Module 10
Reporting and Analyzing
Off-Balance-Sheet Financing
Learning Objectives – coverage by question
LO1 Describe
and illustrate
the accounting
for capitalized
leases.
LO2 Describe
and illustrate
the accounting
for pensions.
LO3 Explain
the accounting
for special
purpose
entities
(SPEs).
Test Bank, Module 10
True/
False
Multiple
Choice
Exercises
Problems
Essay
Questions
1-6, 15
1-10
1-8
1-4
1, 2, 6
7-10, 15
11-21
9-16
5-8
3-6
11-15
22-25
17-20
9-10
7-8
© Cambridge Business Publishers, 2010
10-1
Module 10: Reporting and Analyzing Off-Balance-Sheet Financing
True/False
Topic: Operating leases
LO: 1
1. Operating leases appear as liabilities on the lessee’s balance sheet.
Answer: False
Rationale: Operating leases do not appear on the lessee’s balance sheet. An operating lease is
considered a form of off-balance sheet financing for the lessee. The company merely footnotes
their existence and key details in the annual report. Lease payments are reported as rent
expense on the lessee’s income statement.
Topic: Lease capitalization
LO: 1
2. Capitalizing leases have little effect on a company’s return on equity (ROE) ratio.
Answer: True
Rationale: ROE is largely unaffected since net income and stockholders’ equity are largely
unaffected. However, capitalizing leases does affect the components of ROE such as FLEV and
NOAT and RNOA.
Topic: Leases as a financing source
LO: 1
3. Leases can be a better financing vehicle because leases often require less equity investment
than traditional bank financing.
Answer: True
Rationale: Leases generally require less up-front investment than does bank financing.
Topic: Financial statements of non-capitalization
LO: 1
4. Failure to recognize lease assets and liabilities results in understated financial leverage and
understated net operating profit (NOPAT).
Answer: False
Rationale: Failure to recognize lease assets and liabilities does understate because liabilities are
lower the FLEV numerator. However, failure to recognize lease assets and liabilities usually
overstates NOPAT because the entire lease payment is deducted from NOPAT instead of just the
depreciation portion.
Topic: Expenses and cash flows relating to operating leases
LO: 1
5. Operating leases increase interest expense in the income statement, while decreasing net
cash flows in the cash flow statement, compared with capital leases.
Answer: False
Rationale: Operating leases record rent expense, rather than interest and depreciation. Further,
the lease payments (e.g., cash outflows) are the same, whether or not the lease is capitalized.
Cambridge Business Publishers, ©2010
10-2
Financial Accounting for MBAs, 4th Edition
Topic: Financial statement effects of capital leases
LO: 1
6. Using the capital lease method requires that both the lease asset and lease liability be
reported off the balance sheet.
Answer: False
Rationale: The capital lease method requires that both the lease asset and lease liability be
reported on the balance sheet. The leased asset is depreciated like any other long-term asset.
The lease liability is amortized like a note, with lease payments separated into interest and
principal repayment.
Topic: Actual vs. expected returns on pension investments
LO: 2
7. GAAP permits companies to choose to report pension income based either on actual
investment returns of pension investments or on expected returns. However, once a company
makes the choice, it cannot switch methods.
Answer: False
Rationale: GAAP allows companies to report pension income based on the expected return of
the pension investment. The aim is to stabilize long-term returns versus seeing annual or
quarterly swings due to the fluctuation in the market.
Topic: Reporting of pension investments and liabilities
LO: 2
8. Companies are required to report total pension assets and pension liabilities on their balance
sheets.
Answer: False
Rationale: Companies are required to report only the funded status (that is, the net pension asset
or liability) on their balance sheets.
Topic: Pension plans
LO: 2
9. The defined contribution plan and the defined benefit plan are the two general types of
pension plans offered by companies.
Answer: True
Rationale: For defined contribution plans, the company records the expense at the time the
liability is accrued. For defined benefit plans, the obligation is not satisfied until paid; companies
are only required to report the net pension liability on the balance sheet.
Topic: Service cost
LO: 2
10. The increase in pension obligation due to an employee working an additional year for the
employer will cause the net pension liability on the balance sheet to increase.
Answer: True
Rationale: The increase in the pension obligation arises from increases in service and interest
costs.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-3
Topic: Financing using VIEs
LO: 3
11. Financially savvy companies use VIEs as a last source of financing, due to the significantly
higher cost associated with VIEs compared to traditional debt instruments.
Answer: False
Rationale: VIEs can provide a lower cost financing alternative than borrowing from the traditional
debt markets. This is because the activities of the VIEs are limited, and the cash flows are well
secured. The risk to the lender is, therefore, reduced. Reduced risk requires less of a risk
premium than if the parent company borrows directly from the debt market.
Topic: Financial statement effects of using VIES as a financing source
LO: 3
12. By using VIEs, the sponsoring company realizes an increase in reported assets.
Answer: False
Rationale: One of the reasons for creating VIEs is to remove assets from the balance sheet,
together with their related liabilities.
Topic: Financial reporting of VIEs under FIN 46R
LO: 3
13. FIN 46R makes it less difficult for companies to maintain VIEs as an off-balance sheet
financing source.
Answer: False
Rationale: FIN 46R identifies conditions that will require VIEs be consolidated with the
sponsoring company’s balance sheet, making it more difficult for companies to keep special
purpose entities off of the balance sheet.
Topic: Off-balance sheet financing
LO: 3
14. Off-balance-sheet financing is not reported on the financial statements or the footnotes to
those statements.
Answer: False
Rationale: Although not reported on the face of the financial statements, GAAP requires detailed
footnote disclosures for off-balance-sheet financing.
Topic: Off-balance-sheet financing
LO: 1, 2, & 3
15. Off-balance-sheet financing is the financing of investing activities where both the financing
and investing accounts are not reported in the financial reports.
Answer: False
Rationale: The off-balance-sheet financing means that the assets and the liabilities are both not
reported on the balance sheet. However, these are reported in the footnotes to the financial
statements.
Cambridge Business Publishers, ©2010
10-4
Financial Accounting for MBAs, 4th Edition
Multiple Choice
Topic: Operating lease
LO: 1
1. This type of lease is considered a form of off-balance-sheet financing.
a. Capital lease
b. Special purpose lease
c. Operating lease
d. Variable interest lease
e. None of the above.
Answer: c
Rationale: Under operating leases, neither the leased asset nor the lease liability appear on the
lessee’s balance sheet. Therefore, operating leases are a form of off-balance-sheet financing.
Topic: Reporting of operating leases
LO: 1
2. How are operating leases reported in the lessee’s balance sheet?
a. As an asset that is depreciated, similar to the company’s other assets.
b. As either a short-term or long-term liability, depending on the length of the lease
c. At the present value of the future minimum lease payments.
d. Operating leases are not disclosed in the lessee’s balance sheet or annual report.
e. None of the above
Answer: e
Rationale: Operating leases are not reported on a company’s balance sheet. However,
operating leases are noted in the footnotes to the financial statements, which provide key details
regarding the company’s current and future lease payment obligations.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-5
Topic: Present value of operating lease payments – Numerical calculations required
LO: 1
3. Wickersham Global disclosed the following minimum rental commitments under noncancelable operating leases in its 2009 annual report:
Minimum operating
lease payments
2008
2009
2010
2011
2012
Thereafter
Total
Amount
(in millions)
$ 43
28
22
18
16
15
$142
What is the present value of these operating lease payments, assuming a 6% discount rate?
a. $121 million
b. $142 million
c. $134 million
d. $100 million
e. None of the above
Answer: a
Rationale: The following chart shows the calculation used to determine the present value of
operating leases at Wickersham Global (amounts are in millions):
Minimum operating
lease payments
2008
2009
2010
2011
2012
Thereafter
Total
Amount
(in millions)
$ 43
28
22
18
16
15
Present value
factor
0.94340
0.89000
0.83962
0.79209
0.74726
0.70496
Present value
(in millions)
$ 41
25
18
14
12
11
$121
Topic: Effects of not capitalizing operating leases
LO: 1
4. Failure to appropriately capitalize leased assets and liabilities results in a number of distortions
in the ROE disaggregation analysis. Which of the following is not a distortion?
a. Net operating asset turnover is overstated due to the non-reporting of lease assets.
b. Reported total expense is lower in the early years of a capital lease relative to an operating
lease, but is higher in later years.
c. Financial leverage is understated.
d. Total assets are understated.
e. All of the above are distortions.
Answer: b
Rationale: Reported expense is higher in the early years of a capital lease relative to an
operating lease, but is lower in later years. Capital leases report a depreciation (operating)
expense and an interest (nonoperating) expense; whereas, operating leases report rent
(operating) expenses only.
Cambridge Business Publishers, ©2010
10-6
Financial Accounting for MBAs, 4th Edition
Topic: Effect of lease capitalization – Numerical calculations required
LO: 1
5. Cabela’s Corp. disclosed the following lease information in its 2008 annual report (in millions).
What lease liability does Cabela’s report on its balance sheet?
2009
2010
2011
2012
2013
Thereafter
Total
Amount representing interest
Net present value of leases
Capital
Leases
$ 1,075
1,000
1,000
1,000
1,000
22,500
27,575
(13,910)
$ 13,665
Operating
Leases
$ 5,616
5,090
4,604
4,167
4,167
83,902
$107,546
a. $27,575
b. $13,910
c. $13,665
d. $107,546
e. None of the above
Answer: c
Rationale: The present value of capital leases only is included in the balance sheet.
Topic: Lease capitalization criteria
LO: 1
6. Which of the following is NOT a condition requiring the use of the capital lease reporting
method?
a. The lease, by its terms, automatically transfers ownership of the leased asset from the lessor
to the lessee at the termination of the lease.
b. The lease term is at least 75% of the economic useful life of the leased asset
c. The lease, by its terms, does not automatically transfer ownership of the leased asset from the
lessor to the lessee at the termination of the lease.
d. The lease provides that the lessee can purchase the leased asset for a nominal amount
(bargain purchase price) at the termination of the lease.
e. None of the above
Answer: c
Rationale: For using the operating lease reporting method, the lease, by its terms, does not
automatically transfer ownership of the leased asset from the lessor to the lessee at the
termination of the lease. Transfer of ownership of the leased asset from the lessor to the lessee
at the termination of the lease would be accounted for using the capitalized lease method.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-7
Topic: Financial statement impacts of capital and operating leases
LO: 1
7. GAAP identifies two different approaches in the reporting of leases by the lessee: capital and
operating. Which of the following best describes the effects of leasing on the financial statements
of the lessee?
a.
b.
c.
d.
e.
