Chapter 10

Reporting and Analyzing Leases, Pensions, and Income Taxes

Learning Objectives coverage by question
Miniexercises LO1 Define off-balance-sheet financing and explain its effects on financial analysis. LO2 Account for leases using the operating lease method or the capital lease method. LO3 Convert off-balance-sheet operating leases to the capital lease method. LO4 Explain and interpret the reporting for pension plans. LO5 Analyze and interpret pension footnote disclosures. LO6 Describe and interpret accounting for income taxes. 20, 21 Exercises Problems Cases

47

12, 13, 14

23, 24, 25, 27

33, 36

47

15

25, 26, 27

33, 34, 35, 36, 45

47

16, 17, 18, 19

29, 30

37, 38

46

16, 17, 18, 19

28, 29, 30

37

46

22

31, 32

39, 40, 41, 42, 43, 44

48

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-1

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 doesnt 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 companys 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--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.
Cambridge Business Publishers, 2011 10-2 Financial Accounting, 3rd Edition

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. 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. 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 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 companys 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.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-3

MINI EXERCISES
M10-12 (15 minutes) a. i.
1/1 12/31 ii. 1/1 No entry Rent expense (+E, -SE) . Cash (-A) 12,000 12,000 57,198 57,198

Leased asset (+A) .. Lease liability (+L) $57,198 = $12,000 x 4.76654 12/31 Depreciation expense (+E, -SE) ... Accumulated depreciation (+XA) $9,533 = $57,198 / 6. 12/31 Lease liability (-L) Interest expense (+E, -SE) . Cash (-A) $4,004 = $57,198 x .07; $7,996 = $12,000 - $4,004. b. + Cash (A) 12,000 Leased Asset (A) 57,198 12/31 12/31 + 1/1 12/31 + 12/31 + 12/31 + -

9,533 9,533

7,996 4,004 12,000

Lease Liability (L) 57,198 7,996 Interest Expense (E) 4,004

+ 1/1 -

Accumulated Depreciation (XA) 9,533

Depreciation Expense (E) 9,533

c. Balance Sheet
Transaction Cash Asset

Income Statement
Contrib. Capital + Earned Capital Revenues - Expenses = Net Income

Signed a capital lease. Depreciation on leased asset. Made annual -12,000 lease Cash payment.

Noncash Assets

+57,198
Leased Asset

Contra Assets

= Liabilities +

+57,198
= Lease Liability

-9,533
Retained Earnings

+9,533
- Accumulated = Depreciation

+9,533 Deprec. Expense

= -9,533

-7,996
= Lease Liability

-4,004
Retained Earnings

+4,004 Interest Expense

= -4,004

Cambridge Business Publishers, 2011 10-4 Financial Accounting, 3rd Edition

M10-13 (20 minutes) a. 7/1 Leased asset (+A) .. Lease liability (+L) . 123,100 123,100

$123,100 = 4,500 x 27.35548

b. 9/30

Depreciation expense (+E, -SE) .. Accumulated depreciation (+XA, -A) . Lease liability (-L) .. Interest expense (+E, -SE) Cash (-A)

3,078 3,078 2,038 2,462 4,500 3,078 3,078 2,079 2,421 4,500

$3,078 = $123,100 / (10 x 4).

9/30

$2,462 = $123,100 x (.08/4); $2,038 = $4,500 - $2,462.

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

Cash (A)
4,500 4,500

9/30 12/31

9/30 12/31

Lease Liability (L)

123,100 2,038 2,079

+
7/1

+
7/1

Leased Asset (A)

123,100

+
9/30 12/31

Interest Expense (E)

2,462 2,421

Accumulated Depreciation (XA)

3,078 3,078

+
9/30 12/31

+
9/30 12/31

Depreciation Expense (E)

3,078 3,078

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-5

d. Balance Sheet
Transaction Cash Asset

Income Statement
+ Contrib. Capital + Earned Capital Revenues - Expenses = Net Income

Signed a capital lease. Depreciation on leased asset. Made quarterly -4,500 lease Cash payment. Depreciation on leased asset. Made quarterly -4,500 lease Cash payment.

