CH-13-17 Statement of Cash Flows – Accounting Theory: Conceptual Issues in a Political and Economic Environment : Book Guide

This Document Contains Chapters 13 to 17 Chapter 13: Statement of Cash Flows CHAPTER HIGHLIGHTS Even though SFAS No. 95 replaced the statement of change in financial position with the cash flow statement, Chapter 13 begins with a discussion of funds flow reporting and the statement of change in financial position. There are two reasons for retaining this historical literature in the text. First, the rationale for funds reporting is very similar to that for cash flow reporting—a concern that accrual accounting masks the firm’s operating flows. Therefore, funds reporting was viewed as a supplement to accrual-based statements, and the reporting of more basic funds flow data thus reverses—at least to some extent—the effects of arbitrary allocations and other conventions of historical costing. Second, the cash flow statement can be viewed as a statement of change in financial position, with “funds” defined as cash. While there are some differences in format, the point remains that SFAS No. 95 can be characterized as amending APB Opinion No. 19 by requiring rigid uniformity in the definition of funds as cash plus cash equivalents. The statement of change in financial position (SCFP) is another way of classifying and reporting the firm’s transactions that already appear in the income statement and balance sheet, but with the emphasis on undoing at least some of the effects of accrual accounting in order to get at a more basic measure of flows. The research that has been done supports the notion that a cash definition of “funds” results in the newest information—over and above the accrual data in the balance sheet and income statement. In addition, using a cash definition of funds can also be viewed as being in line with the objective of “predicting, comparing, and evaluating cash flows.” Finally, it should be emphasized that the FASB’s rigid uniformity here is well placed and that, for measuring liquidity, a cash definition of funds is the most representationally faithful. While the SCFP used a very general sources and uses framework, focusing mechanically on the narrow accounting debit-credit relation, the SCF classifies cash receipts and payments into more meaningful categories relating to operating, financing, and investing activities. Cash is defined as literal cash on hand or on demand deposits, plus cash equivalents. There have been questions raised, however, relative to the classification of interest and dividends under SFAS No. 95. In fact, three of the seven members of the FASB dissented from the statement, arguing that interest and dividends received arise from investing activities rather than from operating activities, and that interest paid is an element of financing activities rather than an operating cost. SFAS 95 states that operating cash flows may be presented using either the direct or the indirect method. The direct method reports literal cash flows related to income statement classifications (revenues, cost of sales, etc.). By contrast, the indirect or reconciliation method starts with accrual income and adjusts it for the associated noncash items. Emphasize that the direct method provides users with information that is easy to understand; however, it can be time consuming for a company to prepare. Typical accounting systems do not make it easy to produce direct SCFs in the real world. The indirect method can be easy for a company to prepare, but difficult for users to understand. So, given the preparation cost of each method, which do you think companies usually adopt? Chapter 13: Statement of Cash Flows This Document Contains Chapters 13 to 17 FASB requires that if the direct method is used, a separate schedule shall reconcile net operating cash flow with net income. Thus, the indirect or reconciliation method must be used either alone or as a supplement to the direct method. The great bulk of American firms use the indirect method. From a user perspective, this is backwards. The authors suggest the direct method be required; it provides users with easier to understand cash flows. Nonarticulation is a problem that occurs when the cash flows arising from the changes in the working capital accounts of consolidated enterprises are not equal to the working capital adjustments listed in the operations section of the SCF. This problem arises when the indirect method of reporting is used and non-cash flow elements affect the balances of working capital accounts. The chapter discusses a variety of causes of nonarticulation. The three-part structure of the SCF—operating, financing, investing, is generally in accordance with the finance literature. However, SCF classifies interest and dividend receipts as operating inflows, and interest payments as operating outflows. While this classification might be appropriate for the banking industry, it does not appear to be appropriate for the vast majority of firms. Despite classification and nonarticulation problems, the SCF has been shown to be a very useful statement. The SCF is less manipulable than income, but it is not exempt from the problem. We provide several examples in which operating cash outflows have been misclassified as investing cash flows. To maximize its value to investors and creditors, SCF must be viewed in its entirety. Free cash flow is a recent and increasingly popular cash flow metric. It focuses on the ongoing operations of the firm, including its investing activities. Unlike cash flow from operating activities, free cash flow treats interest expense as a financing item. Finally, we review the cash and funds flow research. While research shows the SCF to be a very useful statement, it is not beyond improvement. In the text, we discuss potential improvements relating to working capital adjustments, the classification of specific cash flows among the SCF's three sections, and the option to use either the direct or indirect method. QUESTIONS Q-1 How did the all-inclusive or all-resources approach to the SCFP with funds defined as working capital differ from the older funds flow statement? The all-resources approach to the SCFP was a broader statement than the older funds flow statement. The older funds flow statement just showed funds flow changes. The all-resources approach also included investing and financing transactions that did not involve the funds accounts. Q-2 SFAS No. 95 allows a choice between the direct and the indirect method for calculating the operations section of the SCF. Do you think this is a case of flexibility? Explain. We do not consider this to be a case of flexibility because direct and indirect methods are different ways of arriving at the one correct number (cash flow from operations) rather than a case of different methods resulting in different net income numbers, the usual result of flexibility. Q-3 What is the “fineness” issue raised by Nurnberg and Largay relative to accounting for hedging transactions in SFAS No. 104? “Fineness” relates to a comparative situation where one method provides more information— hence it would be the “finer” method than a second method of presentation. Hence, SFAS No. 104 allows a flexible presentation approach where the hedge may be shown on the balance sheet with the particular account which it is hedging. Q-4 Does the “fineness” issue arise relative to the handling of capitalized interest costs (SFAS No. 34) relative to the treatment of this item in SFAS No. 95? Explain. Presumably it does. SFAS No. 34 presumably results in a fuller presentation of the costs of self constructed fixed assets built for internal use. Of course this will conflict with the treatment of interest costs in the statement of cash flows. Q-5 What advantages do you see for classifying interest expense as an investing cash flow rather than an operating cash flow? What is the advantage of classifying it as an operating cash flow? What is the advantage of classifying it as a financing cash flow? It is more consistent to classify the interest cost, along with changes in principal, as an investing activity. This would be consistent with the finance function itself and would be an entity theory orientation since interest would no longer be an operating element. Classifying it as we presently do would make the cash flow statement consistent with the income statement. The present approach would be a proprietary theory orientation since interest is considered to be an expense rather than a distribution to a particular set of capital providers. Q-6 Explain how cash flow data complement the income statement and balance sheet. This occurs in two ways. First, it represents a reclassification of the firm’s transactions in a manner that differs from the balance sheet and income statement. Second, it disaggregates the accrual effects by quite literally removing them, thus leaving the realized cash flows. Q-7 What is the “quality of income” concept, and how does cash flow reporting relate to it? This refers to the concern about the impact of accruals on accounting income and how accruals can, in the extreme, create quite a divergence between cash flows and accrual income. Q-8 What attribute is being measured in the SCF and how well is representational faithfulness achieved? Compare this to when funds are defined as working capital. Since it “undoes” the effect of accrual accounting, cash flow reporting quite literally removes the allocations and other arbitrary procedures followed in conventional accounting practices. Q-9 Why is the three-way classification system in the SCF more informative than the two- way source/use classification? In an abstract sense, what is being measured is an indicator of the firm’s operating liquidity, as well as net investment and net financing. Cash most robustly represents liquidity, whereas the more vague “funds” in APB Opinion No. 19 was less representationally faithful. Q-10 How does the source/use classification reflect the structure of double-entry accounting? The two-way source/use structure evolved out of the double-entry structure of accounting. The three-way system in SFAS No. 95 reclassifies the same data to focus separately on operating flows, net financing flows, and net investment flows. Q-11 What is the purpose of reporting noncash items in the SCF? Sources correspond to “credits” such as income, new capital, and new debt. Uses correspond to “debits” such as losses, investments, interest payments, and dividends. Q-12 Why is the SCF called a derivative statement? This is the all-inclusive perspective, and represents the view that all transactions should be reported in the statement, even if there is no effect on funds (i.e., cash). Q-13 What do research findings indicate concerning the relevance of cash and funds flow data? It is derivative in the sense that it is based on the same set of transactions as are reported in the balance sheet and income statement. However, it reports new information in the form of disaggregating the accrual data into accruals and cash flows. Q-14 What does it mean to classify a cash flow according to the basic nature or function of the event as opposed to the ultimate purpose of the transaction? Which method do you prefer? Accounting is a historical record of the firm’s transactions. As such, liquidity and financial flexibility cannot be measured in a representationally faithful fashion. Q-15 Reexamine Exhibit 13.11. Explain the purpose of each performance measure. As a manager, which performance measure would you want to use. Which measure would you want used to evaluate you? Why? How would your decision change if your firm was experiencing a boom? A recession? How would your decision change if your firm's plant and equipment needed to be replaced? What if plant and equipment were new? While the research is limited, there is evidence that cash flow data are informative, over and above accrual accounting data. One should also add that research has shown that accrual data are informative, over and above cash flow data. Neither of these results is surprising since, it can be argued, each represents different attributes of measurement. Q-16 Should a CEO be evaluated based on one year's cash flows? Why or why not? (Your answer might be affected by your definition of cash flow.) Probably not. The value of the firm is equal to the present value of the expected future cash flows. A given year's free cash flow can be increased by deferring investment, probably to the detriment of future free cash flows and firm value. Even cash flow from operating activities can be increased in a given year by deferring maintenance or research and development expenses. Again, this would probably be to the detriment of future free cash flows and the value of the firm. It is important to examine cash flows over longer periods of time. It is equally important to examine the composition of the cash flows. Q-17 The value of the firm is equal to the discounted value of the firm's free cash flows. Is it possible to forecast distant free cash flows? If not, what is the alternative? Accurate forecasting of future free cash flows is not easy. It involves a great degree of uncertainty. Unfortunately, there is no easy, simple, or more accurate alternative. Using simple relative valuation alternatives such as price-to-cash flow or price-to-earnings ratios largely ignores the forecasting problem and bases valuation on only one cash flow or earnings number. (Sometimes the cash flows or earnings used are historical numbers; sometimes they are forecasted one year ahead.) Moreover, both of these ratios have market price in the numerator. One may question whether using a measure that contains the current market price is a reliable way to estimate the underlying intrinsic value. Q-18 Comment on the following statement: Cash flow from operating activities is the most important section of the SCF. Hence, analysis should be focused on this section. Cash flow from operating activities is an important section of the SCF, but not the most important one. The SCF should be viewed as a whole, not with a single-minded emphasis on a single area. The WorldCom Inc. example in the text provides support for carefully examining all three parts of the SCF. Q-19 Does the statement of cash flows obviate the possible need for exit price financial statements? The SCF provides useful information about an entity’s activities in generating cash through operations. It helps to assess factors such as the entity’s liquidity, financial flexibility, profitability, and risk. Moreover, cash flow data provide feedback on actual cash flows, as well as provide help in predicting future cash flows. There is little ambiguity about cash. The exit-price accounting systems are intended to measure flexibility of the firm in terms of the amount of cash that could be realized from non-forced liquidation of assets. However, compared to the data provided in the SCF, exit-price measurement is a crude indicator of liquidity and flexibility. While exit price data might provide an estimate of the cash conversion value of a firm’s resources, it is the speed of conversion that ultimately determines both liquidity and flexibility. Unfortunately, the usefulness of exit-price accounting is for assessing a firm’s flexibility is questionable, especially if the firm intends to keep and utilize the great bulk of fixed assets future operating purposes. Finally, we note that in the analysis of SFAS No. 157 on fair value (Chapter 14), a slightly different twist is put on the exit value approach which stresses estimating cash flows. This is a future events orientation, which stresses the prediction of cash flows, as opposed to an actual accounting of past cash transactions. In contrast, the SCF is an analysis of past cash flows, which stresses accountability and past performance. Hence, SFAS No. 157 does not supplant the SCF. Q-20 What are the benefits of evaluating a CEO based on the sum of earnings and cash flow divided by two? What is the downside to this metric? Make sure you clearly identify which cash flow and earnings you use in your calculation. In the 1970s Teledyne used a similar formula to measure entity performance (based on one author’s experience as an employee in budgeting). The averaging of net cash increase (decrease) between the parent-subsidiary and after-tax income made it very difficult for management to smooth any financial returns using accruals or classification shifting. The downside was that managers still tried to manage/smooth the metric to their self-interest. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Presented in the exhibit for Case 1 (see text) is a graph of accounting income, cash flows from operations, and working capital flows from operations for W. T. Grant Company, a retailer that filed for bankruptcy in 1976. As late as 1973, the company’s stock was selling for 20 times earnings. What does the chart indicate concerning the usefulness of income, cash, and funds flows? What could explain the significant differences between working capital flows and cash flows? This graph provides a classic illustration of how accrual income and working capital funds flow can mask underlying cash flow trends. It is only in 1974 that accrual income and working capital flows declined, while the cash flow decline started in 1969. Inventory buildups (unsold) and liberalized credit policies resulting in accounts receivable increases are two situations that would be concealed by accrual income and working capital flows. One should not infer from this graph that accrual income is useless. The point is that cash flows from operations provide a more useful supplemental disclosure than working capital flows. 