week 10 (module 10) - leases, pension, tax

Question 1

what is a lease?

Answer 1

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

private contract between 2 willing parties, it is governed only by applicable commercial law and can include whatever parties negotiate

Question 2

what do leases generally provide in what terms?

Answer 2

lessor grants lessee unrestricted right to use asset during lease term

lessee agrees to maintain asset and make periodic payments to lessor

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

Question 3

what is first step in lease accounting?

Answer 3

operating or financing lease?

Question 4

how are leases financing vehicles?

Answer 4

like a bank loan with advantages

1. leases often require less equity investment by lessee
   - usually req first lease payment be made up front
   - for 60 month lease, up front payment is 1/60 (1.7%) investment, compared to 20-30% equity investment req by bank
2. lease terms can be structured to meet both parties’ needs
   - allow variable payments to match lessee’s seasonal cash inflows
   - have graduated payments for startups
3. leases can be utilized for vehicles, equipment, real estate
   - advantages have made leasing popular form of financing

Question 5

what criteria do financial/capital leases meet?

Answer 5

meet one OR more of following criteria:

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

Question 6

what criteria is there for an operating lease?

Answer 6

any lease of 12 months or more, NOT classified as a finance lease, is classified as a operating lease

Question 7

what is the difference between a capital lease and an operating lease?

Answer 7

capital lease
- asset moved to lessee b/s
- periodic lease payments
- lessee pays for maintenance for asset
- lessee books depreciation

operating lease
- asset lent to lessee, no b/s entry
- period lease payments
- buyout/asset return on lease end

Question 8

how do companies report leases on the b/s

Answer 8

as both assets and lease

distinguish between operating leases and finance leases in notes

balance sheet presents lease liabilities and right of use assets separately

Question 9

when is a lease liability recognized

Answer 9

at pv of remaining lease payments

Question 10

when is a right of use asset recognized and at what amount?

Answer 10

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

Question 11

where are finance lease and operating leases on the balance sheet?

Answer 11

finance lease assets are typically included in ppe and lease liabilities are included with debt

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

Question 12

how are leases accounted for on the income statement?

Answer 12

total expense over lifetime of lease = total remaining lease payments + total amortization of any up-front costs

ex. a comp executes a 5 year lease requiring annual payments of 22463. they pay 5k of initial direct costs prior to commencing th elease

pv of the lease payments at 4% is 100k and the comp recognizes a lease liability for that amnt.

comp recognizes right of use asset of 105k (100k pv of lease payments + 5k upfront)

regardless of lease type, total lease cost over 5 years is 22463 * 5 years + 5k upfront costs = 117314

Question 13

how would the i/s reflect a total lease cost differently whether it’s a operating or finance lease?

Answer 13

ex. a comp executes a 5 year lease requiring annual payments of 22463. they pay 5k of initial direct costs prior to commencing th elease

pv of the lease payments at 4% is 100k and the comp recognizes a lease liability for that amnt.

comp recognizes right of use asset of 105k (100k pv of lease payments + 5k upfront)

regardless of lease type, total lease cost over 5 years is 22463 * 5 years + 5k upfront costs = 117314

OPERATING -> lease expense of 23463(117314/5 years) is recognized each period as rent expense

FINANCE -> lease expense includes interest on lease liability plus straight line dep of leased asset
- for y1, lease expense 100k * 4%(interest) + 105k/5(depreciation) = 25k

Question 14

what are the two general types of post-retirement benefit plans?

Answer 14

1. defined contribution plan
2. defined benefit plan

Question 15

what is the defined benefit plan?

Answer 15

• requires comp to make periodic payments to aa third party, which then makes payments to employee after retirement
• payments usually based on years of service and employee’s salary
• comp may or may not set aside sufficient funds to cover obligations (fed law sets min funding requirements)
• as a result, defined benefit plans can be over/under-funded
• all pension investments are retained by 3rd party until paid to all employees
• in bankruptcy, employees have standing of gen creditor but usually have additional protection in form of gov pension benefit insurance

Question 16

what is the defined contribution plan?

Answer 16

• requires comp to make periodic contributions to an employee’s account (usually 3rd party trustee like a bank)
• many plans require employee matching contribution
• following retirement employee makes periodic withdrawals
• ex. 401k, under this plan, employee makes contributions that are exempt from federal taxes until they are withdrawn by employee after retirement

Question 17

how to account for defined CONTRIBUTION plans?

Answer 17

similar to accrual of wages payable

• when comp becomes liable to make contribution, accrues liability and related expense
• later when comp makes payment, cash and liability are reduced
• amnt of liability is certain and comp’s obligation is fully satisfied when payment has been made

Question 18

how to account for defined BENEFIT plans?

Answer 18

comp promises to pay retirees based on formula that includes employee’s final salary level and years of service, both of which are unknown

• estimate amnt of liability is difficult and prone to error
• comps usually set aside some cash to fund promised payments, usually only min contribution required by law
• makes it uncertain whether there will be sufficient funds available to make req payments to retirees

accounting for defined benefit plans is subjective, amounts are uncertain and comp’s frequently revise their estimates

• footnote disclosures are often lengthy and difficult to decipher
• possible to use disclosures to assess how a defined benefit plan impacts comp performance and financial condition

Question 19

what is the projected benefit obligation (PBO)

Answer 19

pv of estimated benefit payments to retirees

• estimate of pbo involves # of estimates that include:
  
  • # of employees who will reach retirement age while employed with comp
  • salary levels at retirement; requires estimate of wage inflation
  • years of service at retirement
  • years over which ann payments will be made - requires estimate of life span
• comp uses assumptions to estimate amnt that will be paid ot employees from retirement until the end of their lives
• amnt is discounted at an assumed rate called the “settlement rate” to yield pv of future pension benefits to be paid - the pbo

Question 20

how do companies report and calculate defined BENEFIT plans on the b/s

Answer 20

funded status = projected pbo - pension plan assets

Question 21

what are pension plan assets?

Answer 21

investment portfolio with debt and equity securities

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