BUS 780 Chapter 10 Liabilities: Off-Balance- Sheet Financing.

BUS 780

Chapter 10

Liabilities: Off-Balance-Sheet Financing

Liabilities: Off-Balance-Sheet Financing 2

Off-Balance-Sheet Financing

Off-Balance-Sheet Financing (OBF) is obtaining resources through liability financing without reporting the liabilities on the balance sheet statement.

Although the OBF is not reported in the balance sheet, it is, in most cases, disclosed in the footnotes.


Off-Balance-Sheet Financing: Examples

Cash obtained by selling accounts receivable to company’s non-consolidated special purpose entity (SPE).

Reporting leases as operating leases.

The unreported pension liabilities.


Off-Balance-Sheet Financing: SPE

A SPE is an entity created by a company for one specific purpose (i.e., for the purpose of purchasing company’s accounts receivable.)


Creating A Special Purpose Entity

An independent third party of a company creates a SPE on behalf of the company (referred to as the sponsor) by investing x % (i.e., 10%) of the total assets (i.e., cash) needed for the SPE.

The SPE will finance the remaining (1-x%) (i.e., 90%) by borrowing and the sponsor usually guarantees the loans borrowed by its SPE.


Off-Balance-Sheet Financing: SPE (contd.)

With the cash available, the SPE purchases the accounts receivable of the sponsor.

If the independent third party invests 10% or more of the total assets of the SPE, the sponsor does not have to consolidate the SPE in its financial statements.


Off-Balance-Sheet Financing: SPE (Contd.)

Without consolidation of its SPE, the liabilities of the SPE guaranteed by the sponsor are not reported in the balance sheet of the sponsor.

Therefore, the sponsor receives financing (i.e., cash from sale of A/R to its SPE) without reporting the liabilities of the SPE guaranteed by the sponsor.


Securitization by A Special Purpose Entity

The SPE can issue securities such as bonds backed by the purchased accounts receivable (i.e. use the A/R as collateral to borrow money).

This process is referred to as “securitization”.

The sponsor usually guarantees the securities issued by the SPE.


Off-Balance-Sheet Financing: leases

A Lease is “an agreement conveying the right to use property, plant, or equipment for a stated period of time”. (Source: SFAS No. 13)


Accounting for Leases

A lease involves a lessee and a lessor. A lessee acquires the right to use the

property, plant and equipment (PPE) and a lessor gives up the right.

A lessee will pay the periodic lease payments to the lessor in order to obtain the right to use the PPE.


1. Financing benefits:a. The lease provides 100% financing (no

down payment is needed). For companies with cash shortage, lease is a good alternative to purchase;

b. The lease contract may contain fewer restrictive provisions than other debtagreement; and

c. The lease agreement creates a claim that is against only the leased asset , not against all assets.

Advantages of Leasing from Lessees' Viewpoint


2. Risk benefit:

Reduce the risk of obsolescence.

3. Tax benefit:

Tax deduction may be accelerated since it is often spread over the lease term (rather than the economic life of the property).

Advantages of Leasing from Lessees' Viewpoint :(contd.)


4.Financial reporting benefit (off-balance-sheet financing):

For an operating lease, the lease does not add a liability or an asset to the balance sheet, and therefore does not affect financial ratios.

By maintaining these ratios, the company's borrowing capacity can also

be maintained.



5.Less Costly Financing:

The income tax savings on depreciation expenses for the lessor may be passed on to the lessee in the form of a reduced rental payment.



Advantages of Leasing from Lessors' Viewpoint :(contd.)

1. A way of indirectly making a sale.

2. An alternative means of engaging in a profit opportunity. The lease agreement enables the lessor to earn a normal rate of return (in a form of interest) on the cost of leased asset.


Classification of Personal property Leases

A lease that transfers substantially all the risks and benefits of ownership to the lessee represents a purchase by the lessee and a sale by the lessor and should be treated as a capital lease (SFAS No. 13).

SFAS 13 provides rules for determining the classification of leases by both lessees and lessors.


General Criteria for classifying leases

Column A Criteria Applicable to Both Lessee and

Lessora.The lease transfers ownership of the property to the lessee by the end of the lease term.b.The lease contains a bargain purchase optionc.The lease term is equal to or greater than 75% of the estimated economic life of the leased property.d.The present value of the minimum lease payments (MLP) is equal to 90% or more of the fair value of the leased property to the lessor.