2. This case is adapted from Appendix B of the exposure draft leading up to the FASB’s standard on cash flow reporting. Prepare in good form an SCF. Use the direct format. (Please see the text for background material. Due to its length, we have not repeated it here.) Illustration 1. Cash flow from operating activities is reported directly. Noncash transactions are reported in a separate schedule. Cash flows from operating activities: Cash received from customers $10,000 Dividends received 700 Cash provided by operating activities 10,700 Cash paid to suppliers and employees 6,000 Interest and taxes paid 1,750 Cash disbursed for operating activities 7,750 Net cash flow from operating activities $2,950 Cash flows from investing activities: Purchases of property, plant, equipment (4,000) Proceeds from disposals of property, plant, equipment 2,500 Acquisition of Company ABC (900) Purchases of investment securities (4,700) Proceeds from sales of investment securities 5,000 Loans made (7,500) Collections on loans 5,800 Net cash used by investing activities ($3,800) Cash flows from financing activities: Net increase in customer deposits $1,100 Proceeds of short-term debt 75 Payments to settle short-term debt (300) Proceeds of long-term debt 1,250 Payments on capital lease obligations (125) Proceeds from issuing common stock 500 Dividends paid (450) Net cash provided by financing activities $2,050 Effect of exchange rate changes on cash 100 Net increase (decrease) in cash $1,300 Schedule of noncash investing and financing activities Capital lease obligations incurred for use of equipment $750 Acquisition of Company ABC $(100) Property, plant, and equipment acquired 3,000 Long-term debt assumed (2,000) Cash paid to acquire Company ABC $900 Common stock issued to settle long-term debt $250 Illustration 2. Cash flow from operating activities is presented indirectly and reported in a separate schedule. Noncash transactions are reported in a separate schedule. Net cash flow from operating activities $ 2,950 Schedule reconciling earnings to net cash flow from operating activities: Net income $ 3,000 Noncash expenses, revenues, losses, and gains included in income: Depreciation and amortization 1,500 Deferred taxes 150 Net increase in receivables, inventory, and payables (850) Increase in interest earned but not received (350) Increase in interest accrued but not paid 100 Gain on sale of property (600) Net cash flow from operating activities $ 2,950 Schedule of noncash investing and financing activities: Capital lease obligations incurred for use of equipment $ 750 Acquisition of Company ABC: Working capital other than cash acquired ( 100) Property, plant, and equipment acquired 3,000 Long-term debt assumed ( 2,000) Cash paid to acquire Company ABC $ 900 Common stock issued to settle long-term debt $ 250 3. Due to the length of this case, we have not repeated the background material. Please see the text for details. For N-M Company: a. Do a conventional SCF in accord with SFAS No. 95. (Use the indirect method.) b. Do a second SCF in accordance with the modifications suggested in the section of the chapter entitled “Classification Problems of SFAS No. 95.” c. Discuss the underlying reason for the two approaches. a. Cash flows from operating activities (indirect method) Net income as reported $ 17,358 Depreciation1 15,000 Amortization of bond discount 100 Decrease in accounts receivable 6,000 Gain on sale of fixed asset $ (2,200) Decrease in accounts payable (3,000) Net cash flows from operating activities $ 33,258 Investing activities Lease payments (excluding interest)2 $ (6,830) Sale of fixed asset1 14,200 7,370 Financing activities Dividend payments (7,800) (7,800) Increase in cash $ 32,828 Beginning balance of cash 47,000 Ending balance of cash $ 79,828 1Fixed assets decrease of $20,000 and gain of $2,200 gives total credits of $22,200. Accumulated depreciation debit is $8,000, based on a beginning accumulated depreciation of $72,000, depreciation of $7,075, and ending accumulated depreciation balance of $71,075. 2Total lease payment is $10,000 per year. The present value of the capital lease liability as of 12/31/1999 is an annuity of $10,000 for 4 years at 10%, $31,700. The present value of the capital lease liability as of 12/31/2000 is an annuity of $10,000 for 3 years, $24,870. The difference between 1999 and 2000 is $6,830. Therefore, $10,000-$6,830=$3,170 interest for the year. This $3,170 is included in the $7,270 interest expense shown in the income statement. b. Cash flows from operating activities (indirect method modified) Net income before taxes $ 28,930 Add back other revenues and expenses as reported3 4,070 Net income before taxes exclusive of other revenues and expenses 33,000 Less: Income taxes at 40% (13,200) Modified net income after taxes 19,800 Depreciation 15,000 Decrease in accounts receivable 6,000 21,000 Decrease in accounts payable (3,000) (3,000) Net cash flows from operating activities $ 37,800 Investing activities Lease payment $ (6,830) Sale of fixed asset less tax on gain ($14,200 – $880) 13,320 Interest revenue net of tax 600 7,090 Financing activities Dividends $ (7,800) Interest expense net of tax3 (4,262) (12,062) Increase in cash $ 32,828 Beginning balance of cash 47,000 Ending balance of cash $ 79,828 3Note that by adding back “Other revenues and expenses” in the operating activities section, interest revenues and expenses no longer affect operating cash flows. Interest becomes financing activities (as financial analysts view the SCF) and must be shown net of taxes. Interest expense is $7,270 with tax savings at 40% of $2,908. Noncash flow portions of tax $100 includes bond discount amortization resulting in $7,170 - $2,908 = $4,962. c. The SFAS No. 95 approach conforms to the current format of the U.S. income statement, making it easier to compare cash flows from operating activities to the income statement. The second statement provides a better functional orientation to operating, investing, and financing activities, but at the cost of a closer alignment with the income statement. As a side note, “approach b” is how financial analysts revise the accounting SCF when examining a company’s financials. 4. Ventius Company issued $10,000 of four-year bonds on December 31, 2000. The coupon rate on the bonds is 7½%. The bonds were sold for $9,400. a. Show four possible ways that the interest, principal, and discount can be distributed (allocated) between operating and financing cash flows for the years 2000–2004. b. Discuss these four approaches and state your preferences. a. OF=Operating Flow; FF= Financing Flow Method 1 Method 2 OF FF OF FF 2000 $ 9,400 $ 9,400 2001 $ (750) $ (750) 2002 (750) (750) 2003 (750) (750) 2004 (750) (10,000) (750) 2004 (600) (9,400) Method 3 Method 4 OF FF OF FF 2000 $ (600) $ 10,000 $ 9,400 2001 (750) $ (600) (150) 2002 (750) (600) (150) 2003 (750) (600) (150) 2004 (750) (10,000) (600) (150) 2004 (10,000) b. We believe Method 1 is the clearest and simplest method to follow. Method 3 may have a slight advantage over Method 1 because it breaks the original proceeds into a financing portion equal to the maturity value and sets up the discount or premiums as an operating flow. Method 2 is similar to three except it breaks out the premium or discount in the last year as an operating flow. We prefer the up-front treatment of premium or discount of method 3. Method 4 seems the most illogical. By assigning the premium or discount to each of the four years as an investing flow, it uses an accrual accounting concept. This amount comes out of the cash interest in the operating flow column. Consequently, operating flow and investing flow are both wrong although the total outflow for the two columns combined equals the correct outflow for the operating flow column alone. 5. Please see the text for the balance sheets and income statements for both P Company and S Company. Due to the length of this case, we have not repeated them here. a. Show separate SCFs for P and S for the year 2006 (for S it will be from July 1, 2006 to December 31, 2006) using the indirect method. b. Show a consolidated SCF for 2006 (from January 1, 2006 to December 31, 2006). Hint: Your cash flow will not show the correct cash increase for 2006. c. Where does the discrepancy in b. lie and what is it an example of? How might the situation be remedied? d. In b., show how you think the SCF would be done in actual practice. 5. (a) Separate cash flow statements (S will be from July 1, 2000) for 2000 using the indirect method: P S Operations Income as reported $78 $21 Add: Changes in depreciation 20 10 Working capital changes Inventories 23 (13) Accounts receivable (18) 6 Accounts payable 17 (5) Total $120 $19 Investment Acquisition of S (80) Financing Dividends (15) Change in cash flows $25 $19 5 (b) Consolidated cash flow statements for P and S for 2000 using the indirect method: P S Consolidated Operations Income as reported $ 78 $ 21 $ 99 Add: Changes in depreciation 20 10 30 Working capital changes Inventories 23 (48) (25) Accounts receivable (18) (24) (42) Accounts payable 17 40 57 Total Operating Activities $ 120 $ (1) $ 119 Investment Acquisition of S (80) — (80) Financing Dividends (15) (15) Change in cash flows $ 25 $ (1) $ 24 5 (c) Notice that the total consolidated increase in cash flows for P and S is $44 made up of P’s increase of $25 (ending balance of cash $225 less beginning balance of $200) and S’s increase of $19 (ending balance of $39 minus beginning balance of $20 on July 1 of 2000 when S was acquired). This ties in with the separate totals of P and S in part (a) but does not articulate with the consolidated cash flow of $24 in part (b) because the July 1 balances of S are omitted in the consolidated statement of cash flows. The difference is the omission in (b) of the beginning balances of S’s working capital accounts. These would be accounts receivable, $30; inventory, $35; and accounts payable, ($45). These net out to the $20 difference in total cash flows between (a) and (b). 6. Select a publicly traded company (your instructor may do this for you). Over a 10-year period trace the following elements: a. Net income with depreciation and amortization added back to make it more b. comparable to cash flows. c. Cash flows from operations (from the SCF). d. Cash flows from investing activities. e. Cash flows from financing activities. Required: Assess how closely the company adheres to the Ingram-Lee model in absolute and relative terms: If income increases, does cash flow increase at a lesser rate? Does investing have net outflows and financing have net cash inflows? This should be a fascinating problem. If different companies are assigned to different individuals or teams, and if the results are tabulated, we anticipate that the Ingram and Lee hypothesis will hold. 7. WorldCom, Inc. improperly capitalized $3.8 billion dollars of expense from January 1, 2001 through the first quarter of 2002 ($3.04 billion occurred in 2001). Selected balances from its balance sheets are given in the text. a. What effect did WorldCom’s misclassification have on cash flows (a) in total and (b) by classification? b. Why is it difficult to accept the effects on cash flow from operations of the working capital items listed above? c. WorldCom’s long-term debt went up by approximately $13 billion during 2001. Is it possible that some of WorldCom’s current liabilities were reclassified as long-term during 2001? Bear in mind that we are dealing with fraudulent financial statements and answers are extremely difficult to obtain. 7 (a) Because of the fraudulent overstatement of income for 2001, WorldCom's cash flows would be overstated by $3.04 billion during 2001, less any extra depreciation taken on the $3.04 billion. All of this would appear in the first section of the SCF, cash flow from operations. 7 (b) Assuming that there are no noncash flow elements affecting working capital there are huge unaccounted for differences between the balance sheet changes and the amounts reported in the SCF. In the analysis below, an increase to income in the first part of the SCF (cash flow from operations) means either a decrease in current assets or an increase in current liabilities. The converse applies to decreases. (In the table below, D = decrease, I = increase, numbers are in millions, BS = Balance Sheet, SCF = Statement of Cash Flows) Effect of BS Reported Effect on Change on Cash On SCF Reported Cash Other current assets $ 223 D $164 D $ 59 I Accounts receivable (net) 1,507 I 281 D 1,226 D Accounts payable and other liabilities 1,607 D 1,154 D 453 D The $1,154 decrease to income from the current liabilities indicates that these balances are decreasing but not as much as on the balance sheet. This analysis indicates that they have covered the “shortfall” of cash by $1.62 billion. If we assume a five-year writeoff of the improperly capitalized $3.04 billion, they would still need to cover approximately $1 billion in other parts of the SCF. Oh, what a tangled web we weave when first we practice to deceive! 7 (c) Yes. Reclassifying current liabilities as long-term might provide a good way to cover the cash flow shortage because declines in current liabilities would indicate an outflow of cash. Whether any of the $453 million dollar “excess” outflow from current liabilities went that route cannot be discerned from these numbers, but it is certainly possible. CRITICAL THINKING AND ANALYSIS 1. Do you think that the indirect method of reporting cash flows from operations should be eliminated, allowing only the direct method in the SCFs? Discuss. The present system should probably be eliminated. There really is no choice, since if the direct method is presented, the indirect also must be shown as a supplementary schedule hence the cost of preparing information is lower if one simply presents the indirect method. This one explanation as to why the indirect method is used much more frequently than the direct method. The two methods present slightly different information. The indirect method can be more easily generated by the user than the direct method, but the presence of non-cash flow transactions affecting working capital accounts (nonarticulation) can be a problem. We believe both methods provide useful information with the indirect method presenting a reconciliation through the income statement, while the direct method—as the title indicates—presents a direct cash flow approach to operations, one that is much easier to understand. We propose requiring both methods to be presented since the information is complementary or we just require the direct method. In any case, the present situation is unsatisfactory. 2. What is cash flow? In your answer, be sure to reference the use to which it is put. The term "cash flow" is a term that is frequently used indiscriminately and ambiguously. To be clear and unambiguous, users need to be more precise in the use of their terms. The choice of “definition” depends on time, resources, and its intended use. One simple definition of cash flow that is frequently used in the financial press and in analysts' reports is net income plus depreciation. This definition recognizes that depreciation is a noncash expense. We do not find this definition very useful as it ignores the cash effects of various accruals and investing outflows. Cash flow from operating activities is well defined by SFAS 95. It reflects the cash effects of various accruals such as accounts receivable and accounts payable, and is often used as a check on the “quality” of net income. However, cash flow from operating activities mixes financing activities with operating activities by treating interest expense as an operating expense. Moreover, it does not reflect the cash outflows from investing activities. This can be problematic especially if a firm engages in improperly classifying certain operating expenses as investing cash flows. (See the discussion of WorldCom in the text.) One remedy is to examine all parts of the statement of cash flows, and subtract from cash flow from operating activities, cash flows from investing activities. For focusing on operations or for determining the intrinsic value of a firm, one can use free cash flows. In principle, the definition of the free cash flows is the same as that used for capital budgeting purposes. Free cash flows treat interest expense as a financing expense, and are consistent with the notion of an ongoing firm. Note that in the term “free cash flow,” the word “free” refers to an absence of a superior claim. Paying out free cash flow will not affect the firm’s ability to generate more free cash flows in the future. Free cash flows are defined as NOPLAT – investment in operating invested capital. NOPLAT is net operating profit less adjusted taxes, or taxes paid on operating income. 3. Why is the use of free cash flows increasing? The use of free cash flows is probably growing as a reaction to numerous accounting problems and cases of earnings management over the past 5 – 10 years. It provides investors with a measure of a firm’s operating performance. Free cash flow is much harder to manipulate than is net income. 4. Broome (2004) recommends that the FASB should provide more guidance on classification of cash flows for the three sections. What guidance would you suggest? Broome, O. Whitfield (March/April 2004). “Statement of Cash Flows: Time for Change!” Financial Analysts Journal, 16–22. There are many possible answers for this question. In fact, this type of question would make for good classroom discussion or an extended essay. Below, we provide a few suggestions. In its present form, the adjustments required by the indirect method are sometimes hard for the user to understand. Moreover, more often than not, the working capital adjustments in the operating section of the SCF do not match the changes in their respective balance sheet accounts. It would be helpful if firms provided a schedule reconciling the working capital adjustments in the operating section with the balance sheet changes. Disclosing the effects of reclassifications would be particularly interesting. Firms that are involved in mid-year acquisitions should provide a schedule that reconciles the working capital adjustments in the operating section of the SCF with the respective balance sheet changes. The schedule should allow the user to understand adjustments related to the parent company, adjustments related solely to the acquisition, and adjustments related to the subsidiary as a standalone entity. It might also be helpful to provide details when a subsidiary is acquired via an exchange of stock. While this is technically a noncash transaction, it might be helpful to provide a supplementary schedule indicating the investing activity that would have been recorded had the subsidiary been acquired for cash. Doing so more clearly reveals the true cost of the acquisition. Finally, we note that the possibility of reclassifying interest and dividend receipts as investing activities and interest payments as financing activities in line with finance theory should be carefully considered even though all three are presently classified as operating flows. This is in line with the proprietary theory approach (Chapter 5). 