10
Reporting Chapter and Analyzing Leases,
Pensions, and Income Taxes
Learning Objectives coverage by question
Miniexercises
LO1 Define off-balance-sheet
financing and explain its effects on
financial analysis.
Exercises
Problems
20, 21
Cases
47
LO2 Account for leases using the
operating lease method or the capital
lease method.
12, 13, 14
23, 24, 25, 27
LO3 Convert off-balance-sheet
operating leases to the capital lease
method.
15
25, 26, 27
LO4 Explain and interpret the
reporting for pension plans.
16, 17, 18, 19
29, 30
37, 38
46
LO5 Analyze and interpret pension
footnote disclosures.
16, 17, 18, 19
28, 29, 30
37
46
22
31, 32
LO6 Describe and interpret
accounting for income taxes.
33, 36
33, 34, 35,
36, 45
39, 40, 41,
42, 43, 44
47
47
48
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-1
QUESTIONS
Q10-1. Under an operating lease, the lessor retains the usual risks and rewards of
owning the property. In accounting for an operating lease, the lessee
doesnt record either the leased asset or the lease liability on the balance
sheet, and normally charges each lease payment to rent expense. In
contrast, a capital lease transfers to the lessee substantially all of the risks
and rewards relating to the ownership of the property. Accordingly, the
lessee accounts for a capital lease by recording the leased property as an
asset and establishing a liability for the lease obligation. The leased asset is
subsequently depreciated, and interest expense is accrued on the lease
liability.
Q10-2. The leasing footnote is reasonably complete to allow for capitalization of
operating leases for analysis purposes. Despite the quality of the leasing
disclosures, on-balance-sheet treatment is, arguably, a more direct form of
communication from the company and, as a result, is more easily
interpreted by users of its financial statements.
Q10-3. Yes, over the term of the lease the rent expense on an operating lease will
be equal to the sum of the interest and depreciation on a capital lease. Only
the timing of the expense recognition changes. Expense is ultimately
related to the cash flows required to discharge the obligation. Those cash
flows are the same whether or not the lease is capitalized.
Q10-4. Under defined contribution plans, companies make contributions to the
plans which, together with earnings on the amounts invested, provide the
sole source of funding for payments to retirees. Under defined benefit
plans, the obligations are defined with payment to be made in the future
from general corporate funds. These plans may or may not be fully funded.
Since the companys obligation is extinguished upon payment for a defined
contribution plan, the accounting is relatively simple: record an expense
when paid or accrued. Defined benefit plans present a number of
complications in that the liability is very difficult to estimate and involves a
number of critical assumptions. In addition, companies lobbied for (and the
FASB agreed to) various mechanisms to smooth the impact of pension
costs on reported earnings. These smoothing mechanisms further
complicate the accounting for defined benefit plans vis--vis defined
contribution plans.
Q10-5. Although the accounting can get complicated, a net pension asset will be
reported if the fair market value of the plan assets exceeds the plan
obligation. Otherwise, a net liability will be reported on the balance sheet to
represent the underfunding of the pension obligation.
Q10-6. Service cost, interest cost and the expected return on plan investments (a
reduction of the pension cost) are the basic components of pension
expense. Companies might also report amortization of deferred gains and
losses.
Cambridge Business Publishers, 2011
10-2
Financial Accounting, 3rd Edition
Q10-7. The use of expected returns and the deferral of unexpected gains and
losses act to smooth corporate earnings by removing the effects of swings
in the market values of investments and variation in pension liabilities
resulting from changes in actuarial assumptions or plan amendments.
Q10-8. For a capital lease, the initial value of the lease asset and the lease
obligation are determined by calculating the present value of the minimum
lease payments. The minimum lease payments include those payments
that are not subject to options or contingencies, including any guaranteed
residual value.
Q10-9. Retirement benefits are normally expensed in the period in which they are
earned by the employee, not when they are paid. Some benefits are
calculated for periods of employment prior to the inception of a pension
plan or prior to a plan amendment. The cost of these benefits (called prior
service costs) is expensed by amortizing the cost over the average
expected future period of employee service.
Q10-10. The amount of the accumulated benefit obligation in excess of the fair value
of the plan assets must be reported as a minimum pension liability. If the
accrued pension liability that is reported in the balance sheet is smaller
than the minimum liability, then an additional pension liability, equal to the
difference, must be reported.
Q10-11. A tax payment would be recorded as deferred taxes under two situations.
First, if the company is required to make a tax payment (based on the
higher taxable income reported on the tax return) but not record that
payment as tax expense, a deferred tax asset is recorded. Deferred tax
assets result from those situations where an expense is recognized and
recorded in the income statement, but is not deductible on the companys
tax return in the current period. This produces higher income on the tax
return and tax payments that are higher than tax expense. The excess
payment is recorded as an increase (debit) to a deferred tax asset.
The second situation arises when a deferred tax liability reverses. In this
situation, tax expense has been recognized in excess of tax payments in
prior years. When the tax return catches up with the income statement,
the tax deferral reverses and the deferred tax liability is reduced (debited).
In either situation, the deferred tax account (either asset or liability) is
debited and cash is credited.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-3
MINI EXERCISES
M10-12 (15 minutes)
a. i.
1/1
No entry
12/31
Rent expense (+E, -SE) .
Cash (-A)
12,000
Leased asset (+A) ..
Lease liability (+L)
$57,198 = $12,000 x 4.76654
57,198
Depreciation expense (+E, -SE) ...
Accumulated depreciation (+XA)
$9,533 = $57,198 / 6.
9,533
Lease liability (-L)
Interest expense (+E, -SE) .
Cash (-A)
$4,004 = $57,198 x .07; $7,996 = $12,000 - $4,004.
7,996
4,004
12,000
ii.
1/1
57,198
12/31
9,533
12/31
12,000
b.
+
Cash (A)
12,000
-
12/31
12/31
+
1/1
-
Leased Asset (A)
57,198
-
+
Lease Liability (L)
57,198
7,996
+
1/1
12/31
Accumulated Depreciation (XA)
9,533
+
12/31
Interest Expense (E)
4,004
-
+
12/31
Depreciation Expense (E)
9,533
-
c.
Balance Sheet
Transaction
Cash
Asset
Signed a
capital
lease.
Depreciation
on leased
asset.
Made annual
-12,000
lease
Cash
payment.
Noncash
+ Assets
-
Contra
Assets
= Liabilities +
+57,198
Leased
Asset
Income Statement
Contrib.
Capital
+
Earned
Capital
Revenues
- Expenses =
+57,198
-
=
Lease
Liability
+9,533
Retained
Earnings
-7,996
=
Lease
Liability
-4,004
Retained
Earnings
=
+9,533
-9,533
- Accumulated =
Depreciation
-
-
-
Deprec.
