Chapter 10. Reporting and Analyzing Leases, Pensions, and Income Taxes. Learning Objectives coverage by question. Miniexercises 15 25, 26, 27

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1 Chapter 10 Reporting and Analyzing Leases, Pensions, and Income Taxes Learning Objectives coverage by question Miniexercises Exercises Problems Cases LO1 Define off-balance-sheet financing and explain its effects on financial analysis. 20, LO2 Account for leases using the operating lease method or the capital lease method. 12, 13, 14 23, 24, 25, 27 33, LO3 Convert off-balance-sheet operating leases to the capital lease method , 26, 27 33, 34, 35, 36, LO4 Explain and interpret the reporting for pension plans. 16, 17, 18, 19 29, 30 37, LO5 Analyze and interpret pension footnote disclosures. 16, 17, 18, 19 28, 29, LO6 Describe and interpret accounting for income taxes , 32 39, 40, 41, 42, 43, Solutions Manual, Chapter

2 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-à-vis 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 Financial Accounting, 3 rd Edition

3 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 payments include those payments 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 when they are paid. Some benefits are 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. Q 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. 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. Q 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 assets result from 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 arises when a deferred tax liability reverses. In this situation, tax expense has been recognized in excess of tax payments in prior years. When the tax return catches up with the income statement, the tax deferral reverses and the deferred tax liability is reduced (debited). In either situation, the deferred tax account (either asset or liability) is debited and cash is credited. Solutions Manual, Chapter

4 MINI EXERCISES M10-12 (15 minutes) a. i. 1/1 No entry 12/31 Rent expense (+E, -SE). 12,000 Cash (-A) 12,000 ii. 1/1 Leased asset (+A).. 57,198 Lease liability (+L) 57,198 $57,198 = $12,000 x /31 Depreciation expense (+E, -SE)... 9,533 Accumulated depreciation (+XA) 9,533 $9,533 = $57,198 / 6. 12/31 Lease liability (-L) 7,996 Interest expense (+E, -SE). 4,004 Cash (-A) 12,000 $4,004 = $57,198 x.07; $7,996 = $12,000 - $4,004. b. + Cash (A) - - Lease Liability (L) + 12,000 12/31 57,198 1/1 12/31 7,996 + Leased Asset (A) - + Interest Expense (E) - 1/1 57,198 12/31 4,004 - Accumulated Depreciation (XA) + + Depreciation Expense (E) - 9,533 12/31 12/31 9,533 c. Transaction Signed a capital lease. Depreciation on leased asset. Cash Asset + Noncash Assets +57,198 Leased Asset - Contra Assets Balance Sheet - = - = Liabilities + +57,198 Lease Liability Contrib. Capital + Earned Capital +9,533 Accumulated Depreciation = -9,533 Retained Earnings Income Statement Revenues - Expenses = - = - +9,533 Deprec. Expense Net Income = -9,533 Made annual lease payment. -12,000 Cash - = -7,996 Lease Liability -4,004 Retained Earnings - +4,004 Interest Expense = -4, Financial Accounting, 3 rd Edition

5 M10-13 (20 minutes) a. 7/1 Leased asset (+A).. 123,100 Lease liability (+L). 123,100 $123,100 = 4,500 x b. 9/30 Depreciation expense (+E, -SE).. 3,078 Accumulated depreciation (+XA, -A). 3,078 $3,078 = $123,100 / (10 x 4). 9/30 Lease liability (-L).. 2,038 Interest expense (+E, -SE) 2,462 Cash (-A) 4,500 $2,462 = $123,100 x (.08/4); $2,038 = $4,500 - $2, /31 Depreciation expense (+E, -SE).. 3,078 Accumulated depreciation (+XA, -A). 3,078 12/31 Lease liability (-L).. 2,079 Interest expense (+E, -SE) 2,421 Cash (-A) 4,500 $2,421 = ($123,100 - $2,038) x (.08/4); $2,079 = $4,500 - $2,421. c. + Cash (A) - - Lease Liability (L) + 4,500 9/30 123,100 7/1 4,500 12/31 9/30 2,038 12/31 2,079 + Leased Asset (A) - + Interest Expense (E) - 7/1 123,100 9/30 2,462 12/31 2,421 - Accumulated Depreciation (XA) + + Depreciation Expense (E) - 3,078 9/30 9/30 3,078 3,078 12/31 12/31 3,078 Solutions Manual, Chapter