Noncash Assets

+123,100
Leased Asset

Contra Assets

= =

Liabilities

+123,100
Lease Liability

-3,078
Retained Earnings

+3,078
Accumulated - Depreciation =

+3,078 Deprec. Expense

= -3,078

-2,038
= Lease Liability

-2,462
Retained Earnings

+2,462 Interest Expense

= -2,462

+3,078
- Accumulated = Depreciation

-3,078
Retained Earnings

+3,078 Deprec. Expense

= -3,078 = -2,421

-2,079
= Lease Liability

-2,421
Retained Earnings

+2,421
Interest Expense

e. 7/1 9/31 No entry Rent expense (+E, -SE) Cash (-A) 4,500 4,500 4,500 4,500

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

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.

Cambridge Business Publishers, 2011 10-6 Financial Accounting, 3rd Edition

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 Yums 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) 2009......................... 2010......................... 2011......................... 2012......................... 2013......................... After 2013................ Average life............. * $876 $195/year = 4.5 years. Operating Lease Payment $ 400 335 298 235 195 876 4.5 years * Present Value $ 374 293 243 179 139 521 $1,749

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-7

M10-15continued.
The calculations of the present value of each payment follow: N 1 N 2 N 3 N 4 N 5 I/YR 7 I/YR 7 I/YR 7 I/YR 7 I/YR 7 PV 374 PV 293 PV 243 PV 179 PV 139 PMT 0 PMT 0 PMT 0 PMT 0 PMT 0 FV 400 FV 335 FV 298 FV 235 FV 195

The present value of payments after Year 5 follows: N 4.5 N 5 I/YR 7 I/YR 7 PV 731 PV 521 PMT 195 PMT 0 FV 0 FV 731

b. The capitalization of these operating leases increases Southwests total liabilities by 18% to $11.580 million ($9.831 million + $1.749 million).

M10-16 (15 minutes) a. American Express is reporting $13 million in pension expense for 2008. 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.

Cambridge Business Publishers, 2011 10-8 Financial Accounting, 3rd Edition

M10-17 (15 minutes) a. Yum Brands is reporting $36 million of pension expense for 2008. 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 Targets 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.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-9

M10-20 (15 minutes) a. ($millions) 2009 2010 2011 2012 2013 Thereafter . Total

Payment Obligation $245 216 157 146 143 2,950 $3,857

Present Value (i=6%) $231 192 132 116 107 1,245 $2,023

Average Life: $2,950/$143 = 20.6 years.

The calculations of the present value of each payment follow: N 1 N 2 N 3 N 4 N 5 I/YR 6 I/YR 6 I/YR 6 I/YR 6 I/YR 6 PV 231 PV 192 PV 132 PV 116 PV 107 PMT 0 PMT 0 PMT 0 PMT 0 PMT 0 FV 245 FV 216 FV 157 FV 146 FV 143

The present value of payments after Year 5 follows: N 20.6 N 5 I/YR 6 I/YR 6 PV 1,666 PV 1,245 PMT 143 PMT 0 FV 0 FV 1,666

b.
($millions)

Balance Sheet
Cash Asset Liabil- + Contrib. + + Noncash Assets = ities Capital +2,023 +2,023 = Leased Lease
Asset Liability

Income Statement
Earned Capital Net Revenues - Expenses = Income =

Transaction
To capitalize operating leases

Cambridge Business Publishers, 2011 10-10 Financial Accounting, 3rd Edition

M10-20continued. 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) .. Lease liability (+L) . + Leased Asset (A)
2,023

2,023 2,023 Lease Liability (L) +

2,023

e. Yes. The present value of the operating leases of $2,023 million represent over 45% of Targets operating cash flow in 2008.