Expense
= -9,533
+4,004
-
Interest
Expense
= -4,004
Cambridge Business Publishers, 2011
10-4
Net
Income
Financial Accounting, 3rd Edition
M10-13 (20 minutes)
a.
7/1
Leased asset (+A) ..
Lease liability (+L) .
123,100
123,100
$123,100 = 4,500 x 27.35548
b.
9/30
Depreciation expense (+E, -SE) ..
Accumulated depreciation (+XA, -A) .
3,078
3,078
$3,078 = $123,100 / (10 x 4).
Lease liability (-L) ..
Interest expense (+E, -SE)
Cash (-A)
9/30
2,038
2,462
4,500
$2,462 = $123,100 x (.08/4); $2,038 = $4,500 - $2,462.
12/31 Depreciation expense (+E, -SE) ..
Accumulated depreciation (+XA, -A) .
3,078
12/31 Lease liability (-L) ..
Interest expense (+E, -SE)
Cash (-A)
2,079
2,421
3,078
4,500
$2,421 = ($123,100 - $2,038) x (.08/4); $2,079 = $4,500 - $2,421.
c.
+
Cash (A)
-
-
4,500
4,500
+
7/1
-
Leased Asset (A)
9/30
12/31
+
9/30
12/31
Accumulated Depreciation (XA)
3,078
3,078
+
9/30
12/31
+
123,100
9/30
12/31
-
123,100
Lease Liability (L)
+
9/30
12/31
7/1
2,038
2,079
Interest Expense (E)
-
2,462
2,421
Depreciation Expense (E)
-
3,078
3,078
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-5
d.
Balance Sheet
Transaction
Cash
Asset
Signed a
capital lease.
+
Noncash
Assets
-
Contra
Assets
=
+123,100
Leased
Asset
Liabilities
Income Statement
Contrib.
+
+
Capital
=
Depreciation
on leased
asset.
Made quarterly
-4,500
lease
Cash
payment.
- Expenses =
-
Lease
Liability
Retained
Earnings
Deprec.
- Expense = -3,078
-2,038
-
=
Lease
Liability
+3,078
=
Interest
Retained
Earnings
Lease
Liability
- Expense = -2,462
+3,078
Retained
Earnings
-2,079
-
+2,462
-2,462
-3,078
- Accumulated =
Depreciation
=
-
Deprec.
Expense
= -3,078
+2,421
-2,421
Retained
Earnings
-
Interest
Expense
= -2,421
e.
7/1
No entry
9/31
Rent expense (+E, -SE)
Cash (-A)
4,500
12/31 Rent expense (+E, -SE)
Cash (-A)
4,500
4,500
4,500
The amount of rent expense recognized if the lease is treated as an operating
lease is $9,000 ($4,500 + $4,500). However, if the lease is treated as a capital
lease, interest and depreciation are recognized. The total expense for 2010 is
$11,039 ($2,462 + $2,421 + $3,078 + $3,078). The capital lease method tends to
report higher expense in the early periods of the lease.
Cambridge Business Publishers, 2011
10-6
Net
Income
+3,078
-3,078
Accumulated
- Depreciation =
Made quarterly
-4,500
lease
Cash
payment.
Revenues
+123,100
-
+3,078
Depreciation
on leased
asset.
Earned
Capital
Financial Accounting, 3rd Edition
M10-14 (15 minutes)
a. Capital leases record both the leased asset and the lease liability on the face
of the balance sheet. Operating leases, by contrast, do not record either the
leased asset or the lease liability. They are, as a result, a common t echnique to
achieve off-balance-sheet financing. Concerning the income statement, capital
leases result in depreciation of the leased asset and interest expense on the
lease liability. Operating leases record only rent expense.
b. Analysts frequently add the present value of the operating lease payments to
both assets and liabilities, thus capitalizing the operating lease.
This
adjustment improves the interpretation of measures of financial leverage and
operating performance. If Yums operating lease commitments in total are
substantial, they could have a significant impact on the assessment of
financial leverage. Yum indicates no individual lease is material. However, the
total commitment could be substantial.
M10-15 (20 minutes)
a. Present value of expected operating lease payments for Southwest Airlines
using a financial calculator, I/YR=7:
Year
($ millions)
2009 ........................
Operating Lease
Payment
$ 400
2010 ........................
335
293
2011 ........................
298
243
2012 ........................
235
179
2013 ........................
195
139
After 2013 ...............
876
521
Average life ............
*
4.5 years *
Present Value
$ 374
$1,749
$876 $195/year = 4.5 years.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-7
M10-15continued.
The calculations of the present value of each payment follow :
N
1
I/YR
7
PV
374
PMT
0
FV
400
N
2
I/YR
7
PV
293
PMT
0
FV
335
N
3
I/YR
7
PV
243
PMT
0
FV
298
N
4
I/YR
7
PV
179
PMT
0
FV
235
N
5
I/YR
7
PV
139
PMT
0
FV
195
The present value of payments after Year 5 follows:
N
4.5
I/YR
7
PV
731
PMT
195
FV
0
N
5
I/YR
7
PV
521
PMT
0
FV
731
b. The capitalization of these operating leases increases Southwests total
liabilities by 18% to $11.580 million ($9.831 million + $1.749 million).
M10-16 (15 minutes)
a. American Express is reporting $13 million in pension expense for 2008.
b. Expected returns are an offset to service and interest costs and serve to
reduce reported pension expense.
c. Expected refers to the use of long-term average returns for the investment
portfolio. Expected returns are used in the computation of pension expense,
rather than actual returns, in order to smooth reported income.
Cambridge Business Publishers, 2011
10-8
Financial Accounting, 3rd Edition
M10-17 (15 minutes)
a. Yum Brands is reporting $36 million of pension expense for 2008.
b. Expected returns are an offset to service and interest costs and serve to
reduce reported pension expense.
c. Expected refers to the use of long-term average returns for the investment
portfolio. Expected returns are used in the computation of pension expense,
rather than actual returns, in order to smooth reported income.
M10-18 (15 minutes)
a. A&F maintains a defined contribution plan for the benefit of its employees.
b. Contributions are expensed when made.
c. Only the unpaid contribution, if any, appears on the A&F balance sheet.
M10-19 (15 minutes)
a. Target maintains only a defined contribution plan for the benefit of its
employees.
b. Contributions are expensed when made.
c. Only the unpaid contribution, if any, appears on Targets balance sheet.
d. First, employees who do not meet the unspecified eligibility requiremen t will
not be covered. Second, their investment is tied to whether the employees
leave the contributions undiversified. Third, matching contributions can be
reduced or eliminated in bad times.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-9
M10-20 (15 minutes)
a.