6 Transaction d. Signed a capital lease. Depreciation on leased asset. Cash Asset + Noncash Assets +123,100 Leased Asset - Balance Sheet Contra Assets - = - +3,078 Accumulated Depreciation = = Liabilities + Contrib. Capital ,100 Lease Liability Earned Capital -3,078 Retained Earnings Income Statement Revenues - Expenses = - = - Net Income +3,078 Deprec. Expense = -3,078 Made quarterly lease payment. -4,500 Cash - = -2,038 Lease Liability -2,462 Retained Earnings - +2,462 Interest Expense = -2,462 Depreciation on leased asset. Made quarterly lease payment. -4,500 Cash - +3,078 Accumulated Depreciation = - = -2,079 Lease Liability -3,078 Retained Earnings -2,421 Retained Earnings ,078 Deprec. Expense +2,421 Interest Expense = -3,078 = -2,421 e. 7/1 No entry 9/31 Rent expense (+E, -SE) 4,500 Cash (-A) 4,500 12/31 Rent expense (+E, -SE) 4,500 Cash (-A) 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 lease is treated as a capital lease, interest and depreciation are recognized. The total expense for 2010 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 Financial Accounting, 3 rd Edition

7 M10-14 (15 minutes) a. Capital leases record both the leased asset and the lease liability on 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 off-balance-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 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. M10-15 (20 minutes) a. Present value of expected operating lease payments for Southwest Airlines using a financial calculator, I/YR=7: Year ($ millions) Operating Lease Payment Present Value $ 400 $ After Average life years * $1,749 * $876 $195/year = 4.5 years. Solutions Manual, Chapter

8 M10-15 continued. The calculations of the present value of each payment follow: The present value of payments after Year 5 follows: b. The capitalization of these operating leases increases Southwest s total liabilities by 18% to $ million ($9.831 million + $1.749 million). M10-16 (15 minutes) a. American Express is reporting $13 million in pension expense for 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 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 Financial Accounting, 3 rd Edition

9 M10-17 (15 minutes) a. Yum Brands is reporting $36 million of pension expense for 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 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. M10-18 (15 minutes) a. A&F maintains a defined contribution plan for the benefit of its employees. b. Contributions are expensed when made. c. Only the unpaid contribution, if any, appears on the A&F balance sheet. M10-19 (15 minutes) a. Target maintains only a defined contribution plan for the benefit of its employees. b. Contributions are expensed when made. c. Only the unpaid contribution, if any, appears on Target s balance sheet. d. First, employees who do not meet the unspecified eligibility requirement will not be covered. Second, their investment is tied to whether the employees leave the contributions undiversified. Third, matching contributions can be reduced or eliminated in bad times. Solutions Manual, Chapter

10 M10-20 (15 minutes) a. ($millions) Payment Obligation 2009 $245 $ Thereafter. 2,950 1,245 Present Value (i=6%) Total $3,857 $2,023 Average Life: $2,950/$143 = 20.6 years. The calculations of the present value of each payment follow: The present value of payments after Year 5 follows: , , ,666 b. ($millions) Balance Sheet Income Statement Transaction To capitalize operating leases Cash Asset + Noncash = Liabilities Assets +2,023 +2,023 Leased = Lease Asset Liability + Contrib. Capital + Earned Capital Revenues - Expenses = - = Net Income Financial Accounting, 3 rd Edition

11 M10-20 continued. c. Recognition of the operating leases would affect the current ratio. Recording the lease asset would increase noncurrent assets by $2,023 million, but recording the lease liability would increase current liabilities by $231 million, and noncurrent liabilities by $1,792 million ($2,023 - $231). d. (in $millions) Leased asset (+A).. 2,023 Lease liability (+L). 2,023 + Leased Asset (A) - - Lease Liability (L) + 2,023 2,023 e. Yes. The present value of the operating leases of $2,023 million represent over 45% of Target s operating cash flow in M10-21 (15 minutes) a. The use of contract manufacturers removes the manufacturing assets and related liabilities from 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 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. Solutions Manual, Chapter

