P5-36 (30 minutes)
a. FedEx reports $1,199 million of tax expense in its 2007 income statement.
Of this amount, $1,075 is currently payable.
b. Deferred tax liabilities relating to PPE arise because FDX is depreciating
buildings and equipment (land is not a depreciable asset) more quickly in
its tax return than for its GAAP income statement. Thus, the assets’ taxreporting book value is less than the financial-reporting book value, which
yields a deferred tax liability. For the existing PPE assets, future
depreciation expense in the tax return will be lower and the difference
between the two net book values will shrink and the deferred tax liability
will reverse. However, if FedEx adds significant depreciable assets each
year, the first-year’s accelerated depreciation on the new assets will more
than offset the lower depreciation on the older assets, resulting in a
permanent deferred tax liability. Once assets stop growing subsides, the
depreciation expense deduction in the tax return will as well, and the
deferred tax liability will shrink.
c. FedEx reports an accrued liability for self-insurance on its balance sheet.
This does not create a tax-basis liability however because this sort of
expense is not deductible until paid. Consequently, GAAP liabilities are
greater than tax-basis liabilities and this results in a deferred tax asset that
recognizes the future deductions of the self-insurance payments.
d. Operating loss carryforwards arise when a company reports a tax loss,
which it can carry back for up to two years to offset against taxable income
reported in the past and receive a tax refund. Unused tax losses can be
carried forward for up to 20 years as future tax deductions to reduce future
taxable income and tax liability. This creates a deferred tax asset.
e. The valuation allowance arises when the company believes that some of
the related deferred tax assets will not generate future benefits. These
allowances typically arise because the carryforward deduction will likely
not be used before it expires. Increases and decreases in deferred tax
valuation allowances affect net income dollar-for-dollar. FedEx’s net
income has been reduced cumulatively by $49 million. For 2007, the
increase of $1 million in the allowance, decreased net income by $1 million.
Since establishing and subsequently adjusting the valuation allowance is
highly subjective (dependent upon the company’s estimation of whether
the deductions will or will not be realized), companies might increase or
decrease this account to manage net income to reach income targets.
Financial statement users need to be aware of how changes in the
valuation allowance affects net income in their analysis of the profitability
of the company.
E7-21 (30 minutes)
a. Investments classified as trading
Balance Sheet
Transaction
MS 80,000
Cash 80,000
MS
80,000
Cash
80,000
Cash
DI
6,250
6,250
Cash
6,250
DI
Cash
Asset
1. Ohlson Co.
purchases
5,000 common -80,000
Cash
shares of
Freeman Co. at
$16 per share
2. Ohlson Co.
receives a cash
dividend of
$1.25 per
common share
from Freeman
Income Statement
Noncash
LiabilContrib.
Earned
+
=
+
+
Assets
ities
Capital
Capital
+80,000
Investment
=
+6,250
Cash
Revenues
=
+6,250
+6,250
Retained
Earnings
Dividend
Income
=
+7,500
+7,500
Retained Unrealized
Earnings
Gain
=
Retained
Earnings
–
Expenses
=
Net
Income
–
=
–
=
+6,250
–
=
+7,500
6,250
MS
7,500
UG
7,500 3. Year-end
MS
7,500
UG
market price of
Freeman
common stock
is $17.50 per
share
Investment
4. Ohlson Co.
+86,400
sells all 5,000
Cash
common shares
of Freeman for
$86,400 cash
Investment
+7,500
7,500
Cash 86,400
LS
1,100
MS
87,500
Cash
86,400
LS
1,100
MS
87,500
-87,500
-1,100
–
+1,100
Loss on
Sale
=
–1,100
E7-21—continued.
b. Investments classified as available-for-sale
Balance Sheet
Transaction
MS 80,000
Cash 80,000
MS
80,000
Cash
80,000
Cash
DI
6,250
6,250
Cash
6,250
DI
6,250
MS
7,500
AOCI 7,500
MS
7,500
AOCI
7,500
Cash
Asset
1. Ohlson Co.
purchases
5,000 common -80,000
Cash
shares of
Freeman Co. at
$16 per share
2. Ohlson Co.
receives a cash
dividend of
$1.25 per
common share
from Freeman
+80,000
Investment
=
Cash
+7,500
Investment
Revenues
=
+6,250
3. Year-end
market price of
Freeman
common stock
is $17.50 per
share
Income Statement
Noncash
LiabilContrib.