($millions)
2009
2010
2011
2012
2013
Thereafter .
Payment
Obligation
$245
216
157
146
143
2,950
Present Value
(i=6%)
$231
192
132
116
107
1,245
Total
$3,857
$2,023
Average Life: $2,950/$143 = 20.6 years.
The calculations of the present value of each payment follow :
N
1
I/YR
6
PV
231
PMT
0
FV
245
N
2
I/YR
6
PV
192
PMT
0
FV
216
N
3
I/YR
6
PV
132
PMT
0
FV
157
N
4
I/YR
6
PV
116
PMT
0
FV
146
N
5
I/YR
6
PV
107
PMT
0
FV
143
The present value of payments after Year 5 follows:
N
20.6
I/YR
6
PV
1,666
PMT
143
FV
0
N
5
I/YR
6
PV
1,245
PMT
0
FV
1,666
b.
Balance Sheet
($millions)
Transaction
To capitalize
operating leases
Cash
Asset
Noncash
LiabilContrib.
+
=
+
+
Assets
ities
Capital
+2,023
+2,023
=
Leased
Lease
Asset
Income Statement
Earned
Capital
Revenues - Expenses =
-
Net
Income
=
Liability
Cambridge Business Publishers, 2011
10-10
Financial Accounting, 3rd Edition
M10-20continued.
c. Recognition of the operating leases would affect the current ratio. Recording
the lease asset would increase noncurrent assets by $2,023 million, but
recording the lease liability would increase current liabilities by $231 million,
and noncurrent liabilities by $1,792 million ($2,023 - $231).
d. (in $millions)
Leased asset (+A) ..
Lease liability (+L) .
+
Leased Asset (A)
2,023
-
-
2,023
2,023
Lease Liability (L)
+
2,023
e. Yes. The present value of the operating leases of $2,023 million represent over
45% of Targets operating cash flow in 2008.
M10-21 (15 minutes)
a. The use of contract manufacturers removes the manufacturing assets and
related liabilities from Nikes balance sheet.
Because sales are unaffected, PPE turnover is increased by the removal of
assets. The effect on net operating profit after taxes (NOPAT) is uncertain;
depreciation is removed (interest on the liabilities incurred to purchase the
manufacturing assets is also removed, but this is a nonoperating expense
and, therefore, does not affect NOPAT), but Nike will pay a higher price for its
manufactured goods in order to provide the manufacturer with a return on its
investment. If the contract manufacturer is more efficient than Nike, however,
the price increase is mitigated. Profitability will increase if the turnover effect
more than offsets the negative effect on NOPAT and profit margin, which is
likely.
b. Executory contracts are not recognized under GAAP. As a result, the use of
contract manufacturers achieves off-balance-sheet financing. This is one
motivating factor for their use.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-11
M10-22 (20 minutes)
a, b, c.
Year
Book
value
Temporary
difference
Tax
rate
Deferred
tax liability
2010
$300,000
$173,000
$127,000
40%
$50,800
2011
$200,000
$173,000 - ($100,000 - $31,000) = $104,000
$96,000
40%
$38,400
2012
$100,000
$104,000 - ($100,000 - $31,000) = $35,000
$65,000
40%
$26,000
Tax basis (after depreciation deduction)
d. Because the deferred tax liability is reversing in years 2011, 2012 and 2013, part
of the deferred tax liability should be classified as a current liability each year.
The amounts are presented in the following table.
Year
Deferred tax liability
Long-term amount
reversing beyond one year
Current portion reversing
within one year
2010
$50,800
$38,400
$12,400
2011
$38,400
$26,000
$12,400
2012
$26,000
$0
$26,000
Cambridge Business Publishers, 2011
10-12
Financial Accounting, 3rd Edition
EXERCISES
E10-23 (20 minutes)
a. All of Fortune Brands leases are classified as operating. GAAP requires
companies to provide a table of projected lease payments for both operating and
capital leases (for example, see the Verizon lease footnote example in E10-24).
Because no capital leases are included in the Fortune Brands footnote, we know
that it only has operating leases.
b. Neither the leased asset nor the lease obligation is reported on the balance
sheet for an operating lease. As a result, total assets and total liabilities are
reduced. Over the life of the lease, total rent expense under operating leases will
be equal to the interest and depreciation expense that would have been
recorded under capital leases. Profit is unaffected by this classification. During
the life of the lease, however, the two will not be equal. Even if depreciation is
computed on a straight-line basis, interest is accrued based on the balance of
the lease obligation which is higher in the earlier years of the lease. As a result,
depreciation plus interest will exceed rent expense during the early years of the
lease life and will be less toward the end of the lease.
c.
Year
($ millions)
2009 ........................
Operating Lease
Payment
$ 57.8
2010 ........................
45.4
40
2011 ........................
35.1
29
2012 ........................
26.3
20
2013 ........................
22.4
16
After 2013 ...............
18
12
Average life ............
1 year *
* Average life =$18/$22.4 = 0.8 rounded up to 1
Present Value
$ 54
$171
The lease effect on the D/E ratio changes from $7,420/$4,672 = 1.59 to
($7,420 + $171)/$4,672 = 1.62. This is not a major change.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-13
E10-24 (20 minutes)
a. According to Verizons lease footnote, it has both capital and operating leases.
Only the capital leases are reported on-balance sheet in the amount of $390
million ($63 million in current liabilities and $327 million as long-term liabilities).
This is not the total obligation to its lessors. Verizon also has a significant
amount of leases that it has classified as operating. In fact, the minimum lease
payments under operating leases are over 14 times that for capital leases! These
operating leases are not reported on-balance-sheet.
b. Neither the leased asset nor the lease obligation is reported on the balance
sheet for an operating lease. As a result, total assets and total liabilities are
reduced. Over the life of the lease, total rent expense under operating leases will
be equal to the interest and depreciation expense that would have been
recorded under capital leases. Profit is unaffected by this classification. During
the life of the lease, however, the two will not be equal. Even if depreciation is
computed on a straight-line basis, interest is accrued based on the balance of
the lease obligation which is higher in the earlier years of the lease. As a result,
depreciation plus interest will exceed rent expense during the early years of the
lease life and will be less toward the end of the lease.
E10-25 (25 minutes)
E
a. Our analysis might capitalize (add to both assets and liabilities) the present
value of the expected operating lease payments. The present value is computed
as follows:
Year
($ 000s)
2009.........................
2010.........................
2011.........................
2012.........................
2013.........................