M10-21 (15 minutes) a. The use of contract manufacturers removes the manufacturing assets and related liabilities from Nikes 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.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-11

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

Year 2010 2011 2012 Book value $300,000 $200,000 $100,000 Tax basis (after depreciation deduction) $173,000 $173,000 - ($100,000 - $31,000) = $104,000 $104,000 - ($100,000 - $31,000) = $35,000 Temporary difference $127,000 $96,000 $65,000 Tax rate 40% 40% 40% Deferred tax liability $50,800 $38,400 $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 2010 2011 2012 Deferred tax liability $50,800 $38,400 $26,000 Long-term amount reversing beyond one year $38,400 $26,000 $0 Current portion reversing within one year $12,400 $12,400 $26,000

Cambridge Business Publishers, 2011 10-12 Financial Accounting, 3rd Edition

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) 2009......................... 2010......................... 2011......................... 2012......................... 2013......................... After 2013................ Operating Lease Payment $ 57.8 45.4 35.1 26.3 22.4 18 Present Value $ 54 40 29 20 16 12 $171

Average life............. 1 year * * 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 = 1.62. This is not a major change.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-13

E10-24 (20 minutes)

a. According to Verizons 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.

E10-25 (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) 2009......................... 2010......................... 2011......................... 2012......................... 2013......................... >Thereafter............. Average life.............
*

Operating Lease Payment $ 851,412 803,071 731,808 645,215 556,031 2,132,053 4 years*

Present Value (i=7%) $ 795,713 701,434 597,375 492,235 396,445 1,342,833 $4,326,035

$2,132,053 $556,031/year = 3.834 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 = $11.768 billion).

Cambridge Business Publishers, 2011 10-14 Financial Accounting, 3rd Edition

E10-25continued.
The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 7 795,713 0 851,412 N 2 N 3 N 4 N 5 I/YR 7 I/YR 7 I/YR 7 I/YR 7 PV 701,434 PV 597,375 PV 492,235 PV 396,445 PMT 0 PMT 0 PMT 0 PMT 0 FV 803,071 FV 731,808 FV 645,215 FV 556,031 FV 0 FV 1,883,394

The present value of payments after Year 5 follows: N I/YR PV PMT 4 7 1,883,394 556,031 N 5 I/YR 7 PV 1,342,833 PMT 0

b.
($ 000s)

Balance Sheet
Cash Asset Liabil- + Contrib. + + Noncash Assets = ities Capital +4,326,036 +4,326,036 = Leased Lease
Asset Liability

Income Statement
Earned Capital Net Revenues - Expenses = Income =

Transaction
To capitalize operating leases.

c. 2008 2009

Leased asset (+A) ... Lease liability (+L) Depreciation expense (+E, -SE) .. Accumulated depreciation (XA, -A) .. Interest expense (+E, -SE) .... Lease liability (-L) ... Cash (-A) ..

4,326,036 4,326,036 432,604 432,604 302,823 548,589 851,412

d. + 2008 Leased Asset (A) 4,326,036 2009 + 2009 + 2009 Lease liability (L) + 4,326,036 2008 548,589 Depreciation Expense (E) 432,604 Interest Expense (E) 302,823 -

Accumulated Depreciation (XA) + 432,604 2009 + Cash (A) 851,412 2009

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-15

Cambridge Business Publishers, 2011 10-16 Financial Accounting, 3rd Edition

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) 2009......................... 2010......................... 2011......................... 2012......................... 2013......................... >2013....................... Average life............. * Operating Lease Payment ---Net $ 450 414 375 338 306 2,421 7.912 years* Present Value (i=7%) $ 421 362 306 258 218 1,292 $2,857

$2,421 $306/year = 7.912 years

The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 7 421 0 450 N 2 N 3 N 4 N 5 I/YR 7 I/YR 7 I/YR 7 I/YR 7 PV 362 PV 306 PV 258 PV 218 PMT 0 PMT 0 PMT 0 PMT 0 FV 414 FV 375 FV 338 FV 306 FV 0 FV 1,812

The present value of payments after Year 5 follows: N I/YR PV PMT 7.912 7 1,812 306 N 5 I/YR 7 PV 1,292 PMT 0

The present value of Yums 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).

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-17

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: Operating Lease Payment --- Net $ 312.4 264.4 228.9 192.1 163.9 692.3 4.224 years* Present Value (i=7%) $ 292 231 187 147 117 415 $1,389

Year ($ millions) 2009......................... 2010......................... 2011......................... 2012......................... 2013......................... >2013....................... Average life.............

