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Module 10: Module 10: Leases and PensionsLeases and Pensions

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LeasesLeasesOperating leases

– Lessee assumes no risk of ownership.– Recognize rent expense as each payment

made.– At end of lease term, right to use the

property reverts to the owner.Capital leases

– Effectively an installment purchase.– Lessee assumes rights and risks of

ownership.– Treated as asset purchased with related

liability.

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LeasesLeases

Off-balance-sheet financing– Companies historically liked to contract

for leases rather than asset purchases, to keep the liability off the books.

– FASB issued SFAS No. 13, which requires certain leases to be recorded as capital leases.

– Capital leases record the leased asset as a capital asset, and reflect the present value of the related payment contract as a liability.

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LeasesLeases Requirements of SFAS No. 13 - record as capital

lease for the lessee if any one of the following is present in the lease:– title transfers at the end of the lease period.– the lease contains a bargain purchase option.– the lease life is at least 75% of the useful life of

the asset.– the lessee pays for at least 90% of the fair market

value of the lease. Payments under a lease agreement may include:

– Periodic rental payments (an annuity) and:– Bargain purchase option (BPO): an end of lease

payment to purchase asset at less than market OR

– Guaranteed residual value (GRV): a minimum amount (of cash and asset) required by the lessor if the asset is returned to the lessor.

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LeasesLeasesThe amount to capitalize (record for asset and

related liability) is the present value of the minimum lease payments:

PVMLP = PV RENTS + PVBPO or GRV

If lease contains both BPO and GRV, include only BPO. The assumption is that a rational lessee would exercise the BPO and not have to pay an GRV.

If the rents occur at the beginning of each period, like most leases, the PV RENTS is an annuity due.

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Illustration 1 - LeasesIllustration 1 - LeasesLee Company (the lessee) signed a contract to lease

equipment from Lawrence Company (the lessor). The terms of the lease were as follows:

1. Four year lease starting January 1, 2005.

2.Annual lease payments of $6,000. The first payment is due at lease inception (January 1, 2005), with subsequent payments on December 31, 2005, 2006, and 2007.

3.Bargain purchase option of $1,000 at end of lease (December 31, 2008).

Other information:

Lee’s borrowing rate: 8%

Useful life of equipment: 6 years with no salvage value.

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Illustration 1 - LeasesIllustration 1 - LeasesRequirement 1: Calculate the PVMLP

(Note that the lease payments are an annuity due.)

PVMLP = PV RENTS + PVBPO

PVAD Table PVAD Table

PV RENTS =PVAD= A( ) = 6,000(3.5771) = $21,463 i, n i =8%, n=4

PV1 Table PV1 Table

PVBPO = PV1 = FV1( ) = 1,000(0.73503) = $ 735

i, n i = 8%, n = 4

The present value of the minimum lease pmts = $22,198

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Illustration 1 - LeasesIllustration 1 - LeasesRequirement 2: Prepare the amortization schedule (effective interest method) to recognize the interest payments and principal payments over the life of the lease. This is similar to the amortization schedule for the bonds payable; cash paid is constant, and interest expense =

CV x Market Rate x Time, except that the lease payment includes both an interest payment and a principal payment. The “difference” in this case is the principal reduction each period.

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Illustration 1 - LeasesIllustration 1 - Leases Cash Interest Carrying

Date Paid Expense Difference Value 1/01/05 22,198 1/01/05 6,000 -0- 1 6,000 16,19812/31/05 6,000 1,2962 4,704 11,49412/31/06 6,000 920 5,080 6,41412/31/07 6,000 513 5,487 92712/31/08 1,000 733 927 -0-

1No interest at 1/1/05, because no time has passed. This is equivalent to a “down payment” which immediately reduces the total liability.

2Int. Expense = CV x MR x T = 16,198 x .08 x 1 year 3Rounding difference of $1 absorbed in calculation.