12 M10-22 (20 minutes) a, b, c. Year Book value Tax basis (after depreciation deduction) Temporary difference Tax rate Deferred tax liability 2010 $300,000 $173,000 $127,000 40% $50, $200,000 $173,000 - ($100,000 - $31,000) = $104,000 $96,000 40% $38, $100,000 $104,000 - ($100,000 - $31,000) = $35,000 $65,000 40% $26,000 d. Because the deferred tax liability is reversing in years 2011, 2012 and 2013, part of the deferred tax liability should be 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 2010 $50,800 $38,400 $12, $38,400 $26,000 $12, $26,000 $0 $26, Financial Accounting, 3 rd Edition

13 EXERCISES E10-23 (20 minutes) a. All of Fortune Brands leases are classified as operating. GAAP requires companies to provide a table of projected lease payments for both operating and capital leases (for example, see the Verizon lease footnote example in E10-24). Because no capital leases are included in the Fortune Brands footnote, we know that it only has operating leases. b. Neither the leased asset nor the lease obligation is reported on the balance sheet for an operating lease. As a result, total assets and total liabilities are reduced. 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 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. c. Year ($ millions) Operating Lease Payment Present Value $ 57.8 $ After Average life... 1 year * $171 * Average life =$18/$22.4 = 0.8 rounded up to 1 The lease effect on the D/E ratio changes from $7,420/$4,672 = 1.59 to ($7,420 + $171)/$4,672 = This is not a major change. Solutions Manual, Chapter

14 E10-24 (20 minutes) a. According to Verizon s lease footnote, it has both capital and operating leases. Only the capital leases are reported on-balance sheet in the amount of $390 million ($63 million in current liabilities and $327 million as long-term liabilities). This is not the total obligation to its lessors. Verizon also has a significant amount of leases that it has classified as operating. In fact, the minimum lease payments under operating leases are over 14 times that for capital leases! These operating leases are not reported on-balance-sheet. b. Neither the leased asset nor the lease obligation is reported on the balance sheet for an operating lease. As a result, total assets and total liabilities are reduced. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. During the life of the lease, however, the two will not be equal. Even if depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease. EE10-25 (25 minutes) a. Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. The present value is computed as follows: Year ($ 000s) Operating Lease Payment Present Value (i=7%) $ 851,412 $ 795, , , , , , , , ,445 >Thereafter... 2,132,053 1,342,833 Average life... 4 years* $4,326,035 * $2,132,053 $556,031/year = rounded to 4 years. The present value of Staples operating leases is computed to be $4.326 billion. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. Staples liabilities are 58% higher following this adjustment (adjusted liabilities are $7.442 billion + $4.326 billion = $ billion) Financial Accounting, 3 rd Edition

15 E10-25 continued. The calculations of the present value of each payment follow: , , , , , , , , , ,031 The present value of payments after Year 5 follows: 4 7 1,883, , ,342, ,883,394 b. ($ 000s) Balance Sheet Income Statement Transaction To capitalize operating leases. Cash Asset + Noncash Assets +4,326,036 Leased Asset = Liabilities = +4,326,036 Lease Liability + Contrib. Capital + Earned Capital Revenues - Expenses = - = c Leased asset (+A)... 4,326,036 Lease liability (+L) 4,326, Depreciation expense (+E, -SE).. 432,604 Accumulated depreciation (XA, -A).. 432,604 Net Income Interest expense (+E, -SE) ,823 Lease liability (-L) ,589 Cash (-A).. 851,412 d. + Leased Asset (A) - - Lease liability (L) ,326,036 4,326, ,589 - Accumulated Depreciation (XA) + + Depreciation Expense (E) - 432, ,604 + Cash (A) - + Interest Expense (E) - 851, ,823 Solutions Manual, Chapter

16 E10-26 (25 minutes) Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. The present value is computed as follows: Year ($ millions) > Operating Lease Payment ---Net Present Value (i=7%) $ 450 $ ,421 1,292 Average life years* $2,857 * $2,421 $306/year = years The calculations of the present value of each payment follow: The present value of payments after Year 5 follows: , , ,812 The present value of Yum s net operating leases is computed to be $2,857 million. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. YUM! s liabilities are 43% higher following this adjustment (adjusted liabilities are $6.635 billion + $2.857 billion = $9.492 billion) Financial Accounting, 3 rd Edition