>Thereafter .............
Average life ............
*
Operating Lease
Payment
Present Value
(i=7%)
$ 851,412
$ 795,713
803,071
701,434
731,808
597,375
645,215
492,235
556,031
396,445
2,132,053
1,342,833
4 years*
$4,326,035
$2,132,053 $556,031/year = 3.834 rounded to 4 years.
The present value of Staples operating leases is computed to be $4.326 billion. We
might consider adjusting its balance sheet by adding this amount to both assets
and liabilities. Staples liabilities are 58% higher following this adjustment (adjusted
liabilities are $7.442 billion + $4.326 billion = $11.768 billion).
Cambridge Business Publishers, 2011
10-14
Financial Accounting, 3rd Edition
E10-25continued.
The calculations of the present value of each payment follow :
N
I/YR
PV
PMT
FV
1
7
795,713
0
851,412
N
2
I/YR
7
PV
701,434
PMT
0
FV
803,071
N
3
I/YR
7
PV
597,375
PMT
0
FV
731,808
N
4
I/YR
7
PV
492,235
PMT
0
FV
645,215
N
5
I/YR
7
PV
396,445
PMT
0
FV
556,031
The present value of payments after Year 5 follows:
N
I/YR
PV
PMT
4
7
1,883,394
556,031
N
5
I/YR
7
PV
1,342,833
PMT
0
FV
0
FV
1,883,394
b.
Balance Sheet
($ 000s)
Cash
Asset
Transaction
To capitalize
operating leases.
Noncash
LiabilContrib.
=
+
+
Assets
ities
Capital
+4,326,036
+4,326,036
=
Leased
Lease
+
Asset
c.
2008
Income Statement
Earned
Capital
-
=
Liability
Leased asset (+A) ...
Lease liability (+L)
4,326,036
Depreciation expense (+E, -SE) ..
Accumulated depreciation (XA, -A) ..
432,604
Interest expense (+E, -SE) ....
Lease liability (-L) ...
Cash (-A) ..
2009
Net
Income
Revenues - Expenses =
302,823
548,589
4,326,036
432,604
851,412
d.
+
2008
-
Leased Asset (A)
4,326,036
-
Accumulated Depreciation (XA) +
432,604
2009
+
Cash (A)
851,412
2009
2009
+
2009
+
2009
Lease liability (L)
+
4,326,036
2008
548,589
Depreciation Expense (E) 432,604
Interest Expense (E)
302,823
-
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-15
E10-26 (25 minutes)
Our analysis might capitalize (add to both assets and liabilities) the present value of
the expected operating lease payments. The present value is computed as follows:
Year
($ millions)
2009.........................
Operating Lease
Payment ---Net
Present Value
(i=7%)
$ 450
$ 421
414
362
375
306
338
258
306
218
2010.........................
2011.........................
2012.........................
2013.........................
>2013 ......................
Average life ............
*
2,421
7.912 years*
1,292
$2,857
$2,421 $306/year = 7.912 years
The calculations of the present value of each payment follow :
N
I/YR
PV
PMT
FV
1
7
421
0
450
N
2
I/YR
7
PV
362
PMT
0
FV
414
N
3
I/YR
7
PV
306
PMT
0
FV
375
N
4
I/YR
7
PV
258
PMT
0
FV
338
N
5
I/YR
7
PV
218
PMT
0
FV
306
The present value of payments after Year 5 follows:
N
I/YR
PV
PMT
7.912
7
1,812
306
N
5
I/YR
7
PV
1,292
PMT
0
FV
0
FV
1,812
The present value of Yums net operating leases is computed to be $2,857 million.
We might consider adjusting its balance sheet by adding this amount to both assets
and liabilities. YUM!s liabilities are 43% higher following this adjustment (adjusted
liabilities are $6.635 billion + $2.857 billion = $9.492 billion).
Cambridge Business Publishers, 2011
10-16
Financial Accounting, 3rd Edition
E10-27 (25 minutes)
a.
Our analysis might capitalize (add to both assets and liabilities) the present
value of the expected operating lease payments. The present value is computed
as follows:
Year
($ millions)
2009.........................
Operating Lease
Payment --- Net
Present Value
(i=7%)
$ 312.4
$ 292
264.4
231
228.9
187
192.1
147
163.9
117
692.3
415
2010.........................
2011.........................
2012.........................
2013.........................
>2013 ......................
Average life ............
4.224 years*
$1,389
* $692.3 $163.9/year = 4.224 years.
The calculations of the present value of each payment follow :
N
I/YR
PV
PMT
FV
1
7
292
0
312.4
N
2
I/YR
7
PV
231
PMT
0
FV
264.4
N
3
I/YR
7
PV
187
PMT
0
FV
228.9
N
4
I/YR
7
PV
147
PMT
0
FV
192.1
N
5
I/YR
7
PV
117
PMT
0
FV
163.9
The present value of payments after Year 5 follows:
N
I/YR
PV
PMT
4.225
7
582
163.9
N
5
I/YR
7
PV
415
PMT
0
FV
0
FV
582
The present value of Nikes operating leases is computed to be $1,370 million. We
might consider adjusting its balance sheet by adding this amount to both assets
and liabilities.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-17
E10-27continued.
b.
Balance Sheet
Cash
Asset
Transaction
To capitalize
operating leases.
c.
1.
+
Noncash
=
Assets
+1,389
=
Leased
Asset
Income Statement
LiabilContrib.
+
+
ities
Capital
+1,389
Earned
Capital
-
Lease
Liability
Leased asset (+A) .
Lease Liability (+L) .
139
Lease liability (-L)
Interest expense (+E, -SE) .
Cash (-A) ...
3.
=
1,389
Depreciation expense (+E, -SE) .
Accumulated depreciation (+XA, -A)...
2.
Net
Income
Revenues - Expenses =
1,389
139
215.2
97.2
312.4
d.
+
3
1
Leased Asset (A)
1,389
-
-
- Accumulated Depreciation (XA) +
13 9
2
+ Cash (A) 312.4
3
Lease Liability (L)
1,389
215.2
+
2
+ Depreciation Expense (E) 139
3
+ Interest Expense (E) 97.2
1
E10-28 (20 minutes)
a. Service cost is the increase in the pension obligation resulting from employees
working another year for the company. Interest cost is the accrual of interest on
the (discounted) pension obligation.
b. Payments to retirees are made from the pension investment account. There is a
corresponding reduction in the pension obligation.
c. The funded status is the pension obligation less the fair market value of the
pension investments. In this case $923 million (pension obligation) $513
million (pension investments) = $410 million underfunded amount.
d. A $410 million net pension liability is reported in the balance sheet.