Column B Criteria Applicable to

Lessor Onlya.The collectibility of the

minimum lease payments is reasonably assured (i.e., predictable).

b.No important uncertainties surround the amount of unreimbursable cost yet to be incurred by the lessor under the lease.


Classification by the lessee

Capital lease:

Lease that meets one or more of the criteria in column A.

Lessee should treat capital lease as a purchase of asset; recognize leased asset and lease liabilities under capital lease.

Operating lease:

Lease that does not meet any of the criteria in Column A.


Key Terms Related to Leases

Bargain Purchase Option

A provision allowing the lessee to purchase the leased property at the end of the life of the lease at a price so favorable that the exercise of the option appears, at the inception of the lease, to be reasonably assured.


Key Terms Related to Leases :(contd.)

Fair Value of Leased Property Price for which the property can be sold

in an arm's length transaction between unrelated parties.

For manufacturers and dealers, the fair

value is the selling price. For others, the fair value is the cost of the asset to the lessor.


Key Terms Related to Leases :(contd.) Minimum Lease Payments(MLP):

Payments that are required to be paid by the lessee to the lessor over the life of the lease.


Accounting for Leases -Treatment of operating lease:

Terms and provisions of lease agreement betweenlandlord company (lessor) and tenant company

(lessee) dated January 1, 20x6 1.The lease term is 5 years. The lease is

noncancelable and requires equal rental payments of $50,000 at the beginning of each year.

2.The cost, and also fair value, of the equipment to the Landlord Company at the inception of the lease is $400,000. The equipment has an estimated economic life of 10 years and has a zero estimated residual value at the end of this time.


I. Accounting for Leases -Treatment of Operating Lease: (contd.)3.The equipment reverts to the Landlord Company at

the end of the 5 years; 4.The Tenant Company's incremental borrowing rate

is 12.5% per year.5.For the Landlord Company, the interest rate implicit

in the lease is 12%.6.The present value of an annuity due of 5 payments

of $50,000 each at 12% is 4.037349 * $50,000 = $201,867.45


Application of Criteria for Determination of Lease Classification by Lessee

Classification Criteria Criteria Met? Remarks1. Transfer of ownership at end of lease No2. Bargain purchase option No3. Lease term is 75% of economic life No It is 50%4. Present value of lease payments is 90% of fair value No The present

value is $201,867.45,

or 50.5% of fair value

Conclusion: the lease is an operating lease. It meets none of the criteria.


Journal Entries – Operating Lease for Lessee

The journal entry recorded by the lessee is:1-1-20x6

Rent Expense 50,000 Cash 50,000

Note: Similar entries will be recorded at the beginning of 20x7 through 2010.

Under the operating lease, neither a leased asset nor a lease liability is recognized in the balance sheet statement (i.e.,off-balance-sheet Financing).


Accounting for Leases - Capital Lease for lessees

When a lease is reported as a capital lease, Lessee records an asset (i.e., leased asset) and a liability (i.e., lease liability).

The amount of leased asset equals lease liability at the inception of the lease term and is calculated as the present value of the minimum lease payments (MLP).


Discount Rate used in computing the present value of MLP

In computing the PV of the MLP, lessee should use the lower of a.The lessee's incremental borrowing

rate, or b.The lessor's implicit rate .

If b is unknown to lessee, lessee uses a.


Discount Rate used in computing the present value of MLP (cont.)

The present value of MLP may be different for a lessee and a lessor when different discount rates are used in computing the PV. The lower the rate is, the greater the PV of MLP.


Capital Lease: An Example

Equipment is leased under an agreement without a transfer of ownership, a bargain purchase option or a guaranteed RV.

Terms and provisions of lease agreement between Gardner company (lessor) and Martin company (lessee) dated January 1,20x6:

1.The lease term is 4 years. The lease is noncancelable and requires equal payments of $32,923.45 at the end of each year.


Example A1 (contd.)