17 E10-27 (25 minutes) a. Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. The present value is computed as follows: Year ($ millions) > Average life... * $692.3 $163.9/year = years. Operating Lease Payment --- Net Present Value (i=7%) $ $ years* $1,389 The calculations of the present value of each payment follow: The present value of payments after Year 5 follows: The present value of Nike s operating leases is computed to be $1,370 million. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. Solutions Manual, Chapter

18 E10-27 continued. b. Transaction To capitalize operating leases. Cash Asset + Noncash Assets +1,389 Leased Asset Balance Sheet = = Liabilities +1,389 Lease Liability + Contrib. Capital + Earned Capital Income Statement Revenues - Expenses = - = Net Income c. 1. Leased asset (+A). 1,389 Lease Liability (+L). 1, Depreciation expense (+E, -SE). 139 Accumulated depreciation (+XA, -A) Lease liability (-L) Interest expense (+E, -SE) Cash (-A) d. + Leased Asset (A) - - Lease Liability (L) + 1 1,389 1, Accumulated Depreciation (XA) + + Depreciation Expense (E) Cash (A) - + Interest Expense (E) E10-28 (20 minutes) a. Service cost is 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 from the pension investment account. There is a corresponding reduction in the pension obligation. c. The funded status is the pension obligation less the fair market value of the pension investments. In this case $923 million (pension obligation) $513 million (pension investments) = $410 million underfunded amount. d. A $410 million net pension liability is reported in the balance sheet Financial Accounting, 3 rd Edition

19 E10-29 (20 minutes) a. Service cost is 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. The actual return on pension investments is ($1,527 million in 2008 (this causes the decrease in the pension investment account). c. Actuarial losses (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 called an actuarial loss. d. Payments to retirees are made from the pension investment account. There is a corresponding reduction in the pension obligation. e. Xerox contributed $299 million to its pension plans in f. Xerox paid $657 million to its retirees in g. The funded status is the pension obligation less the fair market value of the pension investments. In this case $8,495 million $6,923 million = $1,572 million underfunded amount. h. A $1,572 million net pension liability is reported on the balance sheet. E10-30 (20 minutes) a. Service cost is 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 obligation less the fair market value of the pension investments. In this case $30,394 million $27,791 million = $2,603 million underfunded amount. d. A $2,603 million net pension liability is reported on the balance sheet. Solutions Manual, Chapter

20 Transaction E10-31 (15 minutes) a. To record income tax expense Cash Asset + Noncash Assets Balance Sheet = Liabilities = Taxes Payable Deferred Taxes + Contrib. Capital + Earned Capital Income Statement Revenues - Expenses = Retained Earnings Income Tax Expense Net Income = b. Deferred income taxes (-L) Income tax expense (+E, -SE) Income taxes payable (+L) c. An expense of $619.5 million is recorded in the income statement, thereby reducing both net income and retained earnings. Liabilities are increased by $619.5 million, $920.1 million in income taxes payable less the decrease of $300.6 million in deferred income taxes. Transaction a. To record income tax expense. E10-32 (15 minutes) a. Cash Asset + Noncash Assets Balance Sheet = Liabilities = +93 Taxes Payable +1,248 Deferred Taxes + Contrib. Capital + Earned Capital -1,341 Retained Earnings Income Statement Revenues - Expenses = - +1,341 Income Tax Expense Net Income = -1,341 b. Income tax expense (+E, -SE).... 1,341 Deferred income taxes (+L). 1,248 Taxes payable (+L). 93 c. An expense of $1,341 million is recorded in the income statement, thereby reducing both net income and retained earnings. Deferred tax liabilities are increased (or deferred tax assets are reduced) by $1,248 million, and tax payable liability was increased by $93 million. d. The refund is most likely due to one of two sources: (1) a loss recorded in an earlier period for financial reporting purposes that was not recognized until 2004 for tax reporting purposes (e.g., a restructuring loss) or (2) a tax loss carryforward Financial Accounting, 3 rd Edition

