FINANCIAL ACCOUNTING
Fifth Edition
CHAPTER 10
Reporting and Analyzing
Leases, Pensions, and
Income Taxes
©Cambridge Business Publishers, 2017
Thomas Dyckman Michelle Hanlon
Robert Magee Glenn Pfeiffer
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FINANCIAL ACCOUNTING
Fifth Edition
CHAPTER 10
Reporting and Analyzing
Leases, Pensions, and
Income Taxes
Thomas Dyckman Michelle Hanlon
Robert Magee Glenn Pfeiffer
Learning Objective 1 Define off-balance-sheet financing and explain its effects on financial analysis. Define off-balance-sheet financing and explain its effects on financial analysis.
Financial Obligations (^) Some are off-balance sheet obligations (^) Others are reported as balance sheet liabilities with management having considerable discretion in their valuation
Taxes
Pensions
Leases
Effects of Off-Balance-Sheet Financing (^) Reduces amount of debt reported in the balance sheet (^) Causing a lower financial leverage ratio (^) All off-balance sheet financing results in either lower assets or higher equity (^) Without negatively affecting profit or revenues (^) Operating ratios are often improved
Leases A lease is a contract between an owner of an asset and a party desiring to use the asset. Common lease provisions:
- Lessee has unrestricted right to use the asset during the lease term.
- Lessee agrees to make periodic payments to the lessor and to maintain the asset.
- Lessor retains title to the leased asset. Lessor The owner of an asset Lessee Party desiring to use the asset
Leases Leases impact the following accounts: Income Statement Balance Sheet Operating leases and capital leases Operating leases and capital leases Capital leases^ Capital leases
Asset may be used for only part of its useful life. Asset may be used for only part of its useful life. Lessor retains tax benefit of depreciation. Lessor retains tax benefit of depreciation. Advantages of Leasing over Bank Financing Often requires less equity investment. Often requires less equity investment. Payments may be structured to meet lessee’s needs Payments may be structured to meet lessee’s needs With proper lease structure, lessee will report neither the leased asset nor the liability. With proper lease structure, lessee will report neither the leased asset nor the liability.
Lessee Reporting of Leases Capital Lease Method (^) Leased asset and lease liability reported on the lessee’s balance sheet (^) Asset is depreciated (^) Lease liability is amortized like debt
Lease payments are divided
between interest and
principal payments
Operating Lease Method (^) No balance sheet reporting of leased asset nor the lease liability (^) Lease payments are recorded as rent expense when paid GAAP allows two approaches:^ GAAP allows two approaches:
Present Value of Capital Lease Payments (^) Asset and liability amounts are valued at the present value of the lease payments Lease example: 5-year lease with an annual payment of $3,256 based on 8% rate due at the end of each year From Table A.3, Present Value of an Ordinary Annuity: PV of lease payments = 3.99271 x $3,256 = $13, (^) Payments can occur at the beginning or end of lease period Debit to Leased Asset & Credit to Lease Liability^ Debit to Leased Asset & Credit to Lease Liability
Capital Lease Recording the Lease by the Lessee Phelps Swimming leases a delivery truck from Ryder Trucks by signing a 5-year lease with an annual payment of $3, due at the end of each year, based on 8% interest.
Leased asset (+A) 13,
Lease liability (+L) 13,
Leased Asset (A) Lease Liability (L)
Balance Sheet Income Statement Transaction Cash Asset
Noncash Asset = Liabilities + Contrib. Capital
Earned Capital
- Revenues – Expense s
Net Income
Leased a
delivery truck
under a capital
lease
Leased
Asset =
Lease
Liability – =
Lease Example – Capital Lease Phelps Swimming will amortize the lease liability over the lease term. Year Beginning- Year Lease Liability Interest Expense Payment Principal Repayment Ending- Year Lease Liability
*rounded
8% × $13,000^ 8% × $13,000^ $13,000 – $2,216$13,000 – $2,
$3,256 – $1,040^ $3,256 – $1,
Capital Lease Recording a Lease Payment - Lessee Phelps Swimming paid its first annual payment of $3,256 on December 31, based on 8% interest.
Lease liability (–L) 2,
Interest expense (+E, –SE) 1,
Cash (–A) 3,
Lease Liability (L) Cash (A)
Balance Sheet Income Statement Transaction Cash Asset
Noncash Asset = Liabilities + Contrib. Capital
Earned Capital
- Revenues – Expenses = Net Income
Lease payment at
end of first year
- 3,
Cash
- 2,
Lease
Liability
- 1,
Retained
Earnings –
Interest
Expense =
- 1,
Interest Expense = $13,000 × 8% = $1,
Principal Reduction = $3,256 – $1,040 = $2,
Interest Expense (E)
Comparing Expenses Under Lease Methods The capital lease method reports a higher total expense in the early years of the lease and a lower expense in the later years.
Capital
Lease Method
Operating
Lease Method
Year
Interest
Expense
Depreciation
Expense
Total
Expense Rent Expense
Total expense is the same over the lease term.^ Total expense is the same over the lease term.
Expenses for the Lessee Annual expenses under operating leases are less than reported under capital leases, causing higher net income in the early years of the lease term. Annual expenses under operating leases are less than reported under capital leases, causing higher net income in the early years of the lease term. 1 2 3 4 5 $ $ $1, $1, $2, $2, $3, $3, $4, Capital Lease