Additional Issues in
Liability Reporting
Chapter 12
Lease Obligations
• A business firm may obtain assets
either by purchase or lease.
Lease Obligations
• A lease is an agreement between the
lessor (owner) and lessee (renter)
which conveys the right to use the
leased property for a designated
future period.
Lease Obligations
• Leases are limited in their terms only
by the creativity of the contracting
parties and by, of course, legal
concerns.
The benefits of leasing
include the following:
• They offer financial flexibility to the lessee
because lessors generally do not have the
power to impose severe restrictions on the
lessee.
• The lessee may have reduced risk of
equipment obsolescence.
• The lessor may be able to resell or re-lease
the asset if there is a well-developed
secondary market.
• Because payments are a set amount, the
lessee usually has reduced financial risk.
A company purchases an
asset:
• The company must use compound
interest tables to compute the present
value of the payment or payments and
record an asset and a liability for the
present value.
A company purchases an
asset:
• The company must record annual
interest expense until the loan is paid
off and must record depreciation
expense for each year that it owns the
asset.
A company purchases an
asset:
• It must also make periodic payments
on the principal of the loan.
A company purchases an
asset:
• On the balance sheet, noncurrent
assets and liabilities are both
increased.
A company purchases an
asset:
• On the income statement, both interest
and depreciation expenses are
recorded.
A company leases an asset:
• The first thing to determine is whether
the lease is a capital or an operating
lease.
A company leases an asset:
• A capital lease is interpreted as if it is
essentially a purchase of an asset,
whereas an operating lease is
interpreted as an ordinary rental.
A company leases an asset:
• A lease is considered to be a capital
lease if it meets any one or more of the
following four criteria:
A company leases an asset:
• The lease transfers ownership of the
property to the lessee by the end of the
lease.
A company leases an asset:
• The lease gives the lessee an option to
purchase the leased asset at a bargain
price (called a bargain purchase
option).
A company leases an asset:
• The lease gives the lessee an option to
purchase the leased asset at a bargain
price (called a bargain purchase
option).
A company leases an asset:
• If a company leases a 700 series BMW
for three years and is given the option
to buy the car for $3,000 at the end of
the lease, then that would probably be
considered a bargain purchase option.
A company leases an asset:
• The lease term is equal to 75% or more
of the estimated economic life of the
leased property.
A company leases an asset:
• If the economic life of the asset is 8
years and the lease term is 7 years,
then that lease meets this criterion.
A company leases an asset:
• The present value of the lease
property (the lease payments) is 90%
or more of the fair value of the
property at the inception of the lease.
A company leases an asset:
• If a lease meets none of these criteria,
then it is treated as an operating lease.
A company leases an asset:
• An operating lease is interpreted as
an ordinary rental.
Capital Leases
• If the lease is a capital lease, then the
lessee records an asset and a liability
at the lower of the fair market value of
the property or the present value of
the minimum lease payments.
Capital Leases
• The present value of the minimum
lease payments must be computed
using the compound interest tables.
Capital Leases
• The cost of the asset is systematically
expensed, or amortized, and the
company must also record interest
expense on the liability.
Capital Leases
• Annual payments on the principal
must also be made.
Capital Leases
• On the balance sheet, noncurrent
assets and liabilities are both
increased.
Capital Leases
• On the income statement, both interest
and amortization expenses are
recorded.
Capital Leases
ASSETS = LIABILITIES + OWNERS’ EQUITY
Leased
Lease
assets
obligations
+$8,222,000
+$8,222,000
Capital Leases
ASSETS = LIABILITIES + OWNERS’ EQUITY
Leased
Retained earnings
assets
–$1,370,333
–$1,370,333
(amortization
expense)
Capital Leases
ASSETS = LIABILITIES + OWNERS’ EQUITY
Cash
Lease
Retained earnings
obligations
–$2,000,000
–$986,640
+$986,640
(interest expense)
–$2,000,000
Operating Leases
• If the lease is an operating lease, then
the lessee will simply record rent
expense for each of the payment
periods.
• No asset or liability is recorded.
Operating Leases
• Thus, the asset cost will not be
amortized because the lessee has not
capitalized the cost of the asset.
Operating Leases
ASSETS = LIABILITIES + OWNERS’ EQUITY
Cash
Retained earnings
–$2,000,000
–$2,000,000
(rent expense)
Accounting for Leases
• Whether the lease is an operating or a
capital lease can have a dramatic effect
on financial ratios.
Accounting for Leases
• Ratios using net income, total assets,
or debt in their calculations will be
affected.
Accounting for Leases
• Return on assets, the debt-to-assets
ratio, and earnings per share will all
appear less favorable in the earlier
years of a capital lease.
Accounting for Leases
• Operating leases are often called "offbalance-sheet" financing because
neither an asset nor a liability is
recorded.
Accounting for Leases
• A company with any type of lease is
required to disclose substantial details
of the lease in the notes to the financial
statements.
Postretirement Benefit
Obligations
• Most medium- and larger-sized firms
provide retired employees with
pensions and other postretirement
benefits.
Postretirement Benefit
Obligations
• These costs are incurred the service
lives of the retirees — the working
years prior to retirement.
