Leases, Pensions; Deferred Taxes

Accounting for Leases

Accounting for Leases

Lease: Contract where owner of assets (lessor) transfers the use of assets to another entity (lessee) for a fixed period of time in exchange for a series of payments. 1. Capital lease -- accounted for as a purchase, i.e., lease is capitalized
1. Recognize the leased asset. 2. Recognize lease liability in equal amount.

2. Operating lease -- lease is not capitalized, it will be treated as rent. Why is there a difference in accounting treatment? -under capital lease lessee (a firm) takes the risks of ownership of the asset and hence must assume the liability for purchasing this asset.

Capital Lease vs. Operating Lease

US GAAP: Firms must use capital lease accounting if lease is non-cancelable and any one of the following applies:
1. Ownership is transferred at the end of the lease. 2. A bargain purchase option exists (right to buy asset at lease end for less than fair value) 3. Lease period covers more than 75% of assets life 4. Present value of contractual future lease payments exceeds 90% of the current market value of the asset What is the idea behind these tests? -to determine the whether, in economic substance, transaction is a purchase.

IFRS does not have such specific requirements. Firms should determine the economic substance of the transaction.

Recently in FT: Lease Accounting

The IASB and FASB said they were committed to abolishing the dual system as operating leases understated leverage Instead, they favour a unified approach in which lessees recorded an asset on their balance sheets Retailers, airlines and ship operators can expect to assume billions of dollars more liabilities The new rules have been drawn up in spite of fierce opposition from some multinationals Impact of the proposed standard could go so far as to cause some companies to breach loan covenants

Capital Lease Accounting

If lease contract passes at least one test, it is accounted for as a Capital Lease:
Dr. Capital Lease Asset Cr. Capital Lease Obligation XXX XXX

Annually record depreciation expense and record cash payments as interest expense and reduction in liability Asset is generally equal to liability only at inception Dr. Depreciation Expense Cr. Accumulated Depreciation Dr. Interest Expense Dr. Capital Lease Liability Cr. Cash XXX XXX

XXX (= market rate * book liability) PLUG Contract Payment

Lease Exercise
$45,000 computer, 3-yr. lease, fixed pmt. of 19,709/year. We determine that 15% is the implied (market) interest rate.
Operating Lease At inception No entry At end of year 1 Rent Expense Cash Capital Lease At inception Leasehold asset Lease liability At end of year 1 Interest Expense Lease liability Cash Depreciation Exp. Leasehold asset At end of year 2 Interest Expense Lease liability Cash Depreciation Exp. Leasehold asset At end of year 3 Interest Expense Lease liability Cash Depreciation Exp. Leasehold asset 45,000 45,000 6,750 12,959 19,709 15,000 15,000 4,806 14,903 19,709 15,000 15,000 2,571 17,138 19,709 15,000 15,000

19,709 19,709

At end of year 2 Rent Expense Cash

19,709 19,709

At end of year 3 Rent Expense Cash

19,709 19,709

Another Lease Exercise

Future minimum commitments under capital leases with lease periods extending beyond one year appear below: Year 2011 2012 2013 2014 2015 2016 Later Years $ 12/31/2010 190 230 268 245 239 220 1,900 3,292 Interest Portion (7%) Capitalized Lease Obligation $ (1,273) 2,019 $ 235 278 255 247 232 2,029 3,276 (1,204) 2,072 12/31/2011

Q1: Account for interest expense under capital leases during 2011 (for leases existing at 12/31/2010)?