2.The cost, and also fair value, of the equipment to the lessor at the inception of the

lease is $100,000. The equipment has an estimated economic life of 4 years and has a zero estimated residual value at the end of lease term. The annual lease payment charged by

the lessor is calculated as follow: $100,000 a/ 3.037349b = 32,923.45b. P.V. of an ordinary annuity of $1 for 4

periods at 12% interest rate


Example A1 (contd.)

3.The equipment reverts to Gardner at the end of the 4 years;

4. Martin Company's (lesee) incremental borrowing rate is 12.5% per year.

5.For Gardner Company (lessor), the interest rate implicit in the lease is 12%. Martin Company knows this rate.

6.Martin Company uses the straight-line method to record depreciation on similar equipment's.3


The Accounting Treatments for Capital Lease-Lessor7. The present value of an ordinary annuity of

four payments of $32,923.45 at 12% is $100,000, calculated as follows:

3.037349 *$32,923.45 = $100,000.


Application of criteria to determine the lease classification by Lessee and Lessor:

Classification Criteria Criteria Met? Remarks1. Transfer of ownership at end of lease No Title reverts

to lessor2. Bargain purchase option No

3. Leas term is 75% or more of economic life Yes 100% of estimated life

4. Present value of MLP is 90% or more of fair value Yes The Present

value is $100,000, or

100% of fair value


The Accounting Treatment for Capital Lease (Lessor):(contd.)The lease is a capital lease for lessee because it meets two of the four criteria under Column A (on p17) .


Journal Entries for the Capital Lease Example

The journal entries to record the acquisition of the leased asset, the amortization (depreciation) for 4 years by the lessee are as follows:

1. Initial Recording of capital lease on 1/1/x6

Leased Equipment 100,000

Lease Payable 100,000

(PV of MLP = $32,923.45 * 3.037349 = 100,000)


Journal Entries for Capital Lease Example (Contd.)

2. First payment (on 12/31/x6)

Interest Expense 12,000* Lease Payable 20,923

Cash 32,923

* 100,000 * 12% = 12,000Interest Expense under effective interest method Interest Expense = P.V. of liability. * effective

interest rate.


Journal Entries (contd.)

3.Recognition of annual depreciation (or amortization)of leased equipment on 12/31/x6:

Depreciation Expense: Leased Equip.* 25,000 Acc. Depreciation: Leased Equip. 25,000

* The asset is amortized over the lease term.



4. Payment on 12/31/x7:Interest Expense 9,489.19a Lease Payable 23,434.26b Cash

32,923.45

a. P.V. of liability at the beginning of 1996 * 12% = (100,000-20,923.45) * 12% = 9,489.12b. 32,923.45 -9489.19 = 23,434.26

5. Depreciation Expense of x7: Depreciation Expense: Leased Equip. 25,000

Acc. Depreciation : Leased Equip 25,000



20x8:Interest Expense 6,677.17Lease Payable 26,246.38

Cash 32,923.45Depreciation Expense : L. E. 25,000

Acc Depreciation: L.E 25,000

20x9:Interest Expense 3,527.54 Lease Payable 29,395.91

Cash 32,923.45Depreciation Expense : L. E. 25,000

Acc Depreciation: LE 25,000



Selected account balance at the end of the lease term:

lease payable = $0

Acc. Depreciation = $100,000

Leased Equipment = $100,000

Journal entry on 12/31/x9:

Acc. Depre. 100,000

Leased Equip. 100,000


Summary of lease payments and interest expense of the Capital lease Example

Payments at End of Year

Annual Lease 12% on Unpaid Reduction of Obligation

Date Payment Obligation a Lease Obligation b Liability c

1/1/20x6 - - - $100,000.00

12/31/20x6 $32,923.45 $12,000.00 $20,923.45 79,076.55

12/31/20x7 32,923.45 9,489.19 23,434.26 55,642.29

12/31/20x8 32,923.45 6,677.07 26,246.38 29,395.91

12/31/20x9 32,923.45 3,527.54d 29,395.91 0 Total 131,694 $31,694 $100,000


Summary of Lease Payments and Interest Expense of Martin company (contd.)

a. Column 5 at beginning of year * 12 %, the effective interest expenseb. Column 2 - Column 3c. Column 5 at beginning of year - Column 4d. adjusted for rounded error of 0.03.


