FADM Final All Info

Intangibles
And
Accounting for Intangibles
1
FASB: Statement of Financial Accounting
Concepts No. 1
Financial reporting should

“provide information about the economic resources of an
enterprise, the claims to those resources, and the effects
of transactions, events, and circumstances that change
its resources and claims to those resources.”
2
Long-Term Operating Assets
Two common characteristics:

▪ Developed or acquired for the purpose of
producing and delivering products and services
that generate revenues
▪ Help produce revenues for multiple periods
3
Tangible Assets
▪ Have physical substance
▪ Usually include land, buildings, machinery, fixtures
and equipment
▪ Recorded at cost
▪ In accounting, depreciated over time (except land)
4
Intangible Assets
▪ Have no physical substance
▪ You can’t touch them
▪ Latin tangibilis, from tangere ‘to touch’.
▪ Provide the owner with specific rights and privileges
▪ Trademark, customer network, reputation, brands…..
▪ Some are recorded at cost
▪ Many are not recognized.
5
Intangible Assets
• Those recorded at cost.

• Must be identifiable
• Can be separated from company and sold; or
• Based on contractual or legal rights
6
Amortization for Intangible Assets
• If intangible asset has a finite (limited) life, its cost must

be amortized (aka depreciated) over the shorter of its
estimated useful life and legal life
• Intangible assets with an indefinite (unlimited) life are
not amortized
7
Intangibles with Finite Lives
• Patents
• Exclusive right to produce for 20 years
• Research and development costs
• All research costs are expensed
• Development costs are capitalized only if
associated with an identifiable, feasible product
• Copyrights ©
• Protection for the life of the creator + 50 years
Cost is amortized over the
shorter of its estimated
useful life and legal life
8
Intangibles with Indefinite Lives
• Trademarks and trade names ™®
• Word, phrase, jingle, symbol that distinguishes
business
• Franchises
• Contractual arrangement to sell products or
services
• McDonald, Pizza Hut, Subway
• Licenses
• Grant the holder operating rights
• E.g. Suzuki under the band name Maruti
These intangibles are
not amortized! 9
Intangible Assets Example
A patent was acquired on May 1, 2015 by Lululemon for Luon, their

newest four-way stretch fabric. Lululemon paid $75,000 in legal
costs to establish the patent and $15,000 in registration costs. It is
estimated that although the patent has a 20 year useful life, the
patent will only be useful for 10 years. Lululemon records adjusting
entries annually.
What would Lululemon record as the amortization

expense for the patent on December 31, 2015?
10
Intangible Assets Answer
A patent was acquired on May 1, 2015 by Lululemon for Luon, their newest four-
way stretch fabric. Lululemon paid $75,000 in legal costs to establish the patent
and $15,000 in registration costs. It is estimated that although the patent has a 20
year useful life, the patent will only be useful for 10 years. Lululemon records
adjusting entries annually
What would Lululemon record as the amortization

expense for the patent on December 31, 2015?
Cost of patent ($75,000 +15,000) 90,000 = 9,000
Useful life (years) 10
Time owned x 8/12
2015 Amortization 6,000
11
Goodwill
What is goodwill?
▪ The excess of the purchase price paid over the fair
value of its identifiable net assets to buy an entire
company
▪ Net assets = Assets – Liabilities is assumed
Purchase of
the net assets
Company A Company B
12
Goodwill
Net Assets = Fair value of assets - Fair value of liabilities

acquired
Purchase Price
Minus Net Assets
=GOODWILL
• Not amortized, but subject to an annual test for

impairment
13
Facebook’s Goodwill
14
Facebook’s Goodwill
15
Facebook Goodwill from WhatsApp
Acquisition
Net Assets = Fair value of assets - Fair value of liabilities acquired
Purchase Price 17,193

Minus Net Assets (1,851)
=GOODWILL =(15,342)
• Strictly speaking, goodwill is not an asset.

• It is “unallocated purchase price” in acquisitions.
16
Revaluation on Acquisition:
Disney’s Disclosure About Marvel
Marvel
On December 31, 2009, the Company completed a cash and stock acquisition for the
outstanding capital stock of Marvel Entertainment, Inc. (Marvel), a character-based
entertainment company. This acquisition is consistent with the Company’s strategic
value creation through utilization of intellectual properties across Disney’s multiple
platforms and territories.
The acquisition purchase price totaled $4.2 billion. In accordance with the terms of the
acquisition, Marvel shareholders received $30 per share in cash and 0.7452 Disney
shares for each Marvel share they owned. In total, the Company paid $2.4 billion in cash
and distributed shares valued at $1.9 billion (approximately 59 million shares of Disney
common stock at a price of $32.25).
At the time of the acquisition, Marvel had a book value of $479 million.
17
Contrasting Marvel and Disney Numbers
Per Marvel’s Per Disney’s
Balance Sheet Item ($ millions) Books Books
9/30/2009 12/31/2009
Cash and cash equivalents $ 147 $ 105
Accounts receivable and other assets 166 137
Film costs 217 304
Intangible assets – 2,870
Goodwill 346 2,269
Total assets acquired 876 5,685
Accounts payable and other liabilities (325) (320)
Deferred income taxes (72) (1,033)
Noncontrolling interests (2) (90)
Net assets acquired, without goodwill $ 479 $ 1,973
Goodwill 2,269
Net assets acquired
479 $ 4,242
18
Disclosure by Disney
The Company is required to allocate the purchase price to tangible and identifiable
intangible assets acquired and liabilities assumed based on their fair values. The excess
of the purchase price over those fair values is recorded as goodwill.
The following table summarizes our allocation of the purchase price:
Estimated Fair
Value
Cash and cash equivalents $ 105
Accounts receivable and other assets 137
Film costs 304
Intangible assets 2,870
Goodwill 2,269
Total assets acquired 5,685
Accounts payable and other liabilities (320)
Deferred income taxes (1,033)
Noncontrolling interests (90)
$ 4,242
19
Yet, Limitations of Financial Reporting
Balance
Financial reporting should
Sheet
(Many assets
“provide information about the developed inhouse
economic resources of an enterprise, are not included)
the claims to those resources, and the
effects of transactions, events, and
circumstances that change its
resources and claims to those
resources.”
20
SESSION: 6
Assets – part 2 :
Intangibles (Async lecture by Prof. Anup Srivastava)
Inter-corporate investments (Sync lecture)
6-1
Learning objectives
1. Know various types of intangible assets

2. Understand the difficulty in accounting for intangibles
3. Explain why firms invest in one another
4. Understand how accounting for investments varies depending on the motivation
for investment
5. Understand the accounting for passive investments, equity method and
consolidation
6. Get familiar with intangible and investment related footnotes
6-2
Intangible assets
Intangible assets are without physical substance. Major categories include -

1. Marketing-related - Trademarks or trade names, newspaper mastheads, Internet
domain names, and non-competition agreements. In the United States trademarks or
trade names have legal protection for indefinite number of 10 year renewal periods.
2. Customer-Related Intangible Assets - Examples: Customer lists, order or production
backlogs, and both contractual and non-contractual customer relationships.
3. Artistic-Related Intangible Assets - Examples: Plays, literary works, musical works,
pictures, photographs, and video and audiovisual material. Copyright granted for the
life of the creator plus 70 years.
4. Contract-Related Intangible Assets - Examples: Franchise and licensing
agreements, construction permits, broadcast rights, and service or supply contracts.
5. Technology-Related Intangible Assets - Examples: Patented technology and trade
secrets granted by a government body. Patent gives holder exclusive use for a period of
20 years
6-3
 There is a great deal of uncertainty about the amount and timing of benefits that many
these assets can generate.
 Only identifiable intangibles are recorded on the balance sheet. These intangibles
 arise out of contractual or other legal rights
 are separable from a company and can be sold
 For an intangible asset to be on the balance sheet, it must arise from a past transaction.
There are several possibilities:
1. Direct purchase of the asset
2. Indirect purchase of the asset via a merger or acquisition. This is the most
common way intangibles land on the balance sheet.
3. Internally generated via research and development activities that lead to a
demonstrable asset. That is, costs are capitalized if future economic benefit can be
shown. IFRS ONLY
6-4
 What about brand name, exceptional management, desirable location, good customer
relations, skilled employees, high-quality of products, etc. These are unidentifiable
intangibles ?
 When a company acquires another, the acquirer often pays an amount more than the fair
value of net identifiable assets of the target company. This extra payment is called
GOODWILL. This can reflect estimated merger synergies / overpayment
 Subsequent to acquisition of intangible assets, their impact on income statement is as

follows -
 Finite life intangibles [ E.g. Patent, copyrights, Capitalized R&D costs] - amortize
the acquisition cost over the shorter of its estimated useful life and legal life
 Infinite life intangible [ trademark, franchises, licenses, goodwill] – no
amortization. There is an annual impairment test
6-5
The Nike Trademark
In the early 1970’s, Carolyn Davidson, a graduate student studying graphic design,
created the Nike swoosh for Phil Knight, owner of Blue Ribbon Sports. Phil was
seeking a new logo and asked Carolyn to create a design. Phil chose the now popular
‘swoosh’ logo and paid Carolyn’s invoice of approximately $35 for her work.*
What do you think is the value of Nike’s Trademark as recorded on its balance sheet?
Source: Nikebiz: Company Overview: History, 1970s. “The Birth of the Nike Brand, and Company.”
http://www.nikebiz.com/company_overview/history/1970s.html
6-6
Facebook’s acquisition of Whatsapp
Whatsapp's balanec sheet ( $ mil)

A 178
L 87
SE 91
Calculation of Net assets

Fair value of A 2,858
Fair value of L 979
FV of Identifiable net assets (1) 1,879
Assets not recorded by Whatsapp Amount Useful life

Users 2,026 7
Tradename 448 5
Technology 288 5
Others 21 2
Purchase consideration (2) 17,193

Goodwill (2) - (1) 15,314
6-7
R&D costs
R&D costs broadly consist of the following -