* $692.3 $163.9/year = 4.224 years. The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 7 292 0 312.4 N 2 N 3 N 4 N 5 I/YR 7 I/YR 7 I/YR 7 I/YR 7 PV 231 PV 187 PV 147 PV 117 PMT 0 PMT 0 PMT 0 PMT 0 FV 264.4 FV 228.9 FV 192.1 FV 163.9 FV 0 FV 582

The present value of payments after Year 5 follows: N I/YR PV PMT 4.225 7 582 163.9 N 5 I/YR 7 PV 415 PMT 0

The present value of Nikes 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.

Cambridge Business Publishers, 2011 10-18 Financial Accounting, 3rd Edition

E10-27continued. b.

Balance Sheet
Transaction
To capitalize operating leases. Cash Asset + Noncash Assets = +1,389 = Leased
Asset

Income Statement
Earned Capital Net Revenues - Expenses = Income =

Liabil- + Contrib. + ities Capital +1,389

Lease Liability

c. 1. 2. 3.

Leased asset (+A) . Lease Liability (+L) . Depreciation expense (+E, -SE) . Accumulated depreciation (+XA, -A)... Lease liability (-L) Interest expense (+E, -SE) . Cash (-A) ... + Leased Asset (A) 1,389 3 -

1,389 1,389 139 139 215.2 97.2 312.4 Lease Liability (L) 1,389 215.2 + 1

d. 1

- Accumulated Depreciation (XA) + 139 2 + Cash (A) 312.4

+ Depreciation Expense (E) 139 + Interest Expense (E) 97.2

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.
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-19

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 2008. f. Xerox paid $657 million to its retirees in 2008. 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.

Cambridge Business Publishers, 2011 10-20 Financial Accounting, 3rd Edition

E10-31 (15 minutes) a.

Balance Sheet
Transaction
To record income tax expense = Cash Asset LiabilContrib. + Noncash Assets = ities + Capital +

Income Statement
Earned Capital Net Revenues - Expenses = Income

+920.1
Taxes Payable

-619.5
Retained Earnings

-300.6
Deferred Taxes

+619.5
Income Tax Expense

-619.5

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

300.6 619.5 920.1

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.

E10-32 (15 minutes) a.

Balance Sheet
Transaction
a. To record income tax expense. Cash Asset LiabilContrib. + Noncash Assets = ities + Capital +

Income Statement
Earned Capital Net Revenues - Expenses = Income

+93

Taxes Payable

-1,341
Retained Earnings

+1,248
Deferred Taxes

+1,341
Income Tax Expense

-1,341

b. Income tax expense (+E, -SE) .... Deferred income taxes (+L) . Taxes payable (+L) . 1,341 1,248 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.
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-21

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 2009 2010 2011 2012 2013 >2013 . Operating Lease Payment 175,367 167,613 156,382 148,186 139,902 831,160 831,160/139,902=5.94 yrs. Present Value at Dec. 31, 2008 (i=8%) 162,377 143,701 124,141 108,921 95,215 436,696 $1,071,051

The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 8 162,377 0 175,367 N 2 N 3 N 4 N 5 I/YR 8 I/YR 8 I/YR 8 I/YR 8 PV 143,701 PV 124,141 PV 108,921 PV 95,215 PMT 0 PMT 0 PMT 0 PMT 0 FV 167,613 FV 156,382 FV 148,186 FV 139,902 FV 0 FV 641,650

The present value of payments after Year 5 follows: N I/YR PV PMT 5.94 8 641,650 139,902 N 5 I/YR 8 PV 436,696 PMT 0

Cambridge Business Publishers, 2011 10-22 Financial Accounting, 3rd Edition

P10-33continued. 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) Transaction Cash Asset Noncash + Assets

Balance Sheet
Contra Assets = Liabilities + Contrib. Capital + Earned Capital

Income Statement
Revenues Expenses = Net Income

2009 Depreciation expense. 2009 Lease payment.

- Accumulated = Depreciation

+107,105*

-107,105
Retained Earnings

+107,105
Deprec. Expense

= -107,105

-175,367
Cash

-89,683
Lease Liability

-85,684**
Retained Earnings

+85,684 = -85,684
Interest Expense

*Accumulated depreciation is a contra asst, so assets are reduced. **$1,071,051 x 0.08 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.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-23

P10-34 (40 minutes)

a.

