FINANCIAL ACCOUNTING

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Chapter 10 Liabilities Off-Balance-sheet
Financing, Leases, Deferred Income Taxes,
Retirement Benefits, and Derivatives

• FINANCIAL ACCOUNTING
• AN INTRODUCTION TO CONCEPTS,
• METHODS, AND USES
• 12th Edition

Clyde P. Stickney and Roman L. Weil
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Learning Objectives

• 1. Understand (a) why firms attempt to structure
  debt financing to keep debt off the balance sheet
  and (b) how standard setters have refined the
  concept of an accounting liability to reduce
  off-balance-sheet financing abuses.
• 2. Distinguish between operating leases and
  capital leases on the bases of their economic
  characteristics, accounting criteria, and
  financial statement effects.

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Learning Objectives

• 3. Understand why firms may recognize revenues
  and expenses for financial reporting in a period
  different from that used for tax reporting and
  the effect of such differences on the measurement
  of income tax amounts on the income statement and
  the balance sheet.
• 4. Understand the accounting issues related to
  retiree benefit plans (such as pensions and
  health-care benefits).

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Chapter Outline

• Off-balance sheet financing
• Leases
• Income tax accounting and deferred income taxes
• Deferred compensation pension benefits and other
  deferred compensation
• Deferred compensation health care and other
  benefits
• An international perspective
• Chapter Summary
• Appendix 10.1 Effects on the statement of cash
  flows of transactions involving liabilities

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Off-Balance Sheet Financing

• Off-balance sheet financing is any means that
  secures the use of assets for the firm without
  having to recognize an off-setting liability.
• If the liability is not recognized, then the
  double-entry system does not allow for the
  recognition of the asset either, but this is a
  tradeoff that some managers are willing to make.

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Off-Balance Sheet Financing

• Off-balance-sheet financing can affect key
  financial ratios, especially the financing ratios
  that use total debt as a denominator, showing
  them to be lower (and more favorable) than they
  would be if the financing were recognized.

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What is the rationale for off-balance sheet
financing?

• 1. It lowers the cost of borrowing if lenders are
  not aware of the unrecorded liabilities.
• This rationale assumes that lenders can be fooled
  by off-balance-sheet methods.
• Standard-setting bodies have required increased
  disclosures of such methods in recent years.
• 2. It avoids violating some debt covenants that
  is, restrictions specified in the debt agreement
  to protect the lender. These restrictions are
  sometimes stated in the form of financial ratios
  which may be effected by whether or not the
  liability is recorded.

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Review the Structuring Off-Balance Sheet Financing

• Off-balance-sheet financing falls into one of two
  categories that accounting does not recognize as
  liabilities
• 1. Executory contracts are promises to pay at a
  future date for future benefits
• These may be legally binding and give both
  parties valuable rights.
• Standard accounting would recognize a liability
  as benefits are received, not when the contract
  is signed.
• 2. Contingent obligations are obligations that
  arise only if a specified set of conditions are
  met.
• Standard accounting would recognize a liability
  as the contingent events occur rather than when
  the contract is signed.

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Leases

• Firms may lease (or rent) assets instead of
  purchasing them.
• A true lease would give the lessee (the one
  paying for use of the asset) flexibility.
• Some leases are so inflexible that they are
  tantamount to a purchase. They may be
  non-cancelable, long-term and impose on the
  lessee all costs of operating.

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Leases (Cont.)

• Private automobile leases are typically so
  restrictive as to be the economic equivalent of a
  purchase.
• A true automobile lease would be more like what
  is called renting a car.
• Because of the possibility that leases may be
  used as a form of off-balance sheet financing,
  GAAP calls for leases to be capitalized under
  certain conditions.

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Capital and Operating Leases

• Capital leases recognize the lease as if it were
  a purchase and thus recognize both the leased
  asset and the lease liability. The lease asset
  may be depreciated over time and the lease
  liability may be amortized as payments are made.
• If the lease is not capitalized, it may be
  treated as a true lease (or operating lease). In
  this case, a lease expense would be recognized as
  payments were made but no asset or long-term
  liability would be recognized.

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Under what conditions is a lease a capital lease?

• GAAP required that a lease be capitalized if any
  one of the following conditions are met
• 1. Transfer of ownership to lessee at end of
  lease
• 2. Transfer at bargain purchase option
• 3. Lease extends for 75 of the assets life
• 4. PV of lease payments is 90 of fair market
  value

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Capital Leases (cont.)

• Of course, if management wants the lease to be
  treated as an operating lease, they will
  structure the lease terms to avoid all four of
  these criteria.
• In such cases, the last requirement (90 of fair
  market value) is considered the most restrictive.

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Accounting For Leases

• Operating lease or true lease
• Neither the leased asset nor the lease liability
  are recorded
• Lease expense is recognized as cash payments are
  made or adjusting entries are required
• Capital lease
• Both a lease asset (leasehold) and a lease
  liability are recognized for the PV of the lease
  obligations
• As payments are made or adjusting entries
  required
• The asset may be depreciated
• The liability is amortized

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Example of Lease Obligation Amortization

• Amortization Schedule for 45,000 lease
  liability, accounted for as a capital lease,
  repaid in three annual payments of 19,709 with
  interest at 15 compounded annually.

