Fa4e Sm Ch10

Chapter 10 Reporting and Analyzing Leases, Pensions, and Income Taxes Learning Objectives – coverage by question MiniExercises

Exercises

21

23

LO2 – Account for leases using the LO2 – operating lease method or the capital lease method.

12 - 15

25, 26, 28

35, 36

45

LO3 – Convert off-balance-sheet LO3 – operating leases to the capital lease method.

14, 16

27, 28

35 - 37

45

LO4 – Explain and interpret the LO4 – reporting for pension plans.

17 - 20

24, 30

38, 39

44

– Analyze and interpret pension LO5 – LO5 footnote disclosures.

18 - 20

24, 29, 30

38, 39

44

22

31 - 34

40 - 43

46, 47

LO1 – Define off-balance-sheet LO1 – financing and explain its effects on financial analysis.

LO6 – Describe and interpret LO6 – accounting for income taxes.

Problems

Cases and Projects

45

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DISCUSSION QUESTIONS Q10-1. Under an operating lease, the lessor retains the usual risks and rewards of owning the property. In accounting for an operating lease, the lessee doesn’t record either the leased asset or the lease liability on the balance sheet, and normally charges each lease payment to rent expense. In contrast, a capital lease transfers to the lessee substantially all of the risks and rewards relating to the ownership of the property. Accordingly, the lessee accounts for a capital lease by recording the leased property as an asset and establishing a liability for the lease obligation. The leased asset is subsequently depreciated, and interest expense is accrued on the lease liability. Q10-2. The leasing footnote is reasonably complete to allow for capitalization of operating leases for analysis purposes. Despite the quality of the leasing disclosures, on-balance-sheet treatment is, arguably, a more direct form of communication from the company and, as a result, is more easily interpreted by users of its financial statements. Q10-3. Yes, over the term of the lease the rent expense on an operating lease will be equal to the sum of the interest and depreciation on a capital lease. Only the timing of the expense recognition changes. Expense is ultimately related to the cash flows required to discharge the obligation. Those cash flows are the same whether or not the lease is capitalized. Q10-4. Under defined contribution plans, companies make contributions to the plans which, together with earnings on the amounts invested, provide the sole source of funding for payments to retirees. Under defined benefit plans, the obligations are defined with payment to be made in the future from general corporate funds. These plans may or may not be fully funded. Since the company’s obligation is extinguished upon payment for a defined contribution plan, the accounting is relatively simple: record an expense when paid or accrued. Defined benefit plans present a number of complications in that the liability is very difficult to estimate and involves a number of critical assumptions. In addition, companies lobbied for (and the FASB agreed to) various mechanisms to smooth the impact of pension costs on reported earnings. These smoothing mechanisms further complicate the accounting for defined benefit plans vis-àvis defined contribution plans. Q10-5. Although the accounting can get complicated, a net pension asset will be reported if the fair market value of the plan assets exceeds the plan obligation. Otherwise, a net liability will be reported on the balance sheet to represent the underfunding of the pension obligation. Q10-6. Service cost, interest cost and the expected return on plan investments (a reduction of the pension cost) are the basic components of pension expense. Companies might also report amortization of deferred gains and losses.

©Cambridge Bu siness Pub lishers, 2014 2014

Q10-7. The use of expected returns and the deferral of unexpected gains and losses act to smooth corporate earnings by removing the effects of swings in the market values of investments and variation in pension liabilities resulting from changes in actuarial assumptions or plan amendments. Q10-8. For a capital lease, the initial value of the lease asset and the lease obligation are determined by calculating the present value of the minimum lease payments. The minimum lease lease payments include those payments that that are not subject to options or contingencies, including any guaranteed residual value. Q10-9. Retirement benefits are normally expensed in the period in which they are earned by the employee, not not when they are paid. Some benefits are calculated calculated for periods of employment prior to the inception of a pension plan or prior to a plan amendment. The cost of these benefits (called prior service costs) is expensed by amortizing the cost over the average expected future period of employee service. Q10-10. The amount of the accumulated benefit obligation in excess of the fair value of the plan assets must be reported as a minimum pension liability. liability. If the accrued pension liability that is reported in the balance sheet is smaller than the minimum liability, then an additional pension liability, equal to the difference, must be reported. Q10-11. A Q10-11. A tax payment would be recorded as deferred taxes under two situations. First, if the company is required to make a tax payment (based on the higher taxable income reported on the tax return) but not record that payment as tax expense, a deferred tax asset is recorded. Deferred tax tax assets result from those those situations where an expense is recognized and recorded in the income statement, but is not deductible on the company’s tax return in the current period. This produces higher income on the tax return and tax payments that are higher than tax expense. The excess payment is recorded as an increase (debit) to a deferred tax asset. The second situation situation, tax expense years. When the tax deferral reverses and situation, the deferred is credited.

arises when a deferred tax liability liability reverses. In this has been recognized in excess of tax payments in prior return “catches up with” the income statement, the tax the deferred tax tax liability is reduced (debited). In either tax account (either asset or liability) is debited and cash


MINI EXERCISES M10-12. (15 minutes) a. i. 1/1

No entry

12/31 Rent expense (+E, -SE) ………………………… ………………………….. Cash (-A) ……………………………………

12,000

1/1

Leased asset (+A) ……………………………….. Lease liability (+L) ………………………… $57,198 = $12,000 x 4.76654

57,198

12/31 Depreciation expense (+E, -SE) ……………...… Accumulated depreciation (+XA) ………… $9,533 = $57,198 / 6.

9,533

12/31 Lease liability (-L) ………………………………… Interest expense (+E, -SE) ……………………… Cash (-A) ………………………………… $4,004 = $57,198 x .07; $7,996 = $12,000 - $4,004.

