Overview of F3: Liabilities, Equity, and EPS

Section F3 of the FAR CPA Exam shifts focus to the other side of the balance sheet – liabilities and equity – along with the critical performance metric of Earnings Per Share (EPS). Weighted similarly to F1 (typically 15-25%), this section covers diverse and often complex areas that require careful application of specific accounting standards. Understanding how entities finance their operations through debt and equity, and how obligations like leases and pensions are accounted for, is central to this part of the exam.

This section integrates concepts of present value, amortization, and allocation across various topics. Mastery requires not only understanding the mechanics of journal entries and calculations but also appreciating the financial reporting implications of different financing and operating decisions. The topics in F3 are particularly challenging because they involve transactions that often span multiple reporting periods and require careful measurement at inception and subsequent periods.

Bonds Payable and Long-Term Debt

Initial Recognition and Measurement

Accounting for bonds payable is a significant component of F3. Candidates must understand the initial measurement of bonds issued at par, a discount, or a premium. The market interest rate (yield) at issuance compared to the stated coupon rate determines whether bonds are issued at par, premium, or discount:

  • When market rate = coupon rate: Bonds issued at par
  • When market rate < coupon rate: Bonds issued at premium
  • When market rate > coupon rate: Bonds issued at discount

The initial carrying value of bonds equals the present value of all future cash flows (principal and interest), discounted at the market rate. For example, if a company issues $1,000,000 face value bonds with a 5% annual coupon rate when the market rate is 6%, the bonds will be issued at a discount. The journal entry would be:

Cash                             XXX
Discount on Bonds Payable        XXX
    Bonds Payable                    1,000,000

Where XXX represents the present value calculation of all future cash flows.

Effective Interest Amortization

Subsequent accounting involves amortizing any discount or premium over the bond’s life, typically using the effective interest method. This method applies a constant interest rate to the carrying value of the debt for each period.

The effective interest method produces the following pattern:

  1. Interest expense = Beginning carrying value × Effective interest rate
  2. Cash paid = Face value × Stated interest rate
  3. Amortization = Difference between interest expense and cash paid
  4. New carrying value = Previous carrying value ± amortization amount

For a bond issued at a discount, interest expense will always exceed the cash paid for interest, with the difference increasing the carrying value over time until it reaches face value at maturity. The opposite occurs for bonds issued at a premium.

Bond Retirements and Modifications

When bonds are retired before maturity, the difference between the carrying value and the reacquisition price results in a gain or loss. This transaction requires removing the carrying value from the books and recording any difference as a gain or loss on bond retirement.

Bond modifications and exchanges must be evaluated to determine whether they represent an extinguishment (resulting in gain/loss recognition) or a modification (requiring prospective adjustment of the effective interest rate). This determination depends on whether the present value of cash flows under the new terms differs by at least 10% from the present value of remaining cash flows under the original terms.

Convertible Debt and Debt with Warrants

The exam may test more complex debt instruments such as convertible bonds or debt issued with warrants. For convertible debt, the entire proceeds are typically recorded as debt unless the conversion feature requires separate accounting as a derivative. For debt with detachable warrants, a portion of the proceeds must be allocated to the warrants based on relative fair values.

Lease Accounting Under ASC 842

Lessee Accounting

Lease accounting under ASC 842 represented a paradigm shift from previous standards. The key principle is that lessees must recognize most leases on the balance sheet. Two types of leases exist for lessees:

  1. Finance Leases (previously called capital leases): Meet any of five criteria:

    • Transfer of ownership by end of lease
    • Option to purchase that’s reasonably certain to be exercised
    • Lease term for major part of asset’s economic life
    • Present value of lease payments equals or exceeds substantially all of the asset’s fair value
    • Asset is so specialized it has no alternative use at end of lease

  2. Operating Leases: All leases that don’t meet finance lease criteria

For both types, the initial recognition is similar: record a right-of-use (ROU) asset and lease liability at the present value of future lease payments. The difference lies in the subsequent accounting:

  • Finance leases: Separate interest expense (on the liability) and amortization expense (on the ROU asset), typically resulting in higher expenses in earlier years.
  • Operating leases: Single straight-line lease expense combining interest and amortization elements.