• Salaries and benefits for researchers and developers.
• Supplies needed to conduct the research.
• Licensing fees for intellectual property or software used in the R&D process.
• Third-party payments to collaborators at other firms and universities.
• Laboratory and other equipment.
• Property and buildings to be used as research facilities. The depreciation on these
research facilities is included in R&D expense each year.
Research and development (R&D) costs are not in themselves intangible assets. It
frequently results in the development of patents or copyrights such as new product,
process, idea, formula, composition, literary work etc.
6-8
• Companies spend considerable sums on research and development.
Sales (bn)
Company FY 2015 R&D / Sales
Canon ¥3,800.3 8.64%
Daimler €149.5 4.41%
GlaxoSmithKline €23.9 14.88%
Johnson & Johnson $70.1 12.91%
Apple $233.7 3.45%
Roche CHF 48.1 19.90%
Procter & Gamble $76.3 2.62%
Samsung $177.4 7.40%
6-9
• Research activities
• Planned search or critical investigation aimed at discovery of new knowledge.
• Examples: Laboratory research aimed at discovery of new knowledge;
searching for applications of new research findings.
• Development activities
• Translation of research findings or other knowledge into a plan or design for a
new product or process or for a significant improvement to an existing product
or process whether intended for sale or use.
• Examples: Conceptual formulation and design of possible product or process
alternatives; construction of prototypes and operation of pilot plants.
6-10
Accounting for R&D
• US GAAP – R&D costs are expensed:

• R&D is an ongoing activity and many R&D efforts fail to produce any benefits
whatsoever.
• High uncertainty about the timing and extent of any potential benefits
• Salaries for R&D personnel are no different than for other personnel whose
salaries and wages are expensed when incurred
• IFRS , Ind AS
• Research costs are expenses
• For development costs, capitalization begins when the project is far enough along
in the process such that the project is economically viable.
• US GAAP also allows capitalization of software development costs after achieving

technical feasibility.
6-11
Inter-Corporate Investments - overview
Why do firms invest in the securities of other companies or entities?
 Passive investments
 invest excess cash to generate returns. These investments include – debt, non-
voting stock, less than 20% of voting stock
 Strategic investments:
 Significant influence – own between 20-50% of the voting stock
 Controlling interest – own more than 50% of the voting stock
6-12
Overview of accounting for investments
6-13
Accounting for passive investments
Fair-Value Method for Investments in Equity Security
 All passive investments in equity securities are reported at fair value.
 As the market value of equity securities fluctuates so do the balance sheet and the
income statement..
 Changes in the fair value of equity securities flow to current period net income.
 Investment is recorded in the balance sheet at its fair value
 Dividends and capital gains and losses included in income
 What is fair value?

 Level 1 Quoted market prices if the security is traded in active markets.
 Level 2 Quoted market prices in active markets for similar securities and
model-based valuation techniques if all significant inputs are observable in the
market or can be derived from observable market data.
6-14
 Level 3 Unobservable inputs that are supported by little or no market activities.
Illustration 6.1. HM Corp. invests in 1% outstanding shares of SM Corp. The stock
price date during the purchase, end of year, and at the time of sale is given below. How
is this investment accounted for?
Purchase at End of year 1 Sale during
beginning of Year 1 the Year 2
Number of shares 100 100 100
Stock price at the time of sale 75 70 80
Fair value method of accounting
Balance sheet impact

• Investment account is reported at fair value
Income statement impact

• Dividends and capital gains and losses included in income
• Interim changes in fair value affect income
6-15
Year 1
Investment Dr (A+) 7500
Cash Cr (A - ) 7500
Unrealized loss – I/S Dr (E+, RHS ↓) 500

Investment Cr (A-) 500
Year 2
Cash Dr (A+) 8000
Realized gain on sale of investment – I/S Cr (R+, RHS ↑) 1000
6-16
Problem with this method
• Unrealized gains / losses arise because of market fluctuations over which a firm has
little control.
• Yet, the overall performance of the firm (net income) is impacted by these unrealized
gains / losses
Potential solution
• All gains/losses can bypass income statement and directly be recorded under the equity
section of balance sheet under the heading AOCI (Accumulated other comprehensive
income)
6-17
Year 1
Investment Dr (A+) 7500
Cash Cr (A - ) 7500
Unrealized loss – OCI Dr (SE-, RHS ↓) 500

Year 2
Cash Dr (A+) 8000
Realized gain on sale of investment – OCI Cr (SE+, RHS ↑) 1000
6-18
Comparison of the two methods
FVTPL Year 1 Year 2 Total
Income statement
Other income / (expense) -500 1000 500
Balance sheet
RE -500 1000 500
OCI
Total SE -500 1000 500
FVTOCI
Income statement
Other income / (expense)
Balance sheet
RE
OCI -500 1000 500
Total SE -500 1000 500
6-19
The second method – where unrealized gains/losses on passive equity investments are
parked in the AOCI till shares are sold, is –
• AVAILABLE under IFRs and Ind AS if such accounting classification (FVTOCI) is

irrevocably elected when shares are bought
• Under US GAAP
• NOT AVAILABLE for equity investments
• AVAILABLE only to account for debt securities. Further, when debt securities are
sold, the unrealized gains / losses stored in the AOCI are also cleared out.
6-20
Fair-Value Method for Investments in Debt Security
Trading (FVTPL) Available for sale Held to maturity HTM

AFS (FVTOCI)
Description held for a short period of may be sold prior to investor has the intent
time and are intended to their scheduled and ability to hold to
be actively traded maturities to meet their maturity
liquidity needs or risk
management objectives.
Investment value Fair value Fair value Amortized cost
Unrealized gain / loss Recognized in net Recognized in AOCI Not recognized
(∆ Fair value) income component of Equity
Other income Interest income, Interest income, Interest income,
gain / loss on sale gain / loss on sale gain / loss on sale
Other names FVTPL FVTOCI Amortized cost
Held for collection and Held for selling
selling
6-21
Fair value options
• Companies have the option to report most financial assets at fair value, with all
gains and losses related to changes in fair value reported in the income statement.
• Applied on an instrument-by-instrument basis.
• Generally available only at the time a company first purchases the financial
asset or incurs a financial liability.
• Company must measure this instrument at fair value until the company no
longer has ownership.
6-22
Accounting for significant influence
 Investment in 20-50% of equity of the other company reflects significant influence.
 Other Indicators of significant influence include

 Representation on investee’s board
 Involvement in the development of investee’s operating and financial policies
 Significant business transactions between investor and investee
 Significant influence is accounted using the equity method
6-23
Need for equity method
 In case of a passive equity investment, the performance of the investment is evaluated

on the basis of dividends received and stock price appreciation
 However, when the investor can influence investee’s operating and financing decisions, it
affects the amount and timing of dividends that the investee pays. In such a scenario, the
performance of investment is not accurately measured by dividend payout
 Further, investor is not looking to liquidate its holding anytime soon as the investment is
for strategic reasons. Hence market value of investee is not an appropriate way to measure
the value of investment.
 Investment performance should parallel the investee’s performance and the

equity method achieves this goal
 Investee’s share of net income increases the investment (asset) and dividends
received decreases the investment. This parallels the investee’s equity accounts.
6-24
Illustration 6.2. A Corp want to have a greater say in the working of its supplier B Corp.
Hence A buys 25% shares of B. At this level of shareholding A can have a significant
influence on B but does not control B. The relevant information about investment is
given below. Describe the impact of this investment on A’s financial statements.
Additional information
MVE of B at the beginning of year = $3,000
MVE of B at the end of the year = $4,000
Dividend declared and paid by B during the year = $60
6-25
At the beginning of year, A would have paid 25% of 3,000 = 750 and bought shares of B.
The journal entry A will post at that time will be –
Investment Dr 750
Cash Cr 750
At the end of the year if this investment were to be FVTPL (trading) then the
following JE would be appropriate –
Investment Dr 250
Unrealized gain (or FV adj.) Cr 250
Cash Dr 15
Dividend income Cr 15
But remember these are equity method investments and hence the above JE are
inappropriate. Why?
6-26
We need to look at the operating performance of B (and not the stock market performance ) to
determine if A’s investment in B has increased in value or not. B’s income statement is as follows
Sales 600
Costs 400
Net income 200
Under equity method we will consider that 25% of B’s net income belongs to A and hence A’s
investment in B will increase by 25%. The journal entry will be –
Investment in B Dr 50
Equity method income Cr 50
However, B has paid dividends, leading to a reduction in overall resources of B. Hence to that extent
the value of A’s investment in B will reduce. The journal entry will be –
Cash Dr 15
Investment in B Cr 15
6-27
Based on these two journal entries, the end of the year value of investment will be
Value of investment at the beginning of the year = 750

Add: A’s share in B’s net income = 50
Less: A’s share in dividend paid by B = (15)
________________________________________________
Value of investment at the end of the year = 785
_________________________________________________
6-28
Accounting for Controlling Interest
Controlling Interest
 When one corporation acquires a voting interest of more than 50% in
another corporation
 Other forms of control include the ability of an entity to elect a majority of

the board of directors of another entity has control over it.
 Control enables the parent:

 Direct the sub to expand, contract or distribute cash to the parent.
 Establish the subsidiary’s financing structure.
 Fire and hire the subsidiary’s management.
 Set compensation level for the subsidiary’s management.
6-29
How do we account for such investments ?
Consolidation: combine the financial statements of the parent company with those of the subsidiary
so that an overall report is created as if they were a single entity
Detailed Mechanics – taught in advanced courses
Rationale
 In an acquisition one firm acquires the majority of the common stock of another company but
each company continues its legal existence. Each company must be accounted for separately and
prepare its own set of financial statements.
 Economically, the parent has the power to liquidate the subsidiary into a branch. In this case the
legal structure of two separate companies will cease to exist.
 Therefore, the two entities should be treated as a single entity and the two sets of financial
statements are then consolidated.
6-30
Illustration 6.3. A Corp buys 100% shares of B Corp for $1.2 billions in cash. Financial
statements of A and B, just before the acquisition are provided below. (all amounts in $ mil)
FINANCIAL STATEMENTS BEFORE ACQUISITION
Income statement A B
Sales 3,000 600
It is also given that the fair value of balance sheet
Cost 2,400 400 items of B at the time of acquisition is as follows
Net income 600 200 Inventory 800
Balance Sheet A B PP&E 3,600
Long term debt 3850
Cash & receivables 2,000 300
Inventory 6,000 850
PP&E 25,000 3,000 The following items are not reported in B’s
balance sheet
Total Assets 33,000 4,150
Patents $ 50
Liabilities & SE Brand name $150
Accounts payable 7,000 300
Long term debt 22,000 3,500 Skilled workforce $300
Favorable press reviews of product $100
Capital 2,600 210
RE 1,400 140
Total L & SE 33,000 4,150
Prepare A’s consolidated financial statement
on the date of acquisition.
6-31
At the time of investment, A will post the following journal entry -
Investment in B 1,200 Dr
Cash 1,200 Cr
What should it do subsequently? Why should it consolidate?
6-32
Understand why A is paying $1,200 million to B
Revised Balance Sheet at FV B
Cash & receivables 300

