Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang ©Cambridge Business Publishers, 2015 M ODULE 10 Off-Balance-Sheet Financing

©Cambridge Business Publishers, Learning Objective 1 Describe and illustrate the accounting for capitalized leases.

Off-Balance Sheet Financing  Off-balance sheet financing means that either assets or liabilities, or both, are not reported on the face of the balance sheet.  Managers generally believe that keeping such assets and liabilities off the balance sheet improves market perception of their operating performance and financial condition.  Empirical evidence suggests that analysts adjust balance sheets to include assets and liabilities that managers exclude. ©Cambridge Business Publishers,

Leasing  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.The lessor allows the lessee the unrestricted right to use the asset during the lease term. 2.The lessee agrees to make periodic payments to the lessor and to maintain the asset. 3.Title to the asset remains with the lessor, who usually retakes possession of the asset at the conclusion of the lease. ©Cambridge Business Publishers,

Capital vs. Operating Leases GAAP identifies for two different approaches in the reporting of leases by the lessee:  Capital lease method - both the lease asset and the lease liability are reported on the balance sheet.  Operating lease method - neither the lease asset nor the lease liability is on the balance sheet. ©Cambridge Business Publishers,

Capital vs. Operating Leases 6 ©Cambridge Business Publishers, 2015

Operating Leases Consequences for the lessee: 1.The lease asset is not reported on the balance sheet - net operating asset turnover (NOAT) is higher. 2.The lease liability is not reported on the balance sheet - financial leverage is improved. 3.Without analytical adjustments (see later section on capitalization of operating leases), the portion of ROE derived from operating activities (RNOA) appears higher, which improves the perceived quality of the company’s ROE. 4.During the early years of the lease term, rent expense reported for an operating lease is less than the depreciation and interest expense reported for a capital lease. This means that net income is higher in those early years with an operating lease. Further, if the company is growing and continually adding operating lease assets, the level of profits will continue to remain higher during the growth period. ©Cambridge Business Publishers,

Southwest Air’s Footnote Disclosures of Lessees 8 ©Cambridge Business Publishers, 2015

Capitalizing Operating Leases for Analysis Purposes 1.Determine the discount rate. 2.Compute the present value of future operating lease payments. 3.Adjust the balance sheet to include the present value of the lease asset and lease liability. Adjust the income statement to include depreciation and interest in lieu of rent expense. ©Cambridge Business Publishers,

Southwest Air’s Implicit Discount Rate 10 ©Cambridge Business Publishers, 2015

Capitalization of Southwest Air’s Operating Leases on the Balance Sheet 11 ©Cambridge Business Publishers, 2015

Adjustments to the Income Statement  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. ©Cambridge Business Publishers,

Capitalization of Southwest Air’s Operating Leases 13 ©Cambridge Business Publishers, 2015

14 Learning Objective 2 Describe and illustrate the accounting for pensions.

Pensions Generally two types of plans:  Defined contribution plan – This plan requires the company to make periodic contributions to an employee’s account, and many plans require an employee matching contribution.  Defined benefit plan – This plan requires the company to make periodic payments to an employee after retirement. ©Cambridge Business Publishers,

Accounting for Defined Contribution Plans  From an accounting standpoint, defined contribution plans offer no particular problems.  The contribution is recorded as an expense in the income statement when cash is paid or the liability accrued. ©Cambridge Business Publishers,

Two Accounting Issues Related to Defined Benefit Plans 1.The appropriate balance sheet presentation of the pension investments and obligation.  The pension standard allows companies to report the net pension liability on their balance sheet.  Underfunded plans are reported on the balance sheet as a long-term liability.  Overfunded plans are reported as a long-term asset. 2.The treatment of fluctuations in pension investments and obligations in the income statement.  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. ©Cambridge Business Publishers,

Plan Assets and PBO Computations 18 ©Cambridge Business Publishers, 2015

Balance Sheet Presentation 19 ©Cambridge Business Publishers, 2015

PBO Components  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. ©Cambridge Business Publishers,

Pension Expense 21 ©Cambridge Business Publishers, 2015

FedEx Corp’s Funded Status 22 ©Cambridge Business Publishers, 2015

FedEx Corp’s Pension Expense 23 ©Cambridge Business Publishers, 2015

Cash Flow Implications One application of the pension footnote is to assess the likelihood that the company will be required to increase its cash contributions to the pension plan. 24 ©Cambridge Business Publishers, 2015

Profit Implications 25 ©Cambridge Business Publishers, 2015

How Pensions Confound Income Analysis General Electric Co. 26 ©Cambridge Business Publishers, 2015

Global Accounting  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.  Special Purpose Entities – Under U.S. GAAP, the primary beneficiary is required to consolidate the SPE. IFRS focuses on the general concept of “control” to determine if the SPE is consolidated. ©Cambridge Business Publishers,

©Cambridge Business Publishers, Learning Objective 3 Explain the accounting for special purpose entities (SPEs).

Special Purpose Entities (SPEs) – Asset Securitization  A sponsoring company forms a subsidiary that is capitalized entirely with equity; this creates a bankruptcy remote transaction, which reduces the likelihood of bankruptcy for subsequent investors).  The subsidiary purchases assets from the sponsoring company and sells them to a securitization trust (the SPE), which purchases the assets using borrowed funds.  Cash flows from the acquired assets are used by the SPE to repay its debt. ©Cambridge Business Publishers,

Special Purpose Entities (SPEs) Ford Motor Credit 30 ©Cambridge Business Publishers, 2015

Ford’s Asset Securitization 31 ©Cambridge Business Publishers, 2015

Rationale for SPE Financing  Lower cost of capital – SPEs can provide lower cost financing for a company.  Liquidity – Securitization of assets provides a consistent cash flow source. ©Cambridge Business Publishers,

Consolidation of SPEs  Generally, any entity that  lacks independence from the sponsoring company  lacks sufficient capital to conduct its operations apart from the sponsoring company  Must be consolidated with whatever entity bears the greatest risk of loss and stands to reap the greatest rewards from its activities.  The effect of consolidation of SPEs is to report both the assets and liabilities on the consolidated balance sheet.  The financing is, therefore, on-balance sheet, but the lower capital costs and liquidity of the market make this an important financing tool for many companies. ©Cambridge Business Publishers,

The End