Transcript Chapter 11 Instructor - Texas Tech University

Module 10:
Leases and Pensions
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Leases

Operating leases
– Lessee assumes no risk of ownership.
– Recognize rent expense as each payment
made.
– At end of lease term, right to use the
property reverts to the owner.
 Capital leases
– Effectively an installment purchase.
– Lessee assumes rights and risks of
ownership.
– Treated as asset purchased with related
liability.
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Leases

Off-balance-sheet financing
– Companies historically liked to contract
for leases rather than asset purchases,
to keep the liability off the books.
– FASB issued SFAS No. 13, which
requires certain leases to be recorded as
capital leases.
– Capital leases record the leased asset as
a capital asset, and reflect the present
value of the related payment contract as
a liability.
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Leases

Requirements of SFAS No. 13 - record as capital
lease for the lessee if any one of the following is
present in the lease:
– title transfers at the end of the lease period.
– the lease contains a bargain purchase option.
– the lease life is at least 75% of the useful life of
the asset.
– the lessee pays for at least 90% of the fair market
value of the lease.
 Payments under a lease agreement may include:
– Periodic rental payments (an annuity) and:
– Bargain purchase option (BPO): an end of lease
payment to purchase asset at less than market
OR
– Guaranteed residual value (GRV): a minimum
amount (of cash and asset) required by the
lessor if the asset is returned to the lessor.
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Leases

The amount to capitalize (record for asset
and related liability) is the present value of
the minimum lease payments:
 PVMLP = PV RENTS + PVBPO or GRV
 If lease contains both BPO and GRV, include
only BPO. The assumption is that a rational
lessee would exercise the BPO and not have
to pay an GRV.
 If the rents occur at the beginning of each
period, like most leases, the PV RENTS is an
annuity due.
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Illustration 1 - Leases
Lee Company (the lessee) signed a contract to lease
equipment from Lawrence Company (the lessor). The terms
of the lease were as follows:
1. Four year lease starting January 1, 2005.
2.Annual lease payments of $6,000. The first payment is due
at lease inception (January 1, 2005), with subsequent
payments on December 31, 2005, 2006, and 2007.
3.Bargain purchase option of $1,000 at end of lease
(December 31, 2008).
Other information:
Lee’s borrowing rate: 8%
Useful life of equipment: 6 years with no salvage value.
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Illustration 1 - Leases
Requirement 1: Calculate the PVMLP
(Note that the lease payments are an annuity due.)
PVMLP = PV RENTS + PVBPO
PVAD Table
PV RENTS =PVAD= A(
PVAD Table
) = 6,000(3.5771) = $21,463
i, n
i =8%, n=4
PV1 Table
PVBPO = PV1 = FV1(
PV1 Table
) = 1,000(0.73503) = $ 735
i, n
i = 8%, n = 4
The present value of the minimum lease pmts = $22,198
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Illustration 1 - Leases
Requirement 2: Prepare the amortization
schedule (effective interest method) to recognize
the interest payments and principal payments
over the life of the lease. This is similar to the
amortization schedule for the bonds payable;
cash paid is constant, and interest expense =
CV x Market Rate x Time,
except that the lease payment includes both an
interest payment and a principal payment. The
“difference” in this case is the principal reduction
each period.
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Illustration 1 - Leases
Date
1/01/05
1/01/05
12/31/05
12/31/06
12/31/07
12/31/08
Cash
Paid
Interest
Expense
6,000
6,000
6,000
6,000
1,000
-0- 1
1,2962
920
513
733
Carrying
Difference Value
22,198
6,000
16,198
4,704
11,494
5,080
6,414
5,487
927
927
-0-
1No
interest at 1/1/05, because no time has passed.
This is equivalent to a “down payment” which
immediately reduces the total liability.
2Int. Expense = CV x MR x T = 16,198 x .08 x 1 year
3Rounding difference of $1 absorbed in calculation.
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Illustration 1 - Leases
Requirement 3: Prepare the following journal
entries for the year 2005:
Initial lease at 1/1/05:
Equipment
22,198
Lease Liability
22,198
First payment at 1/1/05:
Lease Liability
6,000
Cash
6,000
Second payment at 12/31/05:
Interest Expense
1,296
Lease Liability
4,704
Cash
6,000
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Illustration 1 - Leases
For the last entry, we must calculate straightline depreciation on leased asset at
12/31/05. Since we are recording an asset,
we must depreciate the asset.
Note that the calculation here is based on the
length of time that the lessee will actually
use the asset (6 years here because of the
BPO).
(Cost-SV)/Est. life =(22,198 - 0)/6 = $3,700
JE for Depreciation at 12/31/05:
Depreciation expense
Accumulated Depr.
3,700
3,700
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Comments on Leases