7,996 4,004

12,000

ii. 57,198

9,533

12,000

b. +

+ 1/1 -

Cash (A) 12,000

-

12/31

Lease Liability (L) 57,198 7,996

+ 12/31

Interest Expense (E) 4,004

12/31

Leased Asset (A) 57,198

-

Accumulated Depreciation (XA) + 9,533 12/31

+ 1/1 -

+ Depreciation Expense (E) 12/31 9,533

-

c. Income Statement

Balance Sheet Transaction

Cash Asset

Signed a capital lease.

Noncash Assets

-

Contra Assets

=

+57,198 Leased Asset

Depreciation on leased asset.

Made annual lease payment.

+

Liabil -ities

Contrib. Capital

+

Earned Capital

Revenues

- Expenses =

Net Income

+57,198 -

=

-


=

-

Lease Liability

+9,533 Accumulated - Depreciation =

-12,000 Cash

+

-9,533 Retained Earnings -7,996 Lease Liability

-4,004 Retained Earnings

=

-

+9,533 Deprec. Expense

=

-9,533

-

+4,004 Interest Expense

=

-4,004

M10-13. (20 minutes) a. 7/1

Leased asset (+A) ……………………………….. Lease liability (+L) ………………………. $123,100 = 4,500 x 27.35548

123,100 123,100

b. 9/30

Depreciation expense (+E, -SE) ……………….. Accumulated depreciation (+XA, -A) …. $3,078 = $123,100 / (10 x 4).

3,078

9/30

Lease liability (-L) ……………………………….. Interest expense (+E, -SE) ……………………… Cash (-A) …………………………………… $2,462 = $123,100 x (.08/4); $2,038 = $4,500 - $2,462.

2,038 2,462

12/31 Depreciation expense (+E, -SE) ……………….. Accumulated depreciation (+XA, -A) ….

3,078

3,078

4,500

3,078

12/31 Lease liability (-L) ……………………………….. 2,079 Interest expense (+E, -SE) ……………………… 2,421 Cash (-A) …………………………………… $2,421 = ($123,100 - $2,038) x (.08/4); $2,079 = $4,500 - $2,421.

4,500

c. +

+ 7/1 -

Cash Cash (A) 4,500 4,500 Leased Asset (A) 123,100

-

9/30 12/31

9/30 12/31

-

Accumulated Depreciation (XA) 3,078 3,078

+

+ 9/30 12/31

Lease Liability (L) 123,100 2,038 2,079

+

9/30 12/31

Interest Expense (E) 2,462 2,421

+ 9/30 12/31

Depreciation Expense (E) 3,078 3,078

7/1

-

-

continued next page


M10-13. concluded d. Balance Sheet Cash Asset

Transaction Signed a capital lease.

+

Noncash Assets +123,100 Leased Asset

Depreciation on leased asset.

Made quarterly lease payment.

-4,500 Cash

Contra Assets

-

-

+3,078 Accum. Deprec.

-

Depreciation on leased asset. Made quarterly lease payment.

-

-

-4,500 Cash

=

Liabilities

=

+123,100 Lease Liability

-

+

Contrib. + Capital

-2,038 Lease Liability

=

=

Earned Capital

Revenues

-2,079 Lease Liability

- Expenses = -


=

=

+3,078 Accum. Deprec.

Income Statement


=

-

+3,078 Deprec. Expense

=

-3,078

-

+2,462 Interest Expense

=

-2,462

=

-3,078

=

-2,421


-


-

+3,078 Deprec. Expense +2,421 Interest Expense

e. 7/1

No entry

9/31

Rent expense (+E, -SE) ………………………… Cash (-A) ……………………………………

4,500

12/31 Rent expense (+E, -SE) ………………………… Cash (-A) ……………………………………

4,500

4,500 4,500

The amount of rent expense recognized if the lease is treated as an operating lease is $9,000 ($4,500 + $4,500). However, if the the lease is treated as a capital lease, interest and depreciation are recognized. The total expense for 2014 is $11,039 ($2,462 + $2,421 + $3,078 + $3,078). The capital lease method tends to report higher expense in the early periods of the lease. M10-14 (10 minutes) a. Leased asset (+A) ……………………………………… ……………………………………… Lease liability liability (+L) ………………………… ………………………………. ……. b. Prepaid rent (+A) ……………………………………….. ……………………………………….. Cash (- A) A) …………………………………………… ……………………………………………


Net Income

74,520 74,520 1,000 1,000

M10-15. (15 minutes) a. Capital leases record both the leased asset and the the lease liability on the the face of the balance sheet. Operating leases, by contrast, do not record either the leased asset or the lease liability. They are, as a result, a common technique to achieve offbalance-sheet financing. Concerning the income statement, capital leases result in depreciation of the leased asset and interest expense on the lease liability. Operating leases record only rent expense. b. Analysts frequently add the present value of the the operating lease payments to both assets and liabilities, thus capitalizing the operating lease. This adjustment improves the interpretation of measures of financial leverage and operating performance. If Yum’s operating lease commitments in total are substantial, they could have a significant impact on the assessment of financial leverage. Yum indicates no individual lease is material. However, the total commitment could be substantial. M10-16. (20 minutes) a. Present value of expected operating lease payments payments for Yum! Brands using a the Table A2 in Appendix A, I/YR=7: Year ($ millions) 2012 ........................ ........................ 2013 ........................ ........................ 2014 ........................ ........................ 2015 ........................ ........................ 2016 ........................ ........................ 2017 ........................ ........................ 2018 ........................ ........................ 2019 ........................ ........................ 2020 ........................ ........................ 2021 ........................ ........................ 2022 ........................ ........................