All of Abercrombie & Fitchs 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. 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.

b. Total assets and total liabilities are lower than the balance that would have been

c. Using a 10% discount rate, the present value of A&Fs operating leases
payments is computed as follows: Year ($ 000s) 2009......................... 2010......................... 2011......................... 2012......................... 2013......................... >2013....................... Average life.............
*

Operating Lease Payment $314,587 318,845 305,830 287,772 267,951 1,302,139 4.86 years*

Present Value (i=10%) $285,988 263,509 229,773 196,551 166,376 616,821 $1,759,018

$1,302,139 $267,951/year = 4.86 years.

Cambridge Business Publishers, 2011 10-24 Financial Accounting, 3rd Edition

P10-34continued.
The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 10 285,988 0 314,587 N 2 N 3 N 4 N 5 I/YR 10 I/YR 10 I/YR 10 I/YR 10 PV 263,509 PV 229,773 PV 196,551 PV 166,376 PMT 0 PMT 0 PMT 0 PMT 0 FV 318,845 FV 305,830 FV 287,772 FV 267,951 FV 0 FV 993,396

The present value of payments after Year 5 follows: N I/YR PV PMT 4.86 10 993,396 267,951 N 5 I/YR 10 PV 616,821 PMT 0

d.
($ 000s)

Balance Sheet
Cash Asset Liabil- + Contrib. + + Noncash Assets = ities Capital +1,759,018 +1,759,018 = Leased Lease
Asset Liability

Income Statement
Earned Capital Net Revenues - Expenses = Income =

Transaction
To capitalize operating leases.

e. ($ 000s) 2/3/08 Leased asset (+A) .. Lease liability (+L) . 2009 Depreciation expense (+E, -SE) Accumulated depreciation (+XA, -A) .

1,759,018 1,759,018 175,902 175,902

$175,902 = $1,759,018 / 10

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

$175,902 = $1,759,018 x 0.10.

138,685 175,902 314,587

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-25

P10-34continued.
f. ($ 000s) + Cash (A) 314,587 + 1 Leased Asset (A) 1,759,018 3 + 2 + 2 3 3 + Lease Liability (L) 1,759,018 138,685 Interest Expense (E) 175,902 Depreciation Expense (E) 175,902 + 1

Accumulated Depreciation (XA) 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.

Cambridge Business Publishers, 2011 10-26 Financial Accounting, 3rd Edition

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. 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.

b.

c. Using a 10% discount rate, the present value of Best Buys operating leases payments is computed as follows: ($ millions) Year 1............................... 2............................... 3............................... 4............................... 5............................... >5............................. Average life.............
* $3,748 $846/year = 4.43 years.

Operating Lease Payment $ 1,097 1,045 964 900 846 3,748 4.43 years*

Present Value (i=10%) $ 997 864 724 615 525 1,809 $5,534

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-27

P10-35continued.
The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 10 997 0 1,097 N 2 N 3 N 4 N 5 I/YR 10 I/YR 10 I/YR 10 I/YR 10 PV 864 PV 724 PV 615 PV 525 PMT 0 PMT 0 PMT 0 PMT 0 FV 1,045 FV 964 FV 900 FV 846 FV 0 FV 2,914

The present value of payments after Year 5 follows: N I/YR PV PMT 4.43 10 2,914 846 N 5 I/YR 10 PV 1,809 PMT 0

d.

Balance Sheet
Transaction
To capitalize operating leases. Cash Asset Liabil- + Contrib. + + Noncash Assets = ities Capital +5,534 +5,534 = Lease Leased Asset
Liability

Income Statement
Earned Capital Net Revenues - Expenses = Income =

e. 2009 1. Leased asset (+A) . Lease liability (+L) .. 2010 2. Depreciation expense (+E, -SE) . Accumulated depreciation (+XA, -A) ..
$572 = $5,716 / 10

5,534 5,534 553 553

3.