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Illustration 1 - LeasesIllustration 1 - LeasesRequirement 3: Prepare the following journal

entries for the year 2005:Initial lease at 1/1/05:

First payment at 1/1/05:

Second payment at 12/31/05:

Equipment 22,198Lease Liability 22,198

Lease Liability 6,000Cash 6,000

Interest Expense 1,296Lease Liability 4,704

Cash 6,000

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Illustration 1 - LeasesIllustration 1 - LeasesFor the last entry, we must calculate straight-

line depreciation on leased asset at 12/31/05. Since we are recording an asset, we must depreciate the asset.

Note that the calculation here is based on the length of time that the lessee will actually use the asset (6 years here because of the BPO).

(Cost-SV)/Est. life =(22,198 - 0)/6 = $3,700JE for Depreciation at 12/31/05:

Depreciation expense 3,700Accumulated Depr. 3,700

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Comments on LeasesComments on LeasesMany companies still have many leases that

qualify as operating leases for financial reporting.

Comparison to companies with capital leases is difficult (different asset and liability structures).

Off balance sheet financing affects a number of ratios, but the significant effect is on the debt to equity ratio.

Disclosure information regarding operating lease components makes it possible for analysts to “capitalize” the operating leases for financial statement comparison.

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Capitalization of Operating LeasesCapitalization of Operating LeasesThe standard disclosure for operating leases

gives specific payment amounts for each of the next 5 years, then a lump sum amount for all future years.

Step 1: using PV1, calculate the present value of each of the five individual lease payments.

Step 2: using the 5th year payment, assume that amount is an annuity for the remaining years; then divide the lump sum by the fifth year payment to get the number of years.

Step 3: calculate the PV of the annuity (discounting all the way back to year zero)

Step 4: add PV amounts to get PV of lease payments.

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Capitalization of Operating LeasesCapitalization of Operating Leases The resulting PV should be considered for its

effect on assets and liabilities. If capitalization is assumed, the differential

income statement effect should also be considered.

Operating income: reverse out lease expense, and include depreciation expense.

Nonoperating activity: include interest expense on the financing.

Note that I/S difference is effectively zero over the life of the lease, but affects operating and nonoperating activities in different ways.

Discount rate? Use disclosed rates of borrowings, or use disclosed PV of capital leases to back into discount rate used by the company.

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PensionsPensionsTypes of pension plans

– defined contribution plans– defined benefit plans

Defined contribution plan– simple to report– journal entry at time of funding:

Pension expense xxCash xx

– no recognition of asset or liability– promising only accumulated amount in

pension investment.

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Pensions - continuedPensions - continued Defined benefit plan

– promising an eventual benefit to employees– make payments to achieve the benefit– recognize assets/liabilities relating to the plan

if insufficient investment to meet promise: liability if investment in excess of promise: asset

– basic journal entry, as liability is recognized, and plan is funded:Pension Expense xxPension Asset/Liability xx / xx

Cash xx– Note: the recognition of liability is determined by

the recognition of expense; the net effect may be a pension asset, only if the funding is greater than the expense.

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Defined Benefit Plan and SFAS 87Defined Benefit Plan and SFAS 87SFAS 87 measures 3 different levels of

pension obligation:– Vested benefit obligation: for vested

employees at current salaries.– Accumulated benefit obligation (ABO): for all

employees at current salaries.– Projected benefit obligation (PBO): for all

employees at future salaries.PBO is most conservative, and used for most

calculations (including our exercises).SFAS 87 also measures the fair value of plan

assets (FVPA) to indicate the amount of assets accumulated to meet the PBO.

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Compromises in SFAS 87Compromises in SFAS 87Prior to SFAS 87, most companies were

recognizing expense only as they funded the plan (and no future asset or liability):

Pension expense xCash x

FASB initially wanted companies to recognize the difference between PBO and FVPA as the net asset or liability of the plan.

If PBO greater, then company has a net liability (underfunded).

IF FVPA greater, then the company has a net asset (overfunded).

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Compromises in SFAS 87Compromises in SFAS 87At the time of the proposal, most companies

were significantly underfunded.Corporations and CPA firms lobbied the FASB,

saying that, if they had to recognize the full liability, the effect would be disastrous:– they would violate existing debt covenants.– they would be unable to get additional

funding.– the extra expense would make the income

statement look terrible.– they would be driven out of business.– they would eliminate all defined benefit

plans.