Exercise, cont.
Answer:
Dr. Interest expense Dr. Capitalized lease obligation Cr. Cash 141 [2,019 * 7%] 49 190

Q2: What is the amount of new lease obligation a company entered in 2011?
Beginning Balance, Liability + Interest Expense - Cash Payments + PV of New Lease Agreements (Plug) = Ending Balance, Liability 2,019 141 (190) 102 2,072

Amortization of premium

United Airlines
UAL (a), (b)

Aircraft Operating Leases 2011 2012 2013 2014 2015 After 2015

$ Capital Leases (c) 2011 2012 2013 2014 2015 After 2015 Minimum lease payments $

1,711 1,635 1,576 1,503 1,218 3,234 10,877 368 222 211 197 181 850 2,029 (741) 1,288 (252) 1,036

As of December 31, 2010, United's aircraft capital lease minimum payments relate to leases of 61 mainline and 38 regional aircraft United's imputed interest rate ranges are 3.0% to 20.0%. Approximate weighted average interest rate on capital leases? 1,288+interest-368=1,036; Interest=368+(1,036-1,288) =368-252=116 Interest rate = 116/1,288=9%

Imputed interest Present value of minimum lease payments Current portion Long-term obligations under capital leases $

Optional material: Accounting for Lessor

Operating Lease At inception Leased Equipment Inventory Capital Lease At inception Lease Receivable Sales Revenue COGS Inventory

39,000 39,000

45,000 45,000 39,000 39,000

At end of each year Cash 19,709 Rent Revenue 19,709 Depreciation Exp Acm. Depr. 13,000 13,000

At end of first year Cash 19,709 Interest Revenue 6,750 Lease Receivable 12,959 Each payment consists of two elements

Pension Plans, Benefits, Accounting

Pension Benefits and Other Deferred Compensation

When should employer to recognize an expense? -in the period in which the employee provides services (MATCHING). Post-retirement benefits are just another form of compensation.
Defined benefit plan: -Need to worry about obligation to make future payments under pension plan. -Need to start reserving assets to be able to pay the liability (in-house pension fund). Defined contribution plan: -Simply transfer money to fund manager (e.g., Vanguard).

New GM: Pension Obligations

GM: Defined benefit plan: Plans covering eligible U.S. salaried employees hired prior to January 2001 and hourly employees hired prior to October 15, 2007 generally provide benefits of stated amounts for each year of service as well as supplemental benefits for employees who retire with 30 years of service before normal retirement age. -GM owes close to 140B of pensions/benefits. -Service cost what you owe employees for their service in the current period. -Interest cost -- increase in liability due to passage of time (present value of obligation is growing in time).

GM: Pension Plan Assets

Our U.S. defined benefit pension plans are currently underfunded, and our pension funding obligations could increase significantly due to a reduction in funded status as a result of a variety of factors, including weak performance of financial markets, declining interest rates, investment decisions that do not achieve adequate returns, and investment risk inherent in our investment portfolio. What is the liability are on the balance sheet? - Pension obligation less plan assets, i.e., net obligation.

GM: Components of Pension Expense

Pension expense is computed using expected return, not actual return, on plan assets.

Deviations of actual return from expected return do not go via income statement but generally go via to Other Comprehensive Income.

FT/April 2010: IASB reveals proposed pension rules

proposed rules that would stop companies from padding their reported profits with anticipated investment gains that may never be earned on their pension scheme assets. most opaque sections of the corporate profit and loss account companies use overly optimistic estimates. most controversial aspect of pensions accounting: the discount rate used to calculate liabilities. Groups have been using a higher estimate rate on returns than they have been assuming for interest cost require companies to use the same rate for assumed investment returns as it uses for interest cost. European groups with big defined benefit pension schemes that have been most vocal in opposing the changes

Deferred Taxes

Taxes: Concepts
Pre-Tax Income (or Book income) is income before income taxes computed under GAAP. Taxable income is the income on which income tax calculation is based (this income follows IRS or local tax rules and is part of tax return). Which one is closer to cash basis of accounting? -taxable income, since firms need cash to pay taxes. Taxable income is DIFFERENT from pretax income due to: (1) Permanent differences, or (2) Temporary/timing differences. Deferred tax asset (DTA): DTA represents prepaid tax. DTA arises when current events result in future deductions (i.e., tax benefits). Deferred tax liability (DTL): DTL represents future taxable amounts due to tax deductions taken in advance.