Issues in Accounting for Leases

By reporting lease as operating lease, companies can obtain the usage of an asset (i.e., leased asset) without reporting the liability (i.e., lease payable). With the rules established by SFAS No. 13, a company can structure a lease contract to be qualified as an operating lease by setting the present value of MLP to be less than 90% (i.e., 89.99%) of the fair value of the leased asset alone with not meeting the other three criteria.


Issues in Accounting for Leases – the present value of MLP

The present value of MLP depends on the lease payment and the discount rate used. The discount rate used by the lessee is the lower of a. the lessee’s incremental borrowing rate, b. the implicit interest of lessor used in determining the lease payment. If b is unknown to lessee, use a.


The Revisit of Accounting for Leases

Under the rules-based GAAP for leases, two similar lease contracts with a mere 0.01% difference on the present value of MLP could result in different reporting.The contract with PV of MLP equals or greater than 90% of the fair value of asset will report the lease as a capital lease. The other contract with PV of MLP equals 89.99% of the fair value of asset will report the lease as an operating lease.


The Revisit of Accounting for Leases

In an effort to improve the comparability of accounting for leases and eliminate narrow difference between GAAP and IASB, the FASB added the topic of lease accounting on its agenda in July, 2006 as a joint project with the International Accounting Standards Board.


Income Tax Accounting The differences between accounting

income and taxable income include permanent and temporary differences.

Permanent differences: revenues or expenses are included in financial reporting but are never taxable.


Income Tax Accounting Examples of Permanent Differences

1. Accounting revenues which are not taxable:

a. Interest on municipal bonds.

b. Portion of dividends received from investment in U.S. corp. stock is tax exempted (i.e., 70% exemption for if investor owns less that 20% of investee’s shares).


Permanent Differences (contd.)

Examples (contd.)

2. Accounting expense but is never tax deductible:

Employee stock option expense under incentive plans.

3. Tax expense but is never included as accounting expense:

Percentage depletion in excess of cost depletion.


Permanent Differences (contd.)

Accounting Treatment for permanent differences:

Not included in the journal entries as deferred tax liabilities/assets.


Permanent Differences

Temporary Differences:

Revenues or expenses are included in accounting income in one period but are included in tax income in a different period. These differences will eventually be reversed.

Causes of Temporary Difference:

Different treatment between GAAP and IRC.


Difference between IRC and GAAP

Depreciation

GAAP: any systematic depr. method

IRC : MACRS

Installment Sales (future taxable)

GAAP: on accrual basis

IRC : on cash basis


Difference between IRC and GAAP (contd.)

Warranty Expense (future deductible)

GAAP: accrual basis (estimated and recognized at the end of each period)

IRC : cash basis (tax deductible when paid)Bad Debt Expense (future deductible)

GAAP: estimated and recognized at the end of each period.

IRC : tax deductible when accounts defaulted.


Temporary Difference: Example A

Depreciation method:

For tax filing purpose: MACRS, 4-year life For financial reporting purpose: straight-line method, 5-year life

The asset was purchased on 1/1/x1 with a cost of $10,000 and a zero residual value.


Temporary Difference: Example A (contd.)Financial depr. expense vs. tax depr.: Year S-L method

Depr. exp.Tax Depr.exp.

20x1 $2,000 $2,500a

20x2 $2,000 $3,750b

20x3 $2,000 $1,875c

20x4 $2,000 $1,250d

20x5 $2,000 $ 625


Temporary Difference: Example A (contd.)a. $10,000*50% *0.5 = 2,500b. $7,500*50% = 3,750 c. $3,750*50% = 1,875 d. $1,875*50% = 937.5 < (1,875/1.5 =1,250)


Temporary Difference: Example A (contd.)Assuming a 30% tax rate, the following table presents the annual temporary difference and the deferred tax liability:

Annual temp. diff.

Cum. Temp.diff

Ending deferred T/L

Beg. Deferred T/L

Change in defer. Liam.

500 500 150 0 150

1,750 2,250 675 150 525

(125) 2,125 637.5 675 (37.5)

(750) 1,375 412.5 637.5 (225)

(1,375) 0 0 412.5 (412.5)


Temporary Difference: Example A (contd.) T-account of the deferred tax liability

Deferred Tax Liability

20x3….. 37.5 150……..20x1

20x4…. 225 525……..20x2

20x5…. 412.5

0…..20x5


Interperiod Income Tax Allocation

Example B: the following information is available for the year ended 12/31/x1: Accounting income = $10,400 Taxable income = $ 9,000 (AI > TI) Tax Rate = 30% The difference of $1,400 is resulting from using MACRS for tax filing while using S-L for F/R purposes. This difference will be reversed as follows:


Interperiod Income Tax Allocation

Reversed Amount (F/R depr.>Tax Depr.)