Many companies still have many leases that
qualify as operating leases for financial
reporting.
 Comparison to companies with capital
leases is difficult (different asset and liability
structures).
 Off balance sheet financing affects a number
of ratios, but the significant effect is on the
debt to equity ratio.
 Disclosure information regarding operating
lease components makes it possible for
analysts to “capitalize” the operating leases
for financial statement comparison.
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Capitalization of Operating Leases

The standard disclosure for operating leases
gives specific payment amounts for each of
the next 5 years, then a lump sum amount
for all future years.
 Step 1: using PV1, calculate the present
value of each of the five individual lease
payments.
 Step 2: using the 5th year payment, assume
that amount is an annuity for the remaining
years; then divide the lump sum by the fifth
year payment to get the number of years.
 Step 3: calculate the PV of the annuity
(discounting all the way back to year zero)
 Step 4: add PV amounts to get PV of lease
payments.
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Capitalization of Operating Leases






The resulting PV should be considered for its
effect on assets and liabilities.
If capitalization is assumed, the differential
income statement effect should also be
considered.
Operating income: reverse out lease expense,
and include depreciation expense.
Nonoperating activity: include interest expense
on the financing.
Note that I/S difference is effectively zero over
the life of the lease, but affects operating and
nonoperating activities in different ways.
Discount rate? Use disclosed rates of
borrowings, or use disclosed PV of capital
leases to back into discount rate used by the
company.
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Pensions

Types of pension plans
– defined contribution plans
– defined benefit plans

Defined contribution plan
– simple to report
– journal entry at time of funding:
Pension expense
xx
Cash
xx
– no recognition of asset or liability
– promising only accumulated amount in
pension investment.
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Pensions - continued

Defined benefit plan
– promising an eventual benefit to employees
– make payments to achieve the benefit
– recognize assets/liabilities relating to the plan
 if insufficient investment to meet promise: liability
 if investment in excess of promise: asset
– basic journal entry, as liability is recognized, and
plan is funded:
Pension Expense
xx
Pension Asset/Liability
xx / xx
Cash
xx
– Note: the recognition of liability is determined by
the recognition of expense; the net effect may be a
pension asset, only if the funding is greater than
the expense.
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Defined Benefit Plan and SFAS 87

SFAS 87 measures 3 different levels of pension
obligation:
– Vested benefit obligation: for vested
employees at current salaries.
– Accumulated benefit obligation (ABO): for all
employees at current salaries.
– Projected benefit obligation (PBO): for all
employees at future salaries.
 PBO is most conservative, and used for most
calculations (including our exercises).
 SFAS 87 also measures the fair value of plan
assets (FVPA) to indicate the amount of assets
accumulated to meet the PBO.
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Compromises in SFAS 87

Prior to SFAS 87, most companies were
recognizing expense only as they funded the
plan (and no future asset or liability):
Pension expense
Cash



x
x
FASB initially wanted companies to recognize
the difference between PBO and FVPA as the
net asset or liability of the plan.
If PBO greater, then company has a net liability
(underfunded).
IF FVPA greater, then the company has a net
asset (overfunded).
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Compromises in SFAS 87

At the time of the proposal, most companies
were significantly underfunded.
 Corporations and CPA firms lobbied the FASB,
saying that, if they had to recognize the full
liability, the effect would be disastrous:
– they would violate existing debt covenants.
– they would be unable to get additional
funding.
– the extra expense would make the income
statement look terrible.
– they would be driven out of business.
– they would eliminate all defined benefit
plans.
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Compromises in SFAS 87

