10-1 FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition Chapter 10 – Liabilities: Off-Balance- sheet Financing, Leases, Deferred Income Taxes, Retirement Benefits, and Derivatives Clyde P. Stickney and Roman L. Weil

10-2 Learning Objectives 1. Understand (a) why firms attempt to structure debt financing to keep debt off the balance sheet and (b) how standard setters have refined the concept of an accounting liability to reduce off-balance-sheet financing abuses. 2. Distinguish between operating leases and capital leases on the bases of ther economic characteristics, accounting criteria, and financial statement effects. 3. Understand why firms may recognize revenues and expenses for financial reporting in a period different from that used for tax reporting and the effect of such differences. 4. Understand the accounting issues related to retiree benefit plans. 5. Learn the basics about derivative instruments and hedging.

10-3 Chapter Outline 1.Off-balance sheet financing 2.Leases 3.Income tax accounting and deferred taxes 4.Pension benefits and other deferred compensation 5.Health care and other benefits 6.Derivative instruments 7. An international perspective Chapter Summary 8.Appendix 10.1: Effects on the cash flow statement of transactions involving liabilities

Off-Balance Sheet Financing  Off-balance sheet financing is any means that secures the use of assets for the firm without having to recognize an off- setting liability.  If the liability is not recognized, then the double-entry system does not allow for the recognition of the asset either, but this is a tradeoff that some managers are willing to make.  Off-balance-sheet financing can affect key financial ratios, especially the financing ratios that use total debt as a denominator, showing them to be lower (and more favorable) than they would be if the financing were recognized. a. Rationale for off-balance sheet financing b. Structuring off-balance sheet financing

a. Rationale for Off-Balance Sheet Financing 1. It lowers the cost of borrowing if lenders are not aware of the unrecorded liabilities.  This rationale assumes that lenders can be fooled by off- balance-sheet methods.  Standard-setting bodies have required increased disclosures of such methods in recent years. 2. It avoids violating some debt covenants; that is, restrictions specified in the debt agreement to protect the lender. These restrictions are sometimes stated in the form of financial ratios which may be effected by whether or not the liability is recorded.

b. Structuring Off-Balance Sheet Financing Off-balance-sheet financing fall into one of two categories that accounting does not recognize as liabilities: 1. Executory contracts are promises to pay at a future date for future benefits  These may be legally binding and give both parties valuable rights.  Standard accounting would recognize a liability as benefits are received, not when the contract is signed. 2. Contingent obligations are obligations that arise only if a specified set of conditions are met.  Standard accounting would recognize a liability as the contingent events occur rather than when the contract is signed.

Leases  Firms may lease (or rent) assets instead of purchasing them.  A true lease would give the lessee (the one paying for use of the asset) flexibility.  Some leases are so inflexible that they are tantamount to a purchase. They may be non- cancelable, long-term and impose on the lessee all costs of operating.  Private automobile leases are typically so restrictive as to be the economic equivalent of a purchase.  A true automobile lease would be more like what is called renting a car.

Leases (Cont.)  Because of the possibility that leases may be used as a form of off-balance sheet financing, GAAP calls for leases to be capitalized under certain conditions.  Capitalizing a lease means to recognize the lease as if it were a purchase and thus recognize both the leased asset and the lease liability. The lease asset may be depreciated over time and the lease liability may be amortized as payments are made.  If the lease is not capitalized, it may be treated as a true lease (or operating lease). In this case, a lease expense would be recognized as payments were made but no asset or long-term liability would be recognized.

Leases (Cont.) -- Conditions  GAAP required that a lease be capitalized if any one of the following conditions are met: 1. Transfer of ownership to lessee at end of lease 2. Transfer at “bargain purchase” option 3. Lease extends for 75% of the asset’s life 4. PV of lease payments is 90% of fair market value  Of course, if management wants the lease to be treated as an operating lease, they will structure the lease terms to avoid all four of these criteria.  In such cases, the last requirement (90% of fair market value) is considered the most restrictive.

Leases -- Accounting For  Operating lease or true lease:  Neither the leased asset nor the lease liability are recorded  Lease expense is recognized as cash payments are made or adjusting entries are required  Capital lease:  Both a lease asset (leasehold) and a lease liability are recognized for the PV of the lease obligations  As payments are made or adjusting entries required:  The asset may be depreciated  The liability is amortized

10-11 Exhibit 10.1 Example of Lease Obligation Amortization Amortization Schedule for $45,000 lease liability, accounted for as a capital lease, repaid in three annual payments of $19,709 with interest at 15% compounded annually. Interest expense col 3 amt Lease liability col 5 amt Cash col 4 amt

Income Tax Accounting and Deferred Taxes  Terms  Book income is income before income taxes for financial reporting purposes  Taxable income is the amount of income on which the income tax is based  The two may be different because of:  The timing of recognition may be different, or  Some revenues or expenses may have special tax treatments

Income Tax Accounting and Deferred Taxes (Cont.)  The difference between book and taxable income are of two types: 1. Permanent differences are differences in what is recognized or not. For example, a tax-free bond gives book income but not taxable income. 2. Temporary differences are differences that will equal out over a long time. For example, book income may use straight line depreciation while taxable income will use macrs, an accelerated depreciation. Over time, both will depreciate the same amount but at different rates.