Lease Type
Operating
Capital
Capital
Operating
Operating
Assets
Increased
Increased
None
None
None
Liabilities
Increased
Increased
None
None
None
Expenses
Depreciation and Interest
Rent
Depreciation and Interest
Rent
Depreciation and Interest
Answer: d
Rationale: Operating leases have no balance sheet effect and incur rent expense on the income
statement, thus a and e are incorrect. Capital leases increase assets and liabilities and incur
depreciation and interest expense, thus b and c are incorrect.
Topic: Benefits of leasing
LO: 1
8. Which of the following is not a benefit of utilizing operating leases for the lessee?
a. NOPAT is lower.
b. Measures of leverage are improved.
c. Lease liability is not reported on the balance sheet.
d. Net operating asset turnover is higher.
e. None of the above
Answer: a
Rationale: NOPAT is lower with operating leases, as all of the rent payments are classified as an
operating expense. With capital leases, a portion of the payment is classified as nonoperating
interest expense. All other choices are benefits of operating leases for the lessee.
Cambridge Business Publishers, ©2010
10-8
Financial Accounting for MBAs, 4th Edition
Topic: Present value of operating lease payments – Numerical calculations required
LO: 1
9. Whole Foods Markets reports operating lease information in its 2008 annual report (in
thousands). You determine that a discount rate of 4.4% is appropriate for Whole Foods and
calculate the following. What economic liability is potentially left off Whole Foods’ balance sheet?
Year
2009
2010
2011
2012
2013
Thereafter
Minimum
operating lease
payments
$ 261,467
307,356
320,127
321,762
319,666
4,487,385
$6,017,763
Present value of
lease payments at
4.4%
$ 250,447
281,995
281,333
270,852
257,747
2,652,107
$3,994,481
a. $261,467 thousand
b. $2,652,107 thousand
c. $6,017,763 thousand
d. $3,994,481 thousand
e. None of the above
Answer: d
Rationale: The omitted liability is equal to the present value of the future minimum lease
payments - $3,994,481,000.
Topic: Present value of operating lease payments – Numerical calculations required
Note to instructor: this question requires students use a financial calculator, PV tables are not
possible for this question.
LO: 1
10. Cabela’s Corp disclosed the following minimum rental commitments under non-cancelable
operating leases in its 2008 annual report (in millions).
2009
2010
2011
2012
2013
Thereafter
Total
Operating
Leases
$ 5,616
5,090
4,604
4,167
4,167
83,902
$107,546
What is the approximate present value of the minimum lease payments? Assume a discount rate
of 5.9% and assume that payments after 2013 are made evenly over 20 years.
a. $5,616 million
b. $5,303 million
c. $107,546 million
d. $56,337 million
e. None of the above
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-9
Answer: d
Rationale: The present value of the future minimum lease payments is $56,337 million.
Operating
Leases
Discount Factor
I=5.9%
Present
Value
2009
$ 5,616
0.94429
$ 5,303
= 5,616 × 0.94429
2010
5,090
0.89168
4,539
= 5,090 × 0.89168
2011
4,604
0.84200
3,877
= 4,604 × 0.84200
2012
4,167
0.79509
3,313
= 4,167 × 0.79509
2013
4,167
0.75079
3,129
= 4,167 × 0.75079
Thereafter
83,902
11.5636
36,177
Total
$107,546
= 4,167 × 11.5636* × 0.75079
$56,337
*Discount factor for payments after 5 years: N=20, I=5.9%, PMT = 1, FV = 0 and PV = 11.5636.
Topic: Pension expense
LO: 2
11. What are the three basic components of pension expense?
a. Service cost, benefits paid, and expected return on plan assets
b. Service cost, benefits paid, and actual return on plan assets
c. Service cost, interest cost, and actual return on plan assets
d. Service cost, interest cost, and expected return on plan assets
e. None of the above
Answer: d
Rationale: Actual returns affect the pension assets but not the expense, benefits paid affect the
PBO and plan assets but not the expense.
Topic: Actuarial gains and losses
LO: 2
12. Actuarial gains and losses arise from:
a. Changes in pension plan details
b. Changes in mortality rates
c. Changes in discount rate
d. Changes in inflation rates
e. All of the above
Answer: e
Rationale: Actuarial gains and losses arise from changes in all the actuarial assumptions and the
pension plan details.
Cambridge Business Publishers, ©2010
10-10
Financial Accounting for MBAs, 4th Edition
Topic: Factors affecting pension obligation
LO: 2
13. Which one of the following is not a factor that changes a company’s pension obligation during
the year (check all that apply).
a. Interest cost
b. Expected return on plan assets
c. Benefits paid
d. Service cost
e. Contributions to the pension plan
Answer: b and e
Rationale: Options a, c, and d all affect the pension obligation to employees. Expected return on
plan assets affect the pension expense, and contributions to the pension plan affect the
investment account. Both of these do not affect the obligation to employees.
Topic: Pension expense computation – Numerical calculation required
LO: 2
14. Multinational Corp reported the following items in the 2008 pension footnote (in millions).
Service cost
Benefits paid to retirees
Interest cost
Actual returns on pension plan assets
Expected returns on pension plan assets
Amortization of deferred amounts
$506
145
490
700
770
$ 31
The company’s pension expense for the year is:
a. $327 million
b. $226 million
c. $296 million
d. $257 million
e. $151 million
Answer: d
Rationale: The pension expense for the period is computed as follows: service cost + interest
cost + amortization of deferred amounts – expected return on pension plan assets: $506 + $490
+ $31 - $770 = $257.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-11
Topic: Pension obligation computation – Numerical calculation required
LO: 2
15. Multinational Corp reported the following items in the 2008 pension footnote (in millions).
Service cost
Benefits paid to retirees
Interest cost
Actual returns on invested assets
Expected returns on invested assets
Actuarial loss
$506
145
490
700
770
$ 19
The increase in the company’s pension obligation during the year is:
a. $870 million
b. $851 million
c. $832 million
d. $100 million
e. $81 million
Answer: a
Rationale: The pension obligation increases during the period as follows: service cost + interest
cost + actuarial loss – benefits paid to retirees (in millions): $506 + $490 + $19 - $145 = $870.
Topic: Pension expense computation – Numerical calculations required
LO: 2
16. Systems Corp reported the following items in the 2008 pension footnote (in millions).
Service cost
Benefits paid to retirees
Interest cost
Actual returns on pension plan assets
Expected returns on pension plan assets
Amortization of deferred amounts
$ 362
570
453
681
659
50
The company’s pension expense for the year is:
a. $106 million
b. $206 million
c. $184 million
d. $ 84 million
e. None of the above
Answer: b
Rationale: The pension expense for the period is computed as follows: service cost + interest
cost + amortization of deferred amounts – expected return on pension plan assets (in millions):
$362 + $453 + $50 - $659 = $206
Cambridge Business Publishers, ©2010
10-12
Financial Accounting for MBAs, 4th Edition
Topic: Computing pension assets – Numerical calculations required
LO: 2
17: Systems Corp reported the following information in its 2008 annual report (in millions). What
were the pension plan assets at the end of the year?
Plans’ assets at fair value, January 1, 2008
Actual return on plans assets
Company contributions
Benefits paid
Expected return on plan assets
$6,553
681
415
570
659
a. $7,079 million
b. $7,057 million
c. $6,249 million
d. $6,227 million
e. None of the above
Answer: a
Rationale: plan assets at the end of the year = beginning balance + actual return + contributions –
benefits paid: $6,553 + $681 + $415 - $570 = $7,079 million
Topic: Understanding pension footnotes
LO: 2
18. Abbott Laboratories’ has a defined benefit retirement plan. The company’s 2008 annual
report includes the following excerpt about these plans (in millions):
Projected benefit obligations, January 1, 2008
Service cost — benefits earned during the year
Interest cost on projected benefit obligations
Actuarial losses (gains)
Benefits paid
Other, primarily foreign currency translation
Projected benefit obligations, December 31, 2008
$5,783
233
353
(278)
(241)
(309)
$5,541
Plans' assets at fair value, January 1, 2008
Actual return on plan assets
Company contributions
Benefits paid
Other, primarily foreign currency translation
Plan assets at fair value, December 31, 2008
$5,667
(1,568)
285
(241)
(146)
$3,997
What is the funded status of this plan?
a. The plan is overfunded by $1,544 million
b. The plan is underfunded by $1,544 million
c. The plan is underfunded by $5,541 million
d. The plan is overfunded by $3,997 million
e. None of the above.
Answer: b
Rationale: The plan is underfunded by $1,544: Liabilities $5,541 - Assets $3,997 = $1,544.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-13
Topic: Understanding pension footnotes
LO: 2
19. Abbott Laboratories’ has a defined benefit retirement plan. The company’s 2008 annual
report includes the following excerpt about these plans (in million). What was the pension-related
cash flow for Abbott Labs’ during 2008?
Plans' assets at fair value, January 1, 2008
Actual return on plans' assets
Company contributions
Benefits paid
Other, primarily foreign currency translation
Plans' assets at fair value, December 31, 2008
$5,667
(1,568)
285
(241)
(146)
$3,997
a. $241 million cash outflow
b. $285 million cash outflow
c. $285 million cash inflow
d. $1,568 million cash inflow
e. $1,568 million cash outflow
Answer: b
Rationale: During 2008 Abbott Labs made contributions totaling $285 million to the pension plan.
This is the only cash flow effect to the company.