5. Monsen (2001) proposes using cameral accounting to reduce the difficulties in preparing the Statement of Cash Flows using the direct method. Evaluate Monsen’s proposal from an implementation perspective. Monsen, Norvald (2001). “Cameral Accounting and Cash Flow Reporting: Some Implications for Use of the Direct or Indirect Method,” European Accounting Review, 705—724. Most accountants have not studied cameral accounting, essentially single entry accounting used in government. This is a thought provoking challenge to double-entry accounting that should foster a lively classroom discussion. 6. Ohlson and Aier (2009) propose a framework of Modified Cash Accounting (MCA) rather than the current SCF. Evaluate their proposal. Ohlson, James A. and Jagadison K. Aier (Winter 2009). “On the Analysis of Firms’ Cash Flows,” Contemporary Accounting Research, 1091–1114. This is another thinking type read for classroom discussion. We suggest this as a small group exercise in class. Assign the individual reading outside class. Assign 3-4 students per group by counting off in class. Allow about 20-30 minutes to discuss the article and form a group consensus. Bring the small groups together for a whole class discussion. Chapter 14: Income Taxes and Financial Accounting CHAPTER HIGHLIGHTS Students should come away from this chapter with an appreciation of the complexities bearing upon financial accounting stemming from the federal government’s role in the taxation process and fiscal policy. It should also be clear that income tax allocation presents extremely difficult problems of allocation. A full view of the complexities of income tax allocation can be gleaned from discussion using the example of accelerated tax depreciation versus straight-line for financial reporting. The heart of the chapter will probably be on how SFAS No. 109 works and its changes from its predecessor, SFAS No. 96. The change relative to the recognition of tax-loss carryforwards is also discussed. The discounting of deferred tax liabilities is also discussed and illustrated. The investment tax credit, now on the internet, is largely of historical interest at the present time. Some comparisons can be made between investment tax credit and income tax allocation approaches. For example, the net-of-tax approach to income tax allocation and the reduction of asset cost approach for the investment tax credit have the similarity of reducing the cost of the asset. The investment tax credit was previously repealed two times, but it always seems to come back because it is a good macroeconomic tool for stimulating economic investment. QUESTIONS Q-1 As a type of allocation, why is income tax allocation unique? As Thomas has said, “. . . tax allocation may be perceived as an attempt to make allocation consistent, and its allocation problems are the consequences of other arbitrary allocations.” In other words, using different depreciation methods (an allocation) for tax and financial reporting purposes in turn leads to income tax allocation. The question is, “Is all the added complexity worth it? Does it really make a significant difference make when valuing a firm?” Q-2 Relative to depreciation, why is comprehensive allocation an example of rigid uniformity and partial allocation an example of finite uniformity? Comprehensive allocation is rigid because it unconditionally requires allocation as long as a timing difference exists. Partial allocation is finite because it requires allocation only if there is a perceived real payback (as measured by several of the deferred tax liability accounts) of accelerated tax benefits. Q-3 Although net-of-tax depreciation gives the same bottom-line result as comprehensive allocation, are there any financial ratios that would be affected by the choice between these methods? Debt-to-equity ratio would be more favorable under net-of-tax because the “debt” would be classified as additional accumulated depreciation. In addition, net-of-tax would result in a higher return on investment because classification as additional accumulated depreciation would result in a lower asset base than would arise under conventional income tax allocation. Q-4 How do the deferral and liability methods of implementing comprehensive allocation differ? They differ in two respects. The first is the designation of the account. It is referred to as a “deferred credit” under the deferral approach and a liability under the liability approach. However, this distinction has been blurred due to the fact that the definition of a liability from APB Statement No. 4 includes “certain deferred credits that are not obligations but that are recognized and measured in conformity with generally accepted accounting principles.” The second distinction refers to the fact that the balance of the account is adjusted if there is a change in the income tax rate under the liability approach, but no adjustment occurs under the deferred. Q-5 What is the rollover defense of the liability interpretation of deferred taxes, and how has it been attacked? The “rollover” defense views each asset separately. The benefits that are received in the early years of the fixed asset’s existence resulting from excess tax depreciation relative to book depreciation are “paid back” in later years when the relationship between book and tax depreciation reverses. Sometimes the rollover view uses the analogy of accounts payable. Anti-rollover proponents knock this last argument down by saying the analogy between accounts payable and income taxes is not valid, because each individual account payable must be paid off with funds as it comes due. This is not true of income taxes. Consistent with this thinking, anti-rollover proponents tend to look at the behavior of the deferred tax account from a macro viewpoint. At most, they would tend to see a liability when the balance of the deferred tax account decreases (this is the partial allocation position). Q-6 What is the justification for discounting deferred tax liabilities under either comprehensive or partial allocation? Other long-term liabilities that bear interest, such as leases and bonds payable, are carried at their present values. While there is no explicit interest on funds financed by deferred taxes, the opportunity cost concept is applicable: if funds had to be borrowed from the next-best source, they would have a cost. Measuring this cost and keeping it separate from pure income tax expense would, thus, be appropriate. Opportunity costs are, of course, utilized in accounting. Donated land, for example, would be booked at fair market value. Q-7 What is the interpretation of income tax expenses under partial allocation? Income tax expenses equal an amount paid for income taxes attributable to operations of the current year. In addition, the expense will also include an amount attributable to the current year, which will not be paid until a later year (this amount equals the excess of tax depreciation over book depreciation, which is not “shielded” by additional acquisitions of fixed assets). Similarly, tax expenses would be reduced by reversals of taxes previously booked as liabilities under partial allocation. Obviously there are verifiability and agency theory issues here, but that is not the main consideration. Q-8 What is permanent deferral? “Permanent deferral” refers to a situation in which the excess of tax depreciation (MACRS) over book depreciation on newer assets exceeds the reversal (book depreciation exceeding tax depreciation) on older assets. The result is an increase in the credit balance of the deferred tax account. When this situation continues indefinitely, permanent deferral results. The spectre of permanent deferral, which empirical research has shown, raises the issue of whether a liability exists. Q-9 How did SFAS No. 96 differ from APB Opinion No. 11? SFAS No. 96 tried to go from the revenue-expense approach of APB Opinion No. 11, which used deferred debit and credit accounts. SFAS No. 96 required deferred asset and liability accounts. In line with the asset- liability approach, it also required the use of future enacted tax rates and required adjustment of deferred asset and liability accounts if tax rates changed. APB Opinion No. 11 used current rates only and no change in deferred debit and credit accounts if tax rates changed. Q-10 How does SFAS No. 109 differ from SFAS No. 96? The differences between SFAS Nos. 109 and 96 are less extreme than those between APB Opinion No. 11 and SFAS No. 96, but they are nevertheless important. First, SFAS No. 109 is much more liberal in recognizing deferred tax assets than its predecessor. SFAS No. 109 simply requires reasonable certainty of realization of deferred tax assets, whereas its predecessor required much more specificity (carryback against taxable income or offsetting net deferred tax liabilities via carryback or carryforward). In addition, tax loss carryforwards are recognized as deferred tax assets under SFAS No. 109, but not by SFAS No. 96. Finally, classification of current versus noncurrent deferred assets and liabilities differs. SFAS No. 96 based the distinction on when the item reverses. Reversal within a year or the operating period, if longer, would be current under SFAS No. 96, but in SFAS No. 109 the current/noncurrent distinction is based on the item that gives rise to the deferred asset or liability. Thus, deferrals arising from tax and book depreciation differences would be noncurrent, whereas differences between accrual methods of bad debt and actual write-offs of uncollectibles would be current. Q-11 Refer to Exhibit 14.8. Under SFAS No. 96, there was a “conservative” recognition of deferred tax assets. As a result, the $135 deferred tax asset in 1997 needs to be “carried back” to 1994. Why is this result not conservative? The carryback from 1997 to 1993 or 1994 would not be conservative because the deferred tax asset debit would be higher as a result of a 46% tax rate rather than the 34% in 1997. Q-12 If discounting were used in the area of deferred tax assets and liabilities (as this chapter advocates), would there be any particular difficulty relative to tax-loss carryforwards? The problem would be how to deal with the timing (present valuing) of when tax-loss carryforwards should be recognized in the future. This is a very difficult future events situation. Q-13 Do you think that income tax allocation can improve the prediction of future tax payments in the short-run? Yes, a study taking into account the current year’s tax payments plus net increases deferred taxes—whether current or non-current—was better able to predict tax payments for the succeeding year than a model just using the preceding year’s tax payments. Q-14 Do deferred tax liabilities arising from using tax depreciation for tax purposes and straight-line depreciation for financial reporting lead to true future cash flows? Deferred tax liabilities arising from using tax depreciation for tax purposes and straight-line depreciation tend to grow over time. So, the temporary difference apparently becomes a permanent one for companies growing. This suggests a cash flow benefit to the firm. Q-15 What are the weaknesses of partial allocation? Partial allocation records in the books only those deferred credits that can be reasonably expected to reverse in the future. Verifiability and agency theory should be considered with partial allocations. Might management use partial allocation to lower current year income based on a future contingency? The issue of future events is problematic. Also, since the potential liability is beyond one year, should a discounted amount be calculated? Q-16 How are valuation allowances used in income tax allocation? The deferred tax asset measures potential benefits to be received in future years. Since future income may not be large enough to actually receive a benefit from the deferred tax asset, SFAS No. 109 requires that a valuation allowance be used to reduce the deferred tax asset to a level that will likely be realized. Q-17 Should tax-loss carryforwards be booked? Explain. Characteristics of an asset include: probable future benefit that it contributes to future net cash flows, the firm receives the benefit and has control over its access, and the event must have already occurred. The first two characteristics are met, but the third one is not met. These are gain contingencies. So, the portion that can be applied to prior years is an asset, but not the portion applicable to future years. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Refer to Exhibit 14-8. Assume that in 1996 accounting income is $2,000. There is one new temporary difference: installment sale income of $350 is recognized in 1996 but will not be taxed until 1997 when the cash is collected. Required: Prepare the tax entries for 1996 in accordance with SFAS No. 109. Year 1996 1997 1998 1999 2003 Accounting Income 2,000 Temporary Differences Depreciation (120) (60) 100 130 Bad Debts (100) Warranty Expense (125) (75) Installment Sale 50* 350 Deferred Compensation (30) Subtotals (tax income 1996) 1,705 215 100 130 (30) X enacted tax rates 34% 34% 34% 34% 34% = tax liability 580 73 34 44 (10) * 400-350 installment sale=50 The journal entry would be: Account Debit Credit Income Tax Expense ($2,000 × .34) 680 Current Deferred Tax Liability 17 Noncurrent Deferred Tax Asset 41 Current Deferred Tax Asset 76 Income Taxes Payable ($1,705 × .34) 580 The three deferred tax accounts are adjusted to their correct end-of-year balances. The current deferred tax liability should have a balance of $119 ($350 × .34). Noncurrent deferred tax assets should have a balance of $31 ($90 × .34, which includes the originating depreciation difference of $60 in 2002 and $30 of reversing deferred compensation in 2003). Current deferred tax asset should have a balance of $26 ($75 × .34). The amounts in the entry represent the difference between the ending balances in 1997 and the ending balances in 1996 shown in the text. The two current and the two noncurrent accounts could also be combined. 2. Nowell Company is experimenting with comprehensive-liability income tax allocation called for in SFAS No. 109 but, in addition, they are employing discounting. No temporary differences exist up to 2000. Shown here is a schedule of tax depreciation, book depreciation, and income before depreciation. Year Tax Depreciation Book Depreciation Income Before Depreciation A1 A2 A1 A2 2005 $50,000 $35,000 $300,000 2006 40,000 $60,000 35,000 $50,000 400,000 2007 30,000 50,000 35,000 50,000 420,000 2008 20,000 40,000 35,000 50,000 440,000 The tax rate is 45 percent. The discount rate is 8 percent. Required: Prepare income tax entries for 2005, 2006, 2007, and 2008 discounting deferred tax liabilities at 8 percent. Why would using discounting be a stronger asset-liability orientation than not discounting deferred tax liabilities? 2005 Account Debit Credit Income Tax Expense 118,001 Income Taxes Payable ($250,000×.45) 112,500 Noncurrent Deferred Tax Liability 5,501 2007: Income Taxes Payable (5,000 ×.45×.85734) 1,929 2008: Income Taxes Payable (10,000×.45×.79383) 3,572 Total Noncurrent Deferred Tax Liability 5,501 2006 Account Debit Credit Income Tax Expense 140,787 Imputed Interest (5,501×.08) 440 Income Taxes Payable ($250,000×.45) 135,000 Noncurrent Deferred Tax Liability 6,227 2007: Income Taxes Payable (5,000 ×.45×.85734) 1,929 2008: Income Taxes Payable (10,000×.45×.85734) 3,858 Total Noncurrent Deferred Tax Liability 5,787 Asset A1 has an excess of tax over book depreciation reverses in 2003 and Asset A2 has an excess of tax over book which also reverses in 2003. Interest of $440 is also added in. 2007 Account Debit Credit Income Tax Expense 150,750 Imputed Interest (11,728×.08) 938 Noncurrent Deferred Tax Liability 1,312 Income Taxes Payable ($340,000 × .45) 153,000 ($5,000 × .45) – $938 = $1,312 2008 Account Debit Credit Income Tax Expense 159,750 Imputed Interest ($10,417×.08) 833 Noncurrent Deferred Tax Liability 10,417 Income Taxes Payable ($380,000 × .45) 171,000 ($25,000×.45)–$833=$10,417 Notice that Noncurrent Deferred Tax Liability balances to zero (with a $1 rounding error). 3. Accounting income for the Kolbow Company for 2005 (its first year of operations) was $1,700,000. Differences between book and income were as follows: Municipal bond interest (permanent) $ 75,000 Excess of tax over book depreciation 240,000 Excess of installment sales over collections 30,000 Compensatory stock option expense 37,000 Scheduled temporary differences over the next several years are: 2006 2007 2008 2009 Depreciation ($160,000) $100,000 $140,000 $160,000 Excess of installment collections over sales 20,000 10,000 Compensatory stock option expense ($37,000) Parentheses indicate a deduction in the previous schedule. Enacted tax rates are as follows: 2005 40% 2006 40% 2007 35% 2008 30% 2009 30% Required: Determine the taxable income for 2005.Prepare a schedule and do the tax entries for 2005. Taxable income in 2006 is $1,400,000. One new temporary difference has arisen. Bad-debt expense of $22,000 occurred during 2001, but the actual write-off (which is when the tax deduction is taken) is not expected to occur until 2002. Prepare a schedule and do the tax entries for2006. a. Accounting income for 2005 1,700,000 Expense not allowed for taxes 37,000 1,737,000 Less: Permanent differences Municipal bond interest 75,000 Excess of tax over book depreciation 240,000 Excess of installment sales over collections 30,000 (345,000) Taxable income 1,392,000 b. Year 2005 2006 2007 2008 2009 Accounting Income 1,700,000 Municipal bond interest (75,000) Excess of tax over book depreciation (240,000) (160,00 0) 100,000 140,000 160,000 Installment Sales (30,000) 20,000 10,000 Stock options 37,000 (37,000) Subtotals (tax income 1996) 1,392,000 (140,00 0) 110,000 140,000 123,000 X enacted tax rates 40% 40% 35% 30% 30% = tax liability 556,800 (56,000) 38,500 42,000 36,900 2005 journal entries Account Debit Credit Income Tax Expense 618,200 Noncurrent Deferred Tax Asset ($160,000 × .4) + ($37,000 × .3) = $75,100 75,100 Current Deferred Tax Liability ($20,000 × .4) + ($10,000 × .35) = $11,500 11,500 Noncurrent Deferred Tax Liability ($100,000 × .35) + ($140,000 × .3) + ($160,000 × .3) = $125,000 125,000 Income Taxes Payable 556,800 c. Year 2006 2007 2008 2009 Accounting Income 1,518,000 Municipal bond interest Excess of tax over book depreciation (160,000) 100,00 0 140,000 160,000 Installment Sales 20,000 10,000 Stock options (37,000) Bad Debt Expense 22,000 (22,000 ) Subtotals (tax income 1996) 1,400,000 88,000 140,000 123,000 X enacted tax rates 40% 35% 30% 30% = tax liability 560,000 30,800 42,000 36,900 2006 journal entries Account Debit Credit Income Tax Expense 608,300 Current Deferred Tax Asset ($22,000 × .35) = 7,700) 7,700 Current Deferred Tax Liability 8,000 Non-Current Deferred Tax Asset 64,000 Income Taxes Payable 560,000 Current deferred tax liability Ending balance ($10,000 × .35) = $3,500 credit Beginning balance is $11,500 credit; therefore, $8,000 debit adjustment is required Non-Current Deferred Tax Asset Ending balance ($37,000 × .30) = 11,100 debit Beginning balance is $75,100 debit; therefore, $64,000 credit adjustment is required There is no change in the Non-Current Deferred Tax Liability. 