GAAP (pre-tax) income vs. IRS (taxable) income

Temporary differences - differences in revenues/expenses (gains/losses) that enter book income vs. taxable income in different time periods. Reverse over time. Due to timing difference in accounting for revenues/gains (e.g., advance payments/deferred revenue) Due to timing difference in accounting for expenses/losses (depreciation/amortization, bad debt, warranty, inventory, rent, restructuring, litigation settlement, pensions, stock-based compensation). Permanent differences are differences caused by revenue/expense items that either enter book income but never taxable income or vice versa. These never reverse. Examples: State and municipal bond income; Life insurance premiums/proceeds; Penalties and fines; Dividend received deduction; Bribes

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Questions (exercise)
1: Revenue reported under GAAP before they are reported for tax purposes give rise to? (DTA/DTL) these are future taxable amounts, hence DTL 2: Revenue reported for tax purposes before they are reported under GAAP give rise to? (DTA/DTL) lower taxes on future revenue, hence DTA 3: Expenses reported under GAAP before they are deductible for tax purposes give rise to? (DTA/DTL) these are future deductions amounts, hence DTA 4: Deductions are taken for tax purposes before expenses are recorded under GAAP give rise to? (DTA/DTL) these are future taxable amounts, hence DTL

Example: Merck & Co 10-K

Tax regulations require items to be included in the tax return at different times than the items are reflected in the financial statements. Timing differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in the tax return in future years for which the Company has already recorded the tax benefit in the financial statements. Deferred tax liabilities generally represent (1) tax expense recognized in the financial statements for which payment has been deferred or (2) expense for which the Company has already taken a deduction on the tax return, but has not yet recognized as expense in the financial statements.

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Income tax expense

What should tax expense measure? Tax expense measures tax consequences of current earnings transactions, i.e., tax associated with current period revenue and expense transactions regardless of when those taxes are paid, that is: 1. Taxes Payable to the IRS currently. 2. Plus income taxes payable in the future but due to transactions in the current earnings (increase in deferred tax liabilities). 3. Plus income taxes pre-paid in the past but associated with transactions recognized in the current earnings (reduction in deferred tax assets). 4. Less current payment of income taxes associated with transactions recognized earnings in the future (increase in deferred tax assets). 5. Less current payment of taxes related to transactions that went trough the income statement in the past (reduction in deferred tax liability). Tax Expense = Tax Payable (currently) + Change in DTL Change in DTA

Example: Deferred Tax Assets and Liabilities

Deferred Tax Liabilities (future taxable amounts)
Assume temporary differences result in future taxable income (i.e. book tax today > IRS tax today). Example: Book Income = $250; IRS Income = $225 Dr. Income tax expense Cr. Deferred tax liability Cr. Income taxes payable (or cash) DTL of $10 equals ($250 - $225) * 40% tax rate 100 10 90

Deferred Tax Assets (future deductible amounts)

Assume temporary differences result in future tax deductions (i.e. book tax today < IRS tax today). Example: Book Income = $500; IRS Income = $600 Dr. Income tax expense Dr. Deferred tax asset Cr. Income taxes payable (or cash) DTA of $40 equals ($600 - $500) * 40% tax rate 200 40 240

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GAAP/pre-tax income vs. IRS/taxable income

GAAP Revenue1 Revenue2 Revenue3 Total Revenue Expense1 Expense2 Expense3 Expense4 Expense5 Total Expense Pre-Tax Income Differences TEMPORARY1 IRS Revenue1 Revenue2 Revenue3* Total Revenue* Expense1* Expense2 Expense3 Expense4* Expense5 Total Expense* Taxable Income*

TEMPORARY2 PERMANENT1

* Tax Rate = Deferred Tax Assets/Liabilities

* Tax Rate = Income Taxes Payable

Income Tax Expense = Income Taxes Payable + Deferred Tax Liabilities

- Deferred Tax Assets

Simplified Formula
Income Tax Expense (recorded on the firms Income Statement) = =(Pre-Tax Income - Revenue never taxable + Expenses Never Deductible)* Tax Rate

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Example: Economic Stimulus Package

The Recovery and Reinvestment Act of 2009 offered to businesses so called bonus depreciation. Companies can take additional 50% of asset depreciation for tax purposes in the year investment is made. Works only for qualifying investments made before January 1, 2010.