21 PROBLEMS P10-33 (60 minutes) a. Rent expense (+E, -SE). 208,085,000 Cash (-A). 208,085,000 b. Outback would report a lease liability of $1,074,521,000 at December 31, 2008 if the operating leases were capitalized. ($ 000s) Year Operating Lease Payment Present Value at Dec. 31, 2008 (i=8%) , , , , , , , , ,902 95,215 > , , ,160/139,902=5.94 yrs. $1,071,051 The calculations of the present value of each payment follow: , , , , , , , , , ,902 The present value of payments after Year 5 follows: , , , ,650 Solutions Manual, Chapter

22 P10-33 continued. c. In 2009, Outback would report interest expense of $85,684,000 ($1,071,051,000 x.08) and depreciation expense of $107,105,100 ($1,071,051,000/10) instead of rent expense of $175,367,000. These costs ($85,684,000 and $107,105,100) would replace the otherwise reported rent expense of $175,367,000 on the 2009 income statement. 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. d. These transactions/entries are reflected in the financial statement effects template below. ($000s) Balance Sheet Income Statement Transaction 2009 Depreciation expense. Cash Asset + Noncash Assets - Contra Assets ,105* Accumulated Depreciation = Liabilities + = Contrib. Capital + Earned Capital -107,105 Retained Earnings Revenues - Expenses = ,105 Deprec. Expense Net Income = -107, Lease payment. -175,367 Cash - = -89,683 Lease Liability -85,684** Retained Earnings *Accumulated depreciation is a contra asst, so assets are reduced. **$1,071,051 x ,684 Interest Expense = -85,684 e. In the statement of cash flows, the rent expense on operating leases is classified as an operating cash 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 Financial Accounting, 3 rd Edition

23 P10-34 (40 minutes) a. All of Abercrombie & Fitch s leases are classified as operating. U.S. GAAP requires companies to provide a table of projected lease payments for both operating and capital leases. Because no capital leases are included in the Abercrombie & Fitch footnote, we know that it only has operating leases. Because operating leases are not capitalized on the balance sheet, neither the leased asset, nor the lease obligation, appear on-balance-sheet. b. Total assets and total 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. Profit is unaffected by this classification. 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. c. Using a 10% discount rate, the present value of A&F s operating leases payments is computed as follows: Year ($ 000s) Operating Lease Payment Present Value (i=10%) $314,587 $285, , , , , , , , ,376 > ,302, ,821 Average life years* $1,759,018 * $1,302,139 $267,951/year = 4.86 years. Solutions Manual, Chapter

24 P10-34 continued. The calculations of the present value of each payment follow: , , , , , , , , , ,951 The present value of payments after Year 5 follows: , , , ,396 d. ($ 000s) Balance Sheet Income Statement Transaction To capitalize operating leases. Cash Asset + Noncash Assets +1,759,018 Leased Asset = Liabilities = +1,759,018 Lease Liability + Contrib. Capital + Earned Capital Revenues - Expenses = - = Net Income e. ($ 000s) 2/3/08 Leased asset (+A).. 1,759,018 Lease liability (+L). 1,759, Depreciation expense (+E, -SE) 175,902 Accumulated depreciation (+XA, -A). 175,902 $175,902 = $1,759,018 / 10 Lease liability (-L). 138,685 Interest expense (+E, -SE).. 175,902 Cash (-A) 314,587 $175,902 = $1,759,018 x Financial Accounting, 3 rd Edition

25 P10-34 continued. f. ($ 000s) + Cash (A) - - Lease Liability (L) + 1,759, , ,685 + Leased Asset (A) - + Interest Expense (E) - 1 1,759, ,902 - Accumulated Depreciation (XA) + + Depreciation Expense (E) - 175, ,902 The interest expense is the same as the depreciation charge because interest is at 10% and depreciation is over 10 years. g. The effect of a failure to report the leased assets and related lease obligation onbalance-sheet understates fixed commitments. It will leave gross margin largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. The debt to equity ratio is increased by capitalizing the leases. 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. Overall these two factors offset each other leaving ROE only marginally affected. Our conclusion of how A&F is achieving its ROE is likely to be altered because A&F has lower turnover and higher financial leverage than was apparent based on the published (unadjusted) financial statements. Solutions Manual, Chapter