Operating Lease Payment $ 612 578 538 494 462 462 462 462 462 462 343

Present Value Factor 0.93458 0.87344 0.81630 0.76290 0.71299 0.66634 0.62275 0.58201 0.54393 0.50835 0.47509

Present Value $ 572.0 504.8 439.2 376.9 329.4 307.8 287.7 268.9 251.3 234.9 163.0 $3,735.9

b. The capitalization of these operating leases increases Yum ’s total liabilities by 54% to $10,654 million ($6,918 million + $3,736 million).


M10-17 (10 minutes) a. Pension expense (+E, -SE) …………………………… …………………………… Cash (- A) A) ……………… …………………………… ……………………. ……….…….. ……..

16,000 16,000

16,000 = 400,000 x .04. b. Bartov would report a net liability liability of $450,000 ($625,000 - $175,000) in its its 2013 balance sheet. Because Bartov is effectively self-insured, it must report the estimated death benefit obligation net of any assets a ssets set aside to meet that obligation. ob ligation. M10-18. (10 minutes) a. American Express is reporting $51 million million in pension expense for 2011. b. Expected returns are an offset to service and interest costs and serve to reduce reported pension expense. c. “Expected” refers to the use of long-term long -term average returns for the investment portfolio. Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income. M10-19. (10 minutes) a. Yum Brands is reporting $49 million million of pension pension expense for 2011. b. Expected returns are an offset to service and interest costs and serve to reduce reported pension expense. c. “Expected” refers to the use of long-term long -term average returns for the investment portfolio. Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income.


M10-20. (10 minutes) a. A&F maintains a defined contribution contribution plan for the benefit benefit of its employees. b. Contributions are expensed when made. The entry to record expenses for 2011 was ($ millions): Pension expense (+E, -SE) -SE) …………………… Cash (- A) A) ………………………………… …………………………………

16.4 16.4

c. Only the unpaid contribution, if any, appears on the the A&F balance sheet. M10-21. (15 minutes) a. The use of contract manufacturers removes the manufacturing assets and related liabilities from Nike’s Nike’s balance sheet. Because sales are unaffected, PPE turnover is increased by the removal of assets. The effect on net operating profit after taxes (NOPAT) is uncertain; depreciation is removed (interest on the liabilities incurred to purchase the manufacturing assets is also removed, but this is a nonoperating expense and, therefore, does not affect NOPAT), but Nike will pay a higher price for its manufactured goods in order to provide the manufacturer with a return on its investment. If the contract manufacturer is more efficient than Nike, however, the price increase incre ase is mitigated. Profitability will increase if the turnover effect more than offsets the negative effect on NOPAT and profit margin, which is likely. b. Executory contracts are not recognized under GAAP. As a result, the use of contract manufacturers achieves off-balance-sheet financing. This is one motivating factor for their use.


M10-22. (20 minutes) a, b, c. Year

Book Value

Temporary Difference

Tax Rate

Deferred Tax Liability

2014

$300,000

$173,000

$127,000

40%

$50,800

2015

$200,000

$173,000 - ($100,000 - $31,000) = $104,000

$96,000

40%

$38,400

2016

$100,000

$104,000 - ($100,000 - $31,000) = $35,000

$65,000

40%

$26,000

Tax Basis (after depreciation deduction)

d. Because the deferred tax liability is reversing in years 2015, 2016 and 2017, part of the deferred tax liability should be classified classified as a current liability each year. The amounts are presented in the following table. Year

Deferred Tax Liability

Long-Term Amount –Reversing Beyond One Year

Current Portion – Reversing Within One Year

2014

$50,800

$38,400

$12,400

2015

$38,400

$26,000

$12,400

2016

$26,000

$0

$26,000


EXERCISES E10-23. (30 minutes) a. Present value of operating leases = $1,988 million, computed using the NPV function in Excel:

b. ($millions)

Balance Sheet Cash Asset

Transaction To capitalize operating leases

+

Noncash = Assets +1,988 Leased Asset

=

Liabilities

+

Income Statement Contrib. + Capital

Earned Capital

Revenues -


Expenses

-

=

Net Income

=

c. Recognition of the operating operating leases would reduce the current ratio. Recording the leased asset would increase noncurrent assets by $1,988 million, but recording the lease liability would increase current liabilities by $75 million ($194 million - $1,988 million x 0.06), and noncurrent liabilities by $1,913 million ($1,988 - $75). d. (in $millions) Leased asset (+A) ……………………………….. Lease liability (+L) ………………………. +


-

-

1,988 1,988 Lease Liability (L)

+ 1,988

e. No. The fixed commitment for 2012 ($194 million) million) represents less than 4% of Targets operating cash flow.


E10-24. (15 minutes) a. Target maintains only a defined contribution plan for the benefit of its employees. b. Contributions are expensed when when made. c. Only the unpaid contribution, if any, appears on Target’s balance sheet. d. First, employees who who do not meet the unspecified eligibility requirement will not be covered. Second, matching contributions can be reduced or eliminated in bad times. Third, employees covered by defined contribution plans must choose how those funds are invested and, consequently, they bear all of the risks of price volatility. E10-25. (20 minutes) a. The Home depot reports $449 $449 million as capital lease obligations obligations in its 2011 balance sheet. This amount is reported as $420 million million in non-current liabilities and $29 million million as a current liability. At the inception of these these leases, the leased assets and lease obligations were equal to to the present value of the minimum minimum lease payments. Since that point in time, however, the leased assets are depreciated on a straight-line basis and the lease obligations obligations are amortized using the effective interest interest method. The result is that the net asset value declines declines faster than the liability. At the end of fiscal 2011, assets totaled $328 million and obligations ob ligations totaled $449 million. b. Present value = $4,989 million using the NPV function in Excel:

c. Home Depot’s D/E ratio was 1.26 ([$40,518 million - $17,898 million]/$17,898 million). Adding capitalize capitalized d operating operating leases would increase increase the the ratio ratio to 1.54 ([$40,518 ([$40,518 millio million n+ $4,989 million - $17,898 million]/$17,898 million).