Inventory 800
PP&E 3,600
Patent 50
Brand name 150
Total Assets (1) 4,900
Liabilities
Accounts payable 300
Long term debt 3,900
Total Liabilities (2) 4,200
Identifiable net asset (3) = (1) - (2) 700

Price paid (4) 1,200
6-33 GOODWILL (4) - (3) 500

Consolidated financial statements on the date of acquisition -
% shares of B bought by A 100%
Cash paid by A 1200
100% acquisition
Income statement A B CONSOL

Sales 3,000 600 3,600
Cost 2,400 400 2,800
Net income 600 200 800
Balance Sheet A B CONSOL
Cash & receivables 800 300 1,100

Inventory 6,000 800 6,800
PP&E 25,000 3,600 28,600
Patent 50 50
Brand name 150 150
Goodwill 500
Total Assets 37,200
Liabilities & SE
Accounts payable 7,000 300 7,300
Long term debt 22,000 3,900 25,900
Capital 2,600 2,600

RE 1,400 1,400
6-34 Total L & SE 33,000 4,200 37,200
What if it is not a 100% acquisition
 Combine the financial statement of the parent company with that of the subsidiary as if it is a
100% acquisition. Then make adjustments to reflect the fact that parent does not own 100% of the
subsidiary
 Income statement
 First line includes 100% of subsidiary’s net income.
 Then show separately
 Share of net income that belongs to the parent. It is often termed as net income
attributable to controlling interest (NCI)
 Share of net income that does not belong to the parent. It is often termed as net income
attributable to non-controlling interest (NCI)
 Balance sheet
 Add up100% of assets and liabilities of parent and subsidiary.
 Show separately the share of net assets of subsidiary that does not belong to the parent as
noncontrolling interest under the parent’s SE.
6-35
Consolidated financial statements on the date of acquisition -
% shares of B bought by A 75%
Cash paid by A 900
75% acquisition
Income statement A B CONSOL
Sales 3,000 600 3,600
Cost 2,400 400 2,800
Net income 600 200 800
Net income attributable to NCI 50
Net income attributable to A 750
Balance Sheet A B CONSOL
Cash & receivables 1,100 300 1,400

Inventory 6,000 800 6,800
PP&E 25,000 3,600 28,600
Patent 50 50
Brand name 150 150
Goodwill 500
Total Assets 37,500
Liabilities & SE
Accounts payable 7,000 300 7,300
Long term debt 22,000 3,900 25,900
NCI 300
Capital 2,600 2,600
RE 1,400 1,400
6-36 Total L & SE 33,000 4,200 37,500
Certain important considerations while consolidation
 Consolidated financial statements is not merely adding up individual companies’ financial
statements. Any intercompany profits on sales of inventories held by the consolidated entity at
year-end, along with any intercompany profits on other asset transactions, are eliminated
 Companies in poor financial condition sometimes combine with financially strong companies,
thus obscuring analysis
 Financial statements of the individual companies comprising the larger entity are not always
prepared on a comparable basis—these differences can inhibit homogeneity and impair the
validity of ratios, trends, and other analyses
 Consolidated financial statements do not reveal restrictions on use of cash (including dividend
payment) for individual companies--these factors obscure analysis of liquidity
6-37
Next session
• Shareholders’ equity
6-38
SESSION: 7
Shareholders’ equity
7-1
Learning objectives
1. Learn various types of equity

2. Understand the components of stockholders' equity.
3. Understand the effects various transactions have on stockholders' equity.
4. Get familiar with stock based compensation
5. Understand the difference between basic versus diluted EPS
7-2
Components of Shareholders’ equity
Major components of Shareholders’ equity include

⚫ Common stock – the most basic form of shares and represent the residual
corporate interest. Its main features include (i) bears ultimate risks of loss, (ii)
receives the benefits of success, and (iii) not guaranteed dividends nor assets upon
dissolution.
⚫ There can be shares with differential voting rights. Prominent Companies with
Dual-Stock include -
⚫ Historical: Nike, Comcast, New York Times, Ford.
⚫ New economy companies: Facebook, Google, Alibaba, LinkedIn, Zillow, Groupon,
Fitbit, GoDaddy, Planet Fitness, Orbitz, Shake Shack, RE/MAX, WebMD, DreamWorks
Animation, and Yelp.
7-3
Dual Voting Rights
In 2008, Tata Motors became the first

company in India to issue DVR shares.
To fund the acquisition of Jaguar Land
Rover, it issued 6.4 crore DVR shares.
These DVRs offer higher dividends but

carry one-tenth the voting rights of
ordinary shares. This means 10 DVR
shares equal one ordinary share as far as
voting rights are concerned
7-4
Google (Alphabet)
⚫ Class A—Held by a regular investor with regular voting rights (GOOGL)
⚫ Class B—Held by the founders and has 10 times the voting power compared to Class A
⚫ Class C—No voting rights (GOOG)
5
7-5
⚫ Preferred stock - are created by contract, when shareholders’ sacrifice certain rights
( such as voting) in return for other rights or privileges, usually dividend preference
(over common stock)
⚫ Treasury stock and shares held in Trusts - corporation’s own shares that have been
repurchased by the company
⚫ Retained earnings - is net income that a corporation retains for future use in the
business, after paying out dividends
⚫ Accumulated Other Comprehensive Income (Loss), which can arise from:

⚫ Foreign currency translation adjustments
⚫ Unrealized gains and losses on available-for-sale marketable securities
⚫ Unrealized gains and losses on cash-flow derivatives
⚫ Certain pension liability adjustments
⚫ Minority (non-controlling) share of subsidiaries’ equity – this represents the portion

of the subsidiaries’ equity that is not owned by the reporting entity. These shares are
owned by other shareholders – that is, the minority.
7-6
Tracking changes in Shareholders’ equity
Changes in shareholders’ equity can arise because of –

▪ Issuance of common stock
▪ Treasury stock transactions
▪ Dividends
▪ Stock splits
7-7
Issuance of common stock
• Authorized - the total number of shares that a corporation is legally allowed to sell
• Issued - the number of shares that have been sold to stockholders

• Stocks are usually issued for cash
• Noncash exchanges for assets or services
• Conversions of convertible bonds or preferred stock
• Exercise of stock options (involves some cash)
• Outstanding - the number of shares still held by the stockholders. It is calculated as number
issued less number held in treasury
• Par value – Value assigned per share in the company’s charter. It has no bearing on the price
at which the stock will be sold during an IPO / SEO.
• Market value – The price at which the stock is trading in the stock market
• Additional paid in capital = Price at which the stock is sold – par value
7-8
Illustration # 7.1. Assuming a share with a par value of $10 was issued for
$100. How would this transaction be recorded?
7-9
Treasury stock transactions
Corporations buy back their outstanding stock for reasons that include -
1. To reissue shares to officers and employees under bonus and stock
compensation plans
2. To increase trading of the company’s stock in the securities market.
3. To have additional shares available for use in acquiring other companies.
4. To increase earnings per share.
5. To eliminate hostile shareholders.
6. To retire the stock
• In India the treasury stock has to be kept in a separate trust. The

company can’t resell it in the open market.
7-10
Illustration 7.2. Suppose HM Corp, buys back 10,000 of its shares at $11 per
share. How would this transaction be recorded?
• Treasury stock is a contra equity account shown as reduction from shareholders’

equity.
• It is NOT recorded as an asset (Investment) on the balance sheet because it does

not make sense to say that a company owns a part of itself.
7-11
• Suppose of the 10,000 treasury shares, 1,000 shares are re-issued for $15 /
share. How would this transaction be recorded?
• Suppose of the remaining 9,000 treasury shares, 2,000 shares are re-issued for
$8 / share. How would this transaction be recorded?
7-12
Dividends
⚫ Dividends are a distribution to stockholders on a pro rata (proportional to

ownership) basis.
⚫ Dividends can be (i) cash dividend , (ii) stock dividend, (iii) property dividends, or
(iv) liquidating dividends
⚫ Not necessary for the company to have current period income (that is, dividends
can be paid even in year the company reports a loss) unless there are covenant
restrictions
⚫ Dividends must be declared by the board of directors—they are not automatic
⚫ Three important dates associated with dividends:

⚫ Date of declaration - date when dividends are announced
⚫ Date of record - stockholders owning stock on this date receive the dividend
⚫ Date of payment-the date the company pays cash to shareholders of record
7-13
Cash dividend
Illustration# 7.3. A company declares a $20,000 cash dividend on Sept. 26 20X1 to be
paid on Nov. 15 to stockholders of record on Oct. 25. What journal entries would the
company prepare under U.S. GAAP?
Journal entries
Sept 26 20X1 – date of declaration
Date of record – No entry
Nov 15 20X1 – Date of payment
7-14
Stock Dividends
Reasons why corporations issue stock dividends:
1. Satisfy stockholders’ dividend expectations without spending cash.
2. Increase the marketability of the corporation’s stock.
3. Emphasize that a portion of stockholders’ equity has been permanently reinvested
in the business.
Effects of Stock Dividends

◆ Changes the composition of stockholders’ equity.
◆ Total stockholders’ equity remains the same.
◆ No effect on the par or stated value per share.
◆ Increases the number of shares outstanding.
7-15
Illustration# 7.4 HM Corp. declares a 10% stock dividend on its $10 par
common stock when 50,000 shares were outstanding. The market price was
$15 per share.
Before After
Dividend Change Dividend
Stockholders' equity
Paid-in capital
Common stock, $10 par $500,000 $50,000 $550,000
Paid-in capital, in excess of par value - 25,000 25,000
Total paid-in capital 500,000 75,000 575,000
Retained earnings 300,000 (75,000) 225,000
Total stockholders' equity $800,000 - $800,000
Outstanding shares 50,000 5,000 55,000
7-16
Stock splits
Stock Splits - Decreases par value and increase number of shares.

