Chapter 10 from slides

Question 1

what are the general terms provide in the leases

Answer 1

lessor grants the lessee unrestricted right to use the asset during the lease term

lessee agrees to maintain the asset and make periodic payment to the lessor

title to the asset remains with the lessor, who usually takes physical possession of the asset at lease-end unless the lessee negotiate the right to purchase the asset at its market value or other predetermined price

Question 2

define lease

Answer 2

contract between the owner of an asset (lessor) and the party desiring to use that asset (lessee)

it’s a private contract between two willing parties, it’s governed only by applicable commercial law and can include whatever provisions the parties negotiate

Question 3

lease advantages

Answer 3

1. leases require less equity investment by the lessee - leases usually require the first lease payment be made up front
2. lease terms can be structure to meet both parties’ needs - allows variable payments to match the lessee’s seasonal cash inflows, have graduated payments for start-up companies
3. leases can be utilized for vehicles, equipment and real estate

Question 4

what criteria does a lease have to meet to be considered finance/capital lease

Answer 4

1. transfer of ownership: the lease transfers ownership of the underlying asset to the lessee by the end of the lease term
2. purchase option: the lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
3. lease term - the lease term is for a major part of the remaining economic life of the underlying asset
4. present value: the present value of the sum of the lease payments and any residual value guaranteed by the lessee = or exceeds substantially all of the fair value of the underlying asset
5. specialized asset: the underlying asset is so specialized that it’s expected to have no alternative use at the end of the lease term

Question 5

what are any lease of 12 months or more not classified as a finance lease

Answer 5

operating lease

Question 6

capital lease vs operating lease

Answer 6

in a capital lease; the asset is moved to the lessee’s B/S, there’s periodic lease payments, lessee pays maintenance for asset, lessee books depreciation

in an operating lease; asset lent to lessee, no B/S entry, periodic lease payment, buyout or asset return on lease end

Question 7

what’s a rule thumb adjustment for operating lease expense

Answer 7

add 8 times of operating lease expense on the total debt level

Question 8

what’s the impact of IFRS’s lease capitalization

Answer 8

expect an average 22% increase in liability for all IFRS companies, with main increase in debt for retailers (98%) and airlines (47%)

Question 9

IFRS vs GAAP lease capitalization

Answer 9

IFRS: single lease model for lessees, amortization and interest expense (always), focus on transparency and consistency, simpler for lessees

GAAP: separate finance and operating leases, single expense (operating) or split (finance), focus on reflecting lease economics, more detailed for different lease types

Question 10

what’s the formula for a right of use asset

Answer 10

right of use asset
= amount of the lease obligation
+ lease payments made to the lessor at or before the lease commencement date
- lease incentives received from the lessor
+ initial direct costs of right-of-use asset incurred by the lessee

Question 11

where can you find the leases on B/S?

Answer 11

B/S presents lease liabilities and right of use assets separately (not net amount)

finance lease assets = typically included in PP&E and lease liabilities are included with debt

operating lease assets and liabilities are each reported in a separate line item if material

Question 12

what’s the total expense of a lease

Answer 12

total expense over the life of the lease = total remaining lease payments + total amortization fo any upfront costs

Question 13

how are the costs of lease different between operating lease and finance lease

Answer 13

operating lease: lease expense is recognized each period as rent expense

finance lease: lease expense includes the interest on the lease liability plus straight-line depreciation of the leased asset

Question 14

how to and why adjust interest expense from operating leases

Answer 14

why adjust: operating lease payments are recognized each period as an operating activity. but acquisition of an asset via lease = financing activity. in that case, a portion of the operating expense should be treated as nonoperating (like interest on bank loan payment)

how to adjust: separate operating lease payments into operating and nonoperating components with info in lease notes - take the operating lease liabilities x weighted average discount rate of X for operating leases to get the nonoperating expense

Question 15

what are the two post-retirement benefit plans for employees

Answer 15

defined contribution plan - requires the company to make periodic contributions to an employee’s account; many plans require an employee matching contribution, in retirement the employee makes periodic withdrawals from the account (410K)

Define benefit plan: requires the company to make periodic payments to a third party, which then makes payments to an employee after retirement; payments are based on yrs of services and employee’s salary, company may or may not set aside sufficient funds to cover these obligation –> defined benefit plan can be over or underfunded, all pension investments are retained by the third party until paid to employees, in event of bankruptcy, employees have the standing of a general creditors but with the additional protection in the form of government pension benefit insurance

Question 16

accounting for defined contribution plans vs defined benefit plans

Answer 16

defined contribution plan: similar to accrual of wages payable, amount of liability is certain and the company’s obligation is fully satisfied once payment has been made

defined benefit plan: company promises to pay retirees based on a formula that includes the employee’s final salary level and yrs of services, both which are unknown, thus estimating the liability amount is difficult and prone to error, makes it uncertain whether there will be sufficient funds available to make required payments to retirees. accounting is subjective, amount are uncertain, and companies frequently revise estimates

Question 17

whats projected benefit obligations (PBO)

Answer 17

PBO - present value of the estimated benefit payments to retirees

involves number of estimates; number of employees who will reach retirement age while employed with the company, salary levels at retirement (requires estimate of wage inflation), yrs of services at retirement, yrs over which annul payments will be made (estimate of life span)

company uses theses assumptions to estimate the amount that will be paid to employees from retirement until end of their lives

this amount = discounted to yield the present value of the future pension benefits to be paid to PBO