Topic: Changes in pension assumptions
LO: 2
20. During 2008, United Parcel Service (UPS) increased its discount rate used to calculate
pension obligation from 6.47% to 6.75%. The effect on the company’s pension expense for the
year and pension obligation balance at year end is:
a. increase pension expense, decrease pension obligation
b. decrease pension expense, decrease pension obligation
c. decrease pension expense, increase pension obligation
d. increase pension expense, increase pension obligation
e. no effect on pension expense, decrease pension obligation
Answer: a
Rationale: While the higher discount rate decreases the PBO, the lower PBO is multiplied by a
higher rate when the company computes the interest component of pension expense. The rate
effect is higher than the discount effect, resulting in increased pension expense.
Cambridge Business Publishers, ©2010
10-14
Financial Accounting for MBAs, 4th Edition
Topic: Understanding defined contribution pensions
LO: 2
21. The following pension information was disclosed by Smart Corp. (in thousands):
The company sponsors defined contribution retirement plans covering substantially all of its
domestic employees and certain employees of its foreign subsidiaries. Contributions are
determined at the discretion of the Board of Directors. Aggregate amounts charged to operations
under the plans in 2008, 2007, and 2006 were $29,220, $25,025, and $20,246, respectively.
Which of the following is true with respect to Smart’s retirement plan?
a. Smart contributed $29,220 thousand to the plan in 2008.
b. Pension expense in 2008 was $29,220 thousand, comprising service cost and interest cost
less expected return on plan assets.
c. There is not sufficient information, above to determine whether the company’s plan is
overfunded or underfunded.
d. The Board of Directors can manage the pension expense by choosing pension assumptions
such as discount rate and other actuarial factors.
e. None of the above.
Answer: a.
Rationale: Because the plan is a defined contribution plan, the company expenses the
contribution when made. There are no accruals for future costs.
Topic: Understanding special purpose entities (SPEs)
LO: 3
22. Consolidation of SPE’s assets and liabilities is not required, if the SPE meets
a. Independence condition, i.e. SPE is independent of the sponsoring company.
b. Capitalization condition, i.e. SPE has sufficient capital to support its operations without any
assistance from the sponsoring company.
c. Independence or capitalization condition.
d. Independence and capitalization conditions.
e. None of the above.
Answer: d
Rationale: By meeting the independence and capitalization conditions, the SPE becomes QSPE;
therefore, its assets and liabilities are not consolidated.
Topic: FIN 46R
LO: 3
23. Merck Corp structures a lease-related special purpose entity (SPE) as a qualified SPE.
Which of the following would not be a motivation for structuring the entity as a QSPE?
a. To avoid a decrease in solvency.
b. To avoid a decrease in liquidity.
c. To avoid consolidating the SPE’s assets and liabilities.
d. To improve the company’s credit rating.
e. All of the above
Answer: e
Rationale: Both solvency and liquidity are improved with the QSPE treatment. Merck’s credit
rating might be adversely affected if the SPE’s assets and liabilities are kept on Merck’s balance
sheet.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-15
Topic: VIEs as a financing tool
LO: 3
24. Which of the following is not a common use of a VIE as financing tool?
a. Raising equity
b. Securitization of assets
c. Project financing
d. Financing of construction projects
e. None of the above
Answer: a
Rationale: Typically, VIEs are employed for the securitization of assets and the financing of
various projects. They do not, however, provide a means for raising equity capital.
Topic: Use of VIEs as a financing tool
LO: 3
25. Which of the following is not a reason for the popularity of VIEs?
a. Improve financial ratios
b. Provide an alternative lower cost of financing
c. Remove assets and liability from balance sheet
d. Reduce lease liability
e. All of the above are reasons for the popularity of VIEs
Answer: e
Rationale: Variable interest entities are financial tools that are often used to remove the assets
and liabilities from the balance sheet while still obtaining the benefits of those assets. Also, the
resulting variable interest entities have restricted activities and are, therefore, perceived by
lenders as being less risky. As a result, setting up these variable interest entities provide lower
cost financing of the assets for the sponsoring company.
Cambridge Business Publishers, ©2010
10-16
Financial Accounting for MBAs, 4th Edition
Exercises
Topic: Operating leases as assets
LO: 1
1. Among the assets reported on its 2008 balance sheet, IBM Corp. includes operating leases
totaling $24,667 million. These leases represent payments that IBM anticipates receiving in the
future from customers. Explain how these operating leases arose for IBM Corp. Why does IBM
include operating leases on the balance sheet?
Answer:
a) Under an operating lease IBM’s customers pay rent for the leased asset. At the end of the
lease, the assets revert to the lessor (IBM), the lessee company does not enjoy the benefits or
owning nor the related risks.
b) IBM is the lessor on these operating leases and NOT the lessee. IBM’s customers are leasing
equipment from IBM and the benefits and risks of ownership have not transferred to IBM’s
customers. Thus, the customers does not include the assets on their own balance sheets (does
not capitalize the leased equipment) the assets stay on IBM’s balance sheet.
Topic: Analyzing lease footnote
LO: 1
2. The following is an excerpt from the Union Pacific 2008 annual report:
Debt
Equity
Net present value of operating leases
2008
$ 8,927
15,447
$ 3,966
2007
$ 7,682
15,585
$ 4,128
a) Calculate the debt to equity ratio for Union Pacific for 2008 and 2007.
b) Does Union Pacific include the net present value of operating leases in the debt reported on
the balance sheet? Why or why not?
c) Recalculate the debt to equity ratio for Union Pacific for 2008 and 2007 under the assumption
that leases were capitalized. Would capitalizing these leases significantly affect the company’s
debt to equity ratio? Is there a concern about the company’s solvency?
Answer:
a) 2008 Debt to equity = $8,927 / $15,447 = 0.578
2007 Debt to equity = $7,682 / $15,585 = 0.493
b) The debt that Union Pacific reports does not include the net present value of operating leases
because operating leases are not carried on the balance sheet.
c) 2008 Pro forma Debt to equity = ($8,927 + $3,966) / $15,447 = 0.835
2007 Debt to equity = ($7,682 + $4,128) / $15,585 = 0.758
The increases in the company’s debt to equity ratio are significant – for example in 2008,
capitalizing the leases would have increased the ratio by 44% (0.835 / 0.578 = 1.445). However,
the ratio is low even with the leases so there is no cause for concern about the company’s
solvency.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-17
Topic: Analyzing lease footnote
LO: 1
NOTE TO INSTRUCTOR: This exercise requires students use the IRR function of a financial
calculator.
3. On its 2008 balance sheet, First Boston Investors Inc. reports minimum capital lease payments
of $350,000 to be paid as follows: 2009 -- $100 thousand, 2010 -- $140 thousand and 2011 -$110 thousand. The company also discloses a net present value of these payments of $301
thousand.
a. How is First Boston’s balance sheet affected by these capital leases?
b. What is the interest rate implicit in this net present value?
Answer:
a. First Boston includes the net present value of capital lease payments ($301,000) as a liability.
Part of this lease liability is classified as a long-term liability and part is included in current
liabilities. The net book value of the related assets is included in assets on the balance sheet.
b. Using a financial calculator to determine the implicit interest rate, the inputs are as follows: CF0
= -301, CF1 = 100, CF2 = 140 CF3 = 110, calculate IRR = 7.8083%.
Topic: Analyzing lease footnote
LO: 1
NOTE TO INSTRUCTOR: This exercise requires that students are able to use the IRR function of
a financial calculator.
4. Sequester Instruments Corp. 2009 annual report discloses the following lease payments:
Fiscal year
2009
2010
2011
2012
2013
Net minimum lease payments
Less amount representing interest
Present value of lease obligations
Capital
leases
$ 8,000
0
0
0
0
8,000
1,000
$ 7,000
Operating
leases
$ 2,105,000
478,000
323,000
82,000
26,000
$3,014,000
a. How is the balance sheet affected by the capital leases?
b. What is the interest rate implicit in this net present value?
Answer:
a. Sequester includes the net present value of capital lease payments ($7,000) as a liability. Part
of this lease liability is classified as a long-term liability and part is included in current liabilities.
The net book value of the related assets is included in long-term assets on the balance sheet.
b. Using a financial calculator to determine the implicit interest rate, the inputs are as follows: CF0
= -7, CF1 = 8 calculate IRR = 14.2857%.
Cambridge Business Publishers, ©2010
10-18
Financial Accounting for MBAs, 4th Edition
Topic: Analyzing lease footnote
LO: 1
Note to instructor: this exercise requires students use a financial calculator. The interest rate is
14% and thus, the tables in the textbook will not be sufficient.
5. Mylenta Partners LLP, reports the following operating lease payments in its 2009 annual
report. Calculate the present value of operating lease payments using a discount rate of 14%.
Fiscal year
2009
2010
2011
2012
2013
Net minimum lease payments
Operating
leases
$ 1,659,000
1,478,000
1,323,000
1,382,000
826,000
$ 6,668,000
Answer:
Fiscal year
2009
2010
2011
2012
2013
Total
Operating Lease
Payment
1,659,000
1,478,000
1,323,000
1,382,000
826,000
Test Bank, Module 10
Discount Factor
(i=0.14)
0.87719
0.76947
0.67497
0.59208
0.51937
Present Value
1,455,263
1,137,273
892,987
818,254
428,999
4,732,776
© Cambridge Business Publishers, 2010
10-19
Topic: Analyzing lease footnote
LO: 1
6. AMR Corp. disclosed the following lease information in its 2008 annual report related to its
leasing activities (in millions).
2009
2010
2011
2012
2013
Thereafter
Total
Amount representing interest
Net present value of leases
Capital
Leases
$ 182
143
146
97
83
476
1,127
(438)
$ 689
Operating
Leases
$ 998
932
922
739
652
4,944
$9,187
a. What did AMR report on its 2008 balance sheet related to leases?
b. Calculate the lease-related liabilities that are potentially missing from AMR’s 2008 balance
sheet. Assume a discount rate of 11% and assume that the payments made in 2014 and beyond
are made in 8 equal installments.
Answer:
a. AMR would recognize only the capitalized leases on its 2008 balance sheet. The total amount
of lease liabilities that would appear is $689 million. We cannot determine the amount of leased
assets on the balance sheet from the footnote. But the net book value of these assets would be
included in AMR’s balance sheet.
b.