◆ Why would a company do this?
◆ What happens to the market value of shares?

◆ No entry recorded for a stock split. WHY?
7-17
AAPL stock split history
If you bought a share at the time of IPO, how

Stock split Date
7-for-1 9-Jun-14
2-for-1 28-Feb-05 many share do you own now?
2-for-1 21-Jun-00
2-for-1 16-Jun-87
Shareholders' equity: 2013 2012

Common stock, no par value;
1,800,000 shares authorized; 899,213
19,764 16,422
and 939,208 shares issued and
outstanding, respectively
How does this stock split Shareholders' equity: 2014 2013

Common stock and additional paid-in
affect the Shareholders’ capital, $0.00001 par value; 12,600,000
equity? shares authorized; 5,866,161 and 23,313 19,764
6,294,494 shares issued and
outstanding, respectively
7-18
AAPL Share Split
19
7-19
Berkshire Hathaway never split
7-20
Stock based compensation arrangements
Companies use a range of stock-based compensation plans. The intuition is that if

managers of a company own its stock, it will align their interests with those of
shareholders
Advantages -
⚫ The amount of the stock award is often tied to performance targets. Hence stock-based
compensation plans motivate employees to work hard and make decisions that
improve company performance.
⚫ With most plans, employees earn the right to own or purchase shares over time
(vesting period). During this period, employees have greater incentive to stay with the
company
Disadvantage -
⚫ Managers can blindly focus on improving the stock price rather tan making better
products, keeping customers happy, taking care of employees and other stakeholders
7-21
Types of stock-based compensation plans
⚫ Restricted stock. Shares are issued to the employee, but the employee is not free to sell the shares
during a restriction period. This creates an incentive for the employee to remain with the
company.
⚫ Restricted stock units (RSUs). Employee is awarded the right to receive a specified number of
shares (or cash equivalent) after a vesting period. Unlike restricted stock, shares are not issued to
the employee until after the restriction period, at which time the employee has all of the rights of a
shareholder
⚫ Employee stock options. Employees are given the right to purchase shares at a fixed (strike) price
for a specified period of time. Similar to restricted stock, there is a waiting period (called a vesting
period) before the employee can purchase the shares.
⚫ Stock appreciation rights (SARs). Employees are paid in cash or stock for the increase in share
price, but do not purchase shares of stock. This is similar to a stock option but with no share
purchase required.
⚫ Employee share purchase plans. Employees are permitted to purchase shares directly from the
company
7-22
Accounting for Stock-Based Compensation
The common accounting steps -
• When the award is granted to employees, the company estimates the fair value of the
award. [How this is estimated is beyond the scope of this course !]
• The fair value of the award is recorded as an expense in the income statement, ratably
over the vesting period, and APIC is increased by the same amount.
• When the shares are issued, common stock and additional paid-in capital increase in the
same manner as for cash-based stock issuances
7-23
Measuring performance – EPS …basic vs. diluted
⚫ EPS is earnings per share, probably the most sought-after number in the stock
markets
⚫ Basic EPS does not consider the impact of dilutive securities
Net Income − Preferred Dividends

Basic EPS =
Weighted−average number of common shares outstanding
⚫ Diluted EPS represents EPS that would be obtained if all dilutive securities are
converted into common stock. Dilutive securities include convertible bonds, stock
options, warrants etc.
Diluted EPS = Basic EPS - EPS impact of dilutive options and warrants
- EPS impact of dilutive convertibles
7-24
Consider a company with the following securities outstanding:
⚫ Common Stock: 1,000,000 shares outstanding for the entire year.
⚫ Preferred stock: 500,000 shares outstanding for the entire year.
⚫ Convertible bonds: $5,000,000 6% bonds, sold at par, convertible into 200,000 shares of
common stock
⚫ Employee stock options: options to purchase 100,000 shares at $30 have been outstanding for
the entire year. The average market price of the company’s common stock during the year is
$40.
⚫ Net Income = $3,000,000
⚫ Preferred dividends= $50,000
⚫ Marginal tax rate= 35%
Basic EPS
7-25
⚫ Convertible bonds: $5,000,000 6% bonds, sold at par, convertible into 200,000 shares of
common stock
⚫ Net income would go up because interest will not be paid after conversion of debt to equity
⚫ Number of shares outstanding will increase of conversion of debt to equity
⚫ Employee stock options: options to purchase 100,000 shares at $30 have been outstanding for
the entire year. The average market price of the company’s common stock during the year is
$40.
⚫ Employees will pay 100,000*30 = 3000,000
⚫ With this amount, only 3000,000 / 40 = 75,000 shares can be bought in the open market
⚫ But since the company promised to give 100,000 shares to the employees, it will issue 25,000
(100,000 – 75,000) new shares because of which the number of shares outstanding will go up.
Diluted EPS
7-26
Analyzing equity footnotes and statement of shareholders’ equity
Refer to the statement of shareholders’ equity and footnote 2.9 Share Capital (page
210-211) from Dr. Reddy Labs’ annual report and answer the following questions-
Q1. How many shares is the authorized to issue? How many did it issue and how many
are outstanding?
Authorized shares =
Issued shares =
Outstanding shares = 1
Q2. Who are the major shareholders of this company?
7-27
Q3. What are the various components of TOTAL EQUITY for this company? Which is
the largest?
Q4. The company’s stock price was INR 4,587 on Mar 31, 2021. Determine the
company’s market capitalization on that day.
Q5. Calculate and interpret the company’s market-to-book ratio on Mar 31, 2021.
7-28
7-29
7-30
Next Session
• Time value of money (Async)
7-31
SESSION: 8
Time value of money
[Async lecture by Prof. Hariom Manchiraju]
8-1
Learning objectives
1. Learn time-value-of-money techniques
8-2
Time Value of Money
• Which would you prefer?

• $10,000 today
• or $10,000 in 5 years
• You already recognize that there is TIME VALUE TO MONEY. The value of a
dollar today is not the same as the value of a dollar in the past or in the future
• Time value of money differs because of inflation, interest, risk, consumption needs,
etc. These factors combine to determine the “discount rate” or “rate of return”
• Whenever we will receive or pay cash in the future, we must adjust the cash flows to
today’s value as we are evaluating our choices today.
8-3
Compound interest
Illustration 8.1. HM invests $100 in a Fixed Deposit that earns 8% interest per year.
• At the end of the first year, you have:

– $100 + $8 interest = $108
– This is the same as: $100 x (1 + 0.08) = $108
• At the end of the second year, you have:

– $108 x (1.08) = $116.64
– Note that you don’t have: $100 + ($8 x 2) = $116
– But you do have: $100 x (1.08) x (1.08) = $116.64
– Which is the same as: $100 x (1.08)2 = $116.64
• At the end of the third year, you have:

– $116.64 x (1.08) = $125.97 or
– $100 x (1.08)3 = $125.97
8-4
Future value
A more formal representation
If your initial investment was $PV instead of $100 FV = PV x (1 + r)n
Thus, the Present Value (PV) of what you invest today at an interest rate r grows by (1 + r)n
to earn a Future Value (FV) in n years from now
Future value (PV) is directly related to the rate of return (r) and the number of periods (n)
Components of time value calculaitons

1. PV = Present value (value before effects of interest or discounting)
2. FV = Future value (value after effects of interest or discounting)
3. r = Interest rate, discount rate, or rate of return
4. n = Number of periods between present value and future value
8-5
Lets practice …
Illustration 8.2. If you invested $10,000 in the stock market today, how much money would
you have at retirement? Assume the following:
• 20 years to retirement
• Expected rate of return in stock market is 15% (compounded annually)
There are three ways to solve this
1. FV = PV x (1 + r)n this can be solved with the help of a calculator
2. FV = PV x (FV factor for n, r) this can be solved with the help of tables
3. -FV(r,n,0,PV) in Excel
8-6
Future value of a dollar
8-7
Calculation
FV = 10,000 x (1.15)20 = $163,665
Or FV = 10,000 X ( FV Factor for 20, 15%)

FV = 10,000 x 16.3665 = $163,665
8-8
Present value
What if we know the Future Value, but don’t know the Present Value?
FV = PV x (1 + r)n => PV = FV / (1 + r)n
Present value (PV) is inversely related to the rate of return (r) and the number of periods (n)
Illustration 8.3.
(i) How much would you have to invest today in a FD that earns 8% interest/year to have
$108 next year?
PV = $108 / (1.08) = $100
(ii) How about if you want $125.97 in three years?

PV = $125.97 / (1.08)3 = $100
(iii) How about if you want $100 next year?