Earned
+
=
+
+
Assets
ities
Capital
Capital
=
+6,250
+6,250
Retained
Earnings
Dividend
Income
+7,500
AOCI
–
Expenses
=
–
=
–
=
–
=
–
=
Net
Income
+6,250
Cash 86,400
AOCI
7,500
GN
6,400
MS
87,500
Cash
86,400
4. Ohlson Co.
+86,400
sells all 5,000
Cash
common shares
of Freeman for
$86,400 cash
AOCI
7,500
GN
6,400
MS
87,500
-87,500
Investment
-7,500
=
AOCI
+6,400
+6,400
Gain on
Sale
Retained
Earnings
+6,400
E7-22 (15 minutes)
a. Berkshire Hathaway’s 2007 balance sheet reports the equity securities
investment portfolio at the current market value of $74,999 million.
b. Because unrealized gains and losses on investments are reported in
Other Comprehensive Income (OCI), rather than in its current income,
we know that the investment portfolio is accounted for as an availablefor-sale portfolio.
c. The $2,523 million is the unrealized gain on securities that arose during
2007 because stock prices increased during the year. This number is
pretax. Berkshire Hathaway also discloses that it expects to pay taxes of
$872 million on those gains if and when they are realized.
Note: The reclassification adjustment of $(5,494) million represents
unrealized gains on investments that were included in AOCI at the
beginning of the year and were realized in 2007 because the related
investments were sold during the year. Because these gains are now
recognized in current income (and retained earnings), they need to be
removed from AOCI to avoid double-counting the gain in stockholders’
equity (that is, in both AOCI and retained earnings).
M9-23 (10 minutes)
A stock split in which the par value is proportionately reduced does not
create an accounting transaction and, as a result, does not require an entry
into the accounting records. The number of outstanding shares is changed
in the parenthetical note to the common stock account in the stockholders’
equity section of the balance sheet, and the par value of the stock is
proportionately reduced.
In Cigna’s three-for-one stock split effected in the form of a 100% stock
dividend, each shareholder receives two additional shares for each share
owned, thus tripling the outstanding shares, but the par value of the shares
remained at $0.25. Since the par value is not reduced, an accounting entry
is required to transfer the par value of the shares issued from retained
earnings to the common stock account. Earnings per share is also
recomputed for all years presented in the income statement to reflect the
additional shares outstanding after the split.
M9-24 (15 minutes)
a. 103,300,000 shares issued  $0.01 par = $1,033,000. This amount is
reported in thousands as $1,033.
b. Outstanding shares are equal to issued shares less repurchased shares.
For 2008, Abercrombie & Fitch has 103,300,000 – 17,141,116 = 86,158,884
shares outstanding.
c. Total proceeds from the sale are the sum of the common stock and
additional paid-in capital accounts. For 2008, this total is $320,484,000
($1,033,000 + $319,451,000). The average price at which Abercrombie
issued common stock is $3.10 ($320,484,000 / 103,300,000 shares).
d. The average price at which Abercrombie & Fitch repurchased treasury
stock is $44.38 ($760,752,000 / 17,141,116 shares).
E10-19 (20 minutes)
a. No, Lowe’s only has operating leases in 2007. GAAP requires companies
report future minimum lease payments for both operating and capital
leases. Because Lowe’s’ footnote reveals no future payments for capital
leases, we can deduce that the company only has operating leases.
b. Neither the lease asset nor the lease obligation is reported on the balance
sheet for an operating lease. As a result, total assets and total liabilities
are lower than if the lease had been capitalized. Over the lease term, total
rent expense under operating leases is equal to the interest and
depreciation expense that the company would record under capital
leases. Cumulative profit is unaffected by the lease classification. Each
year during the lease, however, the classification will affect net income.