Operating Lease Discount Factor
Year
Payment
(i=0.11)
Present Value
2009
998
0.90090
899
2010
932
0.81162
756
2011
922
0.73119
674
2012
739
0.65873
487
2013
652
0.59345
387
Thereafter
4,944
5.14612*
1,991**
5,194
* Present value of annuity factor for 8 years @ 11%
** $652 × 5.14612 × 0.59345 = $1,991
Cambridge Business Publishers, ©2010
10-20
Financial Accounting for MBAs, 4th Edition
Topic: Analyzing lease footnote
LO: 1
Note to instructor: this exercise requires students use a financial calculator. The interest rate is
6.3% and thus, the tables in the textbook will not be sufficient.
7. Hewlett Packard reports the following operating lease payments in its 2008 annual report.
Year
Minimum lease payment
Less Sub-lease revenue
Net lease payment
2009
1,017
(46)
971
2010
807
(39)
768
2011
550
(27)
523
2012
391
(22)
369
2013
265
(17)
248
Thereafter
724
(34)
690
a. What did HP report on its 2008 balance sheet related to these operating leases?
b. Calculate the lease-related liabilities that are potentially missing from HP’s 2008 balance sheet.
Assume a discount rate of 6.3%. Further assume that payments made after 2013 are made in 3
equal installments.
Answer:
a. HP would not recognize any of these leases on its 2008 balance sheet because they are
operating leases. The company provides information about the leases in a footnote to the annual
report.
b.
Operating Lease Discount Factor
Year
Payment
(i=0.063)
Present Value
2009
971
0.94073
913
2010
768
0.88498
680
2011
523
0.83253
435
2012
369
0.78319
289
2013
248
0.73677
183
Thereafter
690
2.65824*
486**
2,986
* Present value of annuity factor for 3 years @ 6.3%
** $248 × 2.65824 × 0.73677 = $486
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-21
Topic: Analysis of leasing footnote
LO: 1
8. American Eagle Outfitters reported the following operating lease information in a footnote to
the 2008 annual report (in thousands):
Fiscal Years:
2009
2010
2011
2012
2013
Thereafter
Total
Future Minimum
Lease Payments
$234,095
229,702
212,901
195,283
178,133
720,253
$1,770,367
a) Calculate the liabilities potentially left off the balance sheet. Assume that the company’s implicit
discount rate on leases is 5%. Further assume that the lease payments made after 2013 are
made in four (4) equal installments.
b) American Eagle Outfitters’ balance sheet reveals that the company has $1,963,676 thousand
total assets and $554,645 thousand total liabilities. What proportion of assets and liabilities are on
balance sheet versus off balance sheet?
Answer:
a)
Year
Operating Lease
Payment
Discount Factor
(i=0.05)
Present Value
2009
234,095
0.95238
222,947
2010
229,702
0.90703
208,347
2011
212,901
0.86384
183,912
2012
195,283
0.82270
160,659
2013
178,133
0.78353
139,573
720,253
3.54595*
Thereafter
494,917**
1,410,355
* Present value of annuity factor for 4 years @ 5%
** $178,133 × 3.54595 × 0.78353 = $494,917
b)
Assets Reported on Balance Sheet
PV of Operating Leases
Total pro forma assets
$1,963,676
1,410,355
$3,374,031
Liabilities Reported on Balance Sheet
PV of Operating Leases
Total pro forma liabilities
$554,645
1,410,355
$1,965,000
Cambridge Business Publishers, ©2010
10-22
% of Total
58.20%
41.80%
28.23%
71.77%
Financial Accounting for MBAs, 4th Edition
Topic: Interpreting pension footnote
LO: 2
9. International Paper Inc’s 2008 annual report disclosed the following pension information:
Discount rate
Expected long-term return
on plan assets
Rate of compensation
increase
2008
6.20%
2007
5.75%
2006
5.50%
2005
5.75%
8.50%
8.50%
8.50%
8.50%
3.75%
3.75%
3.25%
3.25%
a. What effect does the discount rate of 6.20% have on the company’s pension liability?
b. How does the change in the discount rate from 5.75% in 2007 to 6.20% in 2008 have on the
company’s pension liability?
c. What effect does the expected long-term return on plan assets of 8.50% have on the
company’s pension liability? On the pension assets?
Answer:
a. The discount rate is the rate at which future payments to retirees are discounted to determine
the present value of the pension obligation.
b. Because the pension obligation is the present value of expected future pension payments, an
increase in the discount rate decreases the present value (PBO) reported on the balance sheet.
c. The expected long-term return on plan assets is used to calculate expected earnings on plan
assets during the year. This amount reduces pension expense for the year. The amount does not
affect the PBO reported on the balance sheet except through deferred amounts that are
amortized in future years.
Topic: Interpreting pension footnote
LO: 2
10. International Paper Inc’s 2008 annual report disclosed the following pension information:
Benefit obligations and fair values of plan assets as of December 31, 2008, for International
Paper’s pension and postretirement plans are as follows:
In millions
U.S. qualified pension
Benefit
Fair Value of
Obligation
Plan Assets
$8,960
$6,079
U.S. nonqualified pension
315
–
U.S. postretirement
596
–
Non-U.S. pension
168
115
19
–
Non-U.S. postretirement
a) What is the funded status of the company’s U.S. pension plans? What proportion of total
pension obligation is funded?
b) What proportion of total postretirement obligation is funded? Briefly explain why this is so.
Answer:
a) The pension plan is underfunded by $3,196 million in 2008: Liability ($8,960 + $315) – Assets
($6,079) = $3,196.
b) Postretirement plan are not funded at all. This is typical for U.S. companies because the law
does not require that such plans be funded. Only retirement plans must be funded by law.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-23
Topic: Interpreting pension footnote
LO: 2
11. International Paper Inc’s 2008 annual report disclosed the following pension information:
Actual rates of return earned on U.S. pension plan assets for each of the last 10 years were:
Year
Return
Year
Return
2008
2007
-23.60%
9.60%
2003
2002
26.00%
-6.70%
2006
14.90%
2001
-2.40%
2005
11.70%
2000
-1.40%
2004
14.10%
1999
21.40%
The footnote also reports that International Paper’s expected long-term rate of return on plan
assets is 8.50%.
a) Calculate the actual (long-term) rate of return over the past 10 years.
b) Does the company’s expected rate of return seem reasonable? Why or why not?
Answer:
a) The actual (long-term) rate of return over the past 10 years has been 6.36%. (-23.60% + 9.6%
+ 14.9% + 11.7% + 14.1% + 26.0% – 6.7% – 2.4% –1.4% + 21.4%) / 10 = 6.36%
b) The company’s expected rate of return is high. This is not reasonable because the company is
being more optimistic.
Cambridge Business Publishers, ©2010
10-24
Financial Accounting for MBAs, 4th Edition
Topic: Accounting for other post-retirement obligations
LO: 2
12. International Paper Inc’s 2008 annual report disclosed the following pension information:
In millions
Change in projected benefit obligation:
Benefit obligation, January 1
Service cost
Interest cost
Participants’ contributions
Actuarial (gain) loss
Benefits paid
Less: Federal subsidy
Acquisitions / divestitures
Curtailment
Special termination benefits
Benefit obligation, December 31
Change in plan assets:
Fair value of plan assets, January 1
Company contributions
Participants’ contributions
Benefits paid
Fair value of plan assets, December 31
2008
2007
$632
3
34
48
(28)
(113)
11
7
1
1
$596
$624
1
34
48
40
(134)
11
5
–
3
$632
–
65
48
(113)
$ –
$
$
–
86
48
(134)
$ –
a. How much total benefits did former employees receive during the year?
b. How much did the company pay to former employees for post retirement benefits during the
year?
c. What proportion of the retirement obligation is funded? Explain.
Answer:
a. Former employees received $113 million during the year.
b. The company did not directly pay former employees. The company made contributions of $65
million to the plan during the year and all of this was paid out to former employees.
c. This postretirement plan is not funded at all. This is typical for U.S. companies because the law
does not require that such plans be funded. Only retirement plans must be funded by law.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-25
Topic: Interpreting pension footnote
LO: 2
13. Abbott Laboratories reports the following information in its 2008 annual report (in millions):
Total benefit payments expected to be paid to participants, which includes payments funded from
company assets as well as paid from the plans, are as follows: ($ in millions )
2009
2010
2011
2012
2013
2014 to 2018
Defined
Benefit Plans
237
245
253
266
277
1,706
Medical and
Dental Plans
80
85
90
94
97
557
Abbott Labs reports $6,994 million of net cash inflows from operating activities and $1,288 million
in capital expenditures for 2008. How does this information, combined with the expected benefit
payments above impact our evaluation of Abbott Lab’s financial condition?
Answer:
Abbott Labs’ operating cash flow is more than five times its capital expenditures. Its free cash
flow of $5.7 billion ($6.99 billion - $1.29 billion) is significantly greater than the $1.7 billion of
expected benefit payments to retirees. Abbott Lab’s will likely be able to easily make the pension
contributions in the future.
Topic: Interpreting pension footnote
LO: 2
14. PACCAR reports the following information in its 2008 annual report (in millions):
Projected benefit obligation
Pension plan assets
2008
$1,196.4
913.8
2007
$1,201.0
1,312.5
a. Calculate the funded status of the pension plan in 2008 and compare it to the funded status in
2007. Are these amounts significant?
b. How does this funded status affect the company’s balance sheet?
Answer:
a. 2008 funded status: $282.6 underfunded 2007 funded status: $111.5 overfunded. The 2008
underfunded amount is significant because it represent almost 31% ($282.6 / $913.8) of the plan
assets.
b. In 2008, the underfunded amount will be included as a liability. In 2007, the overfunded amount
will be included with assets.