26 P10-35 (40 minutes) a. Best Buy reports $265 million of capital leases in its liabilities of which $59 million due in 2010 is reported as a current liability. The $8,600 of operating leases are not reported in the balance sheet nor are the related leased assets. b. Total assets and total liabilities are lower than the balance that would have been reported had the leases been capitalized. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. In any given year of the lease, however, the two will not be equal. If depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation, which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease. c. Using a 10% discount rate, the present value of Best Buy s operating leases payments is computed as follows: ($ millions) Year >5... Average life... * $3,748 $846/year = 4.43 years. Operating Lease Payment Present Value (i=10%) $ 1,097 $ 997 1, ,748 1, years* $5, Financial Accounting, 3 rd Edition

27 P10-35 continued. The calculations of the present value of each payment follow: , , The present value of payments after Year 5 follows: , , ,914 d. Transaction To capitalize operating leases. Cash Asset Balance Sheet + Noncash = Liabilities Assets +5,534 Leased Asset = +5,534 Lease Liability + Contrib. Capital + Earned Capital Income Statement Revenues - Expenses = - = Net Income e Leased asset (+A). 5,534 Lease liability (+L).. 5, Depreciation expense (+E, -SE). 553 Accumulated depreciation (+XA, -A) $572 = $5,716 / Lease liability (-L) Interest expense (+E, -SE) Cash (-A) 1,097 $572 = $5,716 x 0.10 Solutions Manual, Chapter

28 P10-35 continued. f. + Cash (A) - - Lease Liability (L) + 5, , Leased Asset (A) - + Interest Expense (E) , Accumulated Depreciation (XA) + + Depreciation Expense (E) The interest expense is the same as the depreciation charge because interest is at 10% and depreciation is over 10 years. g. The effect of a failure to report the leased assets and related lease obligation onbalance-sheet understates fixed commitments. It will leave gross margin largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. The debt to equity ratio is increased. 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. Overall these two factors offset each other leaving ROE only marginally affected. Our conclusion of how Best Buy is achieving its ROE is likely to be altered because Best Buy has lower turnover and higher financial leverage than was apparent based on the published (unadjusted) financial statements. P10-36 (5 minutes) a. Leased asset (+A) 74,520 Lease liability (+L). 74,520 b. Prepaid rent (+A).. 1,000 Cash (-A) 1, Financial Accounting, 3 rd Edition

29 P10-37 (50 minutes) a. $177 million expense b. The expected return is computed as the beginning fair market value of the pension plan assets multiplied by the long-term expected return on these investments. For 2009, this is computed as $11, % = $1010, slightly less than the reported amount of $1,059 million. The plan investment reported an actual loss of $2,306 million. U.S. GAAP permits the use of the expected longterm 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 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 (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 market value of plan assets, the funded status is negative or underfunded. The funded status of the FedEx pension plan is $(238) at the end of Pension obligations are $11,050 million and pension assets are $10,812 million. FedEx should report its net funded status as a net pension liability of $238 million on its balance sheet. e. Because the pension obligation is the present value of expected pension payments, an increase in the discount rate decreases 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 2009, the effect of an increase in the discount rate is to apply a higher discount rate to a lower pension obligation. These two effects are offsetting, but usually result in lower interest cost. f. The 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 decreases the pension obligation reported on the balance sheet and, consequently, the interest component of pension expense. It is an income-increasing action. Solutions Manual, Chapter

30 P10-38 (5 minutes) a. Pension expense (+E, -SE) 16,000 Cash (-A)... 16,000 16,000 = 400,000 x.04. b. Bartov would report a net liability of $450,000 ($625,000 - $175,000) in its 2010 balance sheet. P10-39 (20 minutes) a. $34,106,000 b. $36,470,000 is payable in cash and the remainder is deferred. 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. An example is supplied by certain pension expenses deductible for books before being deductible for taxes. d. Deferred tax assets arise when income is recognized for tax purposes before it is recognized in the financial statements, such as can be case with advance payments from customers. Thus receipt of the cash will decrease the deferred tax asset. Alternatively, deferred tax assets may arise when the tax return defers expenses that are recognized in the financial statements. Examples include bad debt expense and warranty expense. A restructuring charge is an 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). Therefore, the payment of the cash or sale of the assets will decrease the deferred tax asset Financial Accounting, 3 rd Edition

