The Accounting Picture Book - intermediate accounting

97 Pages·2018·9.41 MB·English

by  Michael Fitzgerald

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Copyright © 2018 by Michael Fitzgerald. All rights reserved. Previous © 2011.

No part of this book may be reproduced, stored in a retrieval system, or transmitted by any
means, electronic, mechanical, photocopying, recording, or otherwise, without written
permission from the author.

The information contained within this eBook is strictly for educational purposes. If you wish
to apply concepts or techniques contained in this eBook, you are taking full responsibility
for your actions. The information contained in this eBook is based on American accounting
standards in 2018. Accounting standards change frequently. Consult a Certified Public
Accountant before making any accounting or tax decisions.
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Michael Fitzgerald received his Master of Science in Accounting degree from University of
Connecticut.
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What is this book?

A physics professor once told me, “When you sit down to a problem, the first thing to do is
draw a picture.” The question is, what to draw? Quantitative problems are not just number
soups; they contain underlying relationships. The ideal picture is a display of those
relationships, which allows you to see the structure of the problem instead of a bunch of
numbers.
There are two main advantages of pictures over text in education: (1) When learning a
concept, your eyes take in relationships more efficiently from a picture; and (2) Once you
understand the concept, you can operate your mental picture like a machine to solve
problems. That’s why diagrams are routinely provided in physics and math books.
Many accounting students study textbooks for months, memorizing and forgetting lots of
information while having little understanding. What they’re missing is the right picture.
When I first sat down to study accounting, the first thing I looked for was a diagram of the
fundamental relationships; after scouring the literature, I found the landscape totally void of
life! The structure of accounting is simple to display visually. While other books use a word
soup to describe a number soup, this book shows you the picture.
The Accounting Picture Book is essentially a diagram-based version of a typical accounting
textbook. It aims to deliver higher comprehension than similar textbooks do, in fewer
words, due to the advantages of pictures. The learning experience is different: it’s like
playing with building blocks in your mind, versus memorizing an encyclopedia. The result
is conceptual mastery of basic accounting. This is not a new system of accounting, but a
simple way to visualize the common system.
The Accounting Picture Book is divided into two parts, Part 1: Introductory and Part 2:
Intermediate. Part 1 provides a practical study of basic financial accounting. Part 2 covers a
number of intermediate-level topics. For the topics presented, the intention is not to cover
every detail, but to convey the concepts more effectively than any other source. Significant
detail is provided on many topics. Standard textbooks are useful for further studies.
If you are taking college classes, then studying the first four chapters of Part 1 will
illuminate your entire accounting curriculum. Chapters 8 and 10 are important. And, other
chapters of this book bring to life many of your textbook topics.
Whatever your interest in accounting, I believe you’ll find that this approach is the most
natural and expedient way to develop true understanding of accounting, which is the key to
proficiency.
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Brief Contents

Part 2: Intermediate

1. Bonds 7
2. Leases 20
3. Pensions 39
4. Income Taxes 56
5. Long-Term Contracts 79

Index 97
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Contents: Part 2
1. Bonds 7 3. Pensions 39
Stated Rate vs. Market Rate 7 Defined Contribution Plans 39
Bonds Sold at a Discount 8 Defined Benefit Plans 39
Bonds Sold at a Premium 12 Projected Benefit Obligation 40
Sale After Dated Date 16 Pension Plan Assets 42
Debt Issue Costs 17 Pension Liability and Pension Expense 43
Investments In Bonds 18 Prior Service Cost 44
Net Method 18 Losses or Gains -- PBO 46
Straight-Line Amortization 19 Losses or Gains -- Plan Assets 47
Amortization of Net Loss or Net Gain 50
2. Leases 20 Recording Pension Expense 52
Operating vs.Finance/Sales 20
Short-Term Operating Leases 21 4. Income Taxes 56
Finance/Sales Leases 21 Nontemporary Differences 58
Amortization/Depreciation 25 Temporary Differences 59
Finance/Sales Lease for Finance Purpose 26 Net Operating Losses 70
Finance/Sales Lease for Sales Purpose 26 Valuation Allowance 73
Long-Term Operating Leases 28 Differing Enacted Tax Rates 76
Interest Rates 30
Residual Value 31 5. Long-Term Contracts 79
Guaranteed Residual Value 31 Account Walk-through 80
Unguaranteed Residual Value 34 Percentage-of-Completion Approach 86
Bargain Purchase Options 36 Single Period Loss on Profitable Contract 88
Initial Direct Costs 37 Estimated Loss on Total Contract 92
Completed Contract Approach 95
Index 97
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Chapter 1: Bonds