E10-26. (25 minutes)

a. According According to Verizon’s Verizon’s lease lease footnot footnote, e, it has both both capital capital and operati operating ng leases. leases. Only Only the capital leases are reported on-balance sheet in the amount of $352 million ($66 million in current liabilities and $286 million as long-term liabilities). This is not the total obligation to its lessors. Verizon also has a significant amount of leases that it has classified as operating. In fact, the minimum m inimum lease payments under operating leases are over 26 times that for capital leases! These operating leases are not reported onbalance-sheet.

b. Although Although capital capital leases are reported reported as an asset and liabili liability ty on the balance balance sheet, sheet, neither the leased asset nor the lease obligation is reported on the balance sheet for Verizon’s operating leases. As a result, total assets and total liabilities are lower than they otherwise would be if these leases were reported as capital leases. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. During any give year during the life of the lease, however, the two will not be equal. Even if depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease. million. The entry for 2012 is is as follows: c. Interest expense will be $26 million. Lease obligation (-L) (-L) ………………………… ……………………………. …. Interest expense (+E, -SE) -SE) ……………………… Cash (- A) A) ……………… ………………………… ………………… ………... ...

66 26 92

$9,658 million. This amount d. The present value of Verizon’s operating leases totals $9,658 would be added to Verizon’s noncurrent assets and to its lease obligations if these operating leases were reported as capital leases.


E

E10-27. (20 minutes) a. Our analysis might capitalize capitalize (add to both both assets and liabilities) liabilities) the present value value of the expected operating lease payments. The present value is $1,539 million, computed as follows:

b. In 2012, Dow would report interest expense of $77 million million ($1,539 million x 0.05) and depreciation expense of approximately $96 million ($1,539/16 years), instead of rent expense of $223 million. E10-28. (30 minutes) a. The present value of Nike’s operating lease payments is computed as follows:

The present value of Nike’s Nike’s operating leases is computed to be $1,435 $1,435 million. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. continued next page ©Cambridge Bu siness Pub lishers, 2014 2014

E10-28. concluded b. Transaction

Cash Asset

To capitalize operating leases.

Balance Sheet Noncash LiabilContrib. + = + + Assets ities Capital +1,435 Leased Asset

=

Income Statement Earned Capital

Revenues - Expenses =


-

Net Income

=

c. 1. 2. 3.

Leased asset (+A) ……………………………. Lease Liability (+L) …………………….

1,435

Depreciation expense (+E, -SE) ………….… Accumulated depreciation (+XA, -A)...

143.5

Lease liability (-L) …………………………… Interest expense (+E, -SE) ……………….… Cash (-A) …………………..…………….

273.5 100.5

1,435 143.5

374

d. + 1


-

-

- Accumulated Depreciation (XA) + 143.5 2 + Cash (A) 374

3

3

Lease Liability (L) 1,435 273.5

+

2

+ Depreciation Expense (E) 143.5

3

+ Interest Expense (E) 100.5

1

E10-29. (15 minutes) a. Service cost is the increase in the pension obligation obligation resulting from employees working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation. b. Payments to retirees are made from the pension investment account. There is a corresponding reduction in the pension obligation. c. The funded status is the pension obligation less less the fair value of the plan assets. In this case $1,381 million (pension obligation) – $998 million (plan assets) = $383 million funded status (underfunded amount). d. A $383 million million net pension liability is reported in the balance sheet.


E10-30. (20 minutes) a. Service cost is the the increase in the pension obligation resulting from employees working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation. b. Payments to retirees are made form the pension investment account. There is a corresponding reduction in the pension obligation. c. The funded status is the pension benefit obligation less the fair value of the plan assets. In this case $30,582 million – $24,110 million = $6,472 million funded status (underfunded amount). d. A $6,472 million million net pension pension liability is reported on the balance sheet. E10-31. (20 minutes) a. In 2013, the temporary difference is $8,000. $8,000. $8,000 x 40% = $3,200. In 2014, the temporary difference reverses and no liability would be reported. b. Income tax expense (+E, -SE) ………………….. Income taxes payable* (+L) ………………. Deferred income tax liability (+L) ………..

91,200 88,000 3,200

*($236,000 – *($236,000 – $16,000) x 40% = $88,000.

Income tax expense (+E, -SE) -SE) …………………. Deferred income tax liability (-L) (-L) ……………… Income taxes payable* (+L) ………………

94,800 3,200 98,000

*($245,000 – *($245,000 – $0) x 40% = $98,000.

c. Income tax expense (+E, -SE) …………………. Income taxes payable (+L)* ……………… Deferred income tax liability (+L) ……….

80,200 77,000 3,200

*($236,000 – *($236,000 – $16,000) x 35% = $77,000.

Income tax expense (+E, -SE) -SE) …………………. Deferred income tax liability (-L) (-L) ……………… Income taxes payable (+L)* ………………..

94,800 3,200 98,000

*($245,000 – *($245,000 – $0) x 40% = $98,000. continued next page


E10-31. concluded The solution to part c depends on what the company knew, in 2013, about the tax rate in 2014. In the journal entries above, the the assumption is that the tax rate rate is 35% in 2013, but is supposed to change to 40% in in 2014. However, if the change in the tax tax rate was not known, the following entries would be required:

c. Income tax expense (+E, -SE) …………………. Income taxes payable (+L)* ……………… Deferred income tax liability (+L) ** …….

79,800 77,000 2,800

*($236,000 – *($236,000 – $16,000) x 35% = $77,000. **$8,000 x 0.35 = $2,800

Income tax expense (+E, -SE) ............................ .......................................... .............. ...................................... ........... Deferred income tax liability (-L) ........................... Income taxes payable* (+L) .....................................