20x1 $500 20x2 700 20x3 200 Total 1,400

Tax payable for 20x1 = >

9,000 *30% =$2,700


Interperiod Income Tax Allocation (contd.) Alternative Accounting Treatments

I. No Allocation of Deferred I/T Liam.

Income Tax Exp. 2,700 Income Tax Payable 2,700

II. With Allocation (comply with the matching principle) – Deferred Approach(APB No. 11)

Income Tax Expense 3,120 Income Tax Payable 2,700

Deferred Income Tax Lia. 420a aa plug in number (i.e., 3,120-2,700)


Interperiod Income Tax Allocation (contd.) Alternative Accounting Treatments (contd.)

III.With Allocation- Liability Approach (SFAS 109)

Income Tax Expense 3,120a Income Tax Payable 2,700 Deferred Income Tax Lia. 420b

a. A plug in number (i.e., 2,700+420)


Interperiod Income Tax Allocation (contd.)b Deferred tax lia.is calculated based on the

reversed amount in the future times the future tax rate. If the future tax rate remains at 30%, the deferred tax lib. Is $420. Otherwise, the deferred tax lib. will not be $420 (see next example).


Interperiod Income Tax Allocation (contd.)—Example CExample C: The taxable income of 20x1 = $9,000 The accounting income of 20x1 =$10,400

Partial Income statement: Pretax financial income $10,400 Less: additional accelerated depr. Deducted for I/T (1,400) Taxable Income $9,000


Interperiod Income Tax Allocation (contd.)—Example C (contd.)At the beg. of 20x1, the deferred I/T has a balance of $0 (due to 20x1 is the first year of occurrence of difference in depr.) and the current tax rate is 30%.

There is no expectation of tax rate changes in the future.


Interperiod Income Tax Allocation (contd.)—Example C (contd.)The financial depr. exp. will exceed the taxable depr. by the following amount in the next three years:

a&b: assumed numbers.

Year Acc.Depr.a Tax depr.b Diff.

20x2 $1,000 $500 $50020x3 1,000 300 70020x4 1,000 800 200


Interperiod Income Tax Allocation (contd.)—Example C (contd.)The following table shows the annual temporary difference, accumulative temporary diff. and deferred liability (tax rate = 30%):

Year Temp. Diff Accu.

Temp. DiffEnd. Defer. I/T lia.

Beg. Defer. I/T lia.

Change in def. I/T lia.

20x1 $1,400 $1,400 $420 $0 420

20x2 (500) 900 270 420 (150)

20x3 (700) 200 60 270 (210)

20x4 (200) 0 0 60 (60)


Interperiod Income Tax Allocation (contd.)—Example C (contd.)T-account of Deferred income tax lia.

Deferred I/T Liam.

20x2…..150 420…….20x1 20x3…..210 20x4….. 60

0 (bal)20x4


Interperiod Income Tax Allocation (contd.)—Example C (contd.)J.E. (for 20x1) (based on APB No.11; the deferred approach)Income Tax Expense 3,120a Income Tax Payable 2,700 b Deferred Income Tax Liam. ?

a. $10,400 (accounting income)*30% b. $9,000 (taxable income)*30%c. ? = 3,120-2,700, a plug in number under APB 11.


Interperiod Income Tax Allocation (contd.)—Example C (contd.)J.E. (for 20x1) (based on SFAS 109; the liability approach)Income Tax Expense ?a

Income Tax Payable 2,700 b Deferred Income Tax Lia. 420c

a. ? = b+c = 2,700+420 = 3,120 b.$9,000 (taxable income)*30% c.$420 = $500*30% +700*30% +200*30%

revered revered revered

lia. Of 20x2 lia. Of 20x3 lia. Of

20x4


Interperiod Income Tax Allocation (contd.)—Example C (contd.)Note c is also presented in the following table:

a. Due to future taxable income > future acc. Income. It is a result of future tax depr. < future acc. Depr. b. Future expected tax rate should be used. Example B assumed all future tax rates remain at 30%.