PV = $100 / (1.08) = $92.59
8-9
Illustration 8.4.
How much should you invested in a savings bond today so that you can have $10,000
twenty years from now? Assume the following:
• Savings bonds have no periodic interest payments (interest is added to the principal and
compounded)
• Interest on the bond was 15% (compounded annually)
Calculation
PV = 10,000 X (PV factor for 20, 15%)

PV = 10,000 x 0.0611
PV = $611
8-10
Present value of a dollar
8-11
Annuities
An Annuity is a constant stream of future cash flows
Illustration 8.5. HM will get $500 at the end of every year for the next three years.
Assuming an interest rate of 8%, what is the value of this series of cash flows today?
Calculations
• Using calculator PV = PMT/r x [1 - 1/(1 + r)n] or
• Using tables PV = PMT x (PVA factor for n, r) or
• Using Excel = -PV(r,n,PMT,0)
Where PMT = periodic payment
8-12
Present value of an annuity of a dollar
8-13
PV = PMT x (PVA factor for n, r)
= $500 x 2.57710
= $1,288.55
Note that this is a short cut for the following calculation
PV of $500 one year from now at 8% = 500 x 0.9259 = 462.98

+ PV of $500 two years from now at 8% = 500 x 0.8573 = 428.67
+ PV of $500 three years from now at 8% = 500 x 0.7938 = 396.90
_____________
∑ = 1,288.55
______________
8-14
Illustration 8.6. HM will save $5,000 every year till retirement. Assuming HM will retire in
20 years, and an interest rate of 8%, how much HM will have when he retires ?
Calculations
• Using calculator FV = PMT x [(1 + r)n -1] / r or
• Using tables FV = PMT x (FVA factor for n, r) or
• Using Excel = -FV(r,n,PMT,0)
Where PMT = periodic payment
8-15
Future value of an annuity of a dollar
8-16
FV = PMT x (FVA factor for n, r)
= $500 x 45.7620
= $228,810
Note that this is a short cut for the following calculation
FV of $500 19 years from now at 8% = 500 x 4.3157 = 21,579

+ FV of $500 18 years from now at 8% = 500 x 3.9960 = 19,980
.
.
.
.
.
.
.
.
+ FV of $500 0 year from now at 8% = 500 x 1 = 500
_____________
∑ = 228,810
8-17 ______________
Comprehensive example
Illustration 8.7. You have just won a lottery. The lottery board offers you four
different options for collecting your winnings:
1. Lump-sum payment of $8,000 today.

2. A Lump-sum payment of $20,000 at the end of 10th year.
3. Payments of $1,200 at the end of each year for 10 years.
4. Payments of $1,500 for the first five years and $500 every year (i.e. forever) after the
5th year.
Assume all earnings can be invested at a 10 percent annual rate. Ignoring any tax effects,
which option should you choose and why?
These cash flows arise at different points of time. How can we compare them?
8-18
OPTION 2. A Lump-sum payment of $20,000 at the end of 10th year
? 20,000
1 2 3 4 5 6 7 8 9 10
PV = A/(1+r)^t where A = Amount, r = rate of interest, t = time
= 20,000/(1+10%)^10
8-19
PV = 20,000 * 0.3855 = 7,711
8-20
OPTION 3. Payments of $1,200 at the end of each year for 10 years.
?
1200 1200 1200 1200 1200 1200 1200 1200 1200 1200
1 2 3 4 5 6 7 8 9 10
This series of payment is called ANNUITY
PVANNUITY = A*1/r*[1- 1/(1+r)^n ]
8-21
PV = 1,200*6.1446 = 7,373
8-22
OPTION 4. A payment of $1,500 for the first 5 years and $500 every year thereafter,
forever
STEP 1 ?
PV of 500
perpetuity
1500 1500 1500 1500 1500 500 500 500 500
1 2 3 4 5 6 7 8 Forever
PVANNUITY = A*1/r*[1- 1/(1+r)^n ]

When n becomes very large this formula collapses to A*1/r (PV PERPETUITY)
PV PERPETUITY = 500 * 1/10% = 5,000
8-23
?
5000
1500 1500 1500 1500 1500
1 2 3 4 5 6 7 8 Forever
Amount receivable in lottery = PV Annuity of 2000 for 5 years @ 10% interest

+ PV of 5000 to be received after 5 years
= 1500*3.7907 + 5000*0.6209
= 5686 + 3104
= 8,790
8-24
The present value of four different options for collecting your winnings:
1. Lump-sum payment of $8,000 today. PV = $8,000

2. A Lump-sum payment of $20,000 at the end of 10th year. PV = $7,711
3. Payments of $1,200 at the end of each year for 10 years. PV = $7,373
4. Payments of $1,500 for the first five years and $500 every year (i.e. forever) after the
5th year. PV = $8,790
Now since all these cash flows are comparable, we can make a decision
8-25
Application of the time value concept
Discounted Cash Flow (DCF) analysis allows us to translate cash flows from
different points in time into values at a given point in time.
Common economic questions that require DCF techniques:
 What is the value of the company today given its estimated future cash flows?
 How much will a company be able to borrow from market, given that it promises
certain fixed interest and repay the principal amount after X number of years
 We have promised health care benefits to our employees when they retire. What is
the value of that promise in today’s terms?
8-26
Summary
Whenever we compare cash flows at various times periods we need to determine
1. PV or FV ?
• If we want to know what is the value today – PV
• If we want to know what is the value at some point of time in future – FV
2. Single payment or a series of payment (annuity) ?
3. Different Compounding Periods

• So far, we have done annual compounding.
• What about semi-annual compounding (e.g. Bonds)? Divide the annual rate (r) by 2
and multiply years (n) by 2
• What about quarterly compounding?
8-27
Next session
• Liabilities
8-28
SESSION: 9
Liabilities
9-1
Learning objectives
1. Overview of major liabilities

2. Learn the basic terminology and features of bonds
3. Understand basics of accounting for bonds
4. Learn basic terminology relating to leases
5. Understand basics of accounting for leases
9-2
Overview of liabilities
A liability must meet three essential conditions:

1. The future transfer or sacrifice of economic benefits is probable.
2. The obligation of the future sacrifice of economic benefits is present, known,
3. The present obligation is based on transactions or other events that have already
happened.
• Classification based on credit period / maturity

• Current liabilities are due within one year – e.g. wages payable
• Long-term liabilities due beyond one year – e.g. post retirement benefits
• Classification based on requirement to pay interest

• Interest bearing liabilities – e.g. bank loan
• Non interest bearing liabilities e.g. accounts payables
9-3
Current Liabilities Liabilities that need to be settled within one year
Accounts payable Amounts owed to suppliers for goods and services purchased on credit.
It is normally noninterest-bearing unless it is not paid within the
specified duration.
Accrued expenses Obligations for expenses that have been incurred but not yet paid that
include - wages, rent, utilities, insurance, or other dues. They are
recorded as debits to the relevant expense and credits to an accrued
liability account to correctly include all the expenses owed at the end
of the reporting period. These are normally interest-free.
Deferred revenue Obligations created when the company accepts payment in advance for
good and services it will deliver in the future; also called unearned
revenues
9-4
Short term Short-term loans taken by the company. Eg. Commercial paper, line of
borrowings credit or revolving bank loans etc. These borrowings are normally
interest bearing and are due to the lenders on demand
Current portion of When companies have long-term debt, they must reclassify the portion
long term debt that has to be repaid within the next year as the current portion and
remove it from the long-term debt category.
Income taxes Income taxes due to the federal, state, and/or local government
authorities within a year
Others Miscellaneous and infrequently occurring current liability is shown in

an “other” category.
9-5
Non Current Obligations that are not expected to be settled within one
Liabilities year.
Discounting future payments to their present value [ TIME VALUE OF
MONEY] is an important part of valuing long-term liabilities.
Bank borrowings Installment loan or term loan - Each installment payment equals the
portion of the principal that is due plus the interest accrued on the loan.
Often, the company secures the borrowed funds using some specified
assets as collateral
Bonds Borrowings from the capital market. Because bonds are liquid and
lenders can limit their risk to a particular company, traded bonds are a
cost-effective way for investors to participate in debt markets and for
companies to borrow money.
Others Long-term liabilities may include other obligations such as those

incurred for leases, pension obligations, deferred taxes etc
9-6
Bonds
Repayment date
Face value
Coupon rate
Coupons (Interest payments)

9-7
Basic terms
• Face value – the amount that the company must repay
• Maturity – the date when the company repays the bond in full (face value)
• Stated rate or coupon rate – the rate of interest that the company must pay
• Market rate - the rate of interest demanded in the market place given the risk
characteristics of a bond. This rate can be different from the coupon rate.
• Frequency of interest payment
• Paid periodically typically semi-annually
• Paid cumulatively at the end of the bond’s life, called a zero-coupon bond
9-8
Features
• Covenants – a provision stated in a bond, usually to protect bondholders interest. If these
conditions are violated the bondholders have a right to demand repayment of the loan principal.
Examples of covenants include
• Restriction on sale of certain property
• Restriction on payment of dividends
• Requirement to maintain certain level of retained earnings
• Preference in liquidation -
• Mortgage bonds are secured by the pledge of a specific property. In case of default, these
bondholders have the first right to proceeds from the sale of that property
• Debentures have a general claim against all assets, instead of a specific claim against
particular assets
• Subordinated debenture holders have claims against assets that remain after satisfying the
claims of other general creditors
• Sinking fund – the company is required to put cash aside to repay the bond
• Callable – the firm has the option to prepay the bond (before maturity)
•
9-9 Convertible – the bond holder has the option to convert the bond to equity
Determining bond proceeds
 Every bond has a coupon rate that is promised by the company at the time of filing
prospectus
 On the day when the bond is actually issued in the market, the prevailing interest
rates might be different
 The bond proceeds depend on the market rate of return that prevails for an
investment of like risk, on the issuance day.
 Basic demand and supply economics determines bond proceeds. Bonds are sold for
cash and are issued at:
 Par if coupon rate = market rate
 Premium if coupon rate > market rate
 Discount if coupon rate < market rate
9-10
Illustration# 9.1 Consider a 10%, 3-year bond with a face value of 1,000, issued
1/1/20X1. Assume that the prevailing market rate is 10% the day the bond is issued.
What much will be received in cash when this bond is issued.
Principal repayment of
1000
Interest payment of =
Face value*coupon rate
= 1000*10%
100 100
= 100
0 1 2 3
9-11
Calculation of bond proceeds
Face value 1000

Coupon rate 10%
Discount rate 10%
Year 1 2 3
CF 100 100 1,100
PV Factor 0.9091 0.8264 0.7513
PV 91 83 826
∑PV 1,000
9-12
Illustration# 9.2. Consider a 10%, 3-year bond with a face value of 1,000, issued
1000
= 1000*10%
100 100
= 100
0 1 2 3
Note that there is no change in cash outflows of the company since it is promised. The only change
is the rate used in the PV calculations since market rate on date of issuance is now different.
9-13
Face value 1000

