Reporting and Analyzing Leases, Pensions, and Income Taxes

Question 1

Off-balance-sheet financing

Answer 1

Financial obligations of a company that are not reported as liabilities in the balance sheet

Question 2

Lease

Answer 2

A contract between the owner of an asset and the party desiring to use that asset

Question 3

Advantages of leases

Answer 3

• 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

Question 4

Capital lease vs operating lease

Answer 4

• 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.

Question 5

When must a lessee capitalize a lease?

Answer 5

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.

Question 6

What’s the impact of a capital lease on the SOCF?

Answer 6

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.

Question 7

Impact of capitalizing an operating lease

Answer 7

• 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

Question 8

How do you capitalize an off-balance sheet lease?

Answer 8

1. Estimate the discount rate
2. Estimate the future payments required under operating leases
3. Compute the present value of future operating lease payments
4. Adjust the financial statements to include the present value from Step 3 as both a leased asset and a lease liability.

Question 9

Imputed Discount Rate Computation for Leases

Answer 9

Use the IRR based on data from footnote disclosures or the rate from the any recent borrowings involving intermediate-term secured obligations

Question 10

IRR

Answer 10

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.

Question 11

Fixed Commitments Ratio

Answer 11

• 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

Question 12

Types of pension plans

Answer 12

• 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.

Question 13

Pension plan assets

Answer 13

Primarily stocks and bonds

Question 14

Pension liabilities

Answer 14

The company’s obligations to pay current and former employes

Question 15

Funded status

Answer 15

The difference between the fair value of the pension plan assets and the projected benefit obligation

Question 16

When the pension benefit obligation exceeds the plan’s assets

Answer 16

It is underfunded

Question 17

Pension Plan Asset Calc

Answer 17

Ending balance = Beginning balance + actual returns + contributions - payments to retirees

Question 18

Projected benefit obligation calc

Answer 18

Ending balance = Beginning balance + service cost + interest cost +/- actual losses (gains) - payments to retirees

Question 19

Service costs

Answer 19

The additional future pension benefits earned by employees during the current year

Question 20

Net pension asset (liability)

Answer 20

Funded status = Plan assets - projected future obligations

Question 21

Net pension expense

Answer 21

Net pension expense = Service cost + interest cost - expected return on assets +/- amortization of deferred amounts

Question 22

Other post-employment benefits

Answer 22

Health care and insurance benefits for retired employees

Question 23

Accumulated post-employment benefit obligation (APBO)

Answer 23

The amount of OPEB that are unfunded

Question 24

Two types of differences between taxable income and financial accounting income

Answer 24

Permanent and temporary

Question 25

Temporary tax differences

Answer 25

• 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

Question 26

Deferred tax liability

Answer 26

The book that difference that leads to higher taxable income relative to book income in the future

Question 27

Examples of book-tax differences

Answer 27

• Asset depreciation
• Net operating losses

Question 28

Why is there a valuation allowance?

Answer 28

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.

Question 29

How do you record a valuation allowance?

Answer 29

Deferred tax expense is increased which decreases accounting income.

Question 30

Current tax expense

Answer 30

The amount that has been paid or is payable to tax authorities in the current period

Question 31

Deferred tax expense

Answer 31

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

Question 32

Effective tax rate

Answer 32

Provision for income taxes / income before taxes

Question 33

Where are deferred taxes recorded in the SOCF?

Answer 33

Operating section