20x2 20x3 20x3 Total

Futurea taxable amount

$500 $700 $200 $1,400

I/T Rate 30%b 30% 30%Defer. Liam. reversed

$150 $210 $60 $420


Interperiod Income Tax Allocation (contd.)—Example C (contd.)

Assuming taxable income of 20x2,20x3 and 20x4 are $7,000, $6,000 and $8,000, respectively, journal entries of income tax for those year are as follows (all future tax rate remains at 30%) (follow SAFS 109):20x2 Deferred I/T Lia. 150 a I/T Expense ? b

I/T Payable 2,100c

a. See the previous table for year 20x2 b. income tax expense = $2,100 –150 c. taxable income 7,000*30%


Interperiod Income Tax Allocation (contd.)—Example C (contd.)20x3 Deferred I/T Liam. 210 a I/T Expense ? b

I/T Payable 1,800c

20x4 Deferred I/T Liam. 60 d I/T Expense ? e

I/T Payable 2,400f

a. See the previous table for year 20x3 b. income tax expense = $1,800 –210 c. taxable income 6,000*30%d. See the previous table for year 20x4 e. income tax expense = $2,400 –60 f. taxable income 8,000*30%


Interperiod tax Allocation with Different Expected Tax RateUsing the same information as in Example B except the tax rates are expected to change in the future as follows: 20x1 = 30% (the current year) 20x2 = 40% 20x3 = 40% 20x4 = 40%The ending bal. of the deferred I/T lia. for year 20x1 would be $$560 instead of $420 as in Example B when future rate states at 30%.


Interperiod tax Allocation with Different Expected Tax Rate (cont.)The computation of the ending balance of deferred I/T lia. For 20x1 is as follows:

20x2 20x 3 20x4 TotalTaxable amount $500 $700 $200 $1,400I/T rate 40% 40% 40% 40%

Reversed tax lia. $200 $280 $80 $560


Interperiod tax Allocation with Different Expected Tax Rate (cont.)Journal Entry for 20x1 is as follows based on a 40% expected tax rate for 20x2 to 20x4:

Income Tax Expense ?a Income Tax Payable 2,700 b Deferred Income Tax Liam. 560c

a. ? = b+c = 2,700+560 = 3,260 b.$9,000 (taxable income)*30% c.$560 = $500*40% +700*40% +200*40% or as shown in the previous table


Interperiod tax Allocation with Different Expected Tax Rate (cont.)What if at the end of 20x2, the tax rate has been increased to 45% (instead of 40% as expected at the end of 20x1), the deferred liability at the end of 20x1 should have been $625a rather than $560 as using the 40% expected rate.The following adjusting entry should be prepared on 12/31/20x2: a. $500*45%+700*45%+200*45% = $625


Interperiod tax Allocation with Different Expected Tax Rate (cont.)12/31/20x2

Loss on Adjustment of Deferred Taxes 65 a Deferred I/T Liam. 65

a. $625-560 = $65


Pension Plans

A pension plan is an agreement between a company and its employees that the company promises to provide benefits to its retired employees in return for the services that were provided by the employees during their employment.

Thus, the benefits provided by the pension is a deferred compensation.


Types of Pension Plans

a. Defined contribution plan:

The employers’ contribution to the plan is defined by the terms of the plan.

Future benefits are limited to those that can be provided by the contributions and the returns earned on the investment of those contributions.


Types of Pension Plans (contd.)

b. Defined benefit plan:

A pension plan that states either the benefits to be received by employees after retirement or the method of determining such benefit.


Types of Pension Plans (contd.)

The accounting for defined contribution plan simply recognizes compensation expense for the amount of the contribution as follows:

Pension expense $$$

Cash $$$


Defined Benefit Plans

A defined benefit plan may be funded or unfunded.

Under a funded plan, the company typically makes periodic payments to a funding agency which assumes the responsibilities for safeguarding, investing the pension assets and making payments to the recipients of benefits.


Defined Benefit Plans (contd.)

For an unfunded plan, no periodic payments are made to an external agency.

The Pension Reform Act of 1974 has eliminated unfunded plans.