Coupon rate 10%
Discount rate 9%
Year 1 2 3
CF 100 100 1,100
PV Factor 0.9174 0.8417 0.7722
PV 92 84 849
∑PV 1,025
9-14
Illustration# 9.3. Consider a 10%, 3-year bond with a face value of 1,000, issued
1000
= 1000*10%
100 100
= 100
0 1 2 3
Note that there is no change in cash outflows of the company since it is promised. The only change
is the rate used in the PV calculations since market rate on date of issuance is now different.
9-15
Face value 1000

Coupon rate 10%
Discount rate 11%
Year 1 2 3
CF 100 100 1,100
PV Factor 0.9009 0.8116 0.7312
PV 90 81 804
∑PV 976
9-16
Accounting for bonds
• Because market rate and coupon rate are different, there is likely to be a discount or premium when
a bond is issued.
• When and how much should such discount / premium be recognized
• At the time of issuance
• Over the life of the bond
• At the time when bonds are retired
• Effective interest rate method is used to amortize bond discount or premium
• The effective interest rate (market rate at the time bonds were issued) is multiplied times the bond's
book value at the start of the accounting period to arrive at each period's interest expense.
• The difference between coupon payment and the interest expense will be the amount of amortization
Effective interest rate method
Year Beginning Coupon Interest Amortization Ending Ending net
net liability payment expense of bond unamortized liability
discount discount
0 24 976
1 976 100 107 7 17 983
2 983 100 108 8 9 991
3 991 100 109 9 0 1,000
9-17
1. The journal entry to record the bond issuance:
Cash (A+) Dr 976 (cash received when bonds are issued)
Discount on bond (+XL) Dr 24 (PLUG)
Bonds payable (+L) Cr 1,000 (promised by company to repay)
2. The journal entry to record the interest payment in year 1 is:

Interest expense (+E, -SE) Dr 107 (Net liability*market rate on the date of issuance = 976*11%)
Discount on bond (-XL) Cr 7 (PLUG)
Cash (-A) Cr 100 ( promised payment by company = 1000*10%)
Interest expense is calculated using the market rate at the time of bond issuance.
The market rate will subsequently change but for accounting purposes we continue
to use the market rate at the time of bond issuance.
9-18

5. The journal entry to record the repayment of bond in year 3:
Bond payable (-L) Dr 1000

Cash (-A) Cr 1000 ( promised payment by company)
9-19
Retiring bonds before maturity
Illustration # 9.4. Assume that the company repurchases the bonds on the open market at the
end of year 2 when the current price of the bond is 971. What are the financial statement
effects?
Effective interest rate method
Year Beginning Coupon Interest Amortization Ending Ending
net payment expense of bond unamortized net
liability discount discount liability
0 24 976
1 976 100 107 7 17 983
2 983 100 108 8 9 991
3 991 100 109 9 0 1,000
Bond payable (-L) Dr 1000 (remove liability)

Gain of retirement of bond (+SE) Cr 20 (PLUG)
Discount on bond Cr 9 (remove unamortized bond)
Cash (-A) Cr 971 (cash payment to the bond
holders )
9-20
Leases
Lease is a contract that conveys the right of one party to control the use of an asset owned by
another, for a specified period of time in exchange for consideration.
• Lessee – party using the asset
• Lessor – owner of the asset
• Periodic rental payments called minimum lease payments (MLP)
Commonly leased assets - – Airplanes, buildings, equipment, vehicles
Advantage of lease - Many companies use leases to obtain easier access to assets, to finance
assets, and/or to limit risk ( such as obsolescence) associated with the outright purchase of
assets.
9-21
Classification of leases
Finance lease : Leases that transfer substantially all benefits and risks of ownership. One
of these 5 conditions have to be met -
i. lease transfers ownership of property to lessee by end of the lease term
ii. lease contains an option to purchase the property at a bargain price
iii. lease term is 75% or more of estimated economic life of the property
iv. present value of rentals and other minimum lease payments at beginning of lease
term is 90% or more of the fair value of leased property less any related
investment tax credit retained by lessor
v. The asset being leased is of a specialized nature and is expected to have no
alternative use to the lessor at the end of the lease term.
Operating Lease: Leases other than finance leases
9-22
Accounting by Operating Lease Finance Lease
LESSEE
Balance • All leases are recognized on the balance sheet (except leases with a term of less
than 12 months).
sheet
• Lease asset is reported as either PPE or a “right-of-use” asset that is amortized
over the lease life.
• Lease liability is reduced by principal payments each period, like a mortgage.
• Accounting treatment is similar to recording a PPE asset that is purchased and
financed with borrowed money (both the asset and liability are reported on the
balance sheet).
Income Rent expense is recognized for the • Straight-line amortization expense of

straight-line amortization of the total the right-of-use asset
statement
lease payments plus up-front costs. • Interest expense is recognized on the
lease liability.
9-23
Illustration # 9.5.
HM Co leases an asset on January 1, 20X1
• Lease has a 3 years with annual MLPs of $10,000, $15,000 and $20,000 to be paid at the
end of year 1, 2, and 3 , respectively.
• Assume an interest rate of 8% p.a. for the lease and the PV of MLP is $38,000. The
Is this an operating lease or a finance lease under the following conditions –

(i) Estimated useful life of the asset = 3 years
(ii) Estimated useful life of the asset = 10 years
9-24
Calculation of ∑PV of MLP
Discount rate 8%
Year 1 2 3
CF 10,000 15,000 20,000
PV Factor 0.9260 0.8574 0.7939
PV 9,260 12,861 15,879
∑PV 38,000
Dividing MLP as interest espense and reduction in lease liability

Year Beginning MLP Interest Reduction in Closing
lease liability expense lease liability lease liability
1 38,000 10,000 3,038 6,962 31,038

2 31,038 15,000 2,481 12,519 18,519
3 18,519 20,000 1,481 18,519 0
9-25
Accounting for finance lease
Capitalize the asset as ∑ PV of lease payments and record corresponding liability

Right of use asset Dr 38,000 (A+)
Lease Liability Cr 38,000 (L +)
Income statement impact (JE 1 and 2 repeated every year)
1. Recognize depreciation of ROU asset

Depreciation expense Dr 12,667 [ 38,000/3 = 12,667]
Accumulated depreciation Cr
2. Record MLP as reduction in liability and payment of interest
Lease liability Dr 6,962

Interest expense Dr 3,038
Cash Cr 10000
9-26
Accounting for operating lease
Capitalize the asset as ∑ PV of lease payments and record corresponding liability (same as
finance lease)
Right of use asset Dr 38,000 (A+)
Lease Liability Cr 38,000 (L +)
Income statement impact (JE repeated every year)
Rent expense Dr 15,000 [ (10,000 + 15000 + 20000)/3 = 15,000]

Lease liability Dr 6,962
Cash Cr 10000
Accumulated depreciation Cr 11,962 [ PLUG. 15,000 + 6962 – 10,000]
9-27
Next session
• FSA – part 3
9-28
SESSION: 10
Financial statement analysis – part 3
10-1
Learning objectives
1. Analyze footnotes of the company relating to borrowings various liabilities

2. Calculate ratios to evaluate leverage
3. Get familiar to valuation ratios
10-2
Analyzing footnotes relating to borrowing
Refer to the footnote 2.10 A & 2.10B Borrowings (page 224-227) from Dr. Reddy Labs’
annual report and answer the following questions-
Q1 How much has the company borrowed and from where?

Q2. What are the terms relating to security and interest rates of these borrowings ?
Q3. What portion of this borrowing is to be repaid within one year?
10-3
Total Current Noncurrent Security Interest rate
Long term borrowings

Debentures (NCD) 3,800 0 3,800 none 6.70%
Lease obligations 3,363 864 2,499
Short term borrowings

Pre-shipment credit 10,300 10,300 0 None INR loans - 3 month T-
bill + 30bp, 5.75%
Foreign currency 12,836 12,836 0 None US $ 1.8% - 2.2%,
borrowings Different in other
currencies
Bank OD 9 9 0 None
Total 30,308 24,009 6,299
Uncommitted lines of
38,766 38,766
credit
10-4
Recap of Dupont analysis
What drives the ROE of a company ?
• Profit margin: profitability i.e. profit generated for each $ of sale

• Asset turnover: productivity i.e., sales generated for each $ invested in assets
• Leverage: equity multiplier or level of borrowing
• The benefit of borrowing is that managers can operate from a larger asset base than the
amount that would be financed only from shareholders’ equity.
• This would result in greater profits for shareholders as long as the business generates a
higher return on its assets than what it must pay to service the debt.
• The risk is the company commits to pay certain interest and return the borrowings in
certain pre-committed manner irrespective of profit / loss
10-5
Ratios used in analysis of liabilities
ROE
ROA LEVERAGE
PROFITABILITY PRODUCTIVITY
Liquidity Coverage
Solvency
Current ratio Interest coverage
Total liabilities / ratio
Total assets Quick ratio
Debt service
Debt / Equity coverage ratio
Analysis of liabilities
10-6
1. Total Liabilities/ Total Assets -
Measures the proportion of total assets financed by external funds. Higher this ratio, greater is the
reliance on external funds, and higher is the risk.
Select numbers as per Ind AS 31-Mar-20 31-Mar-21

Total assets 2,32,253 2,66,168
Total liabilities 76,265 89,751
Total liabiltiies / Total assets 33% 34%
10-7
2. Debt/Equity Ratio
Indicates how much of interest bearing liabilities a company is using to finance its assets relative
to the value of shareholders’ equity.