Example: Purchase an asset with 3-year useful life for $600K. Asset generates 400K annual pretax income. Assume normally depreciation is straight-line for book and tax purposes; no other book-tax differences.
Year Book Depreciation Pretax/Book Income Tax expense (40%) Depreciation deduction (stimulus) Taxable Income (stimulus) Tax payable (40%) (stimulus)

Year 1 Year 2 Year 3 Total

400 400 400 1200

160 160 160 480

200 500 500 1200

80 200 200 480

Journal Entry Income tax expense Deferred tax liability Deferred tax liability Income tax payable

Year 1 160 80 80

Year 2 160 40 -200

Year 3 160 40 -200

-Bonus depreciation leads to tax savings in early years. Hence operating cash flow is higher initially but is lower subsequently. No effect on income.

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More elaborate example

($120,000 machine w/3-year useful life; 40% tax rate)
Straight
Yr. Revenue less other expenses Deprec. Expen. book Income before Tax

Line
Tax Exp.

(books)
Acm. Depr. Deprec. Expen. tax

MACRS
Taxable Income

(tax)
Tax Pyble Acm. Depr.

1 2 3

100 100 100

40 40 40 120

60 60 60

24 24 24 72

40 80 120

49 53 18 120

51 47 82

20 19 33 72

49 102 120

Journal Entry Income tax expense Deferred tax liability Deferred tax liability Income tax payable

Year 1 24 4 20

Year 2 24 5 19

Year 3 24 9 33

Note that DTL balance = [AD(tax) AD(book)] * tax rate DTL balance 4 9 4 = (49-40)*.4 9=(102-80)*.4

0 0=(120-120)*.4

Reversing differences

Originating differences

Exercise
2010 Earnings before Income Taxes U.S. Foreign Total U.S. Income Taxes Current Provision Deferred Provision Income Taxes outside the U.S. Current Provision Deferred Provision Total 2009 Deferred Tax Assets Restructuring Programs Warranties Total Deferred Tax Liabilities Depreciable Assets Other Total 105 48 153 2011 2,394 2,844 692 755 3,086 3,599

Q1: Record Income Tax Expense and Taxes payable/paid in 2010

Dr. Income Tax Expense Dr. Deferred Tax Assets Cr. Deferred Tax Liabilities Cr. Income Taxes Payable 429 23 12 440

241 (28) 199 17 429 2010 119 57 176

285 142 302 (37) 692 2011 127 52 179

Q2: 2010 Income Statement reported $615 Warranty Expense. Compute the amount of Warranty tax deduction (tax 25%)?

Change in DTA - Warranty Expense Tax Rate Temp. difference in 2010 Warranty cost between GAAP and tax

9 25% 36

842 17 859

829 42 871

930 49 979

GAAP Warranty Expense IRS Warranty Expense

615 579

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Merck & Co: Deferred Tax Footnotes

Deferred income taxes at December 31 consisted of:

You can use this information to derive the temporary differences in specific items
2008 Assets Liabilities $ 177.3 1,045.10 75.1 129.9 375/0.35 60.2 1,487.60 $ $ $ $ 3.8 312.2 $ Assets 267.4 338.6 239.3 374.8 2,130.00 980.8 339.5 899.1 $ 248.6 796.5 347.5 1,755.10 984.1 224.7 1,012.90 5,369.40 (94.2 ) $ $ $ 5,275.20 3,787.60 2,436.90 1,666.70 $

2007 Liabilities $ 229.7 9 1,096.30 690.2 184 8.7 2,217.90 $ 2,217.90

Other intangibles Inventory related Accelerated depreciation Advance payment Equity investments Pensions and other postretirement benefits Compensation related Vioxx Litigation reserve Unrecognized tax benefits Net operating losses Other Subtotal Valuation allowance Total deferred taxes Net deferred income taxes Recognized as: Deferred income taxes and other current assets Other assets Income taxes payable Deferred income taxes and noncurrent liabilities

5,569.50 (94.0 ) 5,475.50 3,257.60 829.5 2,823.70 $

1,487.60

395.6

The 2007 tax rate reconciliation percentage of (35.5)% for foreign earnings reflects the change in mix of foreign and domestic earnings primarily resulting from the $4.85 billion U.S. Vioxx Settlement Agreement charge.