Corporations commonly obtain long-term debt financing by selling bonds. Like other loans, a
typical bond obligates periodic interest payments to a lender, and repayment of a principal
amount. A large amount of cash can be raised in a single bond issue by selling thousands of
individual bonds, often at $1,000 each, to many investors. When bonds are issued, a contract
called a bond indenture is created which specifies the obligations of the corporation,
including the stated annual interest rate, frequency of interest payments, and final amount
to be repaid on the maturity date—the face amount, or maturity value. Interest payment
amounts depend on payment frequency. If a bond with a $1,000 face amount and stated
annual rate of 10% pays interest every six months, the amount of each interest payment is
1,000(10%/2) = $50.
Stated Rate vs. Market Rate
Accounting for bonds is based on the same principles as for other loans, as in Part 1 of The
Accounting Picture Book, figures 8.10-13. Accounting for bonds is complicated by one main
issue, depicted in figure 1.1: the stated interest rate is generally determined prior to the
actual sale of bonds, and market interest rates fluctuate, so the stated rate is not always
equal to the market rate at the time of sale.

FIGURE 1.1
Figure 1.2 shows the potential situations created by this kind of timing difference, given a
10% stated rate and alternate 8% or 12% market rates at time of sale:
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FIGURE 1.2
Figure 1.2 relates to Part 1 figure 8.10. The proportions in this and other diagrams are
exaggerated to make the relationships highly visible.
The cash payments for periodic interest and maturity value are fixed amounts, assigned by
the bond indenture. The present value of those fixed cash flows calculated at the stated
interest rate equals the bond’s face amount, but the PV calculated at the market rate may
equal less or more than the face amount. Debt investors buy the future cash flows based on
the market interest rate, so the sale price of the bonds is equal to the PV of the payments at
the market rate. That means the cash received when bonds are sold is often not equal to the
maturity value/face amount.
Bonds Sold at a Discount
Figure 1.3 shows the initial sale of bonds when the market interest rate is higher than the
stated rate.
The whole balance of Bonds Payable equals the face amount of the bonds. Discount on Bonds
Payable is a valuation account, a contra account to Bonds Payable. The difference between
those two account balances is the carrying amount of the bonds, which initially equals the
cash received for the bonds. “Carrying amount” is not an account.
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FIGURE 1.3
Here’s the initial entry for bonds with a total face value of $100,000 maturing in four years,
with stated rate of 10% payable annually, sold at a market interest rate of 12% (rounded):
01/01/19 Cash 93,926
Discount on Bonds Payable 6,074
Bonds Payable 100,000

This is a “liability incurred” type transaction. The calculation of the entry amounts reflects
figures 8.10, 1.2, and 1.3, as follows (PV factors from tables on page 145 of Part 1):
Cash interest payments based on stated rate and face value: 10% x 100,000 = $10,000 / year
PV of ordinary annuity of 4 interest payments at 12% market rate: 10,000 x 3.0374 = $30,374
PV of maturity value “single payment” at 12% market rate: 100,000 x 0.63552 = $63,552
Sale price of bonds equals PV of annuity plus PV of single payment: 30,374 + 63,552 =
$93,926
Discount is difference between maturity value and bond sale price: 100,000 - 93,926 = $6,074

The market interest rate used to calculate the initial bond price is called the effective rate. It’s
the interest rate implicit in the arrangement of cash flows—of all cash flows received and
paid.
With a discount, the principal received does not equal the maturity value, so the present
value of the obligation does not progress in a symmetrical path as in figure 8.11 (page 137 of
Part 1). The present value progresses as in figure 1.4:
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FIGURE 1.4
Present value increases at the effective rate, not the stated rate. Interest expense during a
period is equal to the increase in the present value of the obligation (PV is plotted by the
blue line). We can see that interest expense is greater than the cash payment each period; the
difference is recorded as a reduction of the discount (red sections), which increases the bond
carrying amount. The discount is thus reduced (“amortized”) over the life of the bonds,
until carrying amount equals maturity value at maturity date. In other words, each period
some interest expense is paid, and the rest is accrued.
The first period’s expense is shown in figure 1.5. Interest expense equals the effective rate
times the bond carrying amount at the start of the period, as in the following amortization
schedule based on the previous example (amounts rounded):
Cash Paid Interest Expense Discount Unamortized Carrying
Payment # (10% x Face Amount) (12% x Carrying Amount) Amortization Discount Amount
6,074 93,926
1 10,000 12% (93,926) = 11,271 1,271 4,803 95,197
2 10,000 12% (95,197) = 11,424 1,424 3,379 96,621
3 10,000 12% (96,621) = 11,594 1,594 1,785 98,215
4 10,000 12% (98,215) = 11,785 1,785 0 100,000
40,000 46,074 6,074

Discount amortization (accrued interest expense) is the difference between interest expense
and cash payment. The carrying amount increases each period, so interest expense
increases, and discount amortization increases.