Cambridge Business Publishers, ©2010
10-26
Financial Accounting for MBAs, 4th Edition
Topic: Interpreting pension footnote
LO: 2
15. General Motors reports the following information in its 2008 annual report (in millions):
Change in benefit obligations
Benefit obligation at January 1, 2008
SFAS No. 158 measurement date adjustment
Service cost
Interest cost
Plan participants’ contributions
Amendments
Actuarial (gains) losses
Benefits paid
Medicare Part D receipts
Exchange rate movements
Delphi obligation transfer
Curtailments, settlements, and other
Benefit obligation at December 31, 2008
Change in plan assets
Fair value of plan assets at January 1, 2008
SFAS No. 158 measurement date adjustment
Actual return on plan assets
Employer contributions
Plan participants’ contributions
Benefits paid
Exchange rate movements
Delphi plan asset transfer
Other
Fair value of plan assets at December 31, 2008
$85,277
—
527
5,493
—
1,218
5,684
(8,862)
—
—
2,753
6,045
$98,135
$104,070
—
(11,350)
90
—
(8,862)
—
572
25
$84,545
a. What is the funded status of the pension plan in 2008?
b.How does this funded status affect the company’s balance sheet?
Answer:
a. 2008 funded status: $13,590 million underfunded GM’s pension plan is $85 billion, an
underfunding of $13.6 billion is very significant.
b. In 2008, the underfunded amount will be included as a liability.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-27
Topic: Interpreting pension footnote
LO: 2
16. General Motors reports the following information in its 2008 annual report (in millions):
Change in benefit obligations
Benefit obligation at January 1, 2008
SFAS No. 158 measurement date adjustment
Service cost
Interest cost
Plan participants’ contributions
Amendments
Actuarial (gains) losses
Benefits paid
Medicare Part D receipts
Exchange rate movements
Delphi obligation transfer
Curtailments, settlements, and other
Benefit obligation at December 31, 2008
Change in plan assets
Fair value of plan assets at January 1, 2008
SFAS No. 158 measurement date adjustment
Actual return on plan assets
Employer contributions
Plan participants’ contributions
Benefits paid
Exchange rate movements
Delphi plan asset transfer
Other
Fair value of plan assets at December 31, 2008
$85,277
0
527
5,493
0
1,218
5,684
(8,862)
0
0
2,753
6,045
$98,135
$104,070
0
(11,350)
90
0
(8,862)
0
572
25
$84,545
a. How much retirement benefits did former employees receive during the year?
b. How much did the company pay to former employees for retirement benefits during the year?
c. What rate did GM’s pension assets actually earn during 2008?
d. What average rate did GM use to calculate interest cost during 2008?
Answer:
a. Former employees received $8,862 million during the year.
b. The company did not directly pay former employees. The company made contributions of $90
million to the plan during the year and then plan assets were used to pay former employees.
c. -$11,350 / (($104,070 + $84,545) / 2) = -12.04%. The plan assets lost money during 2008.
d. $5,493 / (($85,277 + $98,135) / 2) = 5.99%.
Cambridge Business Publishers, ©2010
10-28
Financial Accounting for MBAs, 4th Edition
Topic: Analysis of VIE disclosure
LO: 3
17. From ConocoPhillips Inc.
Note 7 — Variable Interest Entities (VIEs)
In December 2006, we terminated the lease of certain refining assets which we consolidated due
to our designation as the primary beneficiary of the lease entity. As part of the termination, we
exercised a purchase option of the assets totaling $111 million and retired the related debt
obligations of $104 million 5.847% Notes due 2006.
a. Explain in your own words, the transaction described in the footnote.
b. Why did Conoco Phillips’ designation as primary beneficiary of the lease entity cause the firm
to terminate the lease?
Answer:
a. The leased assets were not owned by ConocoPhillips and so they were not recorded on
ConocoPhillps’ books. With consolidation the company would have had to add the leased assets
and the related debt (notes due 2006) to the balance sheet. The company cancelled the lease
and purchased the assets outright and added them to the balance sheet. The company repaid the
associated notes so that they were no longer on the balance sheet.
b. FIN46(R) required primary beneficiaries to consolidate their VIEs. ConocoPhillips determined
that it was the primary beneficiary of the “lease entity” in control of the leases. Accordingly,
consolidation was required in 2006. Apparently, the company cancelled the lease to avoid
consolidating all of the assets and liabilities of the trust.
Topic: Use of independent contractors for off-balance sheet financing
LO: 3
18. Nike provides the following footnote in its 2008 annual report:
Manufacturing
Almost all of NIKE brand apparel production was manufactured outside of the United States by
independent contract manufacturers located in 34 countries. Most of this apparel production
occurred in China, Thailand, Indonesia, Malaysia, Vietnam, Turkey, Sri Lanka, Honduras, Mexico,
Taiwan, Israel, Cambodia, India and Bangladesh. Our largest single apparel factory accounted for
approximately 8 percent of total fiscal 2008 apparel production.
a. What impact do the independent contractors have on Nike’s financial statements?
b. What is the benefit of using the independent contractors?
Answer:
a. By utilizing independent contractors, Nike can successfully (and legally) maintain all
manufacturing assets and liabilities off the company’s consolidated statements.
b. As a result of the independent contractors, Nike’s financial statements appear leaner than is
really the case. Specifically, consolidated asset turnover, leverage and equity are all lower than
they would have been had the company reported the manufacturing assets and related liabilities
on its balance sheet.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-29
Topic: Analyzing SPE Footnotes
LO: 3
19. Ford Motors Corp. provides the following notes in its 2008 annual report related to the
securitization of loan receivables.
Securitization. Ford Credit securitizes finance receivables and net investment in operating leases
through a variety of programs, utilizing amortizing, variable funding and revolving structures. … In
a securitization transaction, the securitized assets are generally held by a bankruptcy-remote
special purpose entity ("SPE") in order to isolate the securitized assets from the claims of Ford
Credit's creditors and to insure that the cash flows on the securitized assets are available for the
benefit of securitization investors.
a. Explain the benefit Ford is seeking when creating these Variable Interest Entities?
b. What would be the effect on Ford’s balance sheet is its SPEs are required to be consolidated?
Answer:
a. It is likely that Ford is using these financial instruments to transfer assets and liabilities from its
balance sheet. In addition, Ford uses these SPEs as a cost-effective source of funding. Since
SPEs are set up as independent, bankrupt-resistant entities, these entities are usually viewed
favorably by debt providers. As a result, these entities can issue debt at a lower cost. Ford
receives payment for its receivables and is not required to disclose the assets and corresponding
liabilities on its balance sheet so long as the SPE is not consolidated.
b. Ford would have to add the SPE assets and related liabilities to its balance sheet. Its asset
turnover and financial leverage ratios would both suffer.
Topic: Analyzing SPE disclosure
LO: 3
20. AM Corp. provides the following notes in its 2008 annual report related to the securitization of
loan receivables.
December 31
2008
2007
Retail Loans
15,653
5,421
Retail Mortgage Loans
25,154
18,945
Total Consumer Loans
40,807
24,366
Commercial loans
98,142
86,514
Commercial Mortgage Loans
333,786
305,846
Total Commercial Loans
431,928
392,360
Total loan portfolio
472,735
416,726
-159,653
-178,111
313,082
238,615
Securitized finance receivables and loans
Total finance receivables and loans
a. How much is AM Corp’s total loan portfolio in 2008?
b. What is the balance of loans reported on the company’s balance sheet?
c. What activity accounts for the difference between the two?
Answer:
a. Total loans portfolio is $472,735 in 2008.
b. Only $313,082 is reported on the balance sheet in 2008.
c. A VIE for the Securitized finance receivables and loans purchases these loans and therefore
takes them off the balance sheet. This amounted to $159,653 in 2008.
Cambridge Business Publishers, ©2010
10-30
Financial Accounting for MBAs, 4th Edition
Problems
Topic: Capitalizing operating leases
LO: 1
1. American Eagle Outfitters includes the following in its fiscal 2008 annual report (in thousands):
Fiscal
Years:
2009
2010
2011
2012
2013
Thereafter
Total
Future Minimum
Lease Payments
$234,095
229,702
212,901
195,283
178,133
720,253
$1,770,367
Required:
a. Calculate the present value of operating lease payments using a discount rate of 7%.
b. Assume that the leased equipment has a useful life of 8 years and no salvage value. Estimate
the effect on net operating profit before tax of capitalizing these leases. Assume that rental
expense in 2008 is the same as 2009 lease payments.
c. How would ROE and the other financial ratios from the ROE decomposition be affected if the
company capitalized these operating leases?
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-31
Answer:
a.
Year
Operating Lease
Payment
Discount Factor
(i=0.07)
Present Value
2009
234,095
0.93458
218,780
2010
229,702
0.87344
200,631
2011
212,901
0.81630
173,791
2012
195,283
0.76290
148,980
2013
178,133
0.71299
127,006
720,253
3.38721*
Thereafter
Remaining life
4 years***
430,200**
1,299,388
* Present value of annuity factor for 4 years @ 7%
**
$178,133 × 3.38721 × 0.71299 = $430,200
***
$720,253 ÷ $178,133 / year = 4.04334 years, rounded to 4 years
(Alternate solution using present value formula or financial calculator:
Present value of annuity factor for 4.04334 years @ 7% = 3.41913
$178,133 × 3.41913 × 0.71299 = $434,254. Total present value = $1,303,442)
b. Capitalizing the company’s operating leases would increase net operating profit before tax, by
$71,671. In particular, the company would make the following adjustments to its income
statement:
1. Remove rent expense of $234,095
2. Add depreciation expense of $1,299,388 / 8 years = $162,424.
(note: interest expense of $1,299,388 × 7% = $90,957 would be recognized as a nonoperating
expense)
c. Failure to report the lease assets and lease obligation on-balance-sheet overstates asset
turnover (NOAT) because significant assets are omitted from the balance sheet; and understates
financial leverage because significant liabilities are omitted. The net operating profit margin
(NOPM) will be understated because rent expense is greater than the depreciation expense that
would have been recognized had the leases been capitalized. In sum, if these leases are
capitalized: NOAT will be lower, NOPM will be higher, and leverage will be higher. Net income
would be lower if the leases are capitalized because the sum of depreciation expense ($162,424)
and interest expense ($90,957) is $253,381 which is greater than the rent expense of $234,095.
Thus, ROE would be slightly lower if the company capitalized the leases.
