Reporting and Analyzing Leases, Pensions, and Income Taxes Flashcards
Off-balance-sheet financing
Financial obligations of a company that are not reported as liabilities in the balance sheet
Lease
A contract between the owner of an asset and the party desiring to use that asset
Advantages of leases
- Less equity required than bank financing
- Flexibility on payment terms
- Leasing avoids the need to sell the asset
- Tax benefits such as accelerated depreciation
- Provides off-balance-sheet financing
Capital lease vs operating lease
- Capital lease - Requires that both the leased asset and the lease liability be reported on the balance sheet and depreciated like any asset. The lease liability is amortized like debt.
- Operating lease - Neither the leased asset nor the lease liability is on the balance sheet. Lease payments are recorded as rent expense by the lessee when paid.
When must a lessee capitalize a lease?
If one or more criteria are met:
- The lease automatically transfers ownership of the leased asset to the lessee at the lease-end
- The lease agreement allows the lessee to purchase the asset at a discounted price at the lease-end (bargain-purchase option)
- The lease term is at least 75% of the economic useful life of the asset
- The present value of the lease payments is at least 90% of the asset’s fair value.
What’s the impact of a capital lease on the SOCF?
A capital lease results in an increase in long-term operating assets and an increase in long-term liabilities. However, in many cases, there is no effect on cash flows at the inception of the lease. As a consequence, the initial inception of the lease should be reported as a material noncash transaction and not presented in the cash flow statement under either investing or financing cash flows. Subsequently, the depreciation of the leased asset is added to cash flow from operations and the principal portion of the lease payment is treated as debt repayment under cash flows from financing activities.
Impact of capitalizing an operating lease
- ROA and asset turnover ratios are overstated due to nonreporting of leased assets
- Financial leverage ratios are understated by the nonreporting of lease liabilities
- Net operating profit margin (NOPM) is understated since only depreciation expense is included in net operating profit after tax
- Cash flow from ops is higher for capital leases because part of the lease payment is treated as a financing cash outflow
How do you capitalize an off-balance sheet lease?
- Estimate the discount rate
- Estimate the future payments required under operating leases
- Compute the present value of future operating lease payments
- Adjust the financial statements to include the present value from Step 3 as both a leased asset and a lease liability.
Imputed Discount Rate Computation for Leases
Use the IRR based on data from footnote disclosures or the rate from the any recent borrowings involving intermediate-term secured obligations
IRR
The internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. The internal rate of return is used to evaluate the attractiveness of a project or investment.
Fixed Commitments Ratio
- FCR = Operating cash flow before fixed commitments / fixed commitments
- A ratio below 1.0 indicates that a company is generating insufficient cash flows from operations to meet its contractual obligations
Types of pension plans
- Defined contribution plan - Where employer and employee both make contributions on a regular basis. Ex: Tax advantaged 401(k)
- Defined benefit plan - Where the company is required to make periodic payments to a third party which then makes payments to an employee after retirement.
Pension plan assets
Primarily stocks and bonds
Pension liabilities
The company’s obligations to pay current and former employes
Funded status
The difference between the fair value of the pension plan assets and the projected benefit obligation
When the pension benefit obligation exceeds the plan’s assets
It is underfunded
Pension Plan Asset Calc
Ending balance = Beginning balance + actual returns + contributions - payments to retirees
Projected benefit obligation calc
Ending balance = Beginning balance + service cost + interest cost +/- actual losses (gains) - payments to retirees
Service costs
The additional future pension benefits earned by employees during the current year
Net pension asset (liability)
Funded status = Plan assets - projected future obligations
Net pension expense
Net pension expense = Service cost + interest cost - expected return on assets +/- amortization of deferred amounts
Other post-employment benefits
Health care and insurance benefits for retired employees
Accumulated post-employment benefit obligation (APBO)
The amount of OPEB that are unfunded
Two types of differences between taxable income and financial accounting income
Permanent and temporary
Temporary tax differences
- Created by using accrual accounting for book and cash accounting for tax, and/or
- Created by using different rules for determining the accrual amount for book than for tax
Deferred tax liability
The book that difference that leads to higher taxable income relative to book income in the future
Examples of book-tax differences
- Asset depreciation
- Net operating losses
Why is there a valuation allowance?
If management does not think the company will have enough future taxable income to be able to use al the deferred tax assets then a reserve must be established against the deferred tax assets so that the deferred tax assets on the balance sheet will not be overstated.
How do you record a valuation allowance?
Deferred tax expense is increased which decreases accounting income.
Current tax expense
The amount that has been paid or is payable to tax authorities in the current period
Deferred tax expense
The effect on tax expense due to changes in deferred tax liabilities and assets. The result of temporary differences between the reported income statement and the tax return
Effective tax rate
Provision for income taxes / income before taxes
Where are deferred taxes recorded in the SOCF?
Operating section