The statement of cash flows treatment also differs:

  • Finance leases: Principal payments are financing activities; interest payments are operating activities.
  • Operating leases: All payments are operating activities.

Lessor Accounting

Lessor accounting retains more similarities to previous standards but with updated classification criteria. Three types of leases exist for lessors:

  1. Sales-type leases: Meet any of the five criteria above and the collectibility of lease payments is probable
  2. Direct financing leases: Meet any of the five criteria, collectibility is probable, and no other risks render the arrangement a sales-type lease
  3. Operating leases: All leases that don’t meet the criteria for the above

For sales-type and direct financing leases, the lessor derecognizes the underlying asset and recognizes a net investment in the lease (lease receivable plus unguaranteed residual value). For operating leases, the lessor keeps the asset on its books and recognizes rental income, typically on a straight-line basis.

Common Exam Issues

The exam frequently tests complex scenarios involving lease modifications, variable lease payments, lease incentives, and initial direct costs. Calculations may require determining the appropriate discount rate (typically the rate implicit in the lease for lessors, or the incremental borrowing rate for lessees) and applying it correctly to calculate the present value of lease payments.

Be particularly careful with:

  • Lease classification tests
  • Treatment of lease incentives
  • Variable payments based on an index or rate
  • Determining the appropriate lease term when renewal options exist

Pension and Other Postretirement Benefits

Components of Pension Accounting

Pension accounting focuses on defined benefit plans where the employer promises specific benefits upon retirement. The complexity stems from the uncertainty of future obligations and the need to match pension costs to the periods in which employees provide service.

The key components include:

  1. Projected Benefit Obligation (PBO): Present value of projected future benefits earned to date, including estimated future salary increases.
  2. Plan Assets: Fair value of assets set aside to fund the pension obligation.
  3. Funded Status: The difference between PBO and plan assets, reported on the balance sheet.
  4. Net Periodic Pension Cost (NPPC): Annual expense recognized, comprising:
    • Service cost (present value of benefits earned this year)
    • Interest cost (on the PBO)
    • Expected return on plan assets (reduction of expense)
    • Amortization of prior service cost
    • Amortization of actuarial gains/losses

Only service cost is reported within operating income; other components are reported outside operating income.

Other Postretirement Benefits

Accounting for other postretirement benefits (primarily healthcare) follows similar principles to pension accounting but with different terminology. Instead of PBO, the obligation is called the Accumulated Postretirement Benefit Obligation (APBO).

Balance Sheet Presentation

The funded status (PBO minus plan assets) is presented on the balance sheet as either an asset (overfunded) or liability (underfunded). Actuarial gains and losses not yet recognized in the income statement are reported in accumulated other comprehensive income.

Common Exam Issues

Exam questions typically focus on conceptual understanding and the impact of various events:

  • Plan amendments (creating prior service cost)
  • Actuarial assumption changes (creating gains/losses)
  • Partial settlements or curtailments
  • The difference between US GAAP and IFRS treatment

While detailed pension calculations might not be heavily tested, understanding the direction of change caused by different factors is essential. For example, a decrease in the discount rate increases the PBO and creates an actuarial loss.

Stockholders’ Equity

Components of Equity

Stockholders’ equity encompasses transactions involving an entity’s own shares and consists of:

  • Contributed capital: Par value of shares plus additional paid-in capital
  • Retained earnings: Accumulated earnings minus distributions
  • Accumulated other comprehensive income: Items not yet recognized in net income
  • Treasury stock: Cost of repurchased shares (a contra-equity account)

Stock Issuance

When a corporation issues stock, the accounting varies depending on the par value:

Cash                           XXX
    Common Stock (par value)        XXX
    Additional Paid-In Capital      XXX

Non-cash issuances require measuring the fair value of goods or services received or the fair value of equity instruments issued, whichever is more reliably measurable.

Preferred Stock

Preferred stock features require careful analysis. Key characteristics that affect accounting include:

  • Cumulative vs. non-cumulative dividends
  • Participating vs. non-participating features
  • Convertible features
  • Callable or redeemable provisions

Redeemable preferred stock that must be repurchased may require classification outside of equity under certain circumstances.