Cambridge Business Publishers, 2011
10-18
Financial Accounting, Edition
E10-29 3rd (20 minutes)
a. Service cost is the increase in the pension obligation resulting from employees
working another year for the company. Interest cost is the accrual of interest on
the (discounted) pension obligation.
b. The actual return on pension investments is ($1,527 million in 2008 (this
causes the decrease in the pension investment account).
c. Actuarial losses (gains) generally arise as a result of decreases (increases) in
the discount rate used to compute the pension obligation (PBO). Because the
PBO is the present value of expected future payouts to retirees, a decrease in
the discount rate results in an increase in the PBO. This decrease is called an
actuarial loss.
d. Payments to retirees are made from the pension investment account. There is a
corresponding reduction in the pension obligation.
e. Xerox contributed $299 million to its pension plans in 2008.
f. Xerox paid $657 million to its retirees in 2008.
g. The funded status is the pension obligation less the fair market value of the
pension investments. In this case $8,495 million $6,923 million = $1,572 million
underfunded amount.
h. A $1,572 million net pension liability is reported on the balance sheet.
E10-30 (20 minutes)
a. Service cost is the increase in the pension obligation resulting from employees
working another year for the company. Interest cost is the accrual of interest on
the (discounted) pension obligation.
b. Payments to retirees are made form the pension investment account. There is a
corresponding reduction in the pension obligation.
c. The funded status is the pension obligation less the fair market value of the
pension investments. In this case $30,394 million $27,791 million = $2,603
million underfunded amount.
d. A $2,603 million net pension liability is reported on the balance sheet.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-19
E10-31 (15 minutes)
a.
Balance Sheet
Cash
Asset
Transaction
Income Statement
Noncash
LiabilContrib.
+
=
+
+
Assets
ities
Capital
To record income tax
expense
+920.1
=
Taxes
Payable
-300.6
Earned
Capital
Net
Revenues - Expenses =
Income
-619.5
Retained
Earnings
-
Deferred
Taxes
b.
Deferred income taxes (-L) ...
Income tax expense (+E, -SE) ....
Income taxes payable (+L) .
+619.5
Income Tax
Expense
=
-619.5
300.6
619.5
920.1
c. An expense of $619.5 million is recorded in the income statement, thereby
reducing both net income and retained earnings. Liabilities are increased by
$619.5 million, $920.1 million in income taxes payable less the decrease of
$300.6 million in deferred income taxes.
E10-32 (15 minutes)
a.
Balance Sheet
Cash
Asset
Transaction
Noncash
LiabilContrib.
+
=
+
+
Assets
ities
Capital
a. To record income
tax expense.
Income Statement
Earned
Capital
Net
Revenues - Expenses =
Income
+93
=
Taxes
Payable
-1,341
+1,248
Retained
Earnings
Deferred
Taxes
-
+1,341
Income Tax
Expense
=
-1,341
b.
Income tax expense (+E, -SE) ....
Deferred income taxes (+L) .
Taxes payable (+L) .
1,341
1,248
93
c. An expense of $1,341 million is recorded in the income statement, thereby
reducing both net income and retained earnings. Deferred tax liabilities are
increased (or deferred tax assets are reduced) by $1,248 million, and tax
payable liability was increased by $93 million.
d. The refund is most likely due to one of two sources: (1) a loss recorded in an
earlier period for financial reporting purposes that was not recognized until
2004 for tax reporting purposes (e.g., a restructuring loss) or (2) a tax loss
carryforward.
Cambridge Business Publishers, 2011
10-20
Financial Accounting, 3rd Edition
PROBLEMS
P10-33 (60 minutes)
a. Rent expense (+E, -SE) . 208,085,000
Cash (-A) .
208,085,000
b. Outback would report a lease liability of $1,074,521,000 at December 31, 2008 if
the operating leases were capitalized.
($ 000s)
Operating Lease Payment
Present Value at Dec. 31, 2008
(i=8%)
2009
175,367
162,377
2010
167,613
143,701
2011
156,382
124,141
2012
148,186
108,921
2013
139,902
95,215
>2013 .
831,160
436,696
Year
831,160/139,902=5.94 yrs.
$1,071,051
The calculations of the present value of each payment follow :
N
I/YR
PV
PMT
FV
1
8
162,377
0
175,367
N
2
I/YR
8
PV
143,701
PMT
0
FV
167,613
N
3
I/YR
8
PV
124,141
PMT
0
FV
156,382
N
4
I/YR
8
PV
108,921
PMT
0
FV
148,186
N
5
I/YR
8
PV
95,215
PMT
0
FV
139,902
The present value of payments after Year 5 follows:
N
I/YR
PV
PMT
5.94
8
641,650
139,902
N
5
I/YR
8
PV
436,696
PMT
0
FV
0
FV
641,650
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-21
P10-33continued.
c. In 2009, Outback would report interest expense of $85,684,000 ($1,071,051,000
x .08) and depreciation expense of $107,105,100 ($1,071,051,000/10) instead of
rent expense of $175,367,000.
These costs ($85,684,000 and $107,105,100) would replace the otherwise
reported rent expense of $175,367,000 on the 2009 income statement. In the
early years of a lease the higher interest expense causes the capitalization of
leases to increase expenses compared to the rent expense. This situation
reverses in the later years of the lease.
d. These transactions/entries are reflected in the financial statement effects
template below.
Balance Sheet
($000s)
Transaction
Cash
Asset
2009
Depreciation
expense.
2009 Lease
payment.
Noncash
+ Assets -
Contra
Assets
= Liabilities
Cash
-
Earned
Capital
Revenues
-
-107,105
+107,105*
- Accumulated =
Depreciation
-175,367
Income Statement
Contrib.
+
+
Capital
=
Retained
Earnings
-89,683
Lease
Liability
-
-85,684**
Retained
Earnings
-
Expenses
+107,105
Deprec.
Expense
=
= -107,105
+85,684 = -85,684
Interest
Expense
*Accumulated depreciation is a contra asst, so assets are reduced.
**$1,071,051 x 0.08
e. In the statement of cash flows, the rent expense on operating leases is
classified as an operating cash flow. Although the total cash flow is the same,
if the lease is treated as a capital lease, then part of the lease payment (the
interest) is classified as operating and the remainder (the principal) is
classified as a financing cash flow. Depreciation on the lease is deducted in
the computation of income but added back in the operating section of the
cash flow statement because it is not a cash flow.
Cambridge Business Publishers, 2011
10-22
Net
Income
Financial Accounting, 3rd Edition
P10-34 (40 minutes)
a. All of Abercrombie & Fitchs leases are classified as operating. U.S. GAAP
requires companies to provide a table of projected lease payments for both
operating and capital leases. Because no capital leases are included in the
Abercrombie & Fitch footnote, we know that it only has operating leases.