Cambridge Business Publishers, ©2010
10-32
Financial Accounting for MBAs, 4th Edition
Topic: Analyzing lease footnote
LO: 1
2. The following is an excerpt from the Union Pacific 2008 annual report:
The following tables identify material obligations and commitments as of December 31, 2008:
Payments Due by December 31,
After
Contractual Obligations
Total
2009
2010
2011
2012
2013
2013
Other
Millions of Dollars
Debt
$12,627
$1,056
$807
$857
$1,070
$926
$7,911
-
Operating leases
5,909
657
614
580
465
389
3,204
-
Capital lease obligations
1,898
188
168
178
122
152
1,090
-
Purchase obligations
3,323
713
384
344
224
239
1,387
$32
466
42
43
45
45
47
244
-
26
7
-
-
-
-
-
19
$24,249
$2,663
$2,016
$2,004
$1,926
$1,753
$13,836
$51
Other post retirement benefits
Income tax contingencies
Total contractual obligations
Required:
a. Calculate the present value of operating lease payments using a discount rate of 7%.
b. Union Pacific reported net operating assets (NOA) of $24,702 million in 2008. If the operating
leases were capitalized, what would net operating assets have been?
c. Assume that the leased equipment has a useful life of 12 years and no salvage value. Estimate
the effect on net operating profit before tax of capitalizing these leases. Assume that rental
expense in 2008 is the same as 2009 lease payments.
d. Union Pacific reported net operating profit after tax (NOPAT) of $2,670 million and net
operating assets (NOA) of $24,702 million for 2008. Calculate RNOA for 2008. Recalculate
RNOA under the assumption that the company capitalized its operating leases. Is the difference
significant?
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-33
Answer: a)
Year
2009
Operating
Lease Payment
Discount Factor
(i=0.07)
Present Value
657
0.93458
614
2010
614
0.87344
536
2011
580
0.81630
473
2012
465
0.76290
355
2013
389
0.71299
277
3,204
5.97130*
1,656**
Thereafter
Remaining life
8 years***
3,911
* Present value of annuity factor for 8 years @ 7% = 5.97130
** $389 × 5.97130 × 0.71299 = $1,610
*** $3,204 ÷ $389 / year = 8.2365 years, rounded to 8 years
(Alternate solution using present value formula or financial calculator:
Present value of annuity factor for 8.2365 years @ 7% = 6.10328
$389 × 6.10328 × 0.71299 = $1,693. Total present value = $3,948)
b)
NOA
Total before
capitalization
24,702
Capitalization
effect
3,911
Total after
capitalization
28,613
This is a significant increase in total assets and liabilities.
c) Capitalizing the company’s operating leases would increase net operating profit before tax, by
$331. In particular, the company would make the following adjustments to its income statement:
1. Remove rent expense of $657
2. Add depreciation expense of $3,911 / 12 years = $326.
(note: interest expense of $3,911 × 7% = $274 would be recognized as a nonoperating expense)
d)
Total before
Capitalization
Total after
capitalization
effect
capitalization
NOPAT
2,670
331
3,001
NOA
24,702
3,911
28,613
RNOA
10.81%
10.49%
The difference is not significant – RNOA is lower because the denominator increased by slightly
more (proportionately) than the numerator.
Cambridge Business Publishers, ©2010
10-34
Financial Accounting for MBAs, 4th Edition
Topic: Analysis of leasing footnote
LO: 1
3. Federated Investors Inc. includes the following in its 2006 annual report:
The following is a schedule by year of future minimum payments required under the capital
leases and future minimum rental payments required under the operating leases that have initial
or remaining noncancelable lease terms in excess of one year as of December 31, 2008:
in thousands
2009
2010
2011
2012
2013
2014 and thereafter
Total minimum lease payments
Less executory costs and imputed interest costs
Present value of minimum lease payments
Capital
Leases
$86
0
0
0
0
0
86
(9)
$77
Operating
Leases
$10,246
12,077
10,938
10,531
10,408
19,570
$73,770
Required:
a) Calculate the present value of operating lease payments using a discount rate of 7%.
b) For 2008, the company reported total assets of $846,610 and total liabilities of $422,040. What
would total assets and total liabilities have been if the company had capitalized these leases.
Does capitalizing make a significant difference on the company’s balance sheet?
c) Assume that the leased equipment has a useful life of 8 years and no salvage value. Estimate
the effect on net operating profit before tax of capitalizing these leases
d) Explain how ROE, FLEV, RNOA, and NOAT would be affected if these leases are capitalized.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-35
Answer: a)
Year
2009
2010
2011
2012
2013
Thereafter
Remaining life
Operating
Lease
Payment
10,246
12,077
10,938
10,531
10,408
19,570
2 years***
Discount
Factor
(i=0.07)
0.93458
0.87344
0.81630
0.76290
0.71299
1.80802*
Present Value
9,576
10,549
8,929
8,034
7,421
13,417**
57,926
* Present value of annuity factor for 2 years @ 7% = 1.80802
**
$10,408 × 1.80802 × 0.71299 = $13,417
***
$19,570 ÷ $10,408 / year = 1.88028 years, rounded to 2 years
(Alternate solution using present value formula or financial calculator:
Present value of annuity factor for 1.88028 years @ 7% = 1.70654
$10,408 × 1.70654 × 0.71299 = $12,664. Total present value = $57,173)
b)
Assets
Liabilities
Total before
capitalization
846,610
422,040
Capitalized
amount
57,926
57,926
Total after
capitalization
904,536
479,966
Percentage
increase
6.84%
13.73%
This is a significant increase in total assets and liabilities. The effect on liabilities is much greater
because the company is not very leveraged.
c) Capitalization of the company’s operating leases would increase net operating profit before tax
by $3,005. In particular, the company would make the following adjustments to its income
statement:
1. Remove rent expense of $10,246
2. Add depreciation expense of $57,926 / 8 years = $7,241.
(note: interest expense of $57,926 × 7% = $4,055 would be recognized as a nonoperating
expense)
d) Failure to report the lease assets and lease obligation on-balance-sheet overstates asset
turnover (NOAT) because significant assets are omitted from the balance sheet; and understates
financial leverage because significant liabilities are omitted. The net operating profit margin
(NOPM) will be understated by the use of operating leases, as rent expense is greater than the
depreciation expense that would have been recognized had the leases been capitalized. In sum,
if these leases are capitalized: NOAT will be lower, NOPM will be higher and leverage will be
higher. Net income would be lower if the leases are capitalized because the sum of depreciation
expense ($7,241) and interest expense ($4,055) is $11,296 which is more than the rent expense
of $10,246. Thus, ROE would be lower if the company capitalized the leases.
Cambridge Business Publishers, ©2010
10-36
Financial Accounting for MBAs, 4th Edition
Topic: Analysis of leasing footnote
LO: 1
4. Meade Instruments Corp. reports the following in its 2007 annual report:
Capital
Operating
Fiscal year
leases
leases
2009
$ 8,000
$ 1,659,000
2010
0
1,478,000
2011
0
1,323,000
2012
0
1,382,000
2013
0
826,000
Net minimum lease payments
8,000
$ 6,668,000
Less amount representing interest
1,000
Present value of lease obligations
$ 7,000
Required:
a) Calculate the present value of operating lease payments using a discount rate of 5%.
b) Meade Instruments’ balance sheet reports total assets of $45,792,000 and total liabilities of
$21,196,000. Calculate the company’s total liabilities to equity ratio with and without the operating
leases being capitalized.
c) Assume that the leased equipment has a useful life of 2 years and no salvage value. Estimate
the effect on net operating profit before tax of capitalizing these operating leases.
d) Estimate the effect on interest expense of capitalizing these operating leases.
Answer:
a)
Year
2009
Operating
Lease
Payment
Discount
Factor
(i=0.05)
Present
Value
1,659,000
0.95238
1,579,998
2010
1,478,000
0.90703
1,340,590
2011
1,323,000
0.86384
1,142,860
2012
1,382,000
0.82270
1,136,971
2013
826,000
0.78353
647,196
Total
5,847,615
b)
Assets
Liabilities
Equity
Liabilities
to Equity
Total before
capitalization
45,792,000
21,196,000
24,596,000
0.862
Capitalized
amount
5,847,615
5,847,615
Total after
capitalization
51,639,615
27,043,615
24,596,000
Percentage
increase
12.77%
27.59%
1.099
This is a significant increase in total liabilities. The liability to equity ratio weakens, but is not
particularly high.
c) Capitalization of company’s operating leases would decrease net operating profit by
$1,264,808. In particular, the company would: remove rent expense of $1,659,000; and add
depreciation expense of $5,847,615 / 2 years = $2,923,808.
d) Capitalizing operating leases would increase interest expense by $5,847,615 × 5% =
$292,381. The company would recognize this expense as a nonoperating expense.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-37
Topic: Interpreting pension footnote
LO: 2
5. The following pension information was disclosed by PACCAR Inc in its 2008 annual report:
(millions)
2008
2007
$1,201.0
$1,193.4
46.6
49.7
Change in Projected Benefit Obligation:
Benefit obligation at January 1
Service cost
Interest cost
73.9
68.7
(48.8)
(41.4)
3.0
(86.6)
(3.3)
(5.5)
(80.9)
18.1
4.9
4.6
$1,196.4
$1,201.0
$1,312.5
$1,242.1
63.9
13.8
(336.4)
74.3
Benefits paid
(48.8)
(41.4)
Currency translation
(82.3)
19.1
4.9
4.6
$913.8
$1,312.5
Benefits paid
Actuarial loss (gain)
Curtailment
Currency translation
Participant contributions
Projected benefit obligation at December 31
Change in Plan Assets:
Fair value of plan assets at January 1
Employer contributions
Actual return on plan assets
Participant contributions
Fair value of plan assets at December 31
Required:
a. What is “service cost”? How does it affect PACCAR’s total pension expense for the year?
b. PACCAR reports an actuarial loss of $3 million for 2008. What is this loss and how does
PACCAR account for it?
c. How much did PACCAR contribute to the pension plan during the year?
d. What amount of pension benefits were paid to former PACCAR employees during the year?
e. Explain the funded status of the pension plan in 2008 and compare it to the funded status in
2007. Are these amounts significant?
Answer:
a. The service cost represents the additional (future) pension benefits earned by employees
during the current year. Service cost is directly related to the year’s pension expense because it
is one component of pension expense. PACCAR reports service cost of $46.6 million on its 2008
income statement.
b. Actuarial losses (and gains), arise when companies make changes in their pension plans or
make changes in actuarial assumptions including assumptions that are used to estimate the
PBO, such as the rate of wage inflation, termination and mortality rates, and the discount rate
used to compute the present value of future obligations. PACCAR includes the $3 million loss in
calculating pension expense for the year.
c. During the year PACCAR contributed $63.9 million to the pension plan.
d. During the year PACCAR former employees received $48.8 million.
e. At the end of 2008, PACCAR’s pension plan was underfunded by $282.6 million. In the prior
year the plan was overfunded by $111.5 million. These amounts are significant – the
underfunding represents nearly a third of the company’s pension plan assets.