31 P10-40 (20 minutes) a. In 2009, the temporary difference is $8,000. $8,000 x 40% = $3,200. In 2010, the temporary difference reverses and no liability would be reported. b. Income tax expense (+E, -SE).. 91,200 Income taxes payable* (+L). 88,000 Deferred income tax liability (+L).. 3,200 * ($236,000 $16,000) x 40% = $88,000. Income tax expense (+E, -SE). 94,800 Deferred income tax liability (-L) 3,200 Income taxes payable* (+L) 98,000 * ($245,000 $0) x 40% = $98,000. c. Income tax expense (+E, -SE). 80,200 Income taxes payable (+L)* 77,000 Deferred income tax liability (+L). 3,200 * ($236,000 $16,000) x 35% = $77,000. Income tax expense (+E, -SE). 94,800 Deferred income tax liability (-L) 3,200 Income taxes payable (+L)*.. 98,000 * ($245,000 $0) x 40% = $98,000. The solution to part c depends on what the company knew, in 2009, about the tax rate in In the journal entries above, the assumption is that the tax rate is 35% in 2009, but is supposed to change to 40% in However, if the change in the tax rate was not known, the following entries would be required: c. Income tax expense (+E, -SE). 79,800 Income taxes payable (+L)* 77,000 Deferred income tax liability (+L) **. 2,800 * ($236,000 $16,000) x 35% = $77,000. ** $8,000 x 0.35 = $2,800 Income tax expense (+E, -SE)... 95,200 Deferred income tax liability (-L)... 2,800 Income taxes payable* (+L)... 98,000 * ($245,000 $0) x 40% = $98,000. Either way, the amount of income tax expense is determined as a plug amount. Solutions Manual, Chapter

32 P10-41 (20 minutes) a. Temporary differences 2009: $32,000 - $24,000 = $8,000; 2010: ($32,000 + $37,000) ($24,000 + $26,000) = $19,000. b. Deferred tax liability 2009: $8,000 x 40% = $3,200; 2010: $19,000 x 40% = $7,600 c. $19,200 + ($7,600 $3,200) = $23,600 d. Income tax expense (+E, -SE) 23,600 Income taxes payable (+L)... 19,200 Deferred tax liability (+L).. 4,400 + Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) + (d) 23,600 19,200 (d) 4,400 (d) P9-42 (20 minutes) a. Temporary differences 2009: $140,000 - $130,000 = $10,000; 2010: ($140,000 + $122,000) ($130,000 + $128,000) = $4,000. b. Deferred tax liability 2009: $10,000 x 35% = $3,500; 2010: $4,000 x 35% = $1,400 c. $45,150 + ($1,400 $3,500) = $43,050 d. Income tax expense (+E, -SE) 43,050 Deferred tax liability (-L) 2,100 Income taxes payable (+L).. 45,150 + Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) + (d) 43,050 45,150 (d) (d) 2, Financial Accounting, 3 rd Edition

33 P10-43 (15 minutes) a. $12,000 x 40% = $4,800. b. Because the source of the temporary difference is a noncurrent asset (PP&E), the deferred tax liability would be classified as a noncurrent liability. c. $8,000 x 40% = $3,200. P10-44 (20 minutes) Assume that the tax rate increase in 2011 was not known until a. Book value b. Tax basis Temporary difference c. Deferred tax liability 2009 $12,000 $0 $12,000 $4,200 ($12,000 x 0.35) 2010 $6,000 $0 $6,000 $2,400 ($6,000 x 0.40) 2011 $0 $0 $0 $0 d. 12/31/09 Income tax expense (+E, -SE).. 112,000 Deferred income tax liability (+L) 4,200 Income taxes payable (+L)*.. 107,800 * $308,000 x 0.35 = 107, /31/10 Income tax expense (+E, -SE). 138,200 Deferred income tax liability (-L). 1,800 Income taxes payable (+L)* ,000 * $400,000 x 0.35 = $140, /31/11 Income tax expense (+E, -SE).. 165,600 Deferred income tax liability (-L) 2,400 Income taxes payable (+L)* 168,000 * $420,000 x 0.40 = $168,000. The expense is determined as a plug amount. Solutions Manual, Chapter