95,200 2,800 98,000

*($245,000 – *($245,000 – $0) x 40% = $98,000.

Either way, the amount of income tax expense is determined as a plug amount. E10-32. (15 minutes) a. $12,000 x 40% = $4,800. b. Because the source of of the temporary difference is a noncurrent asset (PP&E), the the deferred tax liability would be classified as a noncurrent liability. c. $8,000 x 40% = $3,200. E10-33. (15 minutes) a. Transaction To record income tax expense

Cash Asset

Balance Sheet Noncash LiabilContrib. + = + + Assets ities Capital +787 Taxes Payable = -76 Deferred Taxes



-711 Retained Earnings

-

+711 Income Tax Expense

=

Net Income -711

b. Deferred income taxes (-L) (-L) ………………. ……………….….….… Income tax expense (+E, -SE) ……………. ……………..…..… Income taxes payable (+L) …………………. ………………….

76 711 787 continued next page ©Cambridge Bu siness Publis hers, 2014 2014

E10-33. concluded c. An expense of $711 million is recorded in the income statement, thereby thereby reducing both net income and retained earnings. Liabilities are increased by $711 million, $787 million in income taxes payable less the decrease of $76 million in deferred income taxes. d. 2009: 24.0% ($470/$1,957); 2010: 24.2% ($610/$2,517); 2011: 25.0% ($711/$2,844) E10-34. (15 minutes) a. Transaction a. To record income tax expense.

Cash Asset

Balance Sheet Noncash LiabilContrib. + = + + Assets ities Capital +534 Taxes Payable

+1,916 Deferred = Taxes




-

+1,382 Income Tax Expense

=

Net Income -1,382

b. Income tax expense (+E, -SE) -SE) …..…….. Tax refund receivable (+A) ……………. Deferred income taxes (+L) …….

1,382 534 1,916

c. An expense of $1,382 million is is recorded in the the income statement, thereby reducing both net income and retained earnings. However, Boeing reports a negative current tax expense of $534 million. million. Thus, it expects a net refund of this amount and records a receivable of $534 million million in its balance sheet. It also records an increase in deferred tax liabilities of $1,916 million. The refund is most likely due to one of two sources: (1) an operating loss recorded in 2011 for tax reporting purposes or (2) a tax loss carryforward.


PROBLEMS P10-35. (25 minutes) a. The present value of Staples operating lease payments is computed computed as follows:

The present value of Staples’ operating leases is computed to be $3.574 $ 3.574 billion. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. Staples’ liabilities are 56% 5 6% higher following this adjustment a djustment (adjusted liabilities are $6.408 billion + $3.574 billion = $9.982 billion). b. ($ 000s) Transaction To capitalize operating leases.

Cash Asset

Balance Sheet Noncash LiabilContrib. + = + + Assets ities Capital +3,573,646 Leased Asset

=


+3,573,646 Lease Liability

Revenues - Expenses = -

Net Income

=

c. 2011 2012

Leased asset (+A) ……………………………... Lease liability (+L) ………………………

3,573,646 3,573,646

Depreciation expense (+E, -SE) ……….……. Accumulated depreciation (XA, - A) A) ..…

397,072

Interest expense (+E, -SE) -SE) ……..………..…… Lease liability (-L) (-L) ……………………..……… ……………………..……….. Cash (- A) A) ………………………………….. …………………………………..

250,155 * 616,992

397,072

867,147

* $250,155 = $3,573,646 x 0.07. continued next page ©Cambridge Bu siness Publis hers, 2014 2014

P10-35. concluded d. + 2011

Leased Asset (A) 3,573,646

-

2012

-

Accumulated Depreciation (XA) + 397,072 2012

+

Cash (A) 867,147

+ 2012

-

+ 2012

2012

Lease liability (L) + 3,573,646 616,992

2011

Depreciation Expense (E) 397,072

Interest Expense (E) 250,155

-

-

P10-36. (60 minutes) a. Rent expense (+E, -SE) ………………………………. 209,000,000 Cash (-A) ……………………………………………. 209,000,000 b. Outback would report a lease liability liability of $939,621,000 at December 31, 2011 if the operating leases were capitalized.

c. In 2012, Outback would report interest expense of $75,169,680 ($939,621,000 x .08) and depreciation expense of $93,962,100 ($939,621,000/10) instead of rent expense of $179,814,000. In 2011, it would also report interest and depreciation instead of rent expense. The $209.0 million in in rent expense reported for 2011 most likely includes some contingent rentals (rent based on some measure of usage, such as sales revenue). These contingent rentals are reported as rent expense even if the leases are capitalized. Therefore, it is impossible to say e xactly how much of the 2011 rent expense would be replaced by the interest and depreciation. In the early years of a lease the higher interest expense causes the capitalization of leases to increase expenses compared to the rent expense. This situation reverses in the later years of the lease. continued next page ©Cambridge Bu siness Pub lishers, 2014 2014

P10-36. concluded d. Capitalizing leases is is reflected in the financial statement effects template below. ($000s) Transaction Capitalize operating leases