Because operating leases are not capitalized on the balance sheet, neither the
leased asset, nor the lease obligation, appear on-balance-sheet.
b. Total assets and total liabilities are lower than the balance that would have been
reported had the leases been capitalized. Over the life of the lease, total rent
expense under operating leases will be equal to the interest and depreciation
expense that would have been recorded under capital leases. Profit is unaffected
by this classification. During the life of the lease, however, the two will not be
equal. Even if depreciation is computed on a straight-line basis, interest is
accrued based on the balance of the lease obligation, which is higher in the
earlier years of the lease. As a result, depreciation plus interest will exceed rent
expense during the early years of the lease life and will be less toward the end of
the lease.
c. Using a 10% discount rate, the present value of A&Fs operating leases
payments is computed as follows:
Year
($ 000s)
Operating Lease
Payment
Present Value
(i=10%)
2009 ........................
$285,988
2010 ........................
318,845
263,509
2011 ........................
305,830
229,773
2012 ........................
287,772
196,551
2013 ........................
267,951
166,376
>2013 ......................
1,302,139
616,821
Average life ............
*
$314,587
4.86 years*
$1,759,018
$1,302,139 $267,951/year = 4.86 years.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-23
P10-34continued.
The calculations of the present value of each payment follow :
N
I/YR
PV
PMT
FV
1
10
285,988
0
314,587
N
2
I/YR
10
PV
263,509
PMT
0
FV
318,845
N
3
I/YR
10
PV
229,773
PMT
0
FV
305,830
N
4
I/YR
10
PV
196,551
PMT
0
FV
287,772
N
5
I/YR
10
PV
166,376
PMT
0
FV
267,951
The present value of payments after Year 5 follows:
N
I/YR
PV
PMT
4.86
10
993,396
267,951
N
5
I/YR
10
PV
616,821
PMT
0
FV
0
FV
993,396
d.
Balance Sheet
($ 000s)
Transaction
To capitalize
operating leases.
Cash
Asset
Noncash
LiabilContrib.
=
+
+
Assets
ities
Capital
+1,759,018
+1,759,018
=
Leased
Lease
+
Asset
Income Statement
Earned
Capital
-
Net
Income
=
Liability
e. ($ 000s)
2/3/08 Leased asset (+A) ..
Lease liability (+L) .
2009
Revenues - Expenses =
Depreciation expense (+E, -SE)
Accumulated depreciation (+XA, -A) .
1,759,018
1,759,018
175,902
175,902
$175,902 = $1,759,018 / 10
Lease liability (-L) .
Interest expense (+E, -SE) ..
Cash (-A)
138,685
175,902
314,587
$175,902 = $1,759,018 x 0.10.
Cambridge Business Publishers, 2011
10-24
Financial Accounting, 3rd Edition
P10-34continued.
f. ($ 000s)
+
Cash (A)
-
-
314,587
+
1
-
Leased Asset (A)
1,759,018
3
3
-
Accumulated Depreciation (XA)
175,902
+
3
+
2
+
2
Lease Liability (L)
1,759,018
138,685
+
Interest Expense (E)
175,902
Depreciation Expense (E)
175,902
1
-
-
The interest expense is the same as the depreciation charge because interest is
at 10% and depreciation is over 10 years.
g. The effect of a failure to report the leased assets and related lease obligation onbalance-sheet understates fixed commitments. It will leave gross margin largely
unaffected if we assume that the leases are approximately at the midpoint of
their lives, on average. The debt to equity ratio is increased by capitalizing the
leases. Capitalization of the leases would increase the asset base, which would,
in turn, lower asset turnover. Hence turnover rates are overstated by the failure
to capitalize the leases. Overall these two factors offset each other leaving ROE
only marginally affected. Our conclusion of how A&F is achieving its ROE is
likely to be altered because A&F has lower turnover and higher financial
leverage than was apparent based on the published (unadjusted) financial
statements.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-25
P10-35 (40 minutes)
a. Best Buy reports $265 million of capital leases in its liabilities of which $59
million due in 2010 is reported as a current liability. The $8,600 of operating
leases are not reported in the balance sheet nor are the related leased assets.
b. Total assets and total liabilities are lower than the balance that would have been
reported had the leases been capitalized. Over the life of the lease, total rent
expense under operating leases will be equal to the interest and depreciation
expense that would have been recorded under capital leases. Profit is unaffected
by this classification. In any given year of the lease, however, the two will not be
equal. If depreciation is computed on a straight-line basis, interest is accrued
based on the balance of the lease obligation, which is higher in the earlier years
of the lease. As a result, depreciation plus interest will exceed rent expense
during the early years of the lease life and will be less toward the end of the
lease.
c. Using a 10% discount rate, the present value of Best Buys operating leases
payments is computed as follows:
($ millions)
Year
1 ..............................
Operating Lease
Payment
Present Value
(i=10%)
$ 1,097
$ 997
1,045
864
964
724
900
615
846
525
3,748
1,809
4.43 years*
$5,534
2 ..............................
3 ..............................
4 ..............................
5 ..............................
>5 ............................
Average life ............
*
$3,748 $846/year = 4.43 years.
Cambridge Business Publishers, 2011
10-26
Financial Accounting, 3rd Edition
P10-35continued.
The calculations of the present value of each payment follow :
N
I/YR
PV
PMT
FV
1
10
997
0
1,097
N
2
I/YR
10
PV
864
PMT
0
FV
1,045
N
3
I/YR
10
PV
724
PMT
0
FV
964
N
4
I/YR
10
PV
615
PMT
0
FV
900
N
5
I/YR
10
PV
525
PMT
0
FV
846
The present value of payments after Year 5 follows:
N
I/YR
PV
PMT
4.43
10
2,914
846
N
5
I/YR
10
PV
1,809
PMT
0
FV
0
FV
2,914
d.
Balance Sheet
Transaction
Cash
Asset
To capitalize
operating leases.
+
Noncash
LiabilContrib.
=
+
+
Assets
ities
Capital
+5,534
+5,534
=
Lease
Leased Asset
Income Statement
Earned
Capital
Revenues - Expenses =
-
Net
Income
=
Liability
e. 2009
1.
Leased asset (+A) .
Lease liability (+L) ..
2010
2.
Depreciation expense (+E, -SE) .
Accumulated depreciation (+XA, -A) ..
5,534
5,534
553
553
$572 = $5,716 / 10
3.
Lease liability (-L) ..
Interest expense (+E, -SE) ..
