Module 10
Reporting and Analyzing
Off-Balance Sheet Financing:
Leases
Pensions
Off-Balance Sheet Financing
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Off-balance sheet financing means that either
assets or liabilities, or both, are not reported on
the face of the balance sheet.
Companies try to make their companies look
better to the markets with window dressing:
“unreal” higher returns and lower risk.
Empirical evidence suggests that analysts
adjust balance sheets to include assets and
liabilities that managers exclude.
Leasing
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A lease is a contract between the owner of an
asset (the lessor) and the party desiring to use
that asset (the lessee).
Generally, leases provide for the following
terms:
1. Lessee uses asset over lease term.
2. Lessee pays rent and upkeeps the asset.
3. Lessor keeps title and retakes asset at the
lease term.
Capital vs. Operating Leases
GAAP identifies for two different approaches in the
reporting of leases by the lessee:

Capital lease method – In essence a purchase:
Either title transfers at end of lease or bargain
purchase available or >75% of economic life or PV
of rents are >90% of purchase price.
 both the leased asset and the lease liability are
reported on the balance sheet--results in depreciation
and interest expenses.
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Operating lease method – not a capital lease. The rent
expense is the payment.
Operating vs. Capital Leases
For the lessee:
1. The lease asset is not reported on the balance sheet –
return on net operating assets (RNOA) is higher.
2. The lease liability is not recorded– FLEV is lower.
3. For ROE: operating returns are higher and non-operating
returns are lower: company appears more stable, less risky.
4. During the early years of the lease term, rent expense
reported for an operating lease is lower than the
depreciation plus interest expense reported for a capital
lease. This means that net income is higher in those early
years with an operating lease: ROE & EPS are overstated.
Capitalizing Operating Leases for
Analysis Purposes
1.
2.
3.
Determine the discount rate.
Compute the present value of future
operating lease payments.
Adjust the financials to include the
present value of the lease asset and lease
liability.
Capitalization of Delta’s Operating
Leases on the Balance Sheet
Adjustments to the
Income Statement
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Remove rent expense from operating expense.
Add depreciation expense from the lease assets
to operating expense and add interest expense
from the lease obligation as a nonoperating
expense.
Capitalization of Delta’s’
Operating Leases
Pensions
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Generally two types of plans:
 Defined contribution plan. Typically defines the
contribution as a % of employee salary with both
employer and employee paying in.
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Example: 6.5% of salary paid by both employer and
employee with the funds held by an external company,
typically an insurance company.
Defined benefit plan. This plan has the company
make periodic payments to an employee after
retirement:

Typically a % of ending salary times # of years worked.
Example, 2.25% * 30 years * $50,000 = $33,750 per year.
Accounting for
Defined Contribution Plans
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From an accounting standpoint, defined
contribution plans offer no problems.
The company’s contribution is recorded as an
expense in the income statement when paid or
accrued.
Two Accounting Issues Related
to Defined Benefit Plans
The appropriate balance sheet presentation of the
pension investments and obligation.
1.
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Companies report the net pension liability on their balance sheet.
Underfunded plans are reported on the balance sheet as a longterm liability.
Overfunded plans are reported as a long-term asset.
The treatment of fluctuations in pension investments and
obligations in the income statement.
2.
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The FASB allows companies to report pension income based on
expected long-term returns on pension investments (rather than
actual investment returns), and to defer the recognition of
unrealized gains and losses on both pension investments and
pension obligations.
Plan Assets and PBO
Computations
Balance Sheet Presentation
PBO Components
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Service cost – the increase in the pension
obligation due to employees working another
year for the employer.
Interest cost – the increase in the pension
obligation due to the accrual of an additional
year of interest.
Benefits paid to employees – the company’s
obligation is reduced as benefits are paid to
employees.
Pension Expense
Global Accounting
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Leases - IFRS lease standards currently allow for operating
leases, but the standards are such that it is very difficult for a
lease agreement to qualify as an operating lease.
Pensions - U.S. GAAP permits deferral of actuarial gains and
losses and then amortizes them to net income over time. IFRS
companies can recognize all actuarial gains and losses in
comprehensive income in the year they occur.