Income Tax Accounting and Deferred Taxes (Cont.)  Two views of income taxes: 1. Income taxes are expenses and should be matched or accrued like other expenses. 2. Income taxes are not expenses but are like other taxes and should be recognized at the amount paid in the current period.  U.S. GAAP holds to the first view. Thus, a tax deferral method saves taxes paid during the current period but may not reduce tax expense.  Critics of this view hold that tax expense is unlike other expenses in that it does not give rise to the potential for revenues.

Recording the Income Tax Expense A firm which has temporary differences between tax-based income and book income will record tax expense based on book income, pay the IRS the amount of the tax and the difference generally represents a liability. (See Exhibit 10.3) Year 1 Income tax expense 32,000 Income tax payable 30,400 Deferred tax liability 1,600 Year 4 Income tax expense 32,000 Deferred tax liability 2,240 Income tax payable 34,240 In the future when the deferred taxes become due, the effect is reversed reducing the deferred tax liability.

Pension Benefits and Other Deferred Compensation  Employers may provide benefits to workers after their retirement.  One reason is to build worker loyalty and good will.  Also, at one time, such benefits were a non-cash form of compensation.  Present federal law now requires employers to actually put away cash to cover the obligations of pension benefits.  The amount of cash and the recognition of an expense are complex issues.

Pension Benefits (Cont.) 1. Employers set up a pension plan specifying eligibility, promises, funding and an administrator. 2. Employer computes pension expense for each period. 3. Employer transfers cash to a separate pension fund each period. 4. If cumulative pension expenses exceed cumulative pension funding, a pension liability appears on the balance sheet, else a pension asset is recognized. 5. If the PV of pension commitments to employees exceeds the assets of the fund, a pension liability would also have to be recognized.

Pension Benefits (Cont.) SFAS No. 87 defines two measures of pensions liability: 1. Accumulated benefit obligation -- the present value of amounts expected to be paid to employees during retirement based on accumulated service and current salary. 2. Projected benefit obligation -- the present value of amounts expected to be paid to employees during retirement based on accumulated service to date but using the level of salary expected to serve as a basis for computing pension benefits.

Pension Benefits (Cont.)  The administrator of the pension fund should make prudent and profitable investments of those funds.  If the pension funds grows, this adds to the fund since the fund is not an asset of the firm.  Such growth does however ease the amount of cash that the firm has to transfer to the fund in future periods. Fund assets at beginning of the period +Actual earnings on pension fund investments +Contributions from employer -Payments to retirees =Fund assets at end of the period

Health Care and Other Benefits  Health care, insurance and other benefits resemble pension plans in concept.  The PV of such commitments, or health-care benefits obligation, represents an economic obligation of the employer.  GAAP requires firms to recognize an expense for these obligations and to recognize liabilities for any under funded obligations.  Firms may recognize the full liability in one year or piecemeal over several years.

Derivative Instruments  Firms face risks in carrying out business operations: 1. The risk that customers will stop buying its products and services, 2. The risk that raw material used in production will increase in cost after the firm has committed to a selling price, 3. The risk that currency exchange rates will change after the firm has made commitments fixed in terms of a foreign currency, 4. The risk that interest rates will change, 5. The risk that employees will quit or retire.

Derivative Instruments (Cont.)  Many firms seek to avoid risk even if it is costly.  Some financial firms specialize in helping firms avoid risk through financial instruments which are sold to the firm.  In general, such a financial instrument substitutes a fixed known cost for an unknown cost.  These instruments are analogous to insurance.  These instruments are as hedging when money is involved and as derivative instruments when the payoff is based on economic outcomes.  GAAP requires firms to show the market value of derivatives on their balance sheets.

An International Perspective  Leases -- most industrial countries distinguish between capital and operating leases although the criteria may vary.  Income tax accounting -- in general, countries that allow separate rules for tax and financial reporting allow deferred tax accounting.  Retirement benefits -- most industrial countries provide worker benefits and some are more generous than in the U.S., however, most do not provide the same detail of accounting disclosure.

10-24 Chapter Summary  This chapter completes the discussion of liabilities.  The point was made that liabilities cover some obligations that are difficult to measure.  Leases may represent a significant future obligation.  Pensions certainly do.  Taxes may give rise to future obligations when aggressive deferral methods are practiced.  The intent of this chapter was to acquaint the student with many problems of liability accounting and to give the student an appreciation of some liabilities that appear on the balance sheet.

10-25 Appendix 10.1: Effects on Cash Flows of Transactions Involving Liabilities  Leases -- Capitalizing a lease results in a long-lived asset (use of investing cash) and a liability (financing cash). As the asset is depreciated and the liability amortized, operating cash is effected. The two effects may not cancel out because of differences between the depreciation method and the amortization method.  Pensions -- The pension is a separate legal entity and is not an asset of the firm, so cash paid in by the employee is not an investment.  Derivatives -- changes in the valuation of the derivative will effect operating cash.