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

544 553 1,097

$572 = $5,716 x 0.10

Cambridge Business Publishers, 2011 10-28 Financial Accounting, 3rd Edition

P10-35continued. f. + Cash (A) 1,097 + 1. Leased Asset (A) 5,534 3. + 2. + 2. 3. 3. + Lease Liability (L) 5,534 544 Interest Expense (E) 553 Depreciation Expense (E) 553 + 1.

Accumulated Depreciation (XA) 553

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. b. Leased asset (+A) Lease liability (+L) . Prepaid rent (+A) .. Cash (-A) 74,520 74,520 1,000 1,000

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-29

P10-37 (50 minutes)

a. b.

$177 million expense 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 $11,879 8.5% = $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. 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. 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 2009. 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.

c.

d.

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.

Cambridge Business Publishers, 2011 10-30 Financial Accounting, 3rd Edition

P10-38 (5 minutes) a. Pension expense (+E, -SE) Cash (-A) ...

16,000 = 400,000 x .04.

16,000 16,000

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.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-31

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) .. Income taxes payable* (+L) . Deferred income tax liability (+L) ..
* ($236,000 $16,000) x 40% = $88,000.

91,200 88,000 3,200

Income tax expense (+E, -SE) . Deferred income tax liability (-L) Income taxes payable* (+L)
* ($245,000 $0) x 40% = $98,000.

94,800 3,200 98,000

c.

Income tax expense (+E, -SE) . Income taxes payable (+L)* Deferred income tax liability (+L) .
($236,000 $16,000) x 35% = $77,000.

80,200 77,000 3,200

Income tax expense (+E, -SE) . Deferred income tax liability (-L) Income taxes payable (+L)* ..
* ($245,000 $0) x 40% = $98,000.

94,800 3,200 98,000

The solution to part c depends on what the company knew, in 2009, about the tax rate in 2010. In the journal entries above, the assumption is that the tax rate is 35% in 2009, but is supposed to change to 40% in 2010. However, if the change in the 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 $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) ...............................
* ($245,000 $0) x 40% = $98,000.

95,200 2,800 98,000

Either way, the amount of income tax expense is determined as a plug amount.
Cambridge Business Publishers, 2011 10-32 Financial Accounting, 3rd Edition

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) Income taxes payable (+L) ... Deferred tax liability (+L) ..
+ Income Tax Expense (E) (d) 23,600 - Income Taxes Payable (L) + 19,200 (d)

23,600 19,200 4,400

- Deferred Tax Liability (L) + 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) Deferred tax liability (-L) Income taxes payable (+L) ..
+ Income Tax Expense (E) (d) 43,050 - Income Taxes Payable (L) + 45,150 (d)

43,050 2,100 45,150

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

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-33

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 2010. a. Book value $12,000 $6,000 $0 b. Tax Temporary basis difference $0 $12,000 $0 $6,000 $0 $0 c. Deferred tax liability $4,200 ($12,000 x 0.35) $2,400 ($6,000 x 0.40) $0

2009 2010 2011

d. 12/31/09 Income tax expense (+E, -SE) .. Deferred income tax liability (+L) Income taxes payable (+L)* ..
* $308,000 x 0.35 = 107,800.

112,000 4,200 107,800

12/31/10 Income tax expense (+E, -SE) . Deferred income tax liability (-L) . Income taxes payable (+L)* ...
* $400,000 x 0.35 = $140,000.

138,200 1,800 140,000

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

165,600 2,400 168,000

The expense is determined as a plug amount.

Cambridge Business Publishers, 2011 10-34 Financial Accounting, 3rd Edition

P10-45 (40 minutes) a. According to FedExs 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. An Excel spreadsheet to calculate the interest rate (using the IRR function) would look something like the following:
A 1 N 2 Amount 3 IRR C 0 1 -294 164 4.453% B D 2 20 E F 3 4 8 119 G 5 2 H 6 2 I 7 2 J 8 2 K 9 2 L 10 2 M 11 2 N 12 2 O 13 1

b.