Tax Carryforwards/carrybacks
Companies have an opportunity to offset current operating losses against future (carryforwards) or past (carrybacks) taxable income. This generates tax assets a loss of 1,000,000 generates (assuming no carryback option is chosen, and tax 35%): Dr. DTA (Tax Carryforward Asset) 350,000 Cr. Income tax expense (i.e., benefit) 350,000 General Motors, 2007 10-K disclosure:
The amount and expiration dates of operating loss and tax credit carryforwards as of December 31, 2007 is as follows:
Expiration Dates Amounts (Dollars in millions)

U.S. federal and state net operating loss carryforwards Non-U.S. net operating loss carryforwards Non-U.S. net operating loss carryforwards U.S. alternative minimum tax credit U.S. general business credits(a) U.S. foreign tax credits Total

2024-2027 Indefinite 2008-2026 Indefinite 2008-2027 2010-2017

5,297 2,406 1,648 694 1,514 2,589 14,148

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Deferred Asset Valuation allowance

General Motors: Our ability to realize our deferred tax assets depends on our ability to generate sufficient taxable income In the third quarter of 2007, we recorded a charge of $39 billion related to establishing full valuation allowances against our deferred tax assets in the U.S., Canada and Germany. Valuation allowances have been established for deferred tax assets based on a more likely than not threshold.

Dr. Income tax expense (loss)

$39,000,000,000 Cr. Deferred tax asset allowance (x-A)

$39,000,000,000

December 31,2007

December 31,2006

ASSETS Current Assets Cash and cash equivalents Marketable securities Total cash and marketable securities Accounts and notes receivable, net Inventories Equipment on operating leases, net Other current assets and deferred income taxes Total current assets Financing and Insurance Operations Assets Cash and cash equivalents Investments in securities Equipment on operating leases, net Equity in net assets of GMAC LLC Other assets Total Financing and Insurance Operations assets Non-Current Assets Equity in net assets of nonconsolidated affiliates Property, net Goodwill and intangible assets, net Deferred income taxes Prepaid pension Other assets Total non-current assets Total assets $ $ 24,549 2,139 26,688 9,659 14,939 5,283 3,566 60,135 268 215 6,712 7,079 2,715 16,989 1,919 43,017 1,066 2,116 20,175 3,466 71,759 148,883 $ $ 23,774 138 23,912 8,216 13,921 6,125 12,982 65,156 349 188 11,794 7,523 2,269 22,123 1,969 41,934 1,118 33,079 17,366 3,559 99,025 186,304

GM Balance Sheet

DTA write-off suggest that GM was more likely than not to not realize DTA.

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Citi 2010 10-K, Income Taxes

Disclosures: Deferred tax assets (DTAs) are recognized subject to managements judgment that realization is more likely than not. Citi would need to generate approximately $105 billion of taxable income during the respective carryforward periods to fully realize its U.S. federal, state and local DTAs.

From Financial Times

Citi under fire over deferred tax assets some argue Citi is being too optimistic given its recent record its pre-tax losses in 2008 and 2009 topped $60bn and continued global economic uncertainty. Lynn Turner, a former chief accountant at the Securities and Exchange Commission, said: Citis position defies imagination and logic. Instead of talking about making money, what Citi ought to do is to reserve for at least part of the DTAs and reap the benefit of reducing the reserves once it actually makes money. Citi said it was very comfortable with the recording of our DTAs.

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