Even if depreciation is computed on a straight-line basis, interest is
accrued based on the balance of the lease obligation which is higher in
the earlier years of the lease. As a result, depreciation plus interest will
exceed rent expense during the early years and will be less in the later
years. However, these differences tend to be small for most leases.
c. The present value of the operating leases (using Excel or financial
calculator) is computed as follows:
Operating Lease
Year ($ millions)
Payment
1 ..........................
$ 362
Discount Factor
(i=0.06)
0.94340
Present Value
$ 342
2 ..........................
359
0.89000
320
3 ..........................
359
0.83962
301
4 ..........................
358
0.79209
284
5 ..........................
355
0.74726
265
>5 ..........................
4,131
2,224*
$3,736
*** $4,131 ÷ $355/year = 11.637 years so estimate 12 years
Present value of annuity factor for 12 years @ 6% = 8.38384
$355×8.38384(PVOA to beginning of year 6)×0.74726(to beginning of year 1) =
$2,224.
Applying the information to our analysis: To evaluate all of the
company’s assets and liabilities, we might add the present value of the
operating leases to both operating assets and nonoperating liabilities.
E10-25 (20 minutes)
a. Service cost represents the additional pension benefits earned by
employees during the current year but paid to employees in the future.
Interest cost is an expense (financing) that accrues on the pension
obligation (PBO) during the year.
b. In 2007, Xerox recorded an “actual” return on pension investments of
$667 million (which increases the pension plan assets). There is no
income effect from the actual return on the health care (“Other”) plan
assets.
The expected return (not the actual return) of $668 million on the pension
plan assets impacts Xerox’s income for 2007. Pension expense is reduced
by this amount. Because the health care (“Other”) plan is not funded,
there are no assets generating a return, hence there is no expected return
offset for this plan.
c. Actuarial losses (gains) generally arise as a result of reductions
(increases) in the discount rate used to compute the pension and health
care obligation. Since the pension and health care obligations are the
present value of expected future payouts to retirees, a reduction
(increase) in the discount rate results in an increase (decrease) in the
obligation. A decrease in obligation is called an actuarial gain.
d. Payments to retirees are made from the pension and health care assets.
There is a corresponding reduction in the pension and health care
obligations. For 2007, the pension plan had sufficient assets with which to
make this payment. By contrast, the health care plan is not funded.
Consequently, Xerox must make a contribution to the plan assets as
benefits are paid (partial funding for this also comes from participant
contributions).
e. In 2007, Xerox contributed $298 million to its pension plan and $102 to its
health care plan.
f. In 2007, retirees received $669 million from the Xerox pension plan and
$122 million from the health care plan. For the pension plan, Xerox did not
make these payments directly; rather, they came from the plan
investments. For the health plan, Xerox and employees made the
contributions necessary to fund payments during the year. Because there
are no assets in the health plan, any payments must be matched by
contributions each year.
E10-25 (concluded)
g. The funded status is the obligation less the fair value of the plan
investments. The pension plan is underfunded by $653 million ($10,458
million - $9,805 million).
The health care plan is underfunded by the full $1,501 million obligation as
none of the health care obligation has been funded. This is not atypical as
companies only fund health care plans to the extent that the contributions
are tax deductible, unless mandated by federal law.
h. Actuarial gains and losses, together with the difference between actual
and estimated returns on pension assets and, are recorded in Other
Comprehensive Income in the year they arise and are accumulated on the
balance sheet in the Accumulated Other Comprehensive Income account,
which is part of Stockholders’ Equity. These amounts remain in AOCI
unless they exceed prescribed limits (the greater of 10% of Pension
assets or PBO at the beginning of the year). If the accumulated amounts
exceed the maximum, the excess is amortized to income over the
remaining service lives of the employees. During the year, Xerox
recognized additional pension expense relating to the amortization of a
deferred loss – this is the $75 million amount. It also recognized expense
relating to the amortization of prior service cost – the $20 million. Both of
these amortizations increased AOCI and reduced profitability and, thus,
retained earnings.