Cambridge Business Publishers, ©2010
10-38
Financial Accounting for MBAs, 4th Edition
Topic: Interpreting pension footnote
LO: 2
6. International Paper, Inc. disclosed the following pension information in its 2008 annual report:
Net periodic pension expense for qualified and nonqualified U.S. defined benefit plans comprised
the following:
In millions
2008
2007
2006
Service cost
$ 105
$ 113
$ 141
Interest cost
540
520
506
(672)
(633)
(540)
121
190
243
29
20
27
$ 123
$ 210
$ 377
Expected return on plan assets
Actuarial loss
Amortization of prior service cost
Net periodic pension expense
Required:
a) Briefly explain the following components of the company’s pension expense for the year:
service cost, interest cost, and actuarial loss.
b) International Paper reports an actual return on plan assets of $2,001 for the year. Why is this
different from the expected return of $672 million reported above?
c) What cash contribution did the company make to the pension plan during the year?
d) Comment on the three-year trend you observe for net pension expense. What explains the
trend?
Answer:
a) Service cost: The annual service cost represents the additional (future) pension benefits
earned by employees during the current year.
Interest cost: Interest cost accrues on the outstanding pension liability, just as it would with any
other long-term liability. Because there are no scheduled interest payments on the PBO, the
interest cost accrues each year, that is, interest is added to the existing liability.
Actuarial losses (and gains) arise when companies make changes in their pension plans or make
changes in actuarial assumptions (including assumptions that are used to estimate the PBO,
such as the rate of wage inflation, termination and mortality rates, and the discount rate used to
compute the present value of future obligations).
b) The “actual return” is what the plan assets actually earned during the year. The long-term
expected rate of return on the pension plan assets is what the managers anticipate the assets will
earn. It is the expected return that decreases pension expense instead of actual because the
latter may experience short-term fluctuations from year to year, which would distort the pension
expense.
c) The disclosure about pension expense is not related to the cash contribution the company
made. That information is found in the pension asset table.
d) International Paper’s pension expense has declining sharply over the past three years.
Actuarial losses and expected return on plan assets seem to be a main contributing factors.
Further analysis should seek to determine if the company has curtailed pension benefits and
whether the trend can be expected to continue or if the company has cut back pension costs as
much as possible already.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-39
Topic: Interpreting pension footnote
LO: 2
7. International Paper, Inc. disclosed the following pension information in its 2008 annual report:
In millions
2008
2007
$8,783
$9,237
Service cost
105
113
Interest cost
540
520
Actuarial loss (gain)
327
(599)
(580)
(575)
Divestitures
71
–
Restructuring
(2)
1
Special termination benefits
14
2
Plan amendments
17
84
$9,275
$8,783
Fair value of plan assets, January 1
$8,540
$8,366
Actual return on plan assets
(2,001)
720
Change in projected benefit obligation:
Benefit obligation, January 1
Benefits paid
Benefit obligation, December 31
Change in plan assets:
Company contributions
Benefits paid
Acquisitions
Fair value of plan assets, December 31
Funded status, December 31
25
29
(580)
(575)
95
–
$6,079
$8,540
($3,196)
($243)
Required:
a. The pension plan is underfunded by $3,196 million in 2008. How does this fact affect
International Paper’s 2008 balance sheet?
b. What is “service cost”? How does it affect the company’s pension expense for the year?
c. What average interest rate did International Paper use to calculate interest cost during 2008?
d. How much did International Paper contribute to the pension plan during 2008? How does that
compare to the contribution in 2007?
e. What amount of pension benefits were paid to former employees during the year?
f. Why do the benefits paid affect both the pension obligation and the pension assets?
Answer:
a. The underfunded status of the plan ($3,196 million) is reported on the balance sheet as a
liability in 2008.
b. The service cost represents the additional (future) pension benefits earned by employees
during the current year. Service cost is directly related to the year’s pension expense because it
is one component of pension expense.
c. During 2008, International Paper accrued interest on the average PBO at about 6%. $540 ÷
($8,783 + $9,275 / 2) = 5.981%.
d. During 2008, International Paper made contributions totaling $25 million to the pension plan.
This is about the same contribution as in 2007 when the company contributed only $29 million.
e. During 2008 International Paper’s former employees received payments totaling $580 million.
f. The benefits paid reduce the obligation because part of the liability has been settled. The
benefits paid reduce pension assets by the same amount because it is these assets that are used
to make payments to retirees.
Cambridge Business Publishers, ©2010
10-40
Financial Accounting for MBAs, 4th Edition
Topic: Interpreting pension footnote
LO: 2
8. The following pension information was disclosed by Abbott Laboratories:
(in millions)
Defined Benefit Plans
2008
2007
2006
Projected benefit obligations, January 1
Service cost — benefits earned during the year
Interest cost on projected benefit obligations
Losses (gains), primarily changes in discount
and medical cost trend rates, plan design
changes, law changes and differences between
actual and estimated health care costs.
Benefits paid
Other, primarily foreign currency translation
Projected benefit obligations, December 31
$5,783
233
353
$5,614
249
316
$5,041
219
275
(278)
(241)
(309)
$5,541
(309)
(228)
141
$5,783
64
(213)
228
$5,614
Plans assets at fair value, January 1
Actual return on plans' assets
Company contributions
Benefits paid
Other, primarily foreign currency translation
$5,667
(1,568)
285
(241)
(146)
$5,086
442
283
(228)
84
$4,349
508
266
(213)
176
Plans assets at fair value, December 31
$3,997
$5,667
$5,086
Required:
a. What is the funded status of the pension plan in 2008?
b. How does the funded status affect Abbott’s 2008 balance sheet?
c. What is service cost? How does it affect Abbott Labs’ total pension expense for the year?
d. How much did Abbott Labs contribute to the pension plan during 2008? How does that
compare to the contribution in 2007? Are you concerned about the change in contributions year
over year?
e. What amount of pension benefits were paid to former Abbott Labs’ employees during the year?
f. Why do the benefits paid affect both the pension obligation and the pension assets?
Answer:
a. In 2008, the plan is underfunded by $1,544: Liabilities $5,541 - Assets $3,997 = $1,544. In
2007, the plan was underfunded by $116: Liabilities $5,783 – Assets $5,667 = $116. The
underfunding has increased during 2008.
b. The underfunded status of the plan is reported on the balance sheet as a liability in 2008. This
is new GAAP.
c. As employees continue to work for the company, their pension benefits increase. The service
cost represents the additional (future) pension benefits earned by employees during the current
year. Service cost is directly related to the year’s pension expense because it is one component
of pension expense.
d. During 2008 Abbott Labs made contributions totaling $285 to the pension plan. This is about
the same contributions made in 2007. The pension plan is significantly underfunded, so the low
contributions are alarming signals.
e. During 2008 Abbott Labs’ former employees received payments totaling $241.
f. The benefits paid reduce the obligation because part of the liability has been settled. The
benefits paid reduce pension assets by the same amount because it is these assets that are used
to pay the benefits.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-41
Topic: Analysis of SPE disclosure
LO: 3
9. ConocoPhillips Inc. reported the following information in its 2008 annual report:
Note 4 — Variable Interest Entities (VIEs)
We own a 24 percent interest in West2East Pipeline LLC, a company holding a 100 percent
interest in Rockies Express Pipeline LLC. Rockies Express is constructing a natural gas pipeline
from Colorado to Ohio. West2East is a VIE because a third party has a 49 percent voting interest
through the end of the construction of the pipeline, but has no ownership interest. This third party
was originally involved in the project, but exited and retained their voting interest to ensure project
completion. We have no voting interest during the construction phase, but once the pipeline has
been completed, our ownership will increase to 25 percent with a voting interest of 25 percent. …
Given our 24 percent ownership and the fact the expected returns are shared among the equity
holders in proportion to ownership, we are not the primary beneficiary. We use the equity method
of accounting for our investment. In 2006, we issued a guarantee for 24 percent of the $2 billion
in credit facilities of Rockies Express. In addition, we have a guarantee for 24 percent of $600
million of Floating Rate Notes due 2009 issued by Rockies Express. At December 31, 2008, the
book value of our investment in West2East was $242 million.
Required:
a. What business reasons prompted ConocoPhillips to establish this VIE?
b. How does ConocoPhillips account for these VIEs? Briefly explain this accounting method.
c. How would ConocoPhillips have accounted for the VIE if the company had been the primary
beneficiary of West2East?
Answer:
a. The construction of such a large pipeline is a significant undertaking. ConocoPhillips likely
established this VIE to share the cost and the risk of the project.
b. ConocoPhillips uses the equity method to account for West2East. Under this method the cost
of the original investment is carried as an asset. ConocoPhillips’ proportionate share of
West2East’s income each period is added to the investment account. Any distributions from
West2East, such as dividends, are deducted from the investment account.
c. FIN46(R) required primary beneficiaries to consolidate their VIEs. If ConocoPhillips had been
the primary beneficiary of West2East, all of the assets and liabilities of the VIE would have been
added to ConocoPhillips’ balance sheet (that is the entity would be consolidated). Any portion of
the VIE that the company did not own would have been deducted as a minority interest.