4. Gillette Company, maker of shaving products and many other personal products, showed a net income of $1.428 billion in 1998 and $1.427 billion in 1997 on page one of its 1998 annual report. A note to the 1998 income said that the 1998 income of $1.428 billion was to be reduced $347 million due to reorganization and realignment expenses. Consistent with this, the net income in the consolidated statement of income for 1998 was $1.081 billion. In addition, following information appeared in the footnotes for the 1998 corporate annual report (figures are in millions). See text for remainder of the problem. Required: a. Why do you think Gillette initially showed its income for 1998 to be $1.428 billion? Discuss. b. Is the expensing of the reorganization and realignment costs of $347 million after taxes for 1998 correct? Explain. c. What is the valuation allowance? d. Why do you think Gillette maintains this account? e. Do you think that earnings management is being used by Gillette? 4a. The initial impression that the reader gets is that income is $1,428 billion which is virtually the same as in 1997 ($1,427 billion). Notice that this makes their income look like pro-forma income by leaving the “one time” item out. b. Restructuring charges (which include asset impairments of $153 million before taxes) are considered to be ordinary charges and Gillette shows them in this fashion in their consolidated statement of income. However, the table in the footnote on page 32 does give the impression that these charges contain future benefits. c. The valuation allowance appears to be specifically related to operating loss and credit carryforwards which would have an extremely long carryforward period. During both 1997 and 1998, the valuation allowance is over 90% of the carryforward, an extremely high percentage. d. The results in part (c) do raise the issue that the valuation allowance might be used in the future to manage income by reversing out the allowance and lowering tax expense thus increasing income. e. During this short two year period, earnings management appears to be more implicit than explicit. While the actual income included the effect of the restructuring costs, the highlights omitted them. The valuation allowance might be explicitly used after 1998. 5. Worldcom in 2001 and 2002 capitalized basic switching costs from expenses to capital assets to the tune of $3.8 billion dollars with approximately $3.04 billion occurring in 2001. The corporate tax rate is 35 percent. For 2001, Worldcom’s income before taxes was $2.432 billion and its income tax expense was $0.943 billion for 2001. Assume that Worldcom, on its tax return, expenses the entire $3.04 billion. Required: a. Would Worldcom’s actions have led to a situation of income tax allocation? Explain. b. Do you think, based on the numbers shown above, that Worldcom allocated the income taxes stemming from the incorrect capitalization of the switching expenses? a. Assuming that Worldcom expensed the $3.04 billion there would be a situation of income tax allocation because $3 billion of phony capitalized expenditures arose with the entire $3 billion taken for expense purposes. We suspect that this is exactly what happened because we would not expect Worldcom to forego $3 billion of tax deductions despite the false capitalization. b. The $2.432 of accounting income does not include the expense writeoff of $3.04 billion which was capitalized. Assuming a five year MACRS writeoff, the net reduction from reported income to taxable income would result in the latter being zero ($3.04 –1/5 of $3.04 billion equals exactly $2.432 billion). Hence with taxable income being zero we would expect a zero tax expense. But the $.943 billion of tax expense therefore indicated that they did allocate. The $.943 billion is slightly in excess of the 35% tax rate when related to the $2.432 reported accounting income (actually 38.77%). This strongly indicates that (a) they deducted the $3.04 billion on the tax return and (b) they did allocate. The allocation entry debits tax expense and credits deferred tax liability. 6. Nortel Networks, the Canadian telecommunications equipment manufacturer has recently suffered large losses, creating very large tax loss carryforwards. The company also has a very sizable valuation allowance which it deducts from the tax loss carryforwards on the balance sheet. During the last quarter of 2005, it reduced the valuation allowance by $111 million. In the first quarter of 2006, however, it added back $90 million to the valuation allowance. Required: What do you think may have been the underlying reason for Nortel's behavior relative to the manipulation of the valuation allowance? First, you must buy into the idea that a manipulation of the valuation allowance has occurred. Management may have conducted an objective review of the deferred tax assets and genuinely determined that Nortel’s profitability outlook deems an adjustment to the valuation allowance. Since many corporations do their strategic planning along with high-level financial plans during Q1 of each year, this new information may have resulted in this revision. However, a skeptical individual would likely respond that management used the valuation allowance to “window dress” its year-end financial reports. Why? Perhaps it was done to meet profit plan targets, achieve specific ratios for compensation. Given that it was adjusted at year end and then apparently reversed the next quarter, it is suspicious. Note you can access the Nortel annual reports at http://www.nortel.com. • CRITICAL THINKING AND ANALYSIS 1. What are the strengths and weaknesses of (1) no allocation, (2) comprehensive allocation with an income statement orientation, (3) comprehensive allocation with a balance sheet orientation, and (4) partial allocation. Which would you choose? No allocation is tempting. It is a cash flow number and avoids the complexities of the allocation process and might also be justified on the grounds of permanent deferral in many cases. (2) Comprehensive allocation with an income statement orientation emphasizes the revenue-expense approach but that day appears to be over. (3) Comprehensive allocation with a balance sheet orientation attempts to resurrect the balance sheet which we consider to be an important strength. (4) Partial allocation brings about a stronger definition of liabilities and assets. The future events problem coupled with potential agency theory implications is too strong a deterrent, we believe. Our preference lies with (3) provided it were coupled with discounting using a FIFO orientation which would be highly feasible. 2. Is the deferred tax “liability” really a liability? If it is a liability, it would embody a present obligation to the government in the future. If it is a liability, the firm has little or no discretion to avoid the future sacrifice. If it is a liability, it was created by past events that created the temporary differences. So, it appears that a deferred tax liability is really a liability, at least according to SFAS No. 109. 3. Chludek (2011) finds that deferred tax components have little relevance when valuing a firm. If so, why make the accounting differences so potentially complicated to report? Chludek, Astrid K. (2011). “Perceived versus Actual Cash Flow Implications of Deferred Taxes: An Analysis of Value Relevance and Reversal under IRFS,” Journal of International Accounting,” 1–25. That’s a very good question. Why not just ignore book income tax calculations and record current tax obligations. Perhaps Thoreau had it right, “Simplify. Simplify.” 4. What are some challenges that are specific to a joint converged FASB/IASB Income Tax standard? Convergence of FASB/IASB standards is faced with numerous challenges including cultural, political, and economical differences of the different nations. However, a converged standard on income taxes would present a different set of challenges due to the nature and uniqueness of taxation in different countries. Furthermore, the current IASB and FASB income taxes standards already have some major differences that may present challenges in an attempt to come up with a converged standard. Some of these differences include the use of the enacted tax rate under FASB to calculate deferred taxes. Under IASB, either an enacted tax rate or a substantially enacted tax rate can be used. Another difference between FASB and IASB accounting for income taxes has to do with the allocation of deferred income taxes. While under IASB tax consequences of certain effects are allocated to either comprehensive income or equity (IAS 12, Para. 58), under FASB all tax consequences are allocated to income. Another difference has to do with recognition of deferred tax asset. Under FASB, deferred tax asset is recognized in full and then reduced by a valuation allowance if it is more likely than not that it will not be realize either in part or in full (Kieso et all, 2015). Under IASB, deferred tax asset is realized up to the amount it is probable to be realized (IAS 12, Para. 56). Recognizing these differences and challenges to a converged income taxes standard, FASB and IASB are working towards bridging them. Just recently, FASB proposed eliminating the current/noncurrent classification of deferred taxes and liabilities (FASB, 2015). This is consistent with IASB’s noncurrent treatment of all deferred taxes (IAS 1, Para. 56). Financial Accounting Standards Board. (2015). Exposure Draft: Income Taxes (Topic 740). Retrieved from FASB: http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176164732790&acceptedDisclai mer=true International Accounting Standards Board. (2001) IAS 1 Presentation of Financial Statements. In International Financial Standards London: IFRS. International Accounting Standards Board. (2001) IAS 12 Income Taxes. In International Financial Standards. London: IFRS. Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2013). Intermediate Accounting (15th ed.). Hoboken, NJ: Wiley. 5. In the U.S. federal and state tax is based on taxable net income, excluding “not-for-profit entities. What are the arguments for basing all organizational taxes on cash and cash equivalent receipts rather than net income? If there can be a “fun” question when discussing taxes, this has potential. Basing taxes on net income encourages entities to minimize the bottom line to reduce its taxes. From managerial accounting, “What you measure is what you get.” Current tax loss carryforwards subsidize companies, is that good? If so, should individuals have the potential to carryforward cost of living losses? If the class stumbles, suggest a “receipts tax” on all entities. Assume a simple tax rate of 1% for all cash and cash receipts from any legal entity. Emphasize the term legal entity. That means transfers between parent and subsidiary produce a 1% tax by the receiving entity. Might this revise the complex legal structures we see in corporations today? Business argues for lower taxes; is 1% low enough, just not on income. Is the idea of a simple cash tax reasonable or do we need to complicate it with something like a VAT that it takes reams of accountants to administer? Finally, does something like a receipts tax for everyone make theoretical sense? Maybe it should apply to all businesses, individuals, and even the not-for-profits. If so, then everyone could be in the one-percent that we hear about today. Chapter 15: Pensions and Other Postretirement Benefits CHAPTER HIGHLIGHT Chapter 15 is intended to give the student a comprehensive overview of legal, funding, and accounting aspects of corporate-sponsored pension plans. The lengthy background material at the beginning of the chapter is necessary in order to understand the accounting implications of defined contribution and defined benefit plans. A weakness of most accounting discussion on pensions is the avoidance of technical issues. As a result, the accounting theory and policy issues are not clearly delineated. For example, it is not possible to discuss accounting issues independent of legal and funding aspects. Because of this, it is highly recommended that students read Appendix 15-A on actuarial funding. The chapter also introduces post-retirement benefits other than pensions arising from SFAS No. 106. The fundamental theory and policy issue is whether a pension plan gives rise to an accounting liability for the sponsoring corporation. Past and present accounting standards have said no, and the emphasis has been defining annual pension expense. An arbitrary and flexible policy existed in which accrued pension expense had to be based on one of five actuarial methods prior to SFAS No. 87. The situation was analogous to arbitrary depreciation methods. SFAS No. 87 allows only one actuarial method for calculating pension expense, a rigid uniformity approach. SFAS No. 87 also came down in favor of liability recognition. This position is little more than a belated acknowledgment that ERISA created a legally unavoidable obligation for pension plan sponsors. At this point, the policy issue turns to measuring the liability. Two theories from the labor economics literature, implicit and explicit contract views, are useful in relating what the FASB attempted in Preliminary Views (the implicit contract view, i.e., using projected future salaries to value the pension benefit in real terms) versus the compromise position in SFAS No. 87 (the explicit contract view, i.e., using current salary levels to value projected benefits). SFAS No. 87 is definitely a compromise made in the interest of getting pensions onto the balance sheet, where they do belong. While accrued pension expense is linked to the increase in actuarial valuation of benefits over the period using future salary projections, the standard only requires a liability to be recognized if the value of benefits measured using current salary projections exceeds the pension fund. Naturally, actuarial values are lower when current salaries are used. The other dubious character of the standard, and an issue not fully brought out in the text, concerns the creation of an intangible pension asset on the balance sheet if a pension liability is recognized. Surely this is either a charge to income, or a prior period adjustment. By debiting this “odd” intangible pension asset, a smoothing effect occurs viz. the income statement recognition of unfunded pension liabilities. The economic consequences literature is reviewed in the pension area. One set of studies focuses on whether stocks are priced “as if” pensions are a liability (pre-SFAS No. 87 studies). Generally, the evidence, not surprisingly, is that they are treated as if they are liabilities. There is some limited research that suggests a firm’s bond ratings also reflect pensions as debt equivalents. However, as in other areas, there could still be economic consequences arising from balance sheet recognition, and this is likely to explain why a record number of firms lobbied against the proposal. Appendix 15-A gives a concise example of service cost determination under both projected and accrued benefit cost approaches, and also illustrates two funding approaches. The chapter closes with a brief look at SFAS No. 106. Exhibit 15-2 gives a simple example of the workings of OPEB. The main elements of the standard are then discussed, and some economic consequences are also mentioned. Case 5 compares SFAS No. 87 and SFAS No. 106. QUESTIONS Q-1 What do the following actuarial terms mean: accumulated benefits, actuarial liability, vested benefits, service cost, and unfunded accumulated benefits? How are they measured? How are projected benefit obligations, accumulated benefit obligations, and vested benefit obligations defined in SFAS No. 87, and how are they actuarially calculated? Accumulated benefits and actuarial liability are the same terms, and are calculated by any of several primary actuarial methods for accrued benefits earned to date. Vested benefits are those no longer contingent upon continued employment (i.e., they are legally binding), and unfunded benefits are simply those benefits not funded by a pension fund. Finally, service cost is the increase in accumulated benefits for a year. SFAS No. 87 refers to projected benefit obligations (measured using future salary levels), accumulated benefit obligations (measured using the accrued benefit method without future salary projections), and vested benefit obligations (a subset of accumulated benefit obligations). Q-2 Why is there a pension accounting problem with defined benefit pension plans, but not with defined contribution plans? With defined contribution plans, there is no promise to pay based on future salaries. The employee receives only his or her benefits that have been earned up to retirement without any guaranteed amount. Q-3 Explain how previous pension accounting standards were based on a revenue-expense approach to the financial statements. APB Opinion No. 8 focuses almost exclusively on the problem of determining annual pension expense. The rationale of APB Opinion No. 8 is that the results achieve rational and systematic matching of labor-related pension costs to the revenues generated by labor. No major consideration is given to balance sheet issues. Q-4 Why did APB Opinion No. 8 only minimally improve uniformity between companies? APB Opinion No. 8 closed the “GAAP” between discretionary and nondiscretionary funders (companies). It forced an accrual of pension expense, regardless of actual cash funding. However, flexibility in the choice of actuarial method still results in diversity and poor comparability. Q-5 Is the treatment