Chapter 10
Chapter 10
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 12th Edition
Clyde P. Stickney and Roman L. Weil
Learning Objectives
1. Understand (a) why firms attempt to structure debt financing to keep debt off the balance sheet and (b) how standard setters have refined the concept of an accounting liability to reduce off-balance-sheet financing abuses. 2. Distinguish between operating leases and capital leases on the bases of their economic characteristics, accounting criteria, and financial statement effects.
Learning Objectives
3. Understand why firms may recognize revenues and expenses for financial reporting in a period different from that used for tax reporting and the effect of such differences on the measurement of income tax amounts on the income statement and the balance sheet. 4. Understand the accounting issues related to retiree benefit plans (such as pensions and health-care benefits).
Chapter Outline
1. Off-balance sheet financing 2. Leases 3. Income tax accounting and deferred income taxes 4. Deferred compensation: pension benefits and other deferred compensation
Chapter Summary
7. Appendix 10.1: Effects on the statement of cash flows of transactions involving liabilities
If the liability is not recognized, then the double-entry system does not allow for the recognition of the asset either, but this is a tradeoff that some managers are willing to make.
Off-balance-sheet financing can affect key financial ratios, especially the financing ratios that use total debt as a denominator, showing them to be lower (and more favorable) than they would be if the financing were recognized.
2. It avoids violating some debt covenants; that is, restrictions specified in the debt agreement to protect the lender. These restrictions are sometimes stated in the form of financial ratios which may be effected by whether or not the liability is recorded.
1. Executory contracts are promises to pay at a future date for future benefits
These may be legally binding and give both parties valuable rights. Standard accounting would recognize a liability as benefits are received, not when the contract is signed.
2. Contingent obligations are obligations that arise only if a specified set of conditions are met.
Standard accounting would recognize a liability as the contingent events occur rather than when the contract is signed.
Leases
A true lease would give the lessee (the one paying for use of the asset) flexibility.
Some leases are so inflexible that they are tantamount to a purchase. They may be non-cancelable, long-term and impose on the lessee all costs of operating.
Leases (Cont.)
Private automobile leases are typically so restrictive as to be the economic equivalent of a purchase. A true automobile lease would be more like what is called renting a car. Because of the possibility that leases may be used as a form of off-balance sheet financing, GAAP calls for leases to be capitalized under certain conditions.
a purchase and thus recognize both the leased asset and the lease liability. The lease asset may be depreciated over time and the lease liability may be amortized as payments are made.
If the lease is not capitalized, it may be treated as a true lease (or operating lease). In this case, a lease expense would be recognized as payments were made but no asset or longterm liability would be recognized.
GAAP required that a lease be capitalized if any one of the following conditions are met: 1. Transfer of ownership to lessee at end of lease 2. Transfer at bargain purchase option 3. Lease extends for 75% of the assets life 4. PV of lease payments is 90% of fair market value
course, if management wants the lease to be treated as an operating lease, they will structure the lease terms to avoid all four of these criteria.
In
such cases, the last requirement (90% of fair market value) is considered the most restrictive.
Capital lease:
Both a lease asset (leasehold) and a lease liability are recognized for the PV of the lease obligations As payments are made or adjusting entries required:
col 4 amt
year
(1)
cash payment
(4)
1 2 3
$32,041 17,138 0
Book income is income before income taxes for financial reporting purposes
Taxable income is the amount of income on which the income tax is based The two may be different because of:
The timing of recognition may be different, or Some revenues or expenses may have special tax treatments
U.S. GAAP holds to the first view. Thus, a tax deferral method saves taxes paid during the current period but may not reduce tax expense. Critics of this view hold that tax expense is unlike other expenses in that it does not give rise to the potential for revenues.
In the future when the deferred taxes become due, the effect is reversed reducing the deferred tax liability.
Year 4
32,000 2,240
34,240
Present federal law now requires employers to actually put away cash to cover the obligations of pension benefits.
The amount of cash and the recognition of an expense are complex issues.
The administrator of the pension fund should make prudent and profitable investments of those funds.
If the pension funds grows, this adds to the fund since the fund is not an asset of the firm.
growth does however ease the amount of cash that the firm has to transfer to the fund in future periods.
Fund assets at beginning of the period + Actual earnings on pension fund investments + Contributions from employer - Payments to retirees = Fund assets at end of the period
Health care, insurance and other benefits resemble pension plans in concept.
The PV of such commitments, or health-care benefits obligation, represents an economic obligation of the employer. GAAP requires firms to recognize an expense for these obligations and to recognize liabilities for any under funded obligations. Firms may recognize the full liability in one year or piecemeal over several years.
An International Perspective
Leases -- most industrial countries distinguish between capital and operating leases although the criteria may vary. Income tax accounting -- in general, countries that allow separate rules for tax and financial reporting allow deferred tax accounting. Retirement benefits -- most industrial countries provide worker benefits and some are more generous than in the U.S., however, most do not provide the same detail of accounting disclosure.
Chapter Summary
The point was made that liabilities cover some obligations that are difficult to measure.
Leases may represent a significant future obligation.
Chapter Summary
Taxes
may give rise to future obligations when aggressive deferral methods are practiced. intent of this chapter was to acquaint the student with many problems of liability accounting and to give the student an appreciation of some liabilities that appear on the balance sheet.
The
long-lived asset (use of investing cash) and a liability (financing cash). As the asset is depreciated and the liability amortized, operating cash is effected. The two effects may not cancel out because of differences between the depreciation method and the amortization method.
pension is a separate legal entity and is not an asset of the firm, so cash paid in by the employee is not an investment.
Rapid Review - MC
1. A promise to pay at a future date for future benefits is a a. Lease b. Pension
c. Executory contract
d. Capital lease
1. Any means that secures the use of assets for the firm without having to recognize an offsetting liability is a (an) a. Lease c. Off-balance sheet Financing b. Pension d. Capital lease