Cambridge Business Publishers, ©2010
10-42
Financial Accounting for MBAs, 4th Edition
Topic: Analysis of SPE disclosure
LO: 3
10. The following footnote comes from the 2008 annual report of Charming Shoppes Inc.:
Our asset securitization program primarily involves the sale of proprietary credit card receivables
to a special-purpose entity, which in turn transfers the receivables to a separate and distinct
qualified special-purpose entity (“QSPE”). The QSPE’s assets and liabilities are not consolidated
in our balance sheet and the receivables transferred to the QSPEs are isolated for purposes of
the securitization program. We use asset securitization to fund the credit card receivables
generated by our FASHION BUG, LANE BRYANT, CATHERINES, and PETITE SOPHISTICATE
proprietary credit card programs.
Required:
a. Describe in your own words, the securitization process employed by Charming Shoppes.
b. What is the importance of the characterization of its SPE as a Qualifying Special Purpose
Entity (QSPE)?
c. What are the analysis implications of the use of QSPEs such as this?
Answer:
a. Charming Shoppes generates receivables in the normal course of business. These receivables
are primarily concentrated in the credit card sales at Fashion Bug and Catherine’s stores. The
securitization process for Charming Shoppes involves the sale of these receivables to a trust that
is a qualified SPE. The trust likely funds the purchase by selling securities to investors. The
receivables are either sold or collected when they come due, both of which provide the cash flows
to repay the securities and yield a return to the SPE’s investors.
b. QSPEs are exempt from the consolidation provisions of FIN46(R). This means that because
Charming Shoppes structured the SPE as a QSPE, it retains the off-balance-sheet treatment of
the SPE activities.
c. There are at least two implications of Charming Shoppes’ use of SPEs: cost of capital and
liquidity. SPEs generally allow the sponsoring company to obtain financing at lower interest rates.
Without that financing source, the company will, arguably, be less competitive in the market place
vis-à-vis other, financially stronger, companies that can borrow at lesser rates. With respect to
liquidity, Charming Shoppes’ SPE allows it to sell off receivables, thus providing a significant
source of liquidity. If the company was forced to hold all of those loans on its own balance sheet,
it would, eventually, need to raise costly equity capital to balance the increase in debt financing.
That additional cost would reduce its competitiveness in the market place.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-43
Essay Questions
Topic: Capital and operating leases
LO: 1
1. Generally accepted accounting principles (GAAP) classify leases into two types for accounting
purposes. Explain the accounting treatment for the two types of types of leases. Is one
preferable to the other? Explain.
Answer:
For Capital Leases, the asset is recorded on the lessee’s balance sheet when acquired and is
treated as though it was purchased. The asset is depreciated like all other long-term assets held
by the lessee. The related lease obligation is recorded as a liability on the lessee’s balance sheet
and is amortized over the life of the lease. When a lease payment is made, the amount is
separated as principal repayment and interest expense on the income statement.
Operating Leases are not accounted for on the lessee’s balance sheet. The existence of
operating leases appears only in the footnotes that accompany the lessee’s financial statements.
All lease payments are recorded as rent expense on the lessee’s income statement. The asset
remains on the lessor’s balance sheet where it is depreciated accordingly.
Most managers prefer operating leases because it is a form of off-balance-sheet financing.
Keeping the assets and liabilities of operating leases off the balance sheet improves a company’s
liquidity, debt level, and profitability. The enhancement of these 3 factors reduces the perception
of risk that the company will go bankrupt. The market will perceive the company more favorably,
which could lead to a better debt rating and lower interest rates on borrowed funds.
Topic: Lease capitalization criteria
LO: 1
2. There are four criteria established by GAAP to determine if a lease is capital or operating. List
and briefly explain the four criteria a lease must satisfy in order for it to be considered an
operating lease so it can be reported off-balance sheet.
Answer:
a. Transfer of title – There is no transfer of title to the lessee when the terms of the lease expire.
If ownership did pass to the lessee, than the lease is nothing more than a purchase contract that
was financed by the lessor.
b. Bargain Purchase Option – The lease does not contain a bargain purchase option at the end of
the lease. That means the lessor cannot sell the lessee the asset at a price that is below the
asset’s fair market value. This criterion was established because lessors often structured leases
so the lessee could purchase the asset for $1 at the end of the lease. This structure allowed both
parties to satisfy the transfer of ownership requirement and categorize these leases as operating.
c. The term of the lease is less than 75% of the estimated economic life of the leased asset. If
the lease is for more than 75% of the asset’s economic life, than essentially all risks and benefits
have passed to the lessee.
d. The present value of the lease payments cannot exceed 90% of the fair market value of the
asset. If the present value of the lease payments exceeds 90%, then for all practical purposes,
the lessee has purchased the asset and should capitalize it on his/her balance sheet.
Cambridge Business Publishers, ©2010
10-44
Financial Accounting for MBAs, 4th Edition
Topic: Discussion of pension standard
LO: 2
3. Why would most corporations prefer to use long-term expected return rates instead of actual
returns when computing pension expense?
Answer:
Companies did not want the difference between expected and actual returns to be reported on
the income statement because most pension fund investment portfolios are heavy on government
bonds and the prices of those bonds fluctuate in response to changes in the market and changes
in interest rates. They argued that over time the unrealized gains and losses should cancel each
other out and net around zero. Therefore, by allowing pensions to be recorded in off-balancesheet financing, the income is smoothed. In other words, the income statements are not distorted
by everyday fluctuations.
Topic: Income smoothing features of pension accounting
LO: 2
4. Discuss the concept of “income smoothing” that is built into GAAP as it relates to pensions.
Answer: GAAP permits companies to compute pension expenses using the expected return on
fund assets rather than the actual return on those pension investments. Because investment
returns fluctuate from year to year, the FASB agreed to allow a firm’s managers to report the long
term expected returns rather than the short term returns that would reflect the true effects of a bull
or bear market. This has the effect of “income smoothing” as it “smoothes” out the ups and
downs from the bond and stock markets. The difference between actual and expected returns is
then accumulated off of the balance sheet. The difference between the plans assets and the
plans liabilities is what is reported on the balance sheet.
Topic: Pension accounting issues
LO: 2
5. Companies have raised at least two objections with respect to pention accounting. First,
companies oppose putting pension assets and liabilities on the balance sheet at gross amounts
(as opposed to netting the assets and liabilities). Second, companies oppose marking pension
assets and liabilities to fair value each period. Explain both of these objections and describe how
GAAP accounts for each.
Answer: There are two major accounting issues with respect to pensions. First reporting the
pension assets and liabilities would adversely impact the market’s perception of their companies’
financial reports. This is because both the asset and liabilities would go up on the balance sheet.
This would increase leverage ratios and worsen profitability metrics such as return on assets.
GAAP requires that the net asset or liability be reported, not the gross amounts.
The second objection is the potential effect on the income statement from fluctuations in the
market values of pension investments and pension obligations. These changes would impact
equity and hence the retained earnings. Thus market fluctuations would make the income
statement more volatile. Managers believe that stock prices would be negatively impacted by
such an increase in volatility.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
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Topic: Understanding lease and pension estimates
LO: 1 & 2
6. Alleghany Corporation includes the following in its 2009 annual report (in thousands).
On an ongoing basis, we evaluate our estimates, including those related to the value of long-lived
assets, deferred acquisition costs, incentive compensation, pension benefits, and contingencies
and litigation. Our estimates are based on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances.
a. What estimates does the company make when accounting for capital leases?
b. What estimates does the company make when accounting for defined benefit pensions?
Answer:
a. To account for lease liability, the company must estimate the discount rate. The other inputs
are given by the lease contract. Accounting for the leased assets involves estimating the assets’
expected life, salvage value and the depreciation method.
b. The pension obligation requires the company to estimate discount rate, growth rate in wages,
expected rate of return on plan assets, life span of employees, retirement rates, attrition rates and
inflation rates. Many of these estimates will be made by the actuaries but the company likely has
some input.
Topic: Benefits of using SPEs
LO: 3
7. What are SPE’s? What are the benefits of using them? How do they work? Provide an
example of the use of a SPE.
Answer: A SPE will be structured so that it is a separate entity from the sponsoring company. A
sponsor provides an equity investment to form a SPE. The SPE can leverage that equity with
debt and is then able to purchase assets for or sell assets to the sponsoring company. The SPE
subsequently repays debt with its generated cash flows. This arrangement allows the sponsoring
company to benefit in not listing assets on its balance sheet. This increases the portion of ROE
generated from RNOA.
In addition, SPEs can often secure a lower rate on financing because of the limited nature of a
SPE’s activities (remember that they are sponsored for a specific purpose.) Investors thereby
supply well-secured debt that is not exposed to the same business risks that the sponsor has
(that is, the risk of more creditors lining up to collect on debt) of the sponsoring company.
SPEs are often used to finance construction and real estate projects. SPEs can use contracts
from the sponsoring company in order to collateralize debt, often at a lower rate than the
sponsoring company may be able to secure. The sponsoring company utilizes the asset, such as
a new plant at lower cost, through an operating lease. The company, however, does not report
the asset on the balance sheet. The company also avoids listing the liability on its balance sheet.
Under this operating lease, the company may benefit further by qualifying as an owner and
borrower on the mortgage and, therefore, obtaining the tax benefits.
Cambridge Business Publishers, ©2010
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Financial Accounting for MBAs, 4th Edition
Topic: Off-balance sheet financing
LO: 1, 2, & 3
8. What is off-balance-sheet financing, and why would managers use it?
Answer: Off-balance-sheet financing means that company managers do not report assets,
liabilities, or both, on the balance sheet. For instance, with operating leases, listing assets and
liabilities off of the balance sheet improves market perception of a company’s operating
performance and financial condition. GAAP, however, does require that management disclose
information related to leases in the footnotes.
Managers want to report adequate liquidity and little debt in order to appear more solvent.
Managers also aim to report fewer assets in order to appear more profitable. Fewer assets will
drive ROA and ROE higher, and thus the firm will appear more attractive. In addition, if ROE
and/or cash flows appear inadequate, managers will see their companies’ stock prices and debt
ratings decline significantly. As a result, the pressure to “window dress” a firm to make it appear
more profitable and more solvent is considerably high.
Test Bank, Module 10
© Cambridge Business Publishers, 2010
10-47