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Compromises in SFAS 87Compromises in SFAS 87 The FASB backed down, and created several

techniques to smooth the recognition of liability and expense over time. – Amortization of “transition amount”: allowed

companies to recognize a portion of their initial liability over 15-20 years (now fully amortized for most companies).

– Amortization of “prior service costs”: allowed companies to recognize, over future service years of employees (using technique similar to sum-of-the-years’-digits), the effect of plan adoptions or amendments.

– Amortization of net gains/losses on change in estimates relating to PBO and FVPA. Most of these gains and losses are never recognized.

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Components of Pension Expense in SFAS 87Components of Pension Expense in SFAS 87Pension expense is calculated with the following components:1. Service cost (SC) - present value of new benefits, as

calculated by actuary.(+)2. Interest cost - current period’s estimated interest on

the PBO.(+)3. Expected return on plan assets - expected income

from plan assets this year.(-)4. Amortization of unrecognized PSC - usually an

additional cost, which leads to additional expense. (+)

5. Amortization of unrecognized net G/L - more expense if amortizing loss; opposite for gain.(+/-)

6. Amortization of transition amount (no longer included in most disclosures). More expense if liability. (+/-)

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Explanation of Unrecognized Net G/LExplanation of Unrecognized Net G/L– Given the following example: assume that

the total unrecognized net gain (for the calculation of pension expense) is $251,000.

– FASB applies a corridor to this amount to find the amount subject to amortization. The corridor (a “protected range”) is found by taking the greater of PBO or FVPA, then multiplying that amount by 10% (an arbitrary amount).

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Explanation of Unrecognized Net G/LExplanation of Unrecognized Net G/L– Assume that the UNG/L is $251,000– Assume that PBO = $1,879,000– Assume that FVPA = $1,165,000– Therefore, the corridor limit is +/- $187,900 (10% of greater amount of 1,879,000).– Anything inside this corridor remains

unamortized.– Anything outside this corridor is “subject to

amortization.”– FASB applies an additional level of smoothing

by amortizing only a portion of the G/L subject to amortization (usually based on remaining years of service).

– The rest of the G/L goes back into the “pool”.

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Illustration of Corridor ApproachIllustration of Corridor Approach 251,000 gain

187,900

-0-

(187,900)

Excess subject to recognition = 251,000 - 187,900 = 63,100.FASB smoothes again by allowing only a portion of the 63,100

to be recognized (usually based on remaining years of service). In this example, only 1/10th is recognized, or $6,310 gain. The rest of the gain (251,000 - 6,310) remains unrecognized, and is carried forward and added to the calculation of future unrecognized gains and losses.

} 63,100 excess

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Effect of SFAS 158Effect of SFAS 158A new standard, SFAS 158 is now in effect for

companies whose fiscal year begins after December 15, 2006.

This standard solves one of the problems with SFAS 87 - the full recognition in the financials of the funded status.

However, for the income statement, the FASB chose to continue the non-recognition of full amounts of actuarial gains and losses and prior service costs, thus minimizing the effect on the income statement through pension expense.

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Effect of SFAS 158Effect of SFAS 158These amounts (the unamortized portions) are

recognized instead through “Other Comprehensive Income” or OCI, and the detail is disclosed in the Statement of Stockholders’ Equity.

As new Prior Service Cost or Gains/Losses on estimates are incurred, they are recognized in the Pension Asset/Liability account, but the offset is to OCI.

For gains, the entry would be:Pension Asset/Liability x

Other Comprehensive Inc. xFor PSC and Losses, the entry would be:

Other Comprehensive Inc. xPension Asset/Liability x

(We will do one summary entry for all OCI effects.)

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Pension Reconciliation SchedulePension Reconciliation Schedule The reconciliation schedule is found in the notes

to the financial statements, and it contains all of the summary information regarding the “true” asset or liability.

The remainder of the information regarding the unrecognized amounts is found in the OCI section of the Statement of Stockholders’ Equity.

Now look at class problem on pensions.