of unrecognized prior service cost and actuarial gains/ losses in SFAS No. 87 an example of the asset-liability or revenue-expense orientation? Both would be examples of an expense-revenue orientation because both use an accrual/matching orientation rather than bringing the liability from prior service costs onto the books. Likewise, neither recognizes the asset/liability effect of actuarial gains and losses via the extremely modified corridor amortization approach. Q-6 Why is there a “double counting” problem if the accumulated benefit obligation is used to measure the pension liability and what can be done about it? Economic conceptions of pensions take a long-term implicit contract approach and are thus tied to future salary projections. The accounting view is more difficult to pin down. Current service cost determination is likewise tied to future salaries under SFAS No. 87, but for the presumed purpose of helping users to predict future cash flows. One type of liability arises relative to differences between cash contributions to the pension fund and pension expense amounts (which includes service costs using future salaries). However, the principal accounting approach to pension liabilities would be by means of the minimum liability calculation, which is based on current salaries. A more theoretical reason for rejecting future salaries is that these are executory for both the firm and covered individuals. Future salaries might be justified under a constructive obligation interpretation (Chapter 11), which would bring the accounting orientation closer to the economic one. Q-7 How has ERISA affected pension accounting? ERISA has created a legal obligation for the sponsor to fund vested benefits (guaranteed by the PBGC), as well as to meet annual funding requirements. Prior to ERISA, both of these obligations were “avoidable” by the sponsor—legally, at least. So, a strong case exists that these are also accounting liabilities. Q-8 Given the evidence from the research in the stock market, does it matter whether pension information is disclosed in the formal financial statements or as supplemental disclosure? Looking solely at direct cash consequence, it would not appear to make any difference. However, there could be indirect consequences, which are discussed in the next question. Of course more empirical research, generally speaking, is coming to the conclusion that recognition is preferable to disclosure. Q-9 What economic consequences of SFAS No. 87 were suggested in the chapter? Recognition of a liability would affect debt-equity ratios, which are specified in restrictive debt covenants. There could be an indirect consequence, then, on dividend payments or a company’s borrowing capacity. These are, of course, agency theory arguments. Q-10 Research has shown that discount rates used by firms are generally above rates suggested by the FASB. Will this make the interest cost portion of pension expense higher or lower than if discount rates were lower? Why do you think firms favor using a higher rate? The higher interest rate, in and of itself, would lead to a higher interest expense but it also leads to a lower present value of the pension obligation which would lower the interest expense. The lower present value of the pension obligation reduces the probability of recording a minimum pension liability. Q-11 Is SFAS No. 87’s argument favoring recognition of a pension liability for accumulated benefits consistent with the conceptual framework project? The analysis in the chapter concluded that unfunded accumulated benefits are an unambiguous legal liability in terms of SFAC No. 6 definitions. Q-12 If actuarial gains and losses and prior service costs, in line with SFAS No. 158, are to be recognized in the period when incurred, is there a double counting effect when these elements are recognized as part of net pension expense? The answer would seem to be yes. Projected benefit obligations (to use SFAS No. 87 terminology) must be funded under ERISA and, in the event of plan termination, the sponsor is liable to the PBGC for such benefits if pension assets are insufficient (to a maximum of 30 percent equity). Either way, then, the implicit liability is likely to be funded by the sponsor. SFAS No. 87 is contradictory in that the explicit contract view (accumulated benefit obligations) is used for liability recognition, whereas the implicit contract view (projected benefit obligations) is used to calculate service costs for accruing pension expense. Q-13 How did the “give-and-take” differ between the FASB and its constituents in the drafting of SFAS No. 87 on pensions versus SFAS No. 106? The battle over SFAS No. 87 was quite stormy. The initial proposal was not put out as an exposure draft but as “Preliminary Views.” The exposure draft was also not well received but many compromises were made in arriving at the final standard. While SFAS No. 106 was also greeted with almost 500 letters, its path to final acceptance was much smoother with OPEB accounting seen as being related to and consistent with pension accounting. Relatively few changes were made in going from the exposure draft to the final standard, unlike the pension situation. Q-14 Voluntary pension plan terminations have been increasing [see Stone (1987)] in which surplus plan assets are recaptured by sponsoring companies after deferred annuities (of equivalent value to accrued benefits) are purchased for plan participants. Why do you think this practice has been criticized by some employee groups, and how might SFAS No. 87 affect voluntary terminations? A very serious issue is at stake—who owns pension fund assets. While there are court challenges in process, to date the answer has been that they belong to the sponsoring company as long as they “pay off” existing plan members by buying them insured annuities equal in value to their accumulated benefits. Employee groups have challenged the claim that excess pension funds belong to sponsors rather than to employees. SFAS No. 87 could, possibly, lead to an increase in plan terminations for those plans with excess pension fund assets. The reason is to avoid the possibility of future period recognition of a pension liability, as might occur if pension fund assets drop in value (as indeed occurred in the crash of 1987). Q-15 What issues of qualitative characteristics of accounting information (SFAC No. 2) are important relative to accrual accounting for OPEBs? Costs of measurement may be quite high, which relates to the benefits > costs pervasive constraint. Under reliability there are very serious questions relative to the verifiability of OPEB measurements. Q-16 What types of economic consequences may arise from accrual accounting for OPEBs in SFAS No. 106? Bond covenants could be affected as a result of higher debt-equity ratios. Management compensation could be affected as a result of booking OPEB expenses. The question is also raised relative to curtailing or at least cutting back on OPEB benefits as a result of booking expenses and liabilities. Finally, the issue of competitive disadvantage of American firms in international capital markets has been raised as a result of lowering income and raising liabilities. Q-17 According to The Wall Street Journal article on February 1, 1996 (“Intrinsic Value” by Roger Lowenstein, p. C1), pension fund assets in the United States grew dramatically—by approximately 29 percent—during 1995, an excellent year in the stock market. However, underfunding of pension plans increased by a very sizable amount. Why do you think that this occurred? The problem is that pension liabilities can increase even faster if the discount declines as in 1995, for example. That year the discount rate decreased from 9% to 7% and pension obligations grew by 40% whereas pension assets grew by only 29%. The effect in the year 2000 and beyond will be interesting to see with interest rates rising and earnings rates on pension assets being somewhat sluggish. Q-18 While ERISA has been helpful, how well are employees protected in situations where overfunded pension plans exist? Loopholes still exist. As with the Dillard’s case mentioned in the chapter, if 25% of surplus pension assets are put into a replacement plan, the excise tax on fund assets is only 20% and the remainder of pension assets can be diverted to other uses. Q-19 What is the danger, particularly to older employees of restructuring pension plans into “cash benefit plans?” A movement to “cash benefit plans” may well work to the detriment of older employees in favor of younger employees. Of course the shoe could be on the other foot when the younger employees reach retirement. Hence cash benefit plans could prove to be a shell game. Q-20 What differences exist, relative to the use of future costs and future salaries, in the case of OPEBs (SFAS No. 106) and pensions (SFAS No. 87)? The minimum liability determines any underfunding by using the accrued benefit obligation, whereas the transition gain or loss determines underfunding (or possibly overfunding) using the projected benefit obligation. Both amounts are then combined with the balance of the prepaid/accrued pension cost account. The purpose of the transition gain or loss account is to bring about the switch from the accumulated benefit obligation (current salaries) to a projected benefit orientation (future salaries). Hence, under transition gain or losses the differentials do go through income, whereas minimum liability amounts are oriented only to the balance sheet (the Wolk-Rozycki article in the chapter references illustrates both minimum liabilities and transition gain or losses). Q-21 Is it inconsistent to use future salaries for service cost calculations and current salaries for minimum liability calculation purposes? It is somewhat unsettling but not necessarily inconsistent. The purpose of using future salaries in service cost calculations is to help predict future cash flows. Future salaries would be preferable for this purpose over present salaries though problems of reliability and executory contractual issues have been brought up in the text. It would appear that present salaries would be more representationally faithful for determining minimum liabilities than estimated future salaries. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Refer to Appendix 15-A. Assume that the firm is using projected accrued benefit cost funding. Suppose that a plan amendment was introduced during 2002 granting one year of prior service (for the year 2000) to each employee. Required: Determine the contribution to the pension fund for 2002 and 2003. First find the increase in final benefits as a result of the plan amendment. This can be done by modifying equation 15.1 and using the additional number of years covered, which is one: Additional benefit equals expected final salary times expected number of employees who will be with the firm times the proportion of salary to be received times one year: $25,000 = $50,000 × 5 employees × .10 × 1 year The $25,000 is then added to the expected annual benefits during retirement of $75,000 in 2004 and 2005, as shown in Exhibit 15-4. The new total of $100,000 annual benefits is then discounted back to its present value on December 31, 2003 at the expected earnings rate of 12%: $100,000 × 1.69005 = $169,005 Since only 2002 and 2003 are affected, the $33,682 already paid in on December 31, 2001 (Exhibit 15-4, Panel A) is compounded forward for two years at 12%, which equals $42,251 ($33,682 × 1.2544). The $42,251 is then subtracted from $169,005, which leaves $126,754 to be covered. The $126,754 is divided by two years (the number of remaining years), giving equal undiscounted amounts of $63,377. The $63,377 due on December 31, 1992 is discounted for one year at 12% (.8929), resulting in a payment of $56,589. Hence, the amending of the plan by including one additional year of coverage results in the following changes: 12/31/02 12/31/03 New payment $56,589 $63,377 Old payment (from Exhibit 15-4, Panel A) 37,724 42,251 Differential $18,865 $21,126 2. Smurfit-Stone Container Corporation’s 2004 annual report shows the following information pertaining to its minimum pension liability (this is before SFAS No. 158; 000’s omitted): Accumulated benefits obligation $3,336 Fair value of plan assets 2,466 Underfunded status 870 Unrecognized actuarial loss 762 Unrecognized prior service cost 79 Net unrecognized costs 841 Net minimum liability $ 29 Required: How do you think Smurfit-Stone would justify their calculation of the minimum liability and do you agree with them? You can access a PDF copy of Smurfit-Stone Container Corporation’s 2004 annual report at http://phx.corporate-ir.net/phoenix.zhtml?c=75794&p=irol-reportsannual, but will need to access its 10K report on the SEC’s EDGAR database at http://www.sec.gov . The company’s assumptions related to the discount rates indicates that a reduction was necessary, given the current and projected environment. However, a concurrent review of its rate of compensation assumptions indicates an upward adjustment is necessary. These offsetting assumptions are suspect since they suggest smoothing by management. 3. Using SFAS No. 87 and SFAS No. 106 for additional background, list and briefly discuss as many similarities and differences as you can between pension accounting and OPEB accounting. Appendix B of SFAS No. 106 provides a good comparison between SFAS Nos. 87 and 106. We start with similarities. Similarities • Both appear to be liabilities according to SFAC No. 6 and both are so interpreted. • Both use the benefits/years of service approach and both are based on projected numbers: projected salaries in the case of pensions, and projected health care costs in the case of OPEB. • Service cost, interest cost on the projected benefit obligation, and actual return on plan assets are largely similar. • Prior service costs, including their measurement and amortization, are largely similar, including negative plan amendments. • Gain and loss treatments are largely similar. • Plan assets for both must be segregated and restricted for the sole purpose of providing defined benefits. Differences • The attribution period for pensions covers years of service ending with retirement, but under OPEB it goes only to the date of full eligibility (which frequently may be the retirement date). • There is no minimum liability under OPEB. • Normal pension cost is based on an asset-liability orientation, but normal OPEB costs are basically revenue-expense (for example, see the equalized annual service cost in Exhibit 16-2). • Future salaries used in pension service cost are wholly executory, but future health care costs are only partially executory and are not under management accountability. • There is one major difference between the future cost orientations of SFAS Nos. 87 and 106. The future salaries in SFAS No. 87 are wholly executory on the part of both the firm and the employees. Future salary increases pertain to factors such as advancement and promotion as well as increasing skills. These services have not as yet been provided by employees and, of course, the firm has not started paying for them; hence, the future salary increases are mutually unperformed and executory (raises due to inflation only would automatically discount back to current salary levels). In contrast to future salaries, future health care costs of postretirement benefits do not have this same doubly unperformed aspect. Health care costs provided after retirement are executory relative to the firm, but not to its employees. At the present time, employees do not have to do anything more relative to the amount of health care services received to date. CRITICAL THINKING AND ANALYSIS 1. To qualify as a liability, a past transaction must exist. Is this the case with pensions and OPEBs? How does the use of financial statements for predicting future cash flows as opposed to evaluating management performance enter the picture? First of all it would have put the debt in the balance sheet where, we believe it belongs. Secondly, the orientation of this number would move away from prediction of cash flows to assessment of management performance (accountability). Thirdly, the executory nature of these numbers would be eliminated. Fourthly, verifiability should be improved. We would favor the proposal. 2. Biggs (2010) presents a bleak picture for future generations attempting to meet the obligations related to public pension plans (e.g., State of New York; Jefferson County, Alabama)). How does his logic hold up when reviewing U.S. public corporations? Biggs, Andrew G. (March 22, 2010). “Public Pension Deficits Are Worse Than You Think: How can fund managers assume an 8% rate of return?,” The Wall Street Journal: WSJ.com, accessed March 23, 2010, http://online.wsj.com. Biggs estimates that public pensions are underfunded by $3 trillion. Ouch! And that’s OK per the accounting our public organizations are using? 3. How might standards setters address the concerns that Gordon and Gallery (2012) highlight related to pension accounting comparability? Gordon, Isabel and Natalie Gallery (2012). “Assessing Financial Reporting Comparability Across Institutional Settings: The Case of Pension Accounting,” The British Accounting Review 44: 11–20. The authors suggest that convergence of local accounting standards to international financial reporting standards (IFRS) may render increased comparability of financials unrealistic. They develop a comparability framework to pension accounting in the Australian and USA contexts. They “highlight a dilemma: while regulators seek to increase the likelihood that similar events are accounted for similarly, an unintended consequence may be that preparers are forced to apply similar accounting treatment to events that are, in substance, different.” This is problematic in just about all instances in which IFRS or any other standard might be adopted. Perhaps the standards must be broad enough to encompass differing economic substance, but detailed enough to be a benchmark. Variations from the benchmark should be disclosed via footnotes. Or, perhaps simple comparability may be an unattainable goal across cultures. Offline financial analysis may be the continuing solution to comparability. 