Debt
Short term Borrowings 16,532 23,145
Long term Borrowings - current portion 4,266 864
Long term Borrowings - noncurrent portion 1,304 6,299
Total debt 22,102 30,308
Equity 1,55,988 1,76,417
D/E 0.14 0.17
10-8
3. Current ratio = (Current Assets) / (Current Liabilities)
• High current ratio indicates greater ability to meet short term obligations
• Low current ratio indicates greater reliance on operating cash flows or external financing to
meet short term obligations
• Typically a ratio of 2 : 1 or better is considered good
4. Quick ratio = (Cash + ST marketable securities + AR ) / Current liabilities

• More conservative that current ratio because it considers -
• Inventory may not be quickly converted into cash
• Prepaid expenses, deferred taxes etc. can’t be converted back into cash
10-9
Current assets (1) 1,25,991 1,45,352
Cash (2) 2,053 14,829
Marketable securities (3) 23,687 19,744
Accounts receivables (4) 50,278 49,641
Current liabilities (5) 76,265 89,751

Current ratio (1/5) 1.65 1.62
Quick ratio (2 + 3 + 4)/5 1.00 0.94
10-10
5. Interest coverage ratio = EBIT / Interest expense
• EBIT = Earnings (income) before Interest expense and income Taxes
• Measures how many times a firm’s net income before interest expense and income taxes
exceeds its interest expense.
• Interest coverage ratios less than 2.0 suggest a risky situation.
• Some analyst’s use CFO or EBIDTA in the numerator
6. Fixed charge coverage = EBIT / (Interest payments + Current portion of debt)

• Current potion of long term debt and current portion of lease payments will reflect the
principal repayment due next year. Should include any other repayments also.
• This ratio is also called Debt Service Coverage Ratio (DSCR)
• The ratio of less than 1 indicates that cash generated form operations is not sufficient to
service debt. The debt will have to be refinanced or cash from some other sources has to
be introduced.
10-11
Net income 20,260 19,516
Interest expense 983 970
Tax -1,403 9,319
EBIT 19,840 29,805
Debt to be repaid with 1 year 4,266 864
Interest coverage ratio 20.18 30.73

Fixed charge coverage ratio 3.78 16.25
10-12
Overall evaluation
How well is the company doing compared to (i) its past, and (ii) competition ?
Dr. Reddy Labs Sun Pharma
Select numbers as per Ind AS (Rs mil) 2019 2020 2021 2019 2020 2021
Net income 19,500 20,260 19,516 26,654 37,649 29,038
Sales 1,54,482 1,75,170 1,90,475 2,90,659 3,28,375 3,34,981
Net income / Sales (1) 12.62% 11.57% 10.25% 9.17% 11.47% 8.67%
Average total assets 2,25,050 2,28,840 2,49,211 6,46,051 6,64,731 6,79,595

Sales / Avg total assets (2) 0.69 0.77 0.76 0.45 0.49 0.49
Avg SE 1,32,976 1,48,093 1,66,203 4,34,604 4,69,236 4,58,636

Avg total assets / Avg SE (3) 1.69 1.55 1.50 1.49 1.42 1.48
ROE (1) X (2) X (3) 14.66% 13.68% 11.74% 6.13% 8.02% 6.33%
10-13
How does stock market process this information?
Analysis as of March 2022 DRL SUN

Price (INR) [1] 4,360 905
Shares outstanding (# mil) [2] 166 2,399
Market cap (INR, crores) [ 3 = 1*2] 72,347 2,17,100
If you have to pick between the stock of Dr. Reddy Labs and Sun Pharma, which one would you pick?
You would be able to answer this question correctly if you take the FSA and BVFS
electives
10-14
Quick preview of things to come….
• Three commonly used valuation ratios are -

• P/E = Stock price / Earnings per share
• P/B = Stock price / Book value per share or Market capitalization / Book value of
equity
• P/S = Stock price / Sales per share or Market capitalization / Sales
• These ratios can be interpreted as the price investors are willing to pay to buy a share of a
company has $1 as EPS, BVE/Share, or Sales/share.
• These ratios are often used as a part of relative valuation where we want to pick a
relatively overvalued or undervalued stock among a group of stocks
• All else equal- firms with higher growth prospects and lower risk will have higher
valuation ratios
• P/E and P/B can’t be calculated when EPS and Book value of equity are negative
• Will learn more about these ratios in FSA / Valuation class
10-15
Analysis as of March 2022 DRL SUN
Price (INR) [1] 4,360 905
Shares outstanding (# mil) [2] 166 2,399
Market cap (INR, crores) [ 3 = 1*2] 72,347 2,17,100
EPS TTM [4] 113.80 26.69

P/E [5 = 1/4] 38.31 33.91
• If the industry average PE ratio is 37 then which stock should

you buy?
10-16
Conclusion
• “Education is what remains after one has forgotten what one has learnt in
school.” Albert Einstein
• I hope you have picked up necessary intuition about accounting process

that will help you make better decisions
• Best wishes
10-17
ISB FADM 2021
Practice Set 6: Intangible Assets and Intercorporate investments
QUESTION 1
SOLUTION
a. The acquisition included total assets of $2,652 million. Of that, $2,145 million (or 77%)
was allocated to intangible assets, detailed below.
Goodwill $ 878
Brand 948
Customer relationships 203
Favorable lease 16
Total $2,045
a. All of the assets and liabilities of Versace (the acquired company) are reported on Capri’s
consolidated balance sheet at their fair values on the date of the acquisition, not at their
net book values.
b. The intangible assets with a determinable life are amortized (depreciated) over their
useful lives. Intangible assets with an indeterminate useful life are not amortized, but are
tested annually for impairment, or more often if circumstances require. Goodwill is in this
latter category.
c. Goodwill is reported on the consolidated balance sheet at $848 million and it is not
routinely amortized but rather, tested for impairment at each balance sheet date. Capri
Holdings will consider the fair value of Versace and if that value falls below the investment
carrying value (which is $2.005 billion at December 31, 2018), then Capri would consider
goodwill to be impaired.
QUESTION 2
Kritika Company incurred costs of Rs. 7,50,000 to develop a specific new product in fiscal
2019. Of that amount, Rs. 3,00,000 was incurred up to the point at which the technical
feasibility of the product could be demonstrated and other recognition criteria were met.
In 2020, the company spent an additional Rs. 6,00,000 for product development.
The product was available for sale on 3 January 2021 with the first shipment to the customer
occurring in mid-January, 2021. Sales of the product are expected to continue for four years,
at which point the company thinks a replacement product will need to be developed. The
company believes that 2 million units will be sold during the product’s four-year economic
life, with 8,00,000 units expected to be sold in 2021. Assuming that the company follows Ind
AS, answer the following questions -
a) Explain how the company would treat the amount spent in 2019.
b) How would the additional costs in 2020 affect the balance sheet and income
statement, if we assume that all recognition criteria continued to be met.
c) What is the carrying value (book value) of the development cost asset on 1 January
2021?
d) Determine the expected amortization expense for 2021.
SOLUTION
a) The company would expense the Rs. 3,00,000 on the 2020 income statement
because it did not meet the capitalization criteria. The balance of the costs, Rs.
4,50,000 would be capitalized as an intangible asset called Development costs.
b) The 6,00,000 of product development costs in 2020 would be capitalized if, like in
2019, technical feasibility of the product can be demonstrated and other recognition
criteria are met.
c) Carrying amount = 4,50,000 + 6,00,000 = 10,50,000.
d) Units produced in 2021 (expected) = 8,00,000
Total units expected to be produced = 20,00,000
Percent produced in 2021 = 8,00,000 / 20,00,000 = 40%
Amortization expense in 2021 = 10,50,000 × 40% = 4,20,000
QUESTION 3
SOLUTION
Balance Sheet Income Statement
Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction + = + + – =
Asset Assets ities Capital Capital enues ses Income
MS 216,000
Cash 216,000 1. Purchased
18,000
MS common
-216,000 +216,000
216,000 shares of = – =
Cash Investment
Baez Inc.,
Cash
for $12 per
share
216,000
Cash 21,600 2. Received a

DI 21,600 cash
dividend of +21,600 +21,600
Cash +21,600
$1.20 per = Retained Dividend – = +21,600
21,600 Cash
common Earnings Income
share from
DI Baez
21,600
UL 13,500 3. Year-end
MS 13,500 market price
of Baez -13,500 +13,500
UL -13,500
common = Retained – Unrealized = –13,500
13,500 Investment
stock is Earnings Loss
$11.25 per
MS share.
13,500
Cash 213,600
GN 11,100
MS 202,500
4. Sold all
Cash 18,000
+11,100 +11,100
213,600 common +213,600 -202,500
= Retained Gain on – = +11,100
shares of Cash Investment
Earnings Sale
Baez for
GN $213,600
11,100
MS
202,500
QUESTION 4
SOLUTION

MS 320,000
Cash 320,000 1. Purchased
20,000
MS common
-320,000 +320,000
320,000 shares of = – =
Cash Investment
Heller Co. at
$16 per
Cash
share
320,000
Cash 25,000 2. Received a

DI 25,000 cash
dividend of +25,000 +25,000
Cash +25,000
$1.25 per = Retained Dividend – = +25,000
25,000 Cash
common Earnings Income
share from
DI Heller
25,000
MS 30,000 3. Year-end
UG 30,000 market price
of Heller +30,000 +30,000
MS +30,000
common = Retained Unrealized – = +30,000
30,000 Investment
stock is Earnings Gain
$17.50 per
UG share
30,000
Cash 315,600
LS 34,400
MS 350,000
4. Sold all
20,000
Cash common -34,400 +34,400
315,600 +315,600 -350,000
shares of = Retained – Loss on = –34,400
Cash Investment
Heller for Earnings Sale
LS $315,600
34,400 cash
MS
350,000
QUESTION 5
SOLUTION

EMI 108,000 a. Purchased
Cash 108,000 12,000
common
EMI
shares of
108,000 Bakersfield
Co. at $9 per -108,000 +108,000
Cash = – =
share; the Cash Investment
108,000 shares
represent
30%
ownership in
Bakersfield
Cash 15,000
EMI 15,000 b. Received a
cash dividend
Cash of $1.25 per +15,000 -15,000
15,000 = – =
common Cash Investment
share from
EMI Bakersfield
15,000
EMI 18,000
EI 18,000 c. Recorded
income from
EMI Bakersfield
18,000 stock +18,000 +18,000
+18,000
investment = Retained Equity – = +18,000
Investment
EI when Earnings Income
18,000
Bakersfield's
net income is
$60,000
Cash 114,500
EMI 111,000
GN 3,500
d. Sold all
Cash 12,000
114,500 +3,500 +3,500
common +114,500 -111,000
= Retained Gain – = +3,500
shares of Cash Investment
Earnings on Sale
EMI Bakersfield for
111,000 $114,500
GN
3,500
QUESTION 6
SOLUTION
Consolidating
Liu Reed Adjustments Consolidated
Current assets ................. $950,000 $70,000 $1,020,000
Investment in Reed ......... 380,000 $(380,000) 0
PPE, net........................... 1,600,000 305,000 27,000 1,932,000
Goodwill ........................... . . 33,000 33,000
Total assets ..................... $2,930,000 $375,000 $2,985,000
Liabilities .......................... $ 450,000 $ 55,000 $ 505,000