Cash (-A)
544
553
1,097
$572 = $5,716 x 0.10
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-27
P10-35continued.
f.
+
Cash (A)
-
-
1,097
+
1.
-
Leased Asset (A)
5,534
3.
3.
-
Accumulated Depreciation (XA)
553
+
3.
+
2.
+
2.
Lease Liability (L)
5,534
544
+
1.
Interest Expense (E)
553
-
Depreciation Expense (E)
553
-
The interest expense is the same as the depreciation charge because interest is
at 10% and depreciation is over 10 years.
g. The effect of a failure to report the leased assets and related lease obligation onbalance-sheet understates fixed commitments. It will leave gross margin largely
unaffected if we assume that the leases are approximately at the midpoint of
their lives, on average. The debt to equity ratio is increased. Capitalization of the
leases would increase the asset base, which would, in turn, lower asset
turnover. Hence turnover rates are overstated by the failure to capitalize the
leases. Overall these two factors offset each other leaving ROE only marginally
affected. Our conclusion of how Best Buy is achieving its ROE is likely to be
altered because Best Buy has lower turnover and higher financial leverage than
was apparent based on the published (unadjusted) financial statements.
P10-36 (5 minutes)
a.
b.
Leased asset (+A)
Lease liability (+L) .
74,520
Prepaid rent (+A) ..
Cash (-A)
1,000
74,520
1,000
Cambridge Business Publishers, 2011
10-28
Financial Accounting, 3rd Edition
P10-37 (50 minutes)
a. $177 million expense
b. The expected return is computed as the beginning fair market value of the
pension plan assets multiplied by the long-term expected return on these
investments. For 2009, this is computed as $11,879 8.5% = $1010, slightly less
than the reported amount of $1,059 million. The plan investment reported an
actual loss of $2,306 million. U.S. GAAP permits the use of the expected longterm rate of return in order to smooth earnings. If actual returns were to be
used, corporate profits would fluctuate greatly with swings in investment
returns. The logic behind using the long-term rate is that investment returns
are expected to fluctuate around this average and its use more accurately
captures the average cost of the pension plan. It is similar to the logic of
reporting held-to-maturity bond investments at historical cost rather than
current market value.
c. The pension liability is increased by the service and interest costs and
decreased by any payments made to plan participants. The actuarial loss (gain)
relates to the effects on the pension obligation of changes in assumptions used
to compute it, such as the discount rate or the rate of expected wage inflation.
The pension plan assets are increased (decreased) by investment gains (losses),
are increased by company contributions and are decreased by benefits paid to
plan participants.
d. The funded status is the excess (deficiency) of the pension obligation over
plan assets. If plan assets exceed pension obligation, the funded status is
positive or overfunded. If pension obligations exceed the fair market value of
plan assets, the funded status is negative or underfunded. The funded status of
the FedEx pension plan is $(238) at the end of 2009. Pension obligations are
$11,050 million and pension assets are $10,812 million. FedEx should report its
net funded status as a net pension liability of $238 million on its balance sheet.
e. Because the pension obligation is the present value of expected pension
payments, an increase in the discount rate decreases the present value reported
on the balance sheet. The effect on the income statement is more difficult to
predict. The interest cost component of pension expense is the product of the
beginning of the year pension obligation and the discount rate. In 2009, the
effect of an increase in the discount rate is to apply a higher discount rate to a
lower pension obligation. These two effects are offsetting, but usually result in
lower interest cost.
f. The estimated wage inflation rate is used to project future benefit payments.
Decreasing the estimated inflation rate decreases the pension obligation
because a lower amount of payments to plan participants is projected.
Decreasing the expected wage inflation rate decreases the pension obligation
reported on the balance sheet and, consequently, the interest component of
pension expense. It is an income-increasing action.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-29
P10-38 (5 minutes)
a.
Pension expense (+E, -SE)
Cash (-A) ...
16,000
16,000
16,000 = 400,000 x .04.
b.
Bartov would report a net liability of $450,000 ($625,000 - $175,000) in its 2010
balance sheet.
P10-39 (20 minutes)
a.
$34,106,000
b. $36,470,000 is payable in cash and the remainder is deferred.
c. Deferred tax liabilities are created when a company reports greater revenues
and/or lower expenses in the income statement than are reported on the tax
return. An example is supplied by certain pension expenses deductible for
books before being deductible for taxes.
d. Deferred tax assets arise when income is recognized for tax purposes before it
is recognized in the financial statements, such as can be case with advance
payments from customers. Thus receipt of the cash will decrease the deferred
tax asset. Alternatively, deferred tax assets may arise when the tax return
defers expenses that are recognized in the financial statements. Examples
include bad debt expense and warranty expense. A restructuring charge is an
example of the latter. Restructuring charges are not recognized in the tax
return until they are realized (cash paid or assets sold at a loss). Therefore, the
payment of the cash or sale of the assets will decrease the deferred tax asset.
Cambridge Business Publishers, 2011
10-30
Financial Accounting, 3rd Edition
P10-40 (20 minutes)
a. In 2009, the temporary difference is $8,000. $8,000 x 40% = $3,200.
In 2010, the temporary difference reverses and no liability would be reported.
b. Income tax expense (+E, -SE) ..
Income taxes payable* (+L) .
Deferred income tax liability (+L) ..
*
c.
*
94,800
3,200
98,000
($245,000 $0) x 40% = $98,000.
Income tax expense (+E, -SE) .
Income taxes payable (+L)*
Deferred income tax liability (+L) .
80,200
77,000
3,200
($236,000 $16,000) x 35% = $77,000.
Income tax expense (+E, -SE) .
Deferred income tax liability (-L)
Income taxes payable (+L)* ..
*
88,000
3,200
($236,000 $16,000) x 40% = $88,000.
Income tax expense (+E, -SE) .
Deferred income tax liability (-L)
Income taxes payable* (+L)
*
91,200
94,800
3,200
98,000
($245,000 $0) x 40% = $98,000.
The solution to part c depends on what the company knew, in 2009, about the
tax rate in 2010. In the journal entries above, the assumption is that the tax rate
is 35% in 2009, but is supposed to change to 40% in 2010. However, if the
change in the tax rate was not known, the following entries would be required:
c.
Income tax expense (+E, -SE) .
Income taxes payable (+L)*
Deferred income tax liability (+L) ** .
79,800
77,000
2,800
* ($236,000 $16,000) x 35% = $77,000.
** $8,000 x 0.35 = $2,800
Income tax expense (+E, -SE) ..........................................................................
95,200
Deferred income tax liability (-L) ....................................................................