Treasury Stock

When a company repurchases its own shares, it reduces stockholders’ equity. Two methods exist for accounting for treasury stock:

  1. Cost method: Records treasury stock at repurchase cost
  2. Par value method: Records at par value with adjustments to additional paid-in capital

The cost method is more common and straightforward. Under this method, when shares are reissued above cost, the excess is credited to additional paid-in capital from treasury stock. If reissued below cost, the difference reduces additional paid-in capital from treasury stock (until exhausted) and then reduces retained earnings.

Stock Dividends and Splits

Stock dividends (typically <25% of outstanding shares) are recorded at fair value, transferring amounts from retained earnings to contributed capital:

Retained Earnings              XXX
    Common Stock                    XXX
    Additional Paid-In Capital      XXX

Stock splits and large stock dividends (≥25%) are essentially recalculations of par value and number of shares with no effect on total equity.

Retained Earnings and Appropriations

Retained earnings represent accumulated earnings less distributions to shareholders. Appropriations of retained earnings (e.g., for legal reserves or contractual restrictions) simply reclassify amounts within equity but don’t change total equity.

Other Comprehensive Income

Other comprehensive income includes items like unrealized gains/losses on available-for-sale securities, foreign currency translation adjustments, pension-related adjustments, and certain hedge activities. These items accumulate in equity until “recycled” into net income upon realization.

Earnings Per Share (EPS)

Basic EPS

EPS represents the portion of a company’s profit allocated to each outstanding share of common stock. Basic EPS is calculated as:

Basic EPS = (Net Income - Preferred Dividends) ÷ Weighted-Average Common Shares Outstanding

The weighted-average calculation accounts for changes in shares outstanding during the period:

Weighted Average = Σ (Number of Shares × Fraction of Period Outstanding)

Diluted EPS

Diluted EPS incorporates the potential dilution that would occur if all dilutive securities were converted to common stock. These securities include options, warrants, convertible bonds, and convertible preferred stock.

Two main methods apply:

  1. Treasury Stock Method (for options and warrants): Assumes proceeds from exercise are used to repurchase shares at the average market price
  2. If-Converted Method (for convertible securities): Assumes conversion at the beginning of the period or date of issuance if later

The calculation process involves:

  1. Calculate basic EPS
  2. Identify all potentially dilutive securities
  3. Calculate the incremental effect of each security
  4. Include effects of securities that reduce EPS (dilutive) and exclude those that increase EPS (anti-dilutive)
  5. Recalculate EPS with all dilutive effects

Complex EPS Scenarios

The exam may test more complex scenarios like:

  • Contingently issuable shares
  • Two-class method for participating securities
  • Effects of stock dividends and splits
  • Year-to-date calculations with changing denominators

Mastering EPS calculation requires understanding the treatment of each type of security and developing a systematic approach to the problem.

Study Strategies for F3

Studying effectively for F3 requires both conceptual understanding and computational practice:

  1. Master the time value of money: Present value concepts are foundational for bonds, leases, and pensions.
  2. Create comparison charts: For areas with multiple classification schemes (like leases), create side-by-side comparisons.
  3. Practice journal entries: Write out complete journal entries for key transactions.
  4. Test yourself with calculations: Work through calculations for bond amortization tables, lease present values, and EPS scenarios.
  5. Focus on new standards: Pay special attention to lease accounting under ASC 842, which represented a major change.
  6. Connect concepts across topics: Recognize how present value, amortization, and classification concepts apply across different topics.

Common Exam Pitfalls

Watch out for these common traps:

  1. Classification criteria: Lease and debt classification rules can be subtle and require careful reading.
  2. Anti-dilutive securities: Remember to exclude these from diluted EPS calculations.
  3. Premium vs. discount amortization: The pattern of amortization works in opposite directions.
  4. Balance sheet vs. income statement presentation: Particularly for pensions, where components are split between operating and non-operating income.
  5. Comprehensive income items: Remember which adjustments flow through OCI rather than net income.
  6. Effective interest calculations: Applying the correct rate to the correct carrying value base.

Conclusion

F3 encompasses the liability and equity side of the balance sheet, incorporating sophisticated accounting treatments that span multiple reporting periods. Success in this area requires understanding both the “why” behind accounting treatments and the “how” of calculations and journal entries. By mastering the principles of present value, amortization, classification, and allocation across these diverse topics, candidates will be well-prepared to tackle this significant portion of the FAR exam.