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Example of Lease Obligation Amortization
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Income Tax Accounting and Deferred Taxes

• Define these Terms
• Book income is income before income taxes for
  financial reporting purposes
• Taxable income is the amount of income on which
  the income tax is based
• The two may be different because of
• The timing of recognition may be different, or
• Some revenues or expenses may have special tax
  treatments

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Income Tax Accounting and Deferred Taxes (Cont.)

• What are the difference between book and taxable
  income?
• 1. Permanent differences are differences in what
  is recognized or not. For example, a tax-free
  bond gives book income but not taxable income.
• 2. Temporary differences are differences that
  will equal out over a long time. For example,
  book income may use straight line depreciation
  while taxable income will use macrs. Over time,
  both will depreciate the same amount but at
  different rates.

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Income Tax Accounting and Deferred Taxes (Cont.)

• Two views of income taxes
• 1. Income taxes are expenses and should be
  matched or accrued like other expenses.
• 2. Income taxes are not expenses but are like
  other taxes and should be recognized at the
  amount paid in the current period.
• U.S. GAAP holds to the first view. Thus, a tax
  deferral method saves taxes paid during the
  current period but may not reduce tax expense.
• Critics of this view hold that tax expense is
  unlike other expenses in that it does not give
  rise to the potential for revenues.

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Recording the Income Tax Expense

• A firm which has temporary differences between
  tax-based income and book income will record tax
  expense based on book income, pay the IRS the
  amount of the tax and the difference generally
  represents a liability.

In the future when the deferred taxes become due,
the effect is reversed reducing the deferred tax
liability.
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Pension Benefits and Other Deferred Compensation

• Employers may provide benefits to workers after
  their retirement.
• One reason is to build worker loyalty and
  goodwill.
• Also, at one time, such benefits were a non-cash
  form of compensation.
• Present federal law now requires employers to
  actually put away cash to cover the obligations
  of pension benefits.
• The amount of cash and the recognition of an
  expense are complex issues.

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Pension Benefits (cont.)

• 1. Employers set up a pension plan specifying
  eligibility, promises, funding and an
  administrator.
• 2. Employer computes pension expense for each
  period.
• 3. Employer transfers cash to a separate pension
  fund each period.

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Pension Benefits (cont.)

• 4. If cumulative pension expenses exceed
  cumulative pension funding, a pension liability
  appears on the balance sheet, else a pension
  asset is recognized.
• 5. If the PV of pension commitments to employees
  exceeds the assets of the fund, a pension
  liability would also have to be recognized.

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Pension Benefits (cont.)

• SFAS No. 87 defines two measures of pensions
  liability (Define Them)
• 1. Accumulated benefit obligation
• the present value of amounts expected to be paid
  to employees during retirement based on
  accumulated service and current salary.
• 2. Projected benefit obligation
• the present value of amounts expected to be paid
  to employees during retirement based on
  accumulated service to date but using the level
  of salary expected to serve as a basis for
  computing pension benefits.

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Pension Benefits (cont.)

• The administrator of the pension fund should make
  prudent and profitable investments of those
  funds.
• If the pension funds grows, this adds to the fund
  since the fund is not an asset of the firm.

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Pension Benefits (cont.)

• Such growth does however ease the amount of cash
  that the firm has to transfer to the fund in
  future periods.
• Fund assets at beginning of the period
• Actual earnings on pension fund investments
• Contributions from employer
• - Payments to retirees
• Fund assets at end of the period

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Health Care and Other Benefits

• Health care, insurance and other benefits
  resemble pension plans in concept.
• The PV of such commitments, or health-care
  benefits obligation, represents an economic
  obligation of the employer.
• GAAP requires firms to recognize an expense for
  these obligations and to recognize liabilities
  for any under funded obligations.
• Firms may recognize the full liability in one
  year or piecemeal over several years.

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An International Perspective

• Leases -- most industrial countries distinguish
  between capital and operating leases although the
  criteria may vary.
• Income tax accounting -- in general, countries
  that allow separate rules for tax and financial
  reporting allow deferred tax accounting.
• Retirement benefits -- most industrial countries
  provide worker benefits and some are more
  generous than in the U.S., however, most do not
  provide the same detail of accounting disclosure.

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Chapter Summary

• This chapter completes the discussion of
  liabilities.
• The point was made that liabilities cover some
  obligations that are difficult to measure.
• Leases may represent a significant future
  obligation.
• Pensions certainly do.

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Chapter Summary

• Taxes may give rise to future obligations when
  aggressive deferral methods are practiced.
• The intent of this chapter was to acquaint the
  student with many problems of liability
  accounting and to give the student an
  appreciation of some liabilities that appear on
  the balance sheet.

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Appendix 10.1 Effects on Cash Flows of
Transactions Involving Liabilities

• Leases -- Capitalizing a lease results in a
  long-lived asset (use of investing cash) and a
  liability (financing cash). As the asset is
  depreciated and the liability amortized,
  operating cash is effected. The two effects may
  not cancel out because of differences between the
  depreciation method and the amortization method.

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Appendix 10.1 Effects on Cash Flows of
Transactions Involving Liabilities

• A pension is a separate legal entity and is not
  an asset of the firm, so cash paid in by the
  employee is not an investment.

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Rapid Review - MC

• A promise to pay at a future date for future
  benefits is a
• a. Lease b. Pension
• c. Executory contract d. Capital lease

• Any means that secures the use of assets for the
  firm without having to recognize an off-setting
  liability is a (an)
• a. Lease b. Pension
• c. Off-balance sheet Financing d. Capital lease