4. Novy-Marx and Rauh (2011) estimate state employee pension liabilities in the United States. What thoughts do you have on their findings? Novy-Marx, Robert and Joshua Rauh (August 2011). “Public pension promises: how big are they and what are they worth?” The Journal of Finance, 1211–1249. Abstract We calculate the present value of state employee pension liabilities using discount rates that reflect the risk of the payments from a taxpayer perspective. If benefits have the same default and recovery characteristics as state general obligation debt, the national total of promised liabilities based on current salary and service is $3.20 trillion. If pensions have higher priority than state debt, the value of liabilities is much larger. Using zero-coupon Treasury yields, which are default-free but contain other priced risks, promised liabilities are $4.43 trillion. Liabilities are even larger under broader concepts that account for salary growth and future service. Use this article for discussion on the potential effects of the authors’ findings. Individuals? Corporations? States? U.S. Budgets? Chapter 16: Leases CHAPTER HIGHLIGHTS Lease capitalization is one of the most interesting policy areas in accounting. This is because of the gradual evolution of policy over a long period of time (nearly 40 years). Such a long evolution permits a ready analysis of the theoretical rationale behind the successive accounting standards. The overriding issue presented in the chapter is the search for finite uniformity. In the case of leases, this means classification into capital and operating leases. Capital leases are likened to purchases. By simple analogy, operating leases are made to resemble rentals. This simple two- way dichotomy illustrates the limitation of the accounting model. Leases are obviously neither purchases (sales) nor simple rentals in the strict legal sense. Yet the accounting choice is limited to these two analogies. Given the large number of successive lease accounting standards, the chapter presents a historical development of the arguments pertaining to lease capitalization. This review also illustrates the importance of definitions of accounting elements. The trend toward increased capitalization is closely related to the broadening of asset and liability definitions over the same time period. What emerges from the review is that finite uniformity is difficult to define and implement where there is a continuum of possibilities. The rules of capitalization emerge as an arbitrary point in the continuum; for example, the 75 percent rule in SFAS No. 13. Another important point is the incentive to circumvent lease capitalization, and the ability to do so by defeating the various (arbitrary) capitalization tests. This latter point illustrates a practical weakness in the policy of finite uniformity, and has led many critics to advocate an “all or none” attitude toward lease capitalization (rigid uniformity). The final point to be highlighted concerns the incentives to circumvent capitalization, and the economic consequences of mandatory lease capitalization. Survey evidence indicates a management preference for noncapitalization in order to achieve “off-balance-sheet” financing. There is some evidence that the market was “fooled” by hidden lease contracts: a study of APB Opinion No. 31 by Ro (1978) found evidence that its adoption had “information content” and that security price responses were negative. This could be explained in terms of the revelation of hidden debt. Another study (Pfeiffer, 1980) also found a negative price response to securities during the FASB’s public hearings in late 1974. It was argued that debt covenants would have affected stockholders wealth due to dividend and other restrictions relating to debt levels. In spite of the apparent market effects earlier, there was no evidence that the actual implementation of SFAS No. 13 affected security prices (Abdel-Khalik, 1981). This body of contradictory research can be reconciled. The studies by Ro and Pfeiffer, in effect, support the belief by management that “off-balance-sheet” financing can deceive the market regarding a company’s real debt level. The lack of information content in SFAS No. 13 may be explained by two factors. First, any adverse market reaction would probably have already occurred by the time of its adoption. Second, the long phase-in period may have mitigated any serious consequences in terms of debt covenants and debt-equity ratios. In short, there was ample time to restructure leases to avoid capitalization. Finally, the continued behavior by management to defeat the SFAS No. 13 tests are quite interesting and warrant an explanation. Agency theory arguments concerning debt covenants are one possibility. All in all, there is little doubt that lease capitalization has information content. The evidence is ambiguous on the point of whether it matters how the disclosure is made (footnotes or in the body of the statements). The IASB and FASB added leasing to its agenda in 2006. They have been spinning their wheels, driving in circles, back to where they started several years ago multiple times. Placement of all leases on the balance sheet is the appropriate way to proceed; industry push-back was strongly against its adoption. All leases on the balance sheet shows the fragility of many organizations that they prefer not be so apparent. However, despite strong opposition the new lease standard requires leases on the books for public companies in 2019. Read the following: Rapoport, Michael (Friday, February 26, 2016). “Rule Requires Leases on the Books,” The Wall Street Journal, C3. QUESTIONS Q-1 What is the argument for finite uniformity in accounting for leases? Why is finite uniformity difficult to achieve? Explain what the relevant circumstances are in accounting for different types of leases. The argument reduces to this: some leases are, by analogy, the equivalent of purchases (or sales to a lessor), while others are the equivalent of simple rentals. Finite uniformity is difficult because leases do not naturally fall into these two categories. The criteria (relevant circumstances) have changed over the years, and are discussed at length in the chapter for each standard. In broad terms, they have always been based on the “in-substance-purchase” argument. However, the specific tests have changed often. Q-2 Why is the aspect of conveyance of leases emphasized in capital leases and the contractual element emphasized in operating leases? In law, leases have both elements. Obviously, the conveyancing aspect (purchase/sale) dominates in capitalization, and the contractual element (rental) dominates in noncapitalization. Q-3 What are the similarities and differences between leases and other means of property acquisition? How can these similarities and differences be reported in the financial statements? Some leases are very similar to conditional sales agreements (title passes at end of payments). Title passes immediately under other types of sales, regardless of financing aspects. Remedies are unique for lessors: they must either sell or lease the asset again, then sue for any residual losses. In other words, the lessor must first mitigate the loss, and the loss is not defined as the unpaid future lease payments. This requirement does not exist for conditional sales. This emphasizes the unique nature of leases, and reinforces the weak nature of the “sale analogy” argument used to justify capitalization. Q-4 Is the executory nature of lease contracts important in assessing lease accounting? How have leases been interpreted? Why might noncancellability override the executory nature? The answer depends on how you regard the executory contract argument. If the executor argument is accepted, then leases should not be capitalized (to be consistent). If the executor argument is rejected, then there can be no objection to capitalization on these grounds. This issue illustrates the rather shaky nature of theory. The executory nature of leases certainly distinguishes them from sales-type agreements, as discussed in the previous question. So, even without the executory contract issue, lease capitalization is something unique in accounting. Q-5 Review the evolution of capitalization criteria in lease accounting standards. Why did APB Opinion No. 5 have little impact? What impact has SFAS No. 13 had? Has there been an underlying theme in the development of lease accounting? The broad criterion has always been the “in-substance-purchase” argument. Each standard has developed specific (and different) tests. ARB 38 took a legal approach and restricted capitalization to leases that were de facto conditional sales (installment sales). APB Opinion No. 5 embraced the “material equity” concept and focused on the existence of either a renewal option covering useful life or a bargain purchases option. Five narrower tests were suggested, but ignored due to the wording of the standard. Finally, SFAS No. 13 adopted the concept of a “material transfer of risks and benefit,” and uses any of four specific tests. APB Opinion No. 5 had less impact than expected due to poor wording. SFAS No. 13 has increased capitalization substantially. Q-6 Does it matter if capital leases are reported in a footnote or in the body of the balance sheet? What research evidence exists to help evaluate this question? A simple answer would be no. Disclosure is disclosure; form is unimportant. However, this approach ignores the cost of information processing to the user (in making necessary transformations, say, to a debt-equivalent in the balance sheet). There are also the agency theory arguments. Capitalization will quite clearly affect debt ratios established in restrictive debt covenants. Therefore, there could be wealth effects on stockholders. The study by Pfeiffer (1980) is consistent with this argument. Q-7 Does symmetry exist between lessors and lessees under SFAS No. 13? Should symmetry be a goal of lease accounting? There are two causes of asymmetry. First, traditional sales-type tests apply to lessors. These tests concern the uncertainty of cash collection. Second, the interest rate used for present value calculation could differ. The sales test is legitimate and consistent with the body of practice. For example, installment sales may be accounted for as a normal purchase by the buyer. The second cause creates a unique asymmetry. One cause of difference in interest rates is the inclusion of tax benefits for the lessor. In effect, asset cost was reduced by investment tax credits. This was not done with lessee computations because it was not applicable to them. So, the asymmetry created by the sales tests is logical. However, the computational asymmetry is hard to defend in terms of general practice. Q-8 How is representational faithfulness achieved in the capitalization requirements of SFAS No. 13? In the sense that the measurement may not be representationally faithful (see the previous question), the rules themselves are fairly objective. Key terms (for example, lease life) are open to a wide range of estimates, much in the same way that depreciable lives and estimates of salvage value are subjective in depreciation calculations. In the end, much noncash flow accounting is quite subjective. Q-9 Is there a measurement reliability (verifiability) problem with lease capitalization? Lease capitalization is an interesting example of finite uniformity. The costs are expensed as selling expenses if a sales-type lease, but implicitly amortized against future interest revenue if a financing lease. It is a logical extension of the matching concept, but it implies a precision in lease capitalization that does not exist. Q-10 Evaluate the manner in which initial direct lease costs are accounted for under SFAS No. 13. In going from true “off-balance-sheet” financing, as was the case prior to APB Opinion No. 31, to supplemental disclosure of noncapitalized leases, new information was clearly disclosed, and was potentially negative to stockholders because of larger-than-expected debt claims on the firm. Of course, by disclosing such leases, one appeal of leasing was abolished. Here is where neutrality comes into play. What if accounting policy lowers the incidence of leasing? Is this fair? The SEC argued that if the sole incentive for leasing rested with “off-balance-sheet” financing, then no social good was being achieved. It is useful to point out that leasing continues to be popular for a wide variety of operating, financing, tax, and accounting reasons, and that accounting policy did not kill leasing. Q-11 Why was there reason to expect some negative economic consequences arising from lease capitalization? What is the role of neutrality in such a situation? What is the response based on research findings to date? The Ro (1978) and Pfeiffer (1980) studies, plus surveys of analysts, support the notion that lease capitalization is useful. Costs exist because of the compliance cost (i.e., accounting costs). Q-12 Does the reporting of capital leases appear to have value to users of financial statements? Why are there costs of reporting capital leases? Because of the potential material effect on the balance sheet, the four-year transitional period permitted companies to restructure their leases, or capital structure generally. This political consideration lessened the unpopularity of SFAS No. 13 among companies. Policy making in the lease area has been quite political; for example, the SEC pushed policy-making bodies for increased capitalization during the 1970s. Q-13 What considerations may have motivated the FASB to grant a four-year transitional period in capitalizing pre-1977 leases meeting the capitalization tests of SFAS No. 13? What other political behavior is evident in the evolution of lease accounting? Because of the potential material effect on the balance sheet, the four-year transitional period permitted companies to restructure their leases, or capital structure generally. This political consideration lessened the unpopularity of SFAS No. 13 among companies. Policy making in the lease area has been quite political; for example, the SEC pushed policy-making bodies for increased capitalization during the 1970s. Q-14 Should valuable lease options of lessees be capitalized? Since valuable lease options are valuable, yes, they should be capitalized. Two leases that are exactly the same except for a bargain purchase or lease renewal option should not be capitalized for the same amount. Q-15 Why is the G4+1 like the Big Ten (a.k.a. Western Athletic Conference)? The G4+1 has six members and the Big Ten football conference in the USA has eleven members. At least in the case of the Big Ten this situation shows the importance of branding. Q-16 Why is the IASB standard (IAS 7) substantially shorter than the FASB’s standard (SFAS No. 13)? IAS 17 is more principles-based, lacking the “bright lines” found in SFAS No. 13. IAS 17 requires more judgment on the part of the accountant, but fewer words in the standard itself. Q-17 Current discussions by the Boards leave room open for two Accounting for Leases Standards; one for lessee and another one for lessor. Should two Accounting for Leases Standards be issued? Support your response? The ideal would be for one standard with lessor and lessee making mirror journal entries to record the lease. However, the likelihood that one size fits all is of low probability. Organizational size and industry may differ significantly between lessor and lessee. Q-18 Current discussions by the Boards point to a possibility that a converged standard on leases will not be achieved. How will lack of converged standard on leases affect the Boards’ Joint Project? If a converged standard is not achieved, comparability of FASB and IASB financial reports may be significantly impaired. Depending on the specific company, assets and liabilities may be significantly increased if placing all leases on the balance sheet, therefore, affecting ratios. However, as of February March 2016, the differences appear to be relatively few., CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Human Genome Sciences, Inc., a biopharmaceutical company, discovers, develops, and markets new gene and protein-based drugs. Its 1998 annual report showed property, plant, and equipment net of accumulated depreciation of $20,965,000 with total net assets of $244,247,000. A note on operating leases revealed the following: Operating Leases The Company leases office and laboratory premises and equipment pursuant to operating leases expiring at various dates through 2017. The leases contain various renewal options. Minimum annual rentals are as follows: Years Ending December 31, 1999 $5,990,790 2000 6,074,955 2001 6,197,186 2002 6,278,051 2003 5,353,707 Thereafter (2004–2017) 35,001,144 $64,895,833 Required: a. Assume that the company’s cost of capital is 10 percent and that operating lease payments between 2004 and 2017 are equal amounts per year. By how much would Human Genome Sciences’ property, plant, and equipment and its total net assets increase by on December 31, 1998 if these leases were capitalized? b. Assume that the company’s net income for 1998 was $20 million. What was its return on assets (ROA) (a) before and (b) after capitalizing the operating leases? Use straight-line depreciation over 14 years for the capitalized leases. Operating lease expense for 1998 is $5,900,000. (a) First determine the present value of the future lease payments using 8% discount rate. We use the present value of $1 for the first five years and then an annuity for the remaining nine years: Year Amount PV Factor PV Amount 1 $5,990,790 0.92593 $5,547,052 2 $6,074,955 0.85734 $5,208,302 3 $6,197,186 0.79383 $4,919,512 4 $6,278,051 0.73503 $4,614,556 5 $5,353,707 0.68058 $3,643,626 6-14 $3,889,016 4.25152 $16,534,229 Total $40,467,277 (b) Interest Expense would be 8% × $40,467,277 $3,237,832 Depreciation on a straight-line basis for the newly capitalized leases would be: $40,467,277 ÷ 14 $2,890,520 Total Expenses $6,128,352 (c) Return on Assets (ROA): Before Capitalization $20,000,000/$244,247,000 =8.188% After Capitalization $19,771,648/$284,714,247 = 6.944% The $20,000,000 of income was reduced by the excess of total expenses after capitalization ($6,128,352) over the operating lease expense during 1998 ($5,900,000). The result of the capitalization is a significant reduction in return on assets. 