The FASB backed down, and created several
techniques to smooth the recognition of liability and
expense over time.
– Amortization of “transition amount”: allowed
companies to recognize a portion of their initial
liability over 15-20 years (now fully amortized for
most companies).
– Amortization of “prior service costs”: allowed
companies to recognize, over future service years
of employees (using technique similar to sum-ofthe-years’-digits), the effect of plan adoptions or
amendments.
– Amortization of net gains/losses on change in
estimates relating to PBO and FVPA. Most of these
gains and losses are never recognized.
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Components of Pension Expense in SFAS 87
Pension expense is calculated with the following
components:
1. Service cost (SC) - present value of new benefits, as
calculated by actuary.(+)
2. Interest cost - current period’s estimated interest on
the PBO.(+)
3. Expected return on plan assets - expected income
from plan assets this year.(-)
4. Amortization of unrecognized PSC - usually an
additional cost, which leads to additional expense.
(+)
5. Amortization of unrecognized net G/L - more
expense if amortizing loss; opposite for gain.(+/-)
6. Amortization of transition amount (no longer included
in most disclosures). More expense if liability. (+/-)
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Explanation of Unrecognized Net G/L
– Given the following example: assume that
the total unrecognized net gain (for the
calculation of pension expense) is $251,000.
– FASB applies a corridor to this amount to find
the amount subject to amortization. The
corridor (a “protected range”) is found by
taking the greater of PBO or FVPA, then
multiplying that amount by 10% (an arbitrary
amount).
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Explanation of Unrecognized Net G/L
–
–
–
–
–
–
–
–
Assume that the UNG/L is $251,000
Assume that PBO = $1,879,000
Assume that FVPA = $1,165,000
Therefore, the corridor limit is +/- $187,900
(10% of greater amount of 1,879,000).
Anything inside this corridor remains
unamortized.
Anything outside this corridor is “subject to
amortization.”
FASB applies an additional level of smoothing
by amortizing only a portion of the G/L subject
to amortization (usually based on remaining
years of service).
The rest of the G/L goes back into the “pool”.
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Illustration of Corridor Approach
251,000 gain
} 63,100 excess
187,900
-0-
(187,900)
Excess subject to recognition = 251,000 - 187,900 = 63,100.
FASB smoothes again by allowing only a portion of the 63,100
to be recognized (usually based on remaining years of
service). In this example, only 1/10th is recognized, or
$6,310 gain. The rest of the gain (251,000 - 6,310) remains
unrecognized, and is carried forward and added to the
calculation of future unrecognized gains and losses.
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Effect of SFAS 158

A new standard, SFAS 158 is now in effect for
companies whose fiscal year begins after
December 15, 2006.
 This standard solves one of the problems with
SFAS 87 - the full recognition in the financials
of the funded status.
 However, for the income statement, the FASB
chose to continue the non-recognition of full
amounts of actuarial gains and losses and
prior service costs, thus minimizing the effect
on the income statement through pension
expense.
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Effect of SFAS 158
 These
amounts (the unamortized portions) are
recognized instead through “Other Comprehensive
Income” or OCI, and the detail is disclosed in the
Statement of Stockholders’ Equity.
 As new Prior Service Cost or Gains/Losses on
estimates are incurred, they are recognized in the
Pension Asset/Liability account, but the offset is to OCI.
 For gains, the entry would be:
Pension Asset/Liability
x
Other Comprehensive Inc.
x
 For PSC and Losses, the entry would be:
Other Comprehensive Inc.
x
Pension Asset/Liability
x
(We will do one summary entry for all OCI effects.)
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Pension Reconciliation Schedule

The reconciliation schedule is found in the notes
to the financial statements, and it contains all of
the summary information regarding the “true”
asset or liability.
 The remainder of the information regarding the
unrecognized amounts is found in the OCI section
of the Statement of Stockholders’ Equity.
Now look at class problem on pensions.
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