Module 10: Leases and Pensions

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Module 10 Leases and Pensions

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Leases

• 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.

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Leases

• 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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Leases

• 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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Leases

• 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.

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Illustration 1 - Leases

• 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
• Lees borrowing rate 8
• Useful life of equipment 6 years with no salvage
  value.

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Illustration 1 - Leases

• 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, n4
• 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 - Leases

• 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.

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Illustration 1 - Leases

• Cash Interest
  Carrying
• Date Paid Expense
  Difference Value
• 1/01/05 22,198
• 1/01/05 6,000 -0- 1 6,000 16,198
• 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.

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Illustration 1 - Leases

• 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

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
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Illustration 1 - Leases

• 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

Depreciation expense 3,700 Accumulated Depr.
3,700
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Comments on Leases

• 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.

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Capitalization of Operating Leases

• 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.

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Capitalization 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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Pensions

• 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.

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Pensions - 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 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.

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Defined Benefit Plan and SFAS 87

• 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.

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Compromises in SFAS 87

• 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).

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Compromises in SFAS 87

• 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.

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Compromises 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 87

• 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 periods 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/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/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 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 158

• 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.

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Effect of SFAS 158

• 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.)

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Pension 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.