However, some plans are underfunded.


Defined Benefit Plans (contd.)

The amounts needed to fund a pension plan are estimated by actuaries.

In addition, a defined benefit plan can be contributory or non contributory.


Pension Obligation

Pension obligation (liability):

The deferred compensation that companies have promised to their employees for their service under the terms of pension plan.


Capitalization vs. Non Capitalization

Capitalization: Pension liability is recognized in the balance sheet.

Non capitalization: Pension liability is only reported in the footnote (off-balance-sheet financing).

Prior to FASB No. 87, the accounting for pension liabilities were a non capitalization approach.



FASB No. 87 adopts a partial capitalization approach.

SFAS No. 158 (issued in 9/2006), “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statement NO. 87,88,106 and 132 (R)” also adopts the partial capitalization approach.



The new pension accounting standard intends to improve pension reporting by requiring companies recognize the funded status of defined benefit postretirement plans on the financial statement.

The funded status includes the fair value of the plan assets and the projected pension obligation.


Pension Liability

When pension liability occurs (regardless paid or not), pension expense should be recognized.

Pension liability will only be reduced when benefits are paid.

Funding of pension plans does not reduce pension liability.


Pension Liability (contd.)

The funded assets are considered as a pledged collateral against pension liability.

Pension liability is affected by two factors: employers’ promises (↑ pension lia.) the benefit payment (↓ pension lia.)


Pension Liability (contd.)

Therefore, the under or overfunding pension plans does not affect pension liability at all.


Pension Cost

The determination of pension cost (expense) is extremely complicated because it is a function of the following components:1.(+) Service Cost2.(+) Interest on the Liability3. (-) Actual Return on Plan Assets4. (+) Amortization of Unrecognized Prior

Service Cost5.(- or +) Amortization of Unrecognized Net

Gain or Loss


Accounting for Pension: Example

Assume that on January 1, 20x2, Zarle Company adopts SFAS No. 158 to account for its defined benefit pension plan.

The following facts apply to the pension plan for the year 20x2:


Example (contd.)

Plan assets, January 1, 20x2, are $100,000. Projected benefit obligation, January 1, 20x2,

is $100,000. Annual service cost for 20x2 is $9,000. Settlement rate for 20x2 is 10%. Actual return on plan assets for 20x2 is

$10,000. Contributions (funding) in 20x2 are $8,000. Benefits paid to retirees in 20x2 are $7,000.


Example (contd.)

Using the data presented above, the work sheet presents the beginning balances and all of the pension entries recorded by Zarle Company in 20x2.

The beginning balances for the projected benefit obligation and the pension plan assets are recorded in the first line of the work sheet in the memo record.


Example (contd.)

The projected benefit obligation and the pension plan assets are not recorded in the formal general journal.

Thus, they are not reported as a liability and as an asset in the financial statements of Zarle Company.


Example (contd.)

They (the benefit obligation and the pension assets) are off-balance-sheet items.

They affect pension expense but are not recorded as assets and liabilities in the balance sheet of employers.

Assumptions for the example: actual return equals expected return, no prior service costs, and no net gain or loss.

Liabilities: Off-Balance-Sheet Financing 9999Environment and Theoretical Structure of Financial Accounting

Example (contd.)

20X2

20X2

20X2

20X2


Example (contd.)

The journal entry on 12/31/x2 is:Pension Expense 9,000

Cash 8,000Prepaid/Accrued Pension Cost 1,000

Funded status: Pension assets –Pension lia. = $111,000 – 112,000= $(1,000).

The pension lia. reported on the balance sheet statement is also equal to $1,000, same as the funded status (required by SFAS 158).


Comments on SFAS 158 Under SFAS 158, the funded status of the

pension plan is reported on the balance sheet (i.e., $1,000 underfunded).

However, neither the pension liabilities (i.e., $112,000), nor the pension assets (i.e., $110,000) are reported on the balance sheet statement.

Unless the risk of pension liabilities and assets are the same, the reporting of the net funded status is not equivalent to reporting both pension assets and liabilities.

BUS 780 Chapter 10 Liabilities: Off-Balance- Sheet Financing.

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Transcript of BUS 780 Chapter 10 Liabilities: Off-Balance- Sheet Financing.