Income Statement

Balance Sheet Cash Asset

+

Noncash Assets +939,621 Leased Assets

-

-

Contra Assets

LiabilContrib. + + ities Capital +939,621 Lease = Obligations =

Earned Capital

Revenues

-

-

Expenses

=

Net Income

=

e. In the statement of cash flows, the the rent expense on operating leases is classified as an operating cash flow. flow. Although the total cash flow is the same, if the lease is treated as a capital lease, then part of the lease payment (the interest) is classified as operating and the remainder (the principal) is classified as a financing cash flow. Depreciation on the lease is deducted in the computation of income but added back in the operating section of the cash flow statement because it is not a cash flow. P10-37. (40 minutes) a. Best Buy reports $276 million of capital capital leases as assets and in its liabilities liabilities of which $46 million due in 2013 is reported as a current liability. The $7,517 of operating leases are not reported in the balance sheet nor are the related leased assets. b. Total assets and total liabilities liabilities are lower than the balance that would have been reported had the leases been capitalized. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. In any given year of the lease, however, the two will not be equal. If depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation, which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease. Over the life of the lease, lease, profit is unaffected by this this classification. c. Using a 10% discount rate, the present value of Best Buy’s operating leases payments is $5,203 million, computed as follows:

continued next page ©Cambridge Bu siness Publis hers, 2014 2014

P10-37. continued d. Transaction

Cash Asset

To capitalize operating leases at Mar. 3, 2012. To record depreciation expense in 2013 To record lease payments in 2013

Balance Sheet Noncash LiabilContrib. + = + + Assets ities Capital +5,203 Leased Asset -520.3 Accumulated Depreciation – Depreciation – Leased Asset

-1,216 Cash


=

Earned Capital

+

=

=

Income Statement

-695.7 Lease Liability

-

+

-520.3 Retained Earnings

-

+

-520.3 Retained Earnings

-

e. March 3, 2012 1. Leased asset (+A) ………………………………. Lease liability (+L) ……………………….. 2013 2.


Depreciation expense (+E, -SE) ………………. Accumulated depreciation (+XA, - A) A) …..

Net Income

= +520.3 Depreciation = Expense +520.3 Interest Expense

-520.3

-520.3

5,203 5,203 520.3 520.3

$520.3 = $5,203 / 10

3.

Lease liability (-L) (-L) …………………………… ……………………………….. ….. Interest expense (+E, -SE) -SE) …………………….. Cash (- A) A) …………………………………… ……………………………………

695.7 520.3 1,216

$520.3 = $5,203 x 0.10

f. +

Cash (A)

-

-

1,216

+ 1. -


3.

3.

-

Accumulated Depreciation (XA) 520.3

+ 3. +

+ 2.

2.

Lease Liability (L) 5,203 695.7

+

Interest Expense (E) 520.3 Depreciation Expense (E) 520.3

1.

-

-

Note: The interest expense is the same as the depreciation charge because interest is at 10% and depreciation is over 10 years. This is only true in 2013. Thereafter, interest will decline as the balance in the lease liability declines. continued next page


P10-37. concluded g. The effect of a failure to report the leased assets and related lease obligation obligation onbalance-sheet understates assets and liabilities. Gross margin and net income are largely unaffected if we assume that the leases are approximately at the midpoint m idpoint of their lives, on average. Capitalization of the leases would increase the asset base, which would, in turn, lower asset turnover. Hence turnover rates are overstated by the failure to capitalize the leases. leases. The debt to equity ratio would be increased. increased. Overall these two factors offset each other othe r leaving ROE only marginally affected. Our conclusion of how Best Buy is achieving its ROE is likely to be altered because Best Buy would have lower turnover and higher financial leverage than was apparent based on the published (unadjusted) financial statements. P10-38. (30 minutes) a. FedEx recognized $543 million as pension expense in 2011. b. The expected return is computed as the beginning fair market value value of the pension plan assets multiplied by the long-term expected return on these investments. For 2011, this is computed as $13,295  8% = $1063.6, slightly more than the reported amount of $1,062 million. The plan assets reported an actual return of $2,425 million. U.S. GAAP permits the use of the expected long-term rate of return in order to smooth earnings. If actual returns were to be used, corporate profits would fluctuate greatly with swings in investment returns. The logic behind using the long-term rate is that investment returns are expected to fluctuate around this average and its use more accurately captures the average cost of the pension plan. (It is similar to the logic of reporting held-to-maturity bond investments at historical cost rather than current market value.) c. The pension liability liability is increased by the service and interest costs and decreased by any payments made to plan participants. The actuarial loss (gain) relates to the effects on the pension obligation of changes in assumptions used to compute it, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions and are decreased by benefits paid to plan participants. d. The “funded status” is the excess excess (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive or overfunded. If pension obligations exceed the fair value of plan assets, the funded status is negative or underfunded. The funded status of the FedEx pension plan is $(1,531) million at the end of 2011. Pension obligations are $17,372 million and plan assets are $15,841 million. FedEx should report its net funded status as a net pension liability of $1,531 million on its balance sheet. continued next page


P10-38. concluded e. Because the pension obligation is the present value of expected pension payments, an decrease in the discount rate increases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. In 2011, the effect of a decrease in the discount rate is to apply a lower discount rate to a higher pension obligation. These two effects are offsetting, but usually result in lower interest cost. co st. f. The estimated estimated wage inflation rate is used to project future benefit payments. Decreasing the estimated inflation rate decreases the pension obligation because a lower amount of payments to plan participants is projected. Decreasing the expected wage inflation rate reduces service cost and decreases the pension obligation reported on the balance sheet and, consequently, the interest component of pension expense. It is an income-increasing action. P10-39. (20 minutes) a. Service cost is the increase in the pension obligation obligation resulting from employees working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation. b. The “actual” return on plan assets is $89 million in 2011. c. Actuarial losses (gains) (gains) generally arise as a result of decreases (increases) in the discount rate used to compute the pension obligation (PBO). Because the PBO is the present value of expected future payouts to retirees, a decrease in the discount rate results in an increase in the PBO. This decrease is recorded as an actuarial loss. d. Payments to retirees retirees are made from the plan assets account. There is a corresponding reduction in the pension obligation. e. American Express contributed $35 million to its pension plans in in 2011. f. American Express paid $1287 million million to its retirees in in 2011. g. The funded status is the pension obligation less the fair value value of the plan plan assets. In this case $2,512 million – million – $2,069 million = $443 million underfunded amount. h. A $443 million million net pension liability is reported on the balance sheet. sheet.