The Excel function =IRR(B2:O2) returns a value of 4.453% (which is >3%). c. The present value of FedExs operating leases payments is computed as follows: Year ($ millions) 2010......................... 2011......................... 2012......................... 2013......................... 2014......................... >2014....................... Total Operating Lease Payment $1,759 1,612 1,451 1,316 1,166 7,352 $14,656 Present Value (i=4%) $ 1,691 1,490 1,290 1,125 958 5,246 $11,800

Average Life: $7,352/$1,166 = 6.3 years.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-35

P10-45continued.
The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 4 1,691 0 1,759 N 2 N 3 N 4 N 5 I/YR 4 I/YR 4 I/YR 4 I/YR 4 PV 1,490 PV 1,290 PV 1,125 PV 958 PMT 0 PMT 0 PMT 0 PMT 0 FV 1,612 FV 1,451 FV 1,316 FV 1,166 FV 0 FV 6,382

The present value of payments after Year 5 follows: N I/YR PV PMT 6.3 4 6,382 1,166 N 5 I/YR 4 PV 5,246 PMT 0

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 FedExs 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.

Cambridge Business Publishers, 2011 10-36 Financial Accounting, 3rd Edition

CASES AND PROJECTS

C10-46 (50 minutes)

a. Dow Chemical is reporting net pension expense of $122 million for 2008. 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 2008. 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.
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-37

C10-47 (40 minutes) a. Deltas purchase commitments are not reported on the balance sheet because they are unexecuted contracts. When Delta receives the aircraft from Boeing, Delta will record a debit to PPE assets and a credit to accounts payable. Some of the aircraft appear to have prearranged financing in the form of a saleleaseback arrangement. Thus, when the aircraft are delivered, they will then be sold to a third-party lessor and then leased under a capital lease. Boeing will record a sale, with a debit to accounts receivable and a credit to sales revenue. At the same time, it will record a debit to cost of goods sold and a credit to aircraft inventory. b. Rent expense (+E, -SE) .. Cash (-A) . 850 850

c. The total liability on the balance sheet would be $501million plus a premium of $64 million. Of this amount, $92 million would be classified as a current liability leaving a noncurrent liability of $473 million. d. Delta will record rent expense of $1,646 million less any sublease income. e. Using a 10% discount rate, the present value of Deltas operating lease payments is computed as follows: Year ($ millions) 2009......................... 2010......................... 2011......................... 2012......................... 2013......................... >2014....................... Total Operating Lease Payment $1,646 1,559 1,326 1,204 1,059 5,664 $12,458 Present Value (i=10%) $ 1,496 1,288 996 822 658 2,626 $7,886

Average Life: $5,664 $1,059/year = 5.35 years.

Cambridge Business Publishers, 2011 10-38 Financial Accounting, 3rd Edition

C10-47continued.
The calculations of the present value of each payment follow: N I/YR PV PMT FV 1 10 1,496 0 1,646 N 2 N 3 N 4 N 5 I/YR 10 I/YR 10 I/YR 10 I/YR 10 PV 1,288 PV 996 PV 822 PV 658 PMT 0 PMT 0 PMT 0 PMT 0 FV 1,559 FV 1,326 FV 1,204 FV 1,059 FV 0 FV 4,230

The present value of payments after Year 5 follows: N I/YR PV PMT 5.35 10 4,230 1,059 N 5 I/YR 10 PV 2,626 PMT 0

Given Deltas liabilities total $44.140 billion before capitalizing operating leases, the $7.886 billion of operating leases adds about 17.9% to Deltas total liabilities, which is a material, if not a substantial increase.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 10 10-39

C10-48 (30 minutes) a. $6,822 ($126,904 $136,840) = $16,758 b. Income tax expense (+E, -SE) .. Deferred tax asset current (-A) ... Deferred tax asset noncurrent (-A) .. Income taxes payable (+L) ... *$91,843 $90,349 16,758 1,494* 8,442 6,822

c. The temporary difference due to depreciation was $13,392 / 0.35 = $38,263. The tax basis of PP&E assets was $942,219 - $38,263 = $903,956. d. Prepaid catalog expenses are capitalized and amortized for financial 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 $36,424 represents a temporary difference between financial and tax reporting. The resulting deferred tax liability of $14,589 offsets the other current deferred tax assets in the balance sheet.

Cambridge Business Publishers, 2011 10-40 Financial Accounting, 3rd Edition