2. Wright Company leases an asset for five years on December 31, 2000. Annual lease cost of $10,000 is payable on each December 31 beginning with the year 2001. In addition to the annual lease cost, the lease contract calls for a guaranteed residual value of $3,000. The asset has an economic life of seven years. Wright’s incremental borrowing rate is 8 percent. The asset has an acquisition cost of $45,000. There are no purchase options. Required: a. As things now stand, is this a capital lease or an operating lease? Show figures. b. What can Wright do to convert this lease to an operating lease? Explain and show figures. c. Will lessee and lessor’s accounting for this lease be symmetrical (capital lease for both lessor and lessee or operating lease for both lessor and lessee)? Explain. d. Do you think that Wright’s action in (b) represents a loophole to avoid capitalization or is it a useful part of the present leasing rules? Explain. (a) As it stands now, this is a capital lease. The lease period is less than 75% (five years out of a total economic life of seven years), but the present value of the five year’s worth of lease payments plus the guaranteed residual value exceeds 90% of the fair market value of the property: $10,000 x 3.99271 = $39,927 $3,000 x 0.68058 = $2,042 $41,969 and $41,969/$45,000 = 93.26% (b) Wright can get an outside party to insure that if the fair market value of the property is less than the guaranteed residual value, the outside party will pay the shortfall. If this is done, the guaranteed residual value is left out of the 90% calculation resulting in $39,927/$45,000 = 88.7%. Interesting, since this is under 90%, it is an operating lease. Yes, there is a lack of symmetry because the residual value, whether guaranteed or unguaranteed, is included in the lessor’s 90% calculation. Therefore, it is an operating lease for the lessee and a capital lease for the lessor. We believe it is clearly a loophole. This is an example of possible financial engineering and bright-lines. The lessee’s ability to use an outside third party opens the door to lease term manipulations to ensure operating lease treatment by the lessee. 3. Assume the following facts concerning a sales-type lease: • The lease term is three years and qualifies as a capital lease for both lessor and lessee. The asset reverts to the lessor at the end of the lease term. Assume straight-line depreciation by the lessee. • Payments are $50,000 at the beginning of each year, plus a guaranteed residual value of $10,000 at the end of the lease term. The lessor estimates a total residual value of $15,000. Lease payments include $4,000 for executory costs under a maintenance agreement. • Initial direct costs associated with the lease are $2,700. • Cash sales price of the asset is $137,102.50. Lessor’s manufacturing cost is $100,000. • The lessee does not know the lessor’s implicit rate, but its own incremental borrowing rate is 11 percent. Required: a. Prepare the accounting entries for both lessor and lessee for the three years. What happens in Year 3 if residual value is only $8,000? b. Assume the same facts as before except that the asset is first sold to a finance company, which then leases the asset to the lessee. Prepare the required entries in all three years for lessor and lessee. c. Evaluate the differences between requirements (a) and (b) as well as the differences between lessor and lessee. This is a comprehensive numerical exercise. Depending on the nature of the course, instructors may wish to exclude it. Part (a) Lessor: Year 1 Cost of goods sold 100,000.00 Lease payments receivable 153,000.00 Sales 137,102.50 Inventory (asset) 100,000.00 Unearned interest 15,897.50 Selling costs 2,700.00 Cash 2,700.00 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 9,110.25 Interest revenue 9,110.25 Year 2 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 5,421.28 Interest revenue 5,421.28 Year 3 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 1,365.97 Interest revenue 1,365.97 Asset 15,000.00 Lease payments receivable 15,000.00 Calculation of interest rate: $137,102.50 = 46,000(1+i)0 + 46,000(1+i)1 + 46,000(1+i)2 + 15,000(1+i)3 i = .10 Net Lease Receivable Gross Lease – Unearned Interest = Net × .10 = Interest Revenue Year 1 (153,000 – 46,000) – 15,897.50 = $91,102.50 × .10 = $9,110.25 Year 2 (107,000 – 46,000) – 6,787.25 = $54,212.75 × .10 = $5,421.28 Year 3 (61,000 – 46,000) – 1,365.97 = $13,634.03 × .10 = $1,365.97* *Rounding error Part (a) Lessee: Year 1 Leased asset 132,088.00 Leased obligations 132,088.00 Executory costs 4,000.00 Lease obligations 46,000.00 Cash 50,000.00 Depreciation expense 40,696.00 Accumulated depreciation 40,696.00 Year 2 Executory costs 4,000.00 Lease obligations 36,530.32 Interest expense 9,469.68 Cash 50,000.00 Depreciation expense 40,696.00 Accumulated depreciation 40,696.00 Year 3 Executory costs 4,000.00 Lease obligations 40,548.64 Interest expense 5,451.36 Cash 50,000.00 Interest expense 991.00 Lease obligations 991.00 Lease obligations 10,000.00 Leased asset 10,000.00 Depreciation expense 40,696.00 Accumulated depreciation 40,696.00 Present Value = 46,000(1.11)0 + 46,000(1.11)1 + 46,000(1.11)2 + 10,000(1.11)3 = $132,088 Lease Obligation Outstanding Year 1 132,088 – 46,000 = 86,088 × .11 = $9,469.68 Interest Expense Year 2 86,088 – 36,530.22 = 49,557.78 × .11 = 5,451.36 Interest Expense Year 3 49,557.78 – 40,548.64 = 9,009.14 × .11 = 991.00 Interest Expense Note that interest in Year 3 applies only to the present value of the $10,000 residual value, and that the residual value is written up to the final balance of $10,000 by the Year 3 interest expense. Note also that depreciation is [(132,088 – 10,000)/3] = 40,696. If Year 3 residual value unexpectedly turns out to be only $8,000, the following adjustments would be made, in addition to the above entries: Lessor Cash 2,000 Loss 5,000 Asset 7,000 Lessee Loss 2,000 Cash 2,000 Part (b) Lessor: Year 1 Asset 137,102.50 Cash 137,102.50 Lease payments receivable 153,000.00 Taxes Payable 13,710.25 Asset 137,102.50 Unearned interest 29,607.75 Unearned interest 2,700.00 Cash (initial direct costs) 2,700.00 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 15,177.48 Interest revenue 15,177.48 Year 2 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 11,730.27 Interest revenue 11,730.27 Year 3 Cash 50,000.00 Lease payments receivable 46,000.00 Executory costs 4,000.00 Unearned interest 2,393.66 Interest revenue 2,393.66 Asset 15,000.00 Lease payments receivable 15,000.00 The interest rate that amortizes the adjusted balance of unearned interest (29,607.75 – 2,700.00 = 26,907.75) is arrived at by trial and error: i = 18.95%. Net Lease Receivable Gross Lease Unearned Interest = Net × .1895 = Interest Revenue Year 1 (153,000 – 46,000) – 26,907.75 = 80,092.25 × .1895 = $15,177.48 Year 2 (107,000 – 46,000) – 11,730.27 = 49,269.73 × .1895 = $9,336.61 Year 3 (61,000 – 46,000) – 2,393.66 = 12,606.34 × .1895 = $2,393.66* *Rounding error Part (b) Lessee: Entries the same as for part (a) Part (c) It makes no difference whether a lease is a sales-type or financing type, from a lessee’s viewpoint. In part (a), asymmetry between lessor and lessee exists in terms of the interest rate and the treatment of residual value ($10,000 by the lessee and $15,000 by the lessor). Further asymmetry occurs in part (b) due to the treatment of initial direct costs by the lessor. These calculations should make the rules of SFAS No. 13 seem somewhat arbitrary, particularly in terms of representational faithfulness. 4. One of the four capitalization tests of SFAS No. 13 is that the lease term is 75 percent or more of the asset’s remaining economic life. Lease term is defined as follows in SFAS No. 13 (as amended by SFAS No. 98, para. 22a): The fixed noncancellable term of the lease plus (i) all periods, if any, covered by bargain renewal options, (ii) all periods, if any, for which failure to renew the lease imposes a penalty on the lessee in an amount such that renewal appears, at the inception of the lease, to be reasonably assured, (iii) all periods, if any, covered by ordinary renewal options during which a guarantee by the lessee of the lessor’s debt related to the leased property is expected to be in effect, (iv) all periods, if any, covered by ordinary renewal options preceding the date as of which a bargain purchase option is exercisable, and (v) all periods, if any, representing renewals or extensions of the lease at the lessor’s option; however, in no case shall the lease term extend beyond the date a bargain purchase option becomes exercisable. A lease which is cancellable (i) only upon the occurrence of some remote contingency, (ii) only with the permission of the lessor, (iii) only if the lessee enters into a new lease with the same lessor, or (iv) only upon payment by the lessee of a penalty in an amount such that continuation of the lease appears, at inception, reasonably assured shall be considered “noncancellable” for purposes of this definition. Required: How can this test be circumvented through either the structuring of the lease contract or interpretation of the test? What are other ways in which lease capitalization could be avoided through the structuring of lease terms or interpretation of the tests? What problem does this exercise illustrate? In interpreting “lease term,” judgment is required concerning whether a bargain purchase option or renewal option exists. This determination will affect the derivation of lease term for applying the 75 percent test. Of course, the test could also be manipulated through the estimated economic life. In short, even the 75 percent rule is far from being an objective test. Another way mentioned in the chapter is the use of third-party guarantors for residual value to the lessor. This will result in a lower present value of minimum lease payments for the lessee, and defeat the present value test. So, if a company wishes to avoid lease capitalization, it can do so and still stay within the bounds of SFAS No. 13. For this reason, some critics believe finite uniformity in lease accounting invites such behavior, and is consequently a failure. 5. This problem shows the importance of considering the importance of converting operating leases to capital leases for the purpose of financial statement analysis. It is based upon the techniques developed and illustrated in Imhoff, Lipe, and Wright (1991 and 1997) though it is much simplified from their presentation. See the text for details related to McAdoo Restaurants. Required: a. Convert the operating lease to a capital lease which is 1 year old (Hint: Use the present value of a 10-year ordinary annuity). Assume that straight-line depreciation is used for both book and tax purposes. There would be a zero salvage value. b. Determine the net income after taxes if the leases are treated as capital leases. c. Determine the return on assets under the (a) operating lease assumption and (b) capital lease assumption. d. Determine the debt-equity ratio under the (a) operating lease assumption and (b) capital lease assumption. e. Do you think it is useful to convert operating leases to capital leases for financial statement analysis purposes? Discuss. (a) We determine the capitalized amount of the lease as both an asset and liability by adding to the Jan. 1, 2001 balance sheet the following amount: $3,000 × 6.14457 = $18,434 (b) and (c) For the year 2001 we would deduct the $3,000 in capital lease payments and add depreciation of $1,843 and interest of $1,843 for total additional expenses of $686 ($3,686 – $3,000). However, this reduces taxes by $240 ($686 × .35). Hence through capitalization, income is reduced by $446 ($3,000 – $3,686 + $240). ROA is now shown: Without Capitalization: ROA = $6,500/$80,000 = 8.125% With Capitalization: ROA = $6,046/$98,434= 6.142% (We used beginning-of-year assets.) (d) In computing the debt-equity ratio on December 31, 2001, we deduct the principal reduction of $1,157 ($3,000 payment minus interest at 10% of $1,843 equals principal reduction of $1,157). We assume that there is no change in liabilities, other than the leases during the year and that there were no transactions with owners. Without Capitalization: Debt-Equity Ratio = $45,000/$86,500 = 52.02% With Capitalization: Debt-Equity Ratio = $62,277 b/$102,645c = 60.67% b$45,000 + ($18,434 – $1,157) = $62,277 c$80,000 + ($18,434 – $1,843) + $6,054 = $102,645 (e) Yes, we do think it is useful. Many lease contracts are constructed to avoid capitalization. This is really a facet of earnings management. We believe a much better appraisal of managerial effectiveness (accountability) can be accomplished by capitalizing operating leases. 6. SFAS No. 98, which contained some amendments to SFAS No. 13, passed by a 4 to 3 vote. The following dissent to the opinion was made: Please refer to the text for the details of this lengthy question. Required: Using the perspective on uniformity developed in Chapter 9, analyze the rigid versus finite uniformity approach to the distinction between the two positions. This is a complex area and, among other pronouncements, SFAS No. 98 modifies parts of SFAS No. 13 and SFAS No. 66 and is itself rather complex. Hence, much can be done with this case, including the assignment of term papers evaluating different treatments of sales of real estate and the handling of sale-leaseback transactions. Limiting the scope of this case to issues of comparability and uniformity is still quite revealing. SFAS No. 98 does, at least in part, reasonably employ finite uniformity. Those “sale-leaseback” transactions that do not qualify for sale-leaseback treatment do involve differential cash flow alternatives from ordinary sale-leasebacks. Some of these factors mentioned in paragraphs 11 and 12 of SFAS No. 98 are: a. The seller-lessee has an obligation or option to reacquire the property or the buyer- lessor can force repurchase by the lessee. b. The buyer-lessor’s investment or return thereon is guaranteed by the seller-lessee. c. The seller-lessee provides guarantees to reimburse the buyer-lessor for declines in market value of the property beyond usual wear-and-tear considerations. In these and other cases, the FASB requires methods such as the “deposit” method, in which the property stays on the seller-lessee’s books and depreciation by the seller-lessee continues (see paragraph 65 of SFAS No. 66). Given the finite uniformity treatment, for which a case can certainly be made that comparability is improved, the three dissenters to SFAS No. 98 are, in our opinion, absolutely correct. According to paragraph 7 of SFAC No. 98, to qualify for sale-leaseback accounting treatment under SFAS No. 13, the transaction must involve a “normal leaseback.” The latter cannot involve subleasing of the property unless the subleasing is minor. The question of subleasing involves a different transaction: the usage that the seller-lessee intends for the property. The factors mentioned above from paragraphs 11 and 12 concern cash flow aspects of the sale and leaseback itself. Other examples used throughout this text involving finite uniformity similarly concentrate on analyzing the particular event under discussion, and not a totally separate event that is not an integral part of the transaction at hand. CRITICAL THINKING AND ANALYSIS 1. ”All leases beyond a year be capitalized!” Evaluate this position. The short answer is “Yes, all leases should be capitalized.” It does not make sense that an arbritrary bright-line should require 100% or zero percent to be capitalized. Proportionally capitalization of all leases is a more reasonable route to take. From a legal standpoint we believe that the reality of the situation is that the lessor, by providing the property to the lessee, does not result in a mutually unperformed contract. The fact that the lessor, in case of the lessee’s default, must mitigate the loss is not especially relevant. As long as the lessee has a material equity in the property where rental payments exceed economic value of the property or bargain purchase options or bargain lease renewal options are present, then capitalization is definitely merited. The same end result occurs where benefits and risks incident to property ownership are largely transferred to the lessee. We believe all of these arguments generally lead to the same result: capitalization of the lease. Only if one adopts the narrow legal argument that the lease is mutually unperformed could one avoid capitalization. This is much too narrow a base for accounting to be operating from. 2. Bauman and Francis (2011) propose several improvements to lease accounting standards. Evaluate their proposals and add ones that they may have missed. Bauman, Mark P. and Richard N. Francis (June 2011). “Issues in Lessor Accounting: The Forgotten Half of Lease Accounting,” Accounting Horizons, 247–266. This should be a good class discussion paper. From its abstract about the FASB and IASB 2010 exposure draft on leases, “Disclosure quality, residual values, and the balance sheet impact of the proposal are examined, and numerous suggestions are offered to enhance the usefulness of lessor financial statement disclosures for decision makers.” 