down in value, inflows go down

Question 33

What the difference between monetary and nonmonetary items with respect to foreign currency?

Answer 33

Monetary Items are assets/liabilities that are fixed or denominated in dollars regardless of changes in specific prices or the general price level (ie accounts receivable) Nonmonetary items are assets and liabilities that fluctuate in value with inflation and deflation

Question 34

How is the remeasurement method applied?

Answer 34

First convert the Balance sheet items: 1. Monetary items = current/year-end rate 2. Nonmonetary items = historical rate Then convert the Income Statement items: 1. Non balance sheet related items = weighted average 2. balance sheet related items = historical rate (ie depreciation, cogs, amortization) Plug "currency gain/loss" to get Net Income to the required amount needed to adjust retained earnings in order to make the balance sheet balance. (this impacts EARNINGS)

Question 35

How is the translation method applied?

Answer 35

First Convert the Income Statement Items using the weighted average rate. Then convert the balance sheet items using the current year end rate for assets and liabilities. Common stock/APIC use historical rate. Retained earnings is roll forward. Translation Gain or Loss goes to OCI

Question 36

If a US company purchases foreign goods on account in the foreign currency, what is the impact if the currency goes from 1 USD to 1.2 EURO (date of purchase) to 1 USD to 1.1 EURO (date of receipt).

Answer 36

the company will record a gain on the transaction which will be reported in earnings

Question 37

What profit does the lessor record in a sales type finance lease?

Answer 37

The difference between the PV of the lease payments and the cost of the equipment. Do NOT use the list selling price

Question 38

How does a lessor record an operating lease on their books?

Answer 38

At inception the lessor will recognize a lease receivable and unearned rental income. This amount is calculated by taking the future cash payments UNDISCOUNTED. The lessor will recognize income on a straight-line basis over the life of the lease. Any initial direct cost will be added to lease receivable and amortized over lease term. Lessor will also depreciate the asset

Question 39

When is a sale back lease considered a failed sale?

Answer 39

When the lease is classified as a finance lease

Question 40

Operating (Capital) Lease 3 year lease starts Jan 1, Y1 Payments are $5 a year, on Dec 31 Implicit Interest Rate is 1% PV of annuity is 20 For the lessee, what is the initial entry to record the lease? What are the payments in Y1 and Y2?

Answer 40

the initial entry is: Dr ROU Asset 100 Cr Lease liability 100 Y1 Payment Dr Rent/lease expense 5 Cr Cash 5 Dr Lease Liability 4 Cr Amortization ROU Asset 4 Y2 Payment Dr Rent/lease expense 5 Cr Cash 5 Dr Lease Liability 4.04 Cr Amortization ROU Asset 4.04

Question 41

Company A leases a truck as an operating lease and Company B leases the same truck but as a finance lease, comparing the two leases: 1. who pays more in annual expense in the beg of the lease? 2. who pays more in annual expense towards the end of the lease?

Answer 41

the expense of finance lease is front loaded as interest expense PLUS amortization expense will create a higher total expense when compared to an operating lease, this will reverse in the latter years of the lease. overall expense will be the same across the entire lease.

Question 42

What the difference between a direct financing lease and a sale type lease?

Answer 42

in a direct financing lease the lessee does not gain control of the asset but the asset transfers to the lessee. lessor will recognize gain over the life of the lease in a sales type lease the lessee gains control of the underlying asset. the lessor will derecognize the asset and record a gain/loss at inception

Question 43

What is the difference between intraperiod income tax allocation and interperiod tax allocation?

Answer 43

intraperiod income tax allocation is income tax expense for the period be allocated among continuing operations, discontinued operations, other comprehensive income, and items debited or credited directly to equity. Interperiod income tax allocation is differences in the timing of revenues and expenses for financial statement and tax return purposes

Question 44

The functional currency of Nash, Inc.’s subsidiary is the euro. Nash borrowed euros as a highly effective hedge of its investment in the subsidiary. In preparing consolidated financial statements, Nash’s translation loss on its investment in the subsidiary exceeded its transaction gain on the borrowing. How should the effects of the loss and gain be reported in Nash’s consolidated financial statements?

Answer 44

The transaction loss less the transaction gain is reported in OCI. a gain or loss on a foreign currency transaction that hedges a net investment in a foreign entity is not included in the determination of net income but is reported in the same manner as a translation adjustment.

Question 45

What are the primary objectives of accounting for income taxes?

Answer 45

the primary objectives of accounting for income taxes is to recognize: 1. the amount of taxes currently payable or refundable; and, 2. the deferred tax liabilities and assets for the future consequences of events that have been recognized in the financial statements or tax returns.

Question 46

if financial income is greater than taxable income does this create a DTA or DTL?

Answer 46

DTL

Question 47

Relating to financial instruments, what is credit risk and does it need to be disclosed? Does market risk need to be disclosed?

Answer 47

Credit risk is the possibility of loss from the failure of another party to perform according to the terms of the contract. You must disclose credit risk Market risk is not a required disclosure

Question 48

Should fair value and carrying value be disclosed on all financial instruments?

Answer 48

Yes both should be disclosed (when it is practicable to disclose fair value)