Pension Expenses and
Obligations
• Pension plans are either defined
contribution plans or defined benefit
plans.
Defined Contribution
Pension Plans
• A defined contribution pension plan
specifies the periodic amount that the
firm must contribute to a pension
fund.
Defined Contribution
Pension Plans
• The employer's only obligation is to
make the agreed-upon contributions
to the plan.
Defined Contribution
Pension Plans
• The employee bears all the risks and
rewards. Accounting for these plans
is straightforward and
noncontroversial.
Defined Benefit Pension
Plans
• A defined benefit pension plan
specifies the benefits that employees
will receive at retirement.
Defined Benefit Pension
Plans
• The employer assumes all the risks
and rewards associated with pension
fund investments.
Defined Benefit Pension
Plans
• These types of plans are popular in
U.S. industries having strong labor
union representation.
Defined Benefit Pension
Plans
• The employer knows how much he
must pay to an employee in the future
and must estimate and make
assumptions about investments and
actuarial concerns so that he can
invest enough to have that required
future amount available.
Defined Benefit Pension
Plans
Employer
Firm
Cash
Contribution
Pension
Fund
Benefit
Payments
Obligation to Pay Benefits
Retirees
Basic Accounting for
Pensions
• It is important to differentiate between
the employer and the pension fund.
Basic Accounting for
Pensions
• The employer makes contributions to
the pension fund, and the fund makes
payments to retirees.
Basic Accounting for
Pensions
• Some analysts do not regard the fund
as a separate entity and would like to
see the employer firm and the fund
consolidated for reporting purposes.
Basic Accounting for
Pensions
• An employer must estimate future
payments to retirees and discount the
payments to present values using an
appropriate rate of interest.
Basic Accounting for
Pensions
• The choice of a discount rate is critical.
Basic Accounting for
Pensions
• Many companies use overly optimistic
discount rates, and surveys show that
these companies are severely
underfunded in their pension plans.
Basic Accounting for
Pensions
• Note the following rule of thumb:
Basic Accounting for
Pensions
• A 1% variation in the assumed
discount rate will cause about a 20%
variation in the valuation of pension
obligations.
Measurement of Benefit
Obligations
• There are three possible present value
measurements.
Measurement of Benefit
Obligations
• The vested benefit obligation
indicates amounts to which employees
have irrevocable rights.
Measurement of Benefit
Obligations
• The accumulated benefit obligation
shows the amount of benefits that
employees have earned to date, based
on current salary levels.
Measurement of Benefit
Obligations
• The projected benefit obligation
shows the amount of benefits that
employees have earned to date, based
on expected future salary levels.
Measurement of Benefit
Obligations
• Managers and analysts often disagree
about which of these best represents a
firm's pension obligation.
Measurement of Benefit
Obligations
• Present accounting standards are a
compromise, disclosing two types of
pension costs along with extensive
supplementary disclosures in the
notes to the financial statements.
Measurement of Pension
Expense
• The following are components of
pension expense.
Measurement of Pension
Expense
• Service cost is the value of future
pension benefits that employees have
earned during the current year.
Measurement of Pension
Expense
• Interest cost on the projected benefit
obligation.
Measurement of Pension
Expense
• Return on plan assets, based on
anticipated, not actual, return.
Measurement of Pension
Expense
• Return on plan assets, based on
anticipated, not actual, return.
– The return can be either a positive or a
negative number, depending on how the
investments have done.
Measurement of Pension
Expense
• Other items (net), such as
amortization of prior pension cost,
obligations resulting from changes in
pension benefits, and revision in
assumptions underlying the pension
valuation, among others.
Pension reporting involves
two types of assumptions:
• Actuarial—employee turnover,
services lives, longevity, etc.—which
are fairly standardized and
noncontroversial
Pension reporting involves
two types of assumptions:
• Economic—discount rate and return
on plan assets—which stir up much
controversy.
Reporting Nonpension
Postretirement Benefits
• Firms are required to report their
obligations to provide future
nonpension post-retirement benefits
and accrue the expenses during the
years that employees provide service.
Reporting Nonpension
Postretirement Benefits
• Adoption of this new standard in 1993
reduced profits at the 100 largest U.S.
corporations by about 33%.
Difference Between Pension
and Nonpension Benefits
• The accumulated postretirement
benefit obligation measures the
present value of the future benefits
that employees and retirees have
earned to date.
Difference Between Pension
and Nonpension Benefits
• The fair market values of the plan
assets are minor, relative to the
accumulated benefit obligation.
Nonpension Postretirement
Benefit Expense
• Cost components for nonpension
expenses follow the same format as
those for pension costs.
Nonpension Postretirement
Benefit Expense
• The service cost represents the amount
of the accumulated benefit obligation
earned by employees over the current
year.
Nonpension Postretirement
Benefit Expense
• The interest cost is the beginning-ofthe-year obligation multiplied by the
discount rate.
Nonpension Postretirement
Benefit Expense
• The return on plan assets is only a
minor offset to the other components
because the benefits are not
substantially funded.
Nonpension Postretirement
Benefit Expense
• As is true for pension benefits, the
FASB requires significant disclosures
for nonpension postretirement
benefits in the notes to the financial
statements.
Additional Issues in
Liability Reporting
End of Chapter 12