34 P10-45 (40 minutes) a. According to FedEx s lease footnote, it has both capital and operating leases. Only the capital leases are reported on-balance-sheet in the amount of $294 million (FedEx also reports a lease asset on the balance sheet, but the asset will appear at an amount lower than the lease liability). This amount is not the total obligation to its lessors. FedEx also has a significant amount of leases that it has classified as operating. In fact, the minimum lease payments under operating leases are over 34 times that for capital leases. These operating leases are not reported on-balance-sheet. b. An Excel spreadsheet to calculate the interest rate (using the IRR function) would look something like the following: A B C D E F G H I J K L M N O 1 N Amount IRR 4.453% The Excel function =IRR(B2:O2) returns a value of 4.453% (which is >3%). c. The present value of FedEx s operating leases payments is computed as follows: Year ($ millions) > Total... Operating Lease Payment Average Life: $7,352/$1,166 = 6.3 years. Present Value (i=4%) $1,759 $ 1,691 1,612 1,490 1,451 1,290 1,316 1,125 1, ,352 5,246 $14,656 $11, Financial Accounting, 3 rd Edition

35 P10-45 continued. The calculations of the present value of each payment follow: 1 4 1, , , , , , , , ,166 The present value of payments after Year 5 follows: ,382 1, , ,382 d. Failure to report the leased assets and related lease obligation on-balance sheet has overstated asset turnover ratios and understated financial leverage ratios. For example, the debt to equity ratio would increase from 0.78 ($10,618/$13,626) to 1.65 ([$10,618 + $11,800]/$13,626). Profit margins will not be affected significantly, if we assume that the leases are approximately at the midpoint of their lives, on average. Because the decreased turnover and increased leverage effects offset one another, ROE is unaffected. Our conclusion about how FedEx is achieving its ROE is altered, however, because it has lower turnover and higher financial leverage than is apparent based on a review of the published (unadjusted) financial statements. e. To effectively conduct its business, FedEx requires a significant amount of assets that are not reported on-balance-sheet. In addition, the true extent of FedEx s obligations is substantially understated. In the case of FedEx, therefore, it appears that the balance sheet does not do an adequate job. f. Lease reporting in the U. S. follows U.S. GAAP while lease reporting in France would follow IFRS. U.S. GAAP does not capitalize operating leases. Operating leases are considered executory contracts. Executory contracts are promises to pay defined amounts in the future for future benefits. Such contracts are not recognized as liabilities. The assets supplying the services are also not recognized. The requirements necessary to recognize a lease as a capital lease are not as specific under IFRS and hence a lease that would not be considered a capital lease under U.S. GAAP might be considered a capital lease under IFRS. Specific requirements for capitalization are covered in advanced courses. Solutions Manual, Chapter

36 CASES AND PROJECTS C10-46 (50 minutes) a. Dow Chemical is reporting net pension expense of $122 million for b. The expected rate of return is computed as the beginning fair market value of the pension plan assets multiplied by the long-term expected return on these investments. For 2008, expected return was $$1,232 on assets of $16,130 million. This implies an expected rate of return of 7.64% ($1,232/$16,130). c. The pension 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 (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive. If pension obligations exceed the fair market value of plan assets, the funded status is negative. The funded status of the Dow Chemical pension plan is $(4,000) million at the end of Pension obligations are $15,573 million and pension assets are $11,573 million. Thus, the pension is underfunded and the balance sheet should show a net pension liability of $4,000 million. e. Since the pension obligation is the present value of expected pension payments, a increase in the discount rate decreases 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 an increase in the discount rate is to apply a higher interest rate to a lower pension obligation. Interest expense on the pension liability will usually increase in this circumstance. However, the actuarial gain resulting from the lower liability amount may offset the higher interest cost. f. An increase in expected return unambiguously increases profitability as pension cost is reduced. This result occurs because the long-term rate is used to compute the dollar amount of expected return that is an offset in the computation of pension expense. g. Inflation rates differ from country to country. For 2008, those rates are generally higher outside the U.S. where FedEx operates. Inflation is expected to increase in the U.S. and could exceed the rates in other countries implying relatively higher compensation levels Financial Accounting, 3 rd Edition