P10-40. (20 minutes) a.

Tax expense – expense – 2011: $5,732 million; 2010: 1,033 million; 2009: -1,142 million. Current taxes due – due – 2011: $5,935 mil.; 2010: $103 mil.; 2009: $1,636 mil.

b.

2011: $5,732 / $20,098 = 28.5% 2010: $1,033 / $14,085 = 7.3% 2009: $(1,142) / $9,864 = -11.6%

c. Deferred tax liabilities are created when a company reports greater revenues and/or lower expenses in the income statement than are reported on the tax return. The most common cause is the use of accelerated depreciation for taxes and straightline depreciation for financial reporting. When these deferred taxes reverse (late in the asset’s life) the deferred tax liability is reduced. d. Deferred tax assets arise arise when income is recognized for tax purposes before it is recognized in the financial statements, such as can be the case with advance payments from customers. Receipt of the cash creates a deferred tax asset as revenue is recognized on the tax return but deferred in the financial statements. Alternatively, deferred tax assets may arise when the tax return defers expenses that are recognized in the the financial statements. Examples include bad debt expense expense and warranty expense. A restructuring charge is is another example of the latter. Restructuring charges are not recognized in the tax return until they are realized (cash paid or assets sold at a loss). P10-41. (15 minutes) a. Temporary differences – differences – 2013: $32,000 - $24,000 = $8,000; 2014: ($32,000 + $37,000) – $37,000) – ($24,000 + $26,000) = $19,000. b. Deferred tax liability – liability – 2013: $8,000 x 40% = $3,200; 2014: $19,000 x 40% = $7,600 c. $19,200 + ($7,600 – ($7,600 – $3,200) = $23,600 d. Income tax tax expense (+E, -SE)…………………… -SE)…………………… Income taxes payable (+L) ...……………… ... ……………… Deferred tax liability (+L) …………..……… + Income Tax Expense (E) (d) 23,600

23,600 19,200 4,400

- Income Taxes Payable (L) + 19,200 (d)

- Deferred Tax Liability (L) + 4,400 (d)


P9-42. (15 minutes) a. Temporary differences – differences – 2013: $140,000 - $130,000 = $10,000; 2014: ($140,000 + $122,000) – $122,000) – ($130,000 + $128,000) = $4,000. b. Deferred tax liability – liability – 2013: $10,000 x 35% = $3,500; 2014: $4,000 x 35% = $1,400 c. $45,150 + ($1,400 – ($1,400 – $3,500) = $43,050 d. Income tax tax expense (+E, -SE)…………………… Deferred tax liability (-L) (-L) ………………………… Income taxes payable (+L) ……………….. + Income Tax Expense (E) (d) 43,050

43,050 2,100 45,150

- Income Taxes Payable (L) + 45,150 (d)

- Deferred Tax Liability (L) + (d) 2,100

P10-43. (20 minutes) a, b, c. Assume that the tax rate increase in 2011 was not known until 2010.

2013 2014 2015

a. Book Value $12,000 $6,000 $0

b. Tax Basis $0 $0 $0

Temporary Difference $12,000 $6,000 $0

d. 12/31/09 Income tax expense (+E, -SE) ..………………… ..………………… Deferred income tax liability (+L)………… (+L)………… Income taxes payable (+L)* ……………..…

c.

Deferred Tax Liability $4,200 ($12,000 x 0.35) $2,400 ($6,000 x 0.40) $0 112,000 4,200 107,800

*$308,000 x 0.35 = 107,800.

12/31/10 Income tax expense (+E, -SE) ……. …….…………… Deferred income tax liability (-L) (-L) ….…………… Income taxes payable (+L)* ……..……….

138,200 1,800 140,000

*$400,000 x 0.35 = $140,000.

12/31/11 Income tax expense (+E, -SE) ………………….. ………………… .. Deferred income tax liability (-L) (-L) ……………… Income taxes payable (+L)* ……………… *$420,000 x 0.40 = $168,000.

The expense is determined as a plug amount. ©Cambridge Bu siness Pub lishers, 2014 2014

165,600 2,400 168,000

CASES and PROJECTS C10-44. (30 minutes) a. Dow Chemical reported net pension expense of $561 million for 2011. b. The expected rate of rreturn eturn is computed as the beginning fair value of the pension plan plan assets multiplied by the long-term expected return on these investments. For 2011, expected return was $$1,305 on on assets of $15,851 million. This implies an expected rate of return of 8.23% ($1,305 / $15,851). c. The pension liability liability is increased by the service and interest costs and decreased by any payments made to plan participants. The actuarial loss (gain) relates to the effects of changes in assumptions used to compute the pension obligation, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions, and are decreased by benefits paid to plan participants. d. The “funded status” is the excess (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive. p ositive. If pension obligations exceed the fair value of plan assets, the funded status is negative. The funded status of the Dow Chemical pension plan is $(6,644) million at the end of 2011. Thus, the pension is underfunded and the balance balance sheet should show a net pension liability of $6,644 million. e. Since the pension pension obligation is the present value of expected pension payments, a decrease in the discount rate increases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning-of-the-year pension obligation and the discount rate. The effect of a decrease in the discount rate is to apply a lower interest rate to a larger pension obligation. Interest expense on the pension liability will will usually decrease in in this circumstance. However, the actuarial “gain” resulting from the lower liability amount may offset the higher interest cost. f. An increase in expected expected return unambiguously increases profitability as pension cost is reduced. This result occurs because the long-term expected rate of return is used to compute the expected return that is subtracted in the computation of pension expense. g. Inflation rates differ differ from country to country. For 2011, those those rates are generally higher higher outside the U.S. where Dow operates. Inflation is expected to increase in the U.S. and could exceed the rates in other countries implying relatively higher compensation levels. Discount rates vary vary across countries as well, due in part to differences in inflation.