2,800
Income taxes payable* (+L) ................................................................................ 8,000
9
*
($245,000 $0) x 40% = $98,000.
Either way, the amount of income tax expense is determined as a plug amount.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-31
P10-41 (20 minutes)
a. Temporary differences
2009: $32,000 - $24,000 = $8,000;
2010: ($32,000 + $37,000) ($24,000 + $26,000) = $19,000.
b. Deferred tax liability
2009: $8,000 x 40% = $3,200; 2010: $19,000 x 40% = $7,600
c. $19,200 + ($7,600 $3,200) = $23,600
d. Income tax expense (+E, -SE)
Income taxes payable (+L) ...
Deferred tax liability (+L) ..
+ Income Tax Expense (E) (d)
23,600
- Income Taxes Payable (L) +
19,200
(d)
23,600
19,200
4,400
- Deferred Tax Liability (L) +
4,400
(d)
P9-42 (20 minutes)
a. Temporary differences
2009: $140,000 - $130,000 = $10,000;
2010: ($140,000 + $122,000) ($130,000 + $128,000) = $4,000.
b. Deferred tax liability
2009: $10,000 x 35% = $3,500; 2010: $4,000 x 35% = $1,400
c. $45,150 + ($1,400 $3,500) = $43,050
d. Income tax expense (+E, -SE)
Deferred tax liability (-L)
Income taxes payable (+L) ..
+ Income Tax Expense (E) (d)
43,050
- Income Taxes Payable (L) +
45,150
(d)
43,050
2,100
45,150
- Deferred Tax Liability (L) +
(d)
2,100
Cambridge Business Publishers, 2011
10-32
Financial Accounting, 3rd Edition
P10-43 (15 minutes)
a. $12,000 x 40% = $4,800.
b. Because the source of the temporary difference is a noncurrent asset (PP&E),
the deferred tax liability would be classified as a noncurrent liability.
c. $8,000 x 40% = $3,200.
P10-44 (20 minutes)
Assume that the tax rate increase in 2011 was not known until 2010.
2009
2010
2011
a. Book
value
$12,000
$6,000
$0
b. Tax Temporary
basis difference
$0
$12,000
$0
$6,000
$0
$0
c. Deferred
tax liability
$4,200 ($12,000 x 0.35)
$2,400 ($6,000 x 0.40)
$0
d. 12/31/09
Income tax expense (+E, -SE) ..
Deferred income tax liability (+L)
Income taxes payable (+L)* ..
*
138,200
1,800
140,000
$400,000 x 0.35 = $140,000.
12/31/11
Income tax expense (+E, -SE) ..
Deferred income tax liability (-L)
Income taxes payable (+L)*
*
4,200
107,800
$308,000 x 0.35 = 107,800.
12/31/10
Income tax expense (+E, -SE) .
Deferred income tax liability (-L) .
Income taxes payable (+L)* ...
*
112,000
165,600
2,400
168,000
$420,000 x 0.40 = $168,000.
The expense is determined as a plug amount.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-33
P10-45 (40 minutes)
a. According to FedExs lease footnote, it has both capital and operating leases.
Only the capital leases are reported on-balance-sheet in the amount of $294
million (FedEx also reports a lease asset on the balance sheet, but the asset
will appear at an amount lower than the lease liability). This amount is not the
total obligation to its lessors. FedEx also has a significant amount of leases that
it has classified as operating. In fact, the minimum lease payments under
operating leases are over 34 times that for capital leases. These operating leases
are not reported on-balance-sheet.
b. An Excel spreadsheet to calculate the interest rate (using the IRR function)
would look something like the following:
A
1N
2 Amount
3 IRR
B
C
0
1
-294 164
4.453%
D
2
20
E
F
3
4
8 119
G
5
2
H
6
2
I
7
2
J
8
2
K
9
2
L
10
2
M
11
2
N
12
2
O
13
1
The Excel function =IRR(B2:O2) returns a value of 4.453% (which is >3%).
c. The present value of FedExs operating leases payments is computed as
follows:
Year
($ millions)
2010 ........................
2011 ........................
2012 ........................
2013 ........................
2014 ........................
>2014 ......................
Total........................
Operating Lease
Payment
Present Value
(i=4%)
$1,759
$ 1,691
1,612
1,490
1,451
1,290
1,316
1,125
1,166
958
7,352
5,246
$14,656
$11,800
Average Life: $7,352/$1,166 = 6.3 years.
Cambridge Business Publishers, 2011
10-34
Financial Accounting, 3rd Edition
P10-45continued.
The calculations of the present value of each payment follow:
N
I/YR
PV
PMT
FV
1
4
1,691
0
1,759
N
2
I/YR
4
PV
1,490
PMT
0
FV
1,612
N
3
I/YR
4
PV
1,290
PMT
0
FV
1,451
N
4
I/YR
4
PV
1,125
PMT
0
FV
1,316
N
5
I/YR
4
PV
958
PMT
0
FV
1,166
The present value of payments after Year 5 follows:
N
I/YR
PV
PMT
6.3
4
6,382
1,166
N
5
I/YR
4
PV
5,246
PMT
0
FV
0
FV
6,382
d. Failure to report the leased assets and related lease obligation on-balance sheet
has overstated asset turnover ratios and understated financial leverage ratios.
For example, the debt to equity ratio would increase from 0.78 ($10,618/$13,626)
to 1.65 ([$10,618 + $11,800]/$13,626). Profit margins will not be affected
significantly, if we assume that the leases are approximately at the midpoint of
their lives, on average. Because the decreased turnover and increased leverage
effects offset one another, ROE is unaffected. Our conclusion about how FedEx
is achieving its ROE is altered, however, because it has lower turnover and
higher financial leverage than is apparent based on a review of the published
(unadjusted) financial statements.
e. To effectively conduct its business, FedEx requires a significant amount of
assets that are not reported on-balance-sheet. In addition, the true extent of
FedExs obligations is substantially understated. In the case of FedEx, therefore,
it appears that the balance sheet does not do an adequate job.
f. Lease reporting in the U. S. follows U.S. GAAP while lease reporting in France
would follow IFRS. U.S. GAAP does not capitalize operating leases. Operating
leases are considered executory contracts. Executory contracts are promises to
pay defined amounts in the future for future benefits. Such contracts are not
recognized as liabilities. The assets supplying the services are also not
recognized. The requirements necessary to recognize a lease as a capital lease
are not as specific under IFRS and hence a lease that would not be considered a
capital lease under U.S. GAAP might be considered a capital lease under IFRS.
Specific requirements for capitalization are covered in advanced courses.
Cambridge Business Publishers, 2011
Solutions Manual, Chapter 10
10-35