Liabilities: Off-Balance-Sheet Financing

1
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.

3
Off-Balance-Sheet Financing Examples

• Cash obtained by selling accounts receivable to
  companys non-consolidated special purpose entity
  (SPE).
• Reporting leases as operating leases.
• The unreported pension liabilities.

4
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 companys accounts receivable.)

5
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.

6
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.

7
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.

8
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.

9
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)

10
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.

11
Advantages of Leasing from Lessees' Viewpoint
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 debt agreement and c. The
lease agreement creates a claim that is against
only the leased asset , not against all assets.
12
Advantages of Leasing from Lessees' Viewpoint
(contd.)

• 2. Risk benefit
• Reduce the risk of obsolescence.
• Tax benefit
• Tax deduction may be accelerated since it is
  often spread over the lease term (rather than the
  economic life of the property).

13
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.

14
Advantages of Leasing from Lessees' Viewpoint
(contd.)
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.
15
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.
16
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.

17
General Criteria for classifying leases

• Column B Criteria Applicable to
  Lessor Only
• a.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.

• Column A Criteria Applicable
  to Both Lessee and Lessor
• a.The lease transfers ownership of the property
  to the lessee by the end of the lease term.
• b.The lease contains a bargain purchase option
• c.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.

18
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.

19
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.

20
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.

21
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.

22
Accounting for Leases -Treatment of operating
lease

• Terms and provisions of lease agreement
  between landlord 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.

23
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

24
Application of Criteria for Determination of
Lease Classification by Lessee

• Classification Criteria Criteria Met?
  Remarks
• 1. Transfer of ownership at end of lease No
• 2. Bargain purchase option No
• 3. 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.

25
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).

26
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).

27
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.

28
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.

29
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.

30
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 32,923.45
• b. P.V. of an ordinary annuity of 1 for 4
  periods at 12 interest rate

31
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
32
The Accounting Treatments for Capital Lease-Lessor

• 7. 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.

33
Application of criteria to determine the lease
classification by Lessee and Lessor

• Classification Criteria Criteria Met?
  Remarks
• 1. Transfer of ownership at end of lease No
  Title reverts to lessor
• 2. 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

34
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) .

35
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)

36
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 12,000 Interest Expense
  under effective interest method Interest
  Expense P.V. of liability. effective
  interest rate.

37
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.

38
Journal Entries (contd.)

• 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
  9,489.12
• b. 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

39
Journal Entries (contd.)

• 20x8Interest Expense 6,677.17
• Lease Payable 26,246.38
• Cash 32,923.45
• Depreciation Expense L. E. 25,000
• Acc Depreciation L.E 25,000

• 20x9Interest Expense 3,527.54
• Lease Payable 29,395.91
• Cash 32,923.45
• Depreciation Expense L. E. 25,000
• Acc Depreciation LE 25,000

40
Journal Entries (contd.)

• 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

41
Summary of lease payments and interest expense of
the Capital lease Example

• Payments at End of Year

42
Summary of Lease Payments and Interest Expense of
Martin company (contd.)

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

43
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.

44
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 lessees incremental borrowing rate,
• b. the implicit interest of lessor used in
  determining the lease payment.
• If b is unknown to lessee, use a.

45
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.

46
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.

47
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.

48
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 investees shares).

49
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.

50
Permanent Differences (contd.)

• Accounting Treatment for permanent differences
• Not included in the journal entries as deferred
  tax liabilities/assets.

51
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.

52
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

53
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.

54
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.

55
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
56
Temporary Difference Example A (contd.)

• a. 10,00050 0.5 2,500
• b. 7,50050 3,750
• c. 3,75050 1,875
• d. 1,87550 937.5 lt (1,875/1.5 1,250)
  

57
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)
58
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

59
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 gt 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

60
Interperiod Income Tax Allocation

• Reversed Amount (F/R depr.gtTax Depr.)
• 20x1 500
  20x2 700
  
  20x3 200
  Total 1,400
• Tax payable for 20x1 gt
• 9,000 30 2,700

61
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)

62
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., 2,700420)

63
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).

64
Interperiod Income Tax Allocation
(contd.)Example C

• Example 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

65
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.

66
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
• 
  
  
  
  
• ab assumed numbers.

Year Acc.Depr.a Tax depr.b Diff.
20x2 1,000 500 500
20x3 1,000 300 700
20x4 1,000 800 200
67
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. Diff End. 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)
68
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

69
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.

70
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. ? bc 2,700420 3,120
  b.9,000 (taxable
  income)30
  c.420 50030 70030 20030
  
• revered revered
  revered
  
  lia. Of 20x2 lia. Of 20x3
  lia. Of 20x4

71
Interperiod Income Tax Allocation
(contd.)Example C (contd.)

• Note c is also presented in the following table
• a. Due to future taxable income gt future acc.
  Income. It is a result of future tax depr. lt
  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 30b 30 30
Defer. Liam. reversed 150 210 60 420
72
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
  7,00030

73
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 6,00030
• d. See the previous table for year 20x4
  e. income tax
  expense 2,400 60
  f. taxable income 8,00030

74
Interperiod tax Allocation with Different
Expected Tax Rate

• Using 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.

75
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 Total
Taxable amount 500 700 200 1,400
I/T rate 40 40 40 40
Reversed tax lia. 200 280 80 560
76
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. ? bc 2,700560 3,260
  b.9,000 (taxable
  income)30
  c.560 50040 70040 20040 or as shown
  in the previous table
  

77
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. 500457004520045 625
  

78
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
  

79
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.

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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.

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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.

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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
  

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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.

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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.

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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.

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Pension Obligation

• Pension obligation (liability)
• The deferred compensation that companies have
  promised to their employees for their service
  under the terms of pension plan.

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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.

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Capitalization vs. Non Capitalization

• 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.

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Capitalization vs. Non Capitalization

• 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.

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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.

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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.)

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Pension Liability (contd.)

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

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Pension Cost

• The determination of pension cost (expense) is
  extremely complicated because it is a function of
  the following components
• 1.() Service Cost
• 2.() Interest on the Liability
• 3. (-) Actual Return on Plan Assets
• 4. () Amortization of Unrecognized Prior Service
  Cost
• 5.(- or ) Amortization of Unrecognized Net Gain
  or Loss

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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

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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.

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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.

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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.

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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.

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Example (contd.)
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Environment and Theoretical Structure of
Financial Accounting
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Example (contd.)

• The journal entry on 12/31/x2 is
• Pension Expense 9,000
• Cash 8,000
• Prepaid/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).

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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.