PBO liability decreases when company pays benefits to retirees

Question 18

how do companies report the funded status for pension and other post-employment obligations

Answer 18

on balance sheet, where funded status = projected benefit obligation - pension plan assets (market value of plan assets)

Question 19

whats a pension plan asset

Answer 19

an investment portfolio with debt and equity securities

portfolio provides return that will fund future payments to retirees, each period the investment account increases with investment income (interest, dividends, gains) and as the company contributes additional cash to the portfolio, the investment account decreases with investment loses and as cash is paid to retirees

Question 20

how to determine if defined benefit plan is over or underfunded

Answer 20

if the plan assets > PBO, pension plan = overfunded –> net asset = reported on B/S
and vice versa if opposite

Question 21

where does cash for benefit payments come from

Answer 21

from pension plan assets

if underfunded, company may have to use operating cash flow or borrow

Question 22

what are the items that decrease or increase the funded status liability (creating pension expense)

Answer 22

service cost: relates to the service provided to company by employees that year

interest cost: liability increase by the interest accrued on PBO liability

investment returns: pension investment portfolio generates positive investment return, plan assets increase and the funded status liability decrease and vice versa if there’s a loss

actuarial adjustments: changes estimates affecting PBO and funded status

Question 23

what’s the smooth pension expense

Answer 23

companies can included two items in comprehensive income (and AOCI) instead of net income (and retained earnings) - 1. large investment gains and losses on pension assets
2. changes in the PBO that arise from changes in actuarial assumptions

this is bc of companies having concern on recognizing full PBO as a liability and preferred the net funded status. as well concerns about increase in volatility of reported earning by having plan assets and PBO in current earnings

Question 24

how are the pension plan assets and PBO updated each year?

Answer 24

pension plan assets:
pension plan assets beginning balance
+ actual returns on investments
+ company contributions to pension plan
- benefits paid to retirees
= pension plan assets, ending balance

projected benefit obligation:
projected benefit obligation, beginning balance
+ service cost
+ interest cost
+/- actuarial losses (gains)
- benefits paid to retirees
= projected benefit obligation, ending balance

Question 25

what are the implications of pension plans to analysts

Answer 25

1. to what extent will the company’s pension plans compete with investing and financing needs for available cash flows - minimum standard for pension contributions, companies must make up the shortfall if investment returns are insufficient (competitions for available operating cash flows with other investing and financing activities), companies may need to postpone capital investment, be aware of during requirement when projecting future cash flows
2. in what ways has the company’s choice of estimates affected its profitability? - accounting for pensions needs many assumptions and each assumption affects reported profit, analysts must consider changes in estimates as they evaluate reported profitability

Question 26

what are the timing differences for companies when they use GAAP vs IRC for tax returns

Answer 26

these two sets of rules recognize revenue and expenses differently and yield markedly different income measures

companies desire to report the lowest possible income to reduce tax liability and increase after tax cash flow

in GAAP, companies use straight-line depreciation vs IRC companies use accelerated method

this difference means taxable income is lower in asset’s early years thus tax payments are reduced and after-tax cash flow is increased - this excess cash can be reinvested in business to increase its return to stockholders - but this will flip in the later years

this difference creased deferred tax liabilities which the company can utilize in later years

Question 27

what are deferred tax assets

Answer 27

arise when the tax payment is greater than the tax expense (financial reporting purposes) - restructuring accruals

Question 28

how does net operating loss (NOL) carryforwards have timing differences

Answer 28

IRS permits companies to deduct taxable losses incurred in current yare from taxable income earnied in future

companies can carryforward losses indefinitely to reduce taxes owing in the future

these future taxes saved create a future economic benefit

deferred tax assets arising from NOL carryforward are signficant on many companies balance sheets

Question 29

how to record deferred tax liabilities and assets

Answer 29

deferred tax assets = future estimated tax deductible expense/loss x estimated tax rate

deferred tax liability = future estimated taxable income x estimated tax rate

these change as tax rate changes

Question 30

what do companies do if deferred tax assets is uncertain

Answer 30

companies must establish a valuation allowance for DTA if future realization of the tax benefits is uncertain

allowance reduces reported assets and increases tax expense, which reduces equity

Question 31

how can the valuation allowance be reduced/reversed

Answer 31

1. company writes off a deferred tax asset
   - asset = reduced to zero and the amount written off is subtracted from the deferred tax valuation allowance
   - no effect on income from this write-off
   - occurs when net operating loss carryforwards (NOLs) expire before they can be used to offset other profits
2. the company determines that the DTA will be realized
   - if the company decides that the realization of the DTA is more likely than not, it can reverse the deferred tax asset valuation allowance
   - the DTA allowance is reduced and tax expense is reduced by the same amount, thus increase net income

Question 32

what can the analysis of income tax disclosures reveal?

Answer 32

• an increase in deferred tax liabilities indicates that a company is reporting higher GAAP income relative to taxable income and can indicate the company is managing earning upwards
• tax notes reveal changes in the deferred tax asset valuation account often triggered by the write-off of DTAs typically relating to NOLs
• companies can (and do) increase their estimate on the recoverability of deferred tax assets - if increase, the valuation allowance is reduced increasing DTA and increasing net income dollar-for-dollar
• the reconciliation can reveal important transitory items that might impact forecasts of future tax rates