Contributed capital .......... 1,850,000 280,000 (280,000) 1,850,000
Retained earnings ........... 630,000 40,000 (40,000) 630,000
Total liabilities &
stockholders’ equity ....... $2,930,000 $375,000 $2,985,000
ISB FADM 2021
Practice Set 9: Accounting for Bonds
QUESTION 1
SOLUTION
a. Selling price for $700,000, 9% bonds discounted at 8% (4% semiannually):
Calculator inputs: N = 20 I/Y = 4 PMT = -31,500 FV = -700,000

PV = 747,566.14
Excel inputs: = PV(4%,20,-31500,-700000,0) Cell will display: 747,566.14
Present value of principal repayment ($700,000 × 0.45639a) $319,473

Present value of interest payments ($31,500 × 13.59033b) 428,095
Selling price of bonds $747,568
aPresent value of a lump sum, 20 periods at 4%.

b Present value of an ordinary annuity, 20 periods at 4%.
b. Selling price for $700,000, 9% bonds discounted at 10% (5% semiannually):
Calculator inputs: N = 20 I/Y = 5 PMT = -31,500 FV = -700,000,

PV = 656,382.26
Excel inputs: = PV(5%,20,-31500,-700000,0) Cell will display: 656,382.26

Present value of interest payments ($31,500 × 12.46221b) 392,560
Selling price of bonds $656,383
a Present value of a lump sum, 20 periods at 5%.

b Present value of an ordinary annuity, 20 periods at 5%.
QUESTION 2

SOLUTION
a. Selling price of zero coupon bonds discounted at 8%
Calculator inputs: N =20 I/Y = 4 PMT = 0 FV = -350,000,

PV = 159,735.43
Excel inputs: =PV(4%,20,0,-350000,0) Cell will display: 159,735.43
b. Selling price of zero coupon bonds discounted at 10%
Calculator inputs: N =20 I/Y = 5 PMT = 0 FV = -350,000,

PV = 131,911.32
Excel inputs: =PV(5%,20,0,-350000,0) Cell will display: 131,911.32
QUESTION 3

SOLUTION
QUESTION 4
SOLUTION
QUESTION 5
SOLUTION
Amount paid to retire bonds ($200,000 × 101%) ...................................................... $202,000

Book value of retired bonds, net of $3,400 unamortized discount............................ 196,600
Loss on bond retirement ............................................................................................ $ 5,400
Gains and losses from bond redemptions typically arise during refinancing in which new
bonds are issued to retire existing bonds. The resulting gains or losses are not real
economic gains and losses. The loss on retirement results from Middleton’s use of historical
costing for its bonds. The $5,400 loss will be offset by correspondingly lower interest
payments in the future. Middleton does not recognize the present value of these future
interest payments nor the present value of the difference between the current face amount
of the bond and the former face amount. These present values will exactly offset the
reported loss on retirement and no “real” loss is realized.
QUESTION 4
SOLUTION
a. The leased asset is office space and with a lease term of 5 years, the value of the leased
asset is not being conveyed to CCH. Therefore this is an operating lease (consistent with
most leases for office, retail, or production space).
b. We can use Excel and the PV function to determine that the present value of the future
lease payments as follows: =PV(5%,5,115,487,0,0) = $500,000.
c. CCH Corporation will add $510,000 to the balance sheet as a right-of-use asset. This
includes the $500,000 present value of future lease payments along with the $10,000 up
front fees paid at the lease inception.
d. The lease amortization schedule follows:
e.
Implicit Interest Lease Amortization Lease Liability, End
Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
Year Start Start x 5%) Implicit interest) Lease Amortization)
1 500,000 25,000 90,487 409,513
2 409,513 20,476 95,012 314,501

3 314,501 15,725 99,762 214,738
4 214,738 10,737 104,750 109,988
5 109,988 5,499 109,988 ―
f. The financial statement effects template shows the transactions for the first two years.
Nonca Contrib Rev-

Transacti Cash Liabil- Earned Expen- Net
+ sh = + . + enue – =
on Asset ities Capital ses Income
Asset Capital s
s
ROU 510,000 510,00
LL - 0
Record 500,000
500,000 10,00 Right-
lease at = Lease
Cash 0 of-use
inception Liability
10,000 Cash asset
RE 117,487 Year 1 -92,48 -117,48

LL 90,487 - 117,487
lease 7 -90,487 7
Cash 115,4 Rent
payment Right- = Lease Retaine -117,487
115,487 87 Expens
and lease of-use Liability d
ROU Cash e
amortizati asset Earning
92,487 on s
RE 117,487 Year 2 -97,01 -117,48
LL 95,012 - 117,487
lease 2 -95,012 7
Cash 115,4 Rent
payment Right- = Lease Retaine -117,487
115,487 87 Expens
and lease of-use Liability d
ROU Cash e
amortizati asset Earning
97,012 on s
g. The table below presents future lease payments.
December 2020
2021 $ 115,487
2022 115,487
2023 115,487
2024 115,487
2025 -
Thereafter -
Total undiscounted lease payments 461,948
Imputed interest (52,437)
Total operating lease liability $409,511
Weighted average remaining lease life 4 years

Weighted average discount rate 5%
h. To enhance comparability we could reclassify the rent expense of $117,487 as interest

expense (from the amounts in the lease amortization table, in part d, above) and
 
 
 
 

 
 

 
 

amortization of the ROU asset (the principal portion from the lease amortization table
above PLUS the upfront fee of $10,000 divided by the lease term of 5 years.) These are
the amounts shown for the first two years, in part e, above.
QUESTION 5
SOLUTION
a. The first leased asset is land that the company will convert to an RV park. The lease term is
15 years, the value of the leased asset is not being conveyed to Alexander Mack because
land lasts longer than 15 years. Therefore, this is an operating lease (consistent with most
leases for office, retail, or production space).
The second lease is computer equipment and two facts indicate that this is a finance lease:
1) the lease term of 4 years will cover the bulk of the computer equipment’s life and 2) the
bargain purchase option at the end of the lease term.
b. We can use Excel and the PV function to determine that the present value of the future
lease payments for both leases. This will represent the amount of lease liability that
Alexander Mack will add to its balance sheet. The formulas are as follows:
Operating lease =PV(9%,15,-500,000,0,0) = $4,030,344

Finance lease = PV(9%,4,-24,694,0,0) = $80,000
c. Operating lease: Alexander Mack will add $4,480,344 to the balance sheet as a right-of-use
asset. This includes the $4,030,344 present value of future lease payments (above) along
with the $450,000 up front fees paid at the lease inception.
Finance lease: the company will add $85,000 to the balance sheet as PPE. This includes
the $80,000 present value of future lease payments and the $5,000 upfront fees at the
inception of the lease.
d. The operating lease amortization schedule follows:

Yea Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
r Start Start x 9%) Implicit interest) Lease Amortization)
1 4,030,344 362,731 137,269 3,893,075
2 3,893,075 350,377 149,623 3,743,452

3 3,743,452 336,911 163,089 3,580,363
4 3,580,363 322,233 177,767 3,402,595
5 3,402,595 306,234 193,766 3,208,829
6 3,208,829 288,795 211,205 2,997,623
7 2,997,623 269,786 230,214 2,767,410
8 2,767,410 249,067 250,933 2,516,476
9 2,516,476 226,483 273,517 2,242,959
10 2,242,959 201,866 298,134 1,944,826
11 1,944,826 175,034 324,966 1,619,860
12 1,619,860 145,787 354,213 1,265,647
13 1,265,647 113,908 386,092 879,556
14 879,556 79,160 420,840 458,716
15 458,716 41,284 458,716 0
The finance lease amortization schedule follows:

Yea Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
r Start Start x 9%) Implicit interest) Lease Amortization)
1 80,000 7,200 17,493 62,507
2 62,507 5,626 19,068 43,439

3 43,439 3,909 20,784 22,655
4 22,655 2,039 22,655 ―
e. The operating lease for land will create a rent expense for the lease payment of $500,000
plus $30,000 per year (the upfront cost of $450,000 divided by the lease term of 15 years).
The total rent expense each period will be $530.000.
f. The finance lease for the equipment will create interest expense of $7,200 (from the
amortization table above) and straight-line depreciation of $21,250 (= $85,000/4) on the
PPE asset, for a total expense of $28,450. The expense will decrease over time because
the interest declines each year.
g. At the end of 2020, the company would make the following disclosure:
At the end of the fiscal year, remaining operating lease payments were as following:
December 2020
2021 $ 500,000
2022 500,000
2023 500,000
2024 500,000
2025 500,000
Thereafter 4,500,000
Total undiscounted lease payments 7,000,000
Imputed interest (3,106,925)
Total operating lease liability $3,893,075
Weighted average remaining lease life 14 years

Weighted average discount rate 9%
h. The ROU asset and lease liability would have the following balances at the end of 2021:
Operating lease:
Asset = $4,133,452 calculated as $4,480,344 less two years of principal payments
($137,269 and $149,623 from the table in part d., above) and less two years of
amortization of the up-front costs ($450,000 × 2/15).
Liability = $3,743,452 per the table in part d.
Finance lease:
Asset = $85,000 – 2 × $21,250 = $42,500.
Liability = $43,439 per the table in part d.
i. To enhance comparability, we could convert the operating leases to be equivalent on the

income statement to the finance lease. We would replace the rent expense of $530,000
with interest expense (from the amounts in the lease amortization table, in part d, above)
and SL amortization of the ROU asset ($4,480,344/15).

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Intangibles

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Unrealized loss – OCI Dr (SE-, RHS ↓) 500

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