C10-45. (40 minutes) a. 2011 2012

Rent expense (+E, -SE) ………………………… ………………………….. Cash (- A) A) …………………………………... …………………………………...

847

Rent expense (+E, -SE) ………………………… ………………………….. Cash (- A) A) …………………………………... …………………………………...

640

847 640

Note: the rent expense in 2011 most likely includes contingent rentals, such as charges based on the number of hours a plane is flown. These contingent rentals are not included in the minimum rental obligation for 2012. b. The total liability reported on the 2011 balance sheet is $42 million. Of this amount, $3 million would be classified as a current liability leaving a noncurrent liability of $39 million. This amount only reflects those leases that Southwest classified as capital leases. Operating leases represent many times that amount and are not recorded on its balance sheet. c. i. ii.

Leased assets (+A) ( +A) ……………………………… ……………………………… Lease liability (+L) ………………………..

45

Depreciation expense (+E, -SE) ………………. Accumulated depreciation (+XA, - A) A) …..

7

+ i. -

Leased Asset (A) 45

-

Accumulated Depreciation (XA) 7

45 7 -

+

+ ii.

ii.

Lease Liability (L) 45

+ i.

Depreciation Expense (E) 7

-

d. Lease liability (-L) (-L) ……………………………… ……………………………….. .. Interest expense (+E, -SE) -SE) …………………….. …………………….. Cash (- A) A) …………………………………… …………………………………… + Cash (A) 6

- Lease Obligation (L) + 3

3 3 6 + Interest expense (E) 3

continued next page


C10-45. concluded e. Using a 6% discount rate, the present value of Southwest’s of Southwest’s operating lease payments is computed as follows:

If operating leases were capitalized, Southwest would wou ld report additional assets of $4,182 million and additional liabilities liabilities of $4,182 million million as well. The liabilities would be split between current liabilities of $389 million ($640 million - $4,182 million x 0.06) and noncurrent liabilities of $3,793 million ($4,182 - $389). Its long-term debt would would increase by 122% from $3,107 million to $6,900 million ($3,107 + $3,793). f. Not including the entry to record payments on existing capital leases, which are recorded in d above, the entry to record lease payments would be: Lease liability (-L) (-L) ……………………………… ……………………………….. .. Interest expense (+E, -SE) -SE) …………………….. …………………….. Cash (- A) A) …………………………………… …………………………………… + Cash (A) 640

- Lease Obligation (L) + 389

389 251 640 + Interest expense (E) 251


C10-46. (30 minutes) a. $144,899 b. 2012: $144,899 / $381,830 = 37.95%. 2011: $122,833 / $323,060 = 38.02% Current: $104,370 / $367,620 = 28.4% Deferred: $15,650 / $367,620 = 4.26% c. $41,997 - $22,435 + $130,689 = $150,251 million million d. Income tax tax expense (+E, -SE) -SE) …………………….……. …………………….……. Deferred tax asset – asset – current (+A) …..…………………. …..…………………. Income taxes payable p ayable …………………………………... …………………………………... Deferred tax asset – asset – noncurrent (- A) A) ………….. Cash (- A) A) …..………………………………………… …..………………………………………… * $91,744 – $91,744 – $85,612 = $6,132; **Plug to balance.

144,899 6,132* 19,652 20,432** 150,251

e. $734,672 – $734,672 – $9,008/0.35 = $708,935 million. f. Prepaid catalog catalog expenses are capitalized capitalized and and amortized amortized for financial financial reporting reporting purposes. However, for tax reporting purposes, the costs are expensed when paid. Consequently, the tax deduction is recognized before the expense is recognized in the income statement. The prepaid catalog expense of $34,294 represents a temporary temporary difference between financial financial and tax reporting. The resulting deferred tax liability liability of $12,869 offsets the current deferred tax assets in the balance sheet. C10-47. (30 minutes) a. Domestic: 2011: ($1,724 + $274 + $452 - $109) / $4,693 = 49.9% 2010: ($1,657 + $458 - $25 + $47) / $4,948 = 43.2% 2009: ($1,531 + $450 - $273 + $13) / $3,579 = 48.1% Foreign: 2011: ($248 + $0) / $7,633 = 3.2% 2010: ($167 - $13) / $5,848 = 2.6% 2009: ($148 - $8) / $4,802 = 2.9% Total: 2011: $2,589 / ($4,693 + $7,633) = 21.0% 2010: $2,291 / ($4,948 + $5,848) = 21.2% 2009: $1,861 / ($3,579 + $4,802) = 22.2% continued next page


C10-47. concluded b. Of its retained earnings of $37.6 billion, billion, $24.8 billion, billion, or 66%, have been earned and retained in operations outside outside of the United United States. Because retained earnings is a stockholders’ equity account, its location is meaningless. Of greater importance is the location of net assets that were obtained by reinvesting operating cash flows. Whenever resources are transferred into the United States, companies must typically pay U.S. taxes on those profits that were earned in a foreign country, but will receive a credit for any taxes paid to foreign entities. c. Using 2011 tax rates, Google might owe owe $24.8 billion x (49.9% - 3.2%) = $11.6 billion. billion. This is a very rough guess, however. As long as Google doesn’t move its assets from foreign subsidiaries into the U.S., U.S., it may never have to pay these taxes. In the mean time however, there are plenty of ways that Google can get access to these resources without paying U.S. taxes. For example, a bank in the U.S. U.S. can lend money in the U.S. using foreign assets as collateral. As long as Google doesn’t default on the loan, the collateral remains in the foreign country and Google can use the borrowed funds within the U.S. without paying taxes on the collateral funds.


Fa4e Sm Ch10

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