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Module 10: Leases and Pensions

Module 10: Leases and Pensions. Operating 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.

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Module 10: Leases and Pensions

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  1. Module 10: Leases and Pensions

  2. Operating 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. Leases

  3. 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. Leases

  4. 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. Leases

  5. The 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. Leases

  6. Lee 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. Illustration 1 - Leases

  7. Requirement 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, ni = 8%, n = 4 The present value of the minimum lease pmts = $22,198 Illustration 1 - Leases

  8. Requirement 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. Illustration 1 - Leases

  9. Cash Interest Carrying Date Paid Expense DifferenceValue 1/01/05 22,198 1/01/05 6,000 -0- 1 6,000 16,198 12/31/05 6,000 1,2962 4,704 11,494 12/31/06 6,000 920 5,080 6,414 12/31/07 6,000 513 5,487 927 12/31/08 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. Illustration 1 - Leases

  10. Requirement 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: Illustration 1 - Leases Equipment 22,198 Lease Liability 22,198 Lease Liability 6,000 Cash 6,000 Interest Expense 1,296 Lease Liability 4,704 Cash 6,000

  11. For 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 = $3,700 JE for Depreciation at 12/31/05: Illustration 1 - Leases Depreciation expense 3,700 Accumulated Depr. 3,700

  12. Many 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. Comments on Leases

  13. The 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. Capitalization of Operating Leases

  14. 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. Capitalization of Operating Leases

  15. Types of pension plans defined contribution plans defined benefit plans Defined contribution plan simple to report journal entry at time of funding: Pension expense xx Cash xx no recognition of asset or liability promising only accumulated amount in pension investment. Pensions

  16. 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 xx Pension 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. Pensions - continued

  17. SFAS 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. Defined Benefit Plan and SFAS 87

  18. Prior to SFAS 87, most companies were recognizing expense only as they funded the plan (and no future asset or liability): Pension expense x Cash 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). Compromises in SFAS 87

  19. At 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. Compromises in SFAS 87

  20. 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. Compromises in SFAS 87

  21. Pension 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. (+/-) Components of Pension Expense in SFAS 87

  22. 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). Explanation of Unrecognized Net G/L

  23. 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”. Explanation of Unrecognized Net G/L

  24. 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. Illustration of Corridor Approach }63,100 excess

  25. A 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. Effect of SFAS 158

  26. These 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. x For PSC and Losses, the entry would be: Other Comprehensive Inc. x Pension Asset/Liability x (We will do one summary entry for all OCI effects.) Effect of SFAS 158

  27. 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. Pension Reconciliation Schedule

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