3. Zechman (2010) studies firms using synthetic leases. How might her findings influence the setting of lease accounting standards? Zechman, Sarah L. C. (June 2010). “The Relationship Between Voluntary Disclosure and Financial Reporting: Evidence From Synthetic Leases,” Journal of Accounting Research, 725–765. Synthetic leases are leases that are kept off the balance sheet and recorded as an expense only. They allow a company to control assets without showing them on the balance sheet. Zechman finds that cash constrained companies are more likely to finance purchases using synthetic leases. Knowing this, standards should be less flexible when set. Chapter 17: Intercorporate Equity Investments CHAPTER HIGHLIGHTS This chapter focuses on the general question of how to account for equity investments. Framed in this way, one can see how there is an extensive structure of finite uniformity and how this structure ties together the separate topics of equity versus fair value method for nonconsolidated equity investments, plus consolidation ). The overriding relevant circumstance has to do with “effective control” by the investor over the investee company. Exhibit 17-1 sets out the finite uniformity framework for equity investments. Of course the elimination of pooling and the elimination of goodwill but subject to impairment are the big issues in intercorporate equity investments. The question might be raised as to the “symmetry” of the fair value to equity method to consolidation . This may be a rather creaky finite uniformity approach. Hence, proportionate consolidation might provide a worthwhile rigid uniformity alternative. SFAS No. 94 has brought rigid uniformity to consolidation policy by requiring that all majorityowned equity investments be consolidated. ARB 51 allowed exemptions for heterogeneous subsidiaries and for foreign subsidiaries. A criticism of SFAS No. 94 is that it blindly presumes that consolidated accounting “fictions” are informative. In fact, it’s easy to think of situations in which they aren’t—for example, when there are no cross-guarantees of debt between a parent and subsidiary. Therefore, it is regrettable that the FASB did not wait until it thought through the reporting entity project before issuing SFAS No. 94. Foreign currency translation is traced from SFAS No. 8 to SFAS No. 52, showing how the conflicts between accounting exposure and economic exposure were reduced. QUESTIONS Q-1 Are there relevant circumstance differences between purchase and pooling of interests? Explain No, we do not believe so. Suffice it to say that relevant circumstances do not deal with how assets are acquired; they deal with potential uses thereafter. Q-2 The logic of pooling rests heavily on the assumption that no substantive economic transaction occurs between the combinor and stockholders of the combinee. Evaluate this assumption. We suggest this is a weak argument. Clearly a transaction between the combinor and stockholders of the combinee has occurred. Q-3 Why may companies not be indifferent to purchase and pooling accounting, and what do we know about this issue from research studies? Pooling produces a better income statement because combinee assets aren’t written up and goodwill is not recognized. ROI is also higher due to a lower asset base in the combined balance sheet. The limited research has not shown that the use of pooling versus purchase accounting produces any gains viz. security prices. Q-4 Why would proportionate consolidation result in rigid uniformity for intercorporate equity investment accounting? Consolidation would occur throughout the spectrum of percentage of common stock owned on a proportionate basis without introducing any arbitrary percentage breaks. Q-5 Compare proportionate consolidation with capitalizing of all leases extending beyond a year, another example of rigid uniformity. The comparison is quite close between proportionate consolidation and capitalization of all leases beyond a year. One way to institute proportionate consolidation would be for all equity investments above 10 percent to avoid the “nuisance” problem of consolidating many very small and temporary equity investments. Q-6 The equity method reports neither the investor’s cost nor the market value of the investment. Do you believe the equity method provides useful information? Why or why not? The equity method is a kind of perverse extension of the accrual concept to equity investments. But it is a completely fictitious attribute, and it is probably not more informative than the cost basis of accounting. Q-7 Compare the present system involving consolidation, equity method, and fair value accounting for intercorporate equity investments with finite uniformity as it exists in lease accounting. Leasing has a dichotomy: capital lease or operating lease. Inter-corporate equity investments have a trichotomy. The alternatives of capitalization versus expensing have stronger economic consequence results in leasing (keep debt off the balance sheet) than in inter-corporate equity investments, For both leases and inter-corporate equity investments, the distinctions are on a continuum involving percentages, so the breaks between categories are not very clear-cut in either case. Q-8 What is meant by the term one-line consolidation? What differences occur in financial statements when a one-line consolidation rather than full consolidation is used? The equity method essentially picks up the proportionate change in investee book value and records this in the investment account and the income statement—hence, its name as a one-line consolidation. There is no persuasive rationale for the method. APB Opinion No. 18 tries to tell a tale about “influence” that is substantial but less in degree than “control.” The tale is, in our view, a tall tale. The best method would be to carry at market value where the security is traded, and to approximate fair value for unlisted investments. Q-9 What are some reasons why consolidated reports are thought to be relevant? By custom, we have grown to uncritically accept the accounting fiction of consolidation as truly representing the “firm” (an interesting question of faithful representation). Accounting is a powerful language of reduction, and we believe this is the best way to make sense of complex, related entities, such as those that exist in consolidations. Q-10 Discuss the limitations of consolidated financial statements and why dual reporting (consolidated and separate entity statements) as well as other forms of disaggregated reporting, such as SFAS No. 131, make sense. Consolidations tell one story—indeed, a fictitious story at that. There are other possible accounting stories that can also be told, including parent-only statements and disaggregated data (e.g., the segmental disclosures of SFAS No. 131 ). In simple terms, detail is lost in consolidated reports. In some cases, such a loss might not matter—in other cases, it could easily distort the picture. Q-11 Why does the FASB’s reporting entity project logically precede any conclusion regarding consolidated financial reporting? “…an entity for financial reporting purposes should not be limited to legal entities, such as companies, trusts, and partnerships. Rather, an entity should be defined more broadly to include other types of organizational structures, including a natural person, a sole proprietorship, and, in some circumstances, a branch or segment of a legal entity.” “Some Board members reached the conclusion that a parent-only entity could be a reporting entity but view the parent-only financial statements and the consolidated financial statements as different forms of presentation for the same entity.” (from April 5, 2006 FASB Board Meeting minutes). The FASB appears to agree that the notion of the consolidated entity is a useful fiction for the purpose of financial reporting. This conclusion should become the basis for a consolidation standard. Q-12 Describe the implicit assumption made in SFAS No. 94 about the reporting entity. SFAS No. 94 presumes that the fiction of a consolidated entity is appropriate for financial reporting purposes. Q-13 What is push-down accounting? What problems would arise in connection with the implementation? Push down accounting refers to attempts to require firms that have been acquired in purchases to keep their accounts on the basis of the combinor’s purchase price rather than their own (combinee’s) historical costs. There would be a lack of comparability between those combinee entities carried on a fair value basis and other separate entities that are not combinee firms. Push down accounting also raises significant questions about debt covenants involving ratios such as debt-equity ratios. Debt holders would not be happy to have equity measured in fair value terms. Q-14 How are minority interests handled in consolidations? Note that the term, minority interests, is an older one that is now called “noncontrolling interests.” Flexibility of presentation exists relative to minority interests. It has appeared as a liability, between liabilities and stockholders’ equity, and within the stockholders’ equity section. Q-15 What is an equity carve-out? Equity carve-outs arise when a parent dilutes its interest in a subsidiary by setting a portion of its interest thereof to another entity or even has an initial public offering of the subsidiary (keeping at least a 50% ownership share). Q-16 Distinguish among sell-offs, spin-offs, split-offs, and split-ups. • Sell-offs occur when a subsidiary’s stock is sold for cash, other assets, or in settlement of a debt. • Spin-offs arise when the subsidiaries shares are distributed to the parent’s shareholders as a dividend. • Split-offs arise when the subsidiaries shares are distributed to the parent’s shareholders in exchange for the parent’s stock. • A split-up occurs when the shares of two or more subsidiaries are distributed to the parent’s shareholders in exchange for all of the parent’s shares. The parent is then liquidated. The split-up is similar to the split-off with the difference that the parent is liquidated under the split-up. Q-17 Why does the elimination of poolings (SFAS No. 141) and the indefinite life of goodwill subject to impairment (SFAS No. 142) represent a possible “quid pro quo?” The “bad news” of pooling elimination was offset by the “good news” of not having to amortize goodwill at least as long as it is not impaired. Q-18 Why does the elimination of poolings improve representational faithfulness and comparability We do not believe that pooling was representationally faithful because a transaction occurred but the combinee’s assets are treated as if there was no transaction. Q-19 What are the main issues surrounding the special purpose entity and its successor, the variable interest entity. Despite up to a 97% investment, the sponsoring firm can keep the SPE’s debts off the sponsors books. In the case of Enron, considerable questions arose relative to the activities being carried on under the banner of the SPE. For example, poor performing asset’s on Enron’s books were sold to one of its SPEs. A huge amount of Enron derivative transactions were transferred to an SPE’s books. These problems more than offset the legitimate use of SPEs in financing activities. Q-20 What are the differences between a foreign currency orientation and a U.S. dollar orientation regarding the translation of foreign currency operations? A U.S. dollar orientation attempts to make the foreign currency operations appear as if they occurred in U.S. dollars. A foreign currency orientation recognizes that the foreign operations occurred in a foreign currency and that those operations may not affect U.S. dollars; therefore, accounting should be consistent with the foreign currency economic impact of the operations. Q-21 How do accounting exposure and economic exposure differ? Accounting exposure is the exposure to exchange gains and losses resulting from translating foreign-currency-denominated financial statements into U.S. dollars. Basically, it is the result of translating various items at different exchange rates and usually does not affect cash flows. For example, if a building was purchased by long-term debt and the building was translated at historical exchange rates while the debt was translated at current exchange rates, accounting exposure would equal the amount of the difference. If both were translated at current exchange rates, there would not be an accounting exposure. Economic exposure is the exposure to cash flow changes resulting from dealings in foreign-currency-denominated transactions and commitments, e.g., the necessity to use more U.S. dollars to settle a foreign-currency- denominated debt. Q-22 Why would balance sheets prepared under SFAS No. 8 lack additivity? Items carried on balance sheets at current price, such as monetary items and inventories and investments at market (when lower than cost), were translated at current exchange prices. Conversely, items carried at historical costs, such as fixed assets, were translated at the historical exchange rate (rates existing when the item was acquired). This would, of course, also impact the income statement. Q-23 Why does SFAS No. 52 provide an example of finite uniformity in terms of the use of remeasurement? If a subsidiary is really an extension of the parent, with frequent remissions of cash to the parent, the U.S. dollar is the functional currency. If a subsidiary is self-contained, however, its own (or another nation’s) currency would be the functional currency. Hence, the question of whether a subsidiary is merely an extension of the parent versus being self-contained has cash flow implications and is, thus, a relevant circumstance. Q-24 What is the disappearing asset problem? The disappearing asset problem occurs whenever the current exchange rate is used for translation purposes and the functional currency is experiencing rapid inflation much in excess of that experienced in the reporting currency. The result is that the exchange rate deteriorates to such a point that the historical cost of fixed assets (as measured by the functional currency) is so small that it becomes misleading when translated into the reporting currency. SFAS No. 52 states that in highly inflationary economies, defined as those with a cumulative inflation rate of approximately 100 percent over three years, the U.S. dollar should be used as if it were the func- tional currency. Translations, therefore, are similar to the SFAS No. 8 approach, and fixed assets are translated at the historical rate. Q-25 What does the term functional currency mean? The term, functional currency, refers to what might be called the main or primary national economic environment in which a subsidiary operates regarding events leading to cash inflows and outflows. Q-26 What prompted FASB Accounting Standards Update 2009-09? This ASU makes a correction to the codification and includes SEC observer comments to the standards. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Examine the 2001 and 2002 annual reports for a corporation having a financial subsidiary. (Your instructor may suggest a corporation on the EDGAR Website. http://www.sec.gov/edgarhp.htm). Determine the effect of SFAS No. 94 on operating ratios, profitability ratios, liquidity ratios, and leverage ratios. We recommend that you assign different companies on an individual or small team basis; the range of results should be quite interesting. 2. The following items pertain to a parent company and its 60 percent-owned subsidiary at year end. There are no cross-guarantees of debt between the parent and subsidiary. Parent Subsidiary Current assets $ 500,000 $1,000,000 Noncurrent assets(excluding subsidiary investment) 5,000,000 2,000,000 Current liabilities 750,000 250,000 Noncurrent liabilities 2,000,000 750,000 Revenues 1,700,000 1,500,000 Expenses 1,600,000 900,000 Dividends 100,000 600,000 Required: Explain and illustrate how consolidated reporting using the previous data can be misleading. Consolidation is misleading for several reasons: (a) The current debt-paying ability of the parent does not appear good, while that of the subsidiary appears excellent; consolidated, it appears mixed, thus not truly reflecting either enterprise’s position. (b) The parent’s income, return on sales, and return on assets appear low, while the subsidiary’s appear high; consolidated, they appear mixed, thus not truly reflecting either enterprise’s position. (c) The dividends of the subsidiary are substantial, while those of the parent are minimal; consolidation again produces a misleading picture. 3. Acquirer Company bought Servile Company for $5,000,000 on January 2, 2004. The fair market value of the individual net assets was $3,500,000. In succeeding years, the fair market value of Servile’s costs and goodwill were as follows: Year Fair Market Value of Servile Cost of Servile’s Net Assets and Goodwill 2005 $7,000,000 $7,100,000 2006 7,300,000 6,700,000 2007 8,000,000 9,300,000 Required: a. What amount of goodwill should be recognized as a result of the acquisition of Servile in 2004? b. Determine the amounts of the goodwill write-offs (if any) in 2005, 2006, and 2007. a. Goodwill would be $1,500,000. b. 2005: Writeoff of $100,000. 2006: No change. 2007: Writeoff of $1,300,000. 4. Why do the six criteria or guidelines for determining the functional currency in SFAS No. 52 provide a good example of finite uniformity? The six indicators are clearly grounded in distinctions involving cash flow differentials. The first one, labeled cash flow indicators, concerns whether funds are rapidly transmitted to the parent or stay with the subsidiary. Obviously, given fluctuations among currencies, the rapidity with which funds are transmitted to the parent affects both the amount and timing of cash flows. Whether sales prices are primarily affected, local competition in the subsidiary’s currency are determined by worldwide competition affecting the amounts of cash flows. The same is true for sales market indicators and expense indicators. The latter is concerned with amounts of cash flows in terms of whether prices are determined in the local currency of the subsidiary or whether expenses depend on the situation in the parent company’s country. Financing indicators are concerned with whether financing is done primarily in the subsidiary’s currency or the parent’s currency. Given exchange rate differentials, the amount of cash flows is impacted by these financing considerations. The last indicator, inter-company transactions and arrangements indicators, appears to be a “safety blanket” covering the previous five indicators in terms of whether the subsidiary is largely independent and does most of its business in its own country, or whether there is a high volume of transactions between parent and subsidiary. CRITICAL THINKING AND ANALYSIS 1. If you had to choose among the current method of consolidation for combinees where the combinor owns at least 50 percent, the new entity approach, or proportionate consolidation, which would you choose? Explain. We would remain with the current approach; the subsidiary forms part of the combined entity despite the presence of minority ownership. The new entity approach would be very appealing but runs into verifiability issues relative to valuing all parts of the consolidated entity. It also has comparability problems because some enterprises may not have acquired subsidiaries recently so their valuation would not be comparable to firms that just acquired subsidiaries. Proportionate consolidation is also appealing but the consolidated entity would be very artificial comprising fractional estimates of subsidiaries. The elimination of the minority interest is a beneficial aspect of this approach. Solution Manual for Accounting Theory: Conceptual Issues in a Political and Economic Environment Harry I. Wolk, James L. Dodd, John J. Rozycki 9781483375021, 9781412991698