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©Cambridge Business Publishers, 2011

Solutions Manual, Chapter 10 10-1

Chapter 10

Reporting and Analyzing Leases, Pensions, and Income Taxes

Learning Objectives – coverage by question

Mini-exercises

Exercises Problems Cases

LO1 – Define off-balance-sheet financing and explain its effects on financial analysis.

20, 21 47

LO2 – Account for leases using the operating lease method or the capital lease method.

12, 13, 14 23, 24, 25, 27 33, 36 47

LO3 – Convert off-balance-sheet operating leases to the capital lease method.

15 25, 26, 27 33, 34, 35,

36, 45 47

LO4 – Explain and interpret the reporting for pension plans.

16, 17, 18, 19 29, 30 37, 38 46

LO5 – Analyze and interpret pension footnote disclosures.

16, 17, 18, 19 28, 29, 30 37 46

LO6 – Describe and interpret accounting for income taxes.

22 31, 32 39, 40, 41,

42, 43, 44 48


Financial Accounting, 3rd Edition 10-2

QUESTIONS Q10-1. Under an operating lease, the lessor retains the usual risks and rewards of

owning the property. In accounting for an operating lease, the lessee doesn’t record either the leased asset or the lease liability on the balance sheet, and normally charges each lease payment to rent expense. In contrast, a capital lease transfers to the lessee substantially all of the risks and rewards relating to the ownership of the property. Accordingly, the lessee accounts for a capital lease by recording the leased property as an asset and establishing a liability for the lease obligation. The leased asset is subsequently depreciated, and interest expense is accrued on the lease liability.

Q10-2. The leasing footnote is reasonably complete to allow for capitalization of operating leases for analysis purposes. Despite the quality of the leasing disclosures, on-balance-sheet treatment is, arguably, a more direct form of communication from the company and, as a result, is more easily interpreted by users of its financial statements.

Q10-3. Yes, over the term of the lease the rent expense on an operating lease will be equal to the sum of the interest and depreciation on a capital lease. Only the timing of the expense recognition changes. Expense is ultimately related to the cash flows required to discharge the obligation. Those cash flows are the same whether or not the lease is capitalized.

Q10-4. Under defined contribution plans, companies make contributions to the plans which, together with earnings on the amounts invested, provide the sole source of funding for payments to retirees. Under defined benefit plans, the obligations are defined with payment to be made in the future from general corporate funds. These plans may or may not be fully funded. Since the company’s obligation is extinguished upon payment for a defined contribution plan, the accounting is relatively simple: record an expense when paid or accrued. Defined benefit plans present a number of complications in that the liability is very difficult to estimate and involves a number of critical assumptions. In addition, companies lobbied for (and the FASB agreed to) various mechanisms to smooth the impact of pension costs on reported earnings. These smoothing mechanisms further complicate the accounting for defined benefit plans vis-à-vis defined contribution plans.

Q10-5. Although the accounting can get complicated, a net pension asset will be reported if the fair market value of the plan assets exceeds the plan obligation. Otherwise, a net liability will be reported on the balance sheet to represent the underfunding of the pension obligation.

Q10-6. Service cost, interest cost and the expected return on plan investments (a reduction of the pension cost) are the basic components of pension expense. Companies might also report amortization of deferred gains and losses.



Q10-7. The use of expected returns and the deferral of unexpected gains and losses act to smooth corporate earnings by removing the effects of swings in the market values of investments and variation in pension liabilities resulting from changes in actuarial assumptions or plan amendments.

Q10-8. For a capital lease, the initial value of the lease asset and the lease obligation are determined by calculating the present value of the minimum lease payments. The minimum lease payments include those payments that are not subject to options or contingencies, including any guaranteed residual value.

Q10-9. Retirement benefits are normally expensed in the period in which they are earned by the employee, not when they are paid. Some benefits are calculated for periods of employment prior to the inception of a pension plan or prior to a plan amendment. The cost of these benefits (called prior service costs) is expensed by amortizing the cost over the average expected future period of employee service.

Q10-10. The amount of the accumulated benefit obligation in excess of the fair value of the plan assets must be reported as a minimum pension liability. If the accrued pension liability that is reported in the balance sheet is smaller than the minimum liability, then an additional pension liability, equal to the difference, must be reported.

Q10-11. A tax payment would be recorded as deferred taxes under two situations. First, if the company is required to make a tax payment (based on the higher taxable income reported on the tax return) but not record that payment as tax expense, a deferred tax asset is recorded. Deferred tax assets result from those situations where an expense is recognized and recorded in the income statement, but is not deductible on the company’s tax return in the current period. This produces higher income on the tax return and tax payments that are higher than tax expense. The excess payment is recorded as an increase (debit) to a deferred tax asset.

The second situation arises when a deferred tax liability reverses. In this situation, tax expense has been recognized in excess of tax payments in prior years. When the tax return “catches up with” the income statement, the tax deferral reverses and the deferred tax liability is reduced (debited). In either situation, the deferred tax account (either asset or liability) is debited and cash is credited.



MINI EXERCISES M10-12 (15 minutes) a. i.

1/1 No entry 12/31 Rent expense (+E, -SE) ……………………………………. 12,000 Cash (-A) …………………………………………… 12,000 ii. 1/1 Leased asset (+A) ………………………………………….. 57,198 Lease liability (+L) ………………………………… 57,198

$57,198 = $12,000 x 4.76654 12/31 Depreciation expense (+E, -SE) ………………………...… 9,533 Accumulated depreciation (+XA) ………………… 9,533

$9,533 = $57,198 / 6. 12/31 Lease liability (-L) …………………………………………… 7,996 Interest expense (+E, -SE) …………………………………. 4,004 Cash (-A) ……………………………………………… 12,000

$4,004 = $57,198 x .07; $7,996 = $12,000 - $4,004. b.

+ Cash (A) - - Lease Liability (L) +

12,000 12/31 57,198 1/1 12/31 7,996

+ Leased Asset (A) - + Interest Expense (E) -

1/1 57,198 12/31 4,004

- Accumulated Depreciation (XA) + + Depreciation Expense (E) -

9,533 12/31 12/31 9,533

c.

Balance Sheet Income Statement

Transaction Cash Asset

+

Noncash Assets -

Contra Assets

= Liabilities + Contrib. Capital

+ Earned Capital

Revenues - Expenses = Net

Income

Signed a capital lease.

+57,198 Leased Asset

-

=

+57,198 Lease

Liability

- =

Depreciation on leased asset.

-

+9,533 Accumulated Depreciation

=

-9,533

Retained Earnings

-

+9,533 Deprec. Expense

= -9,533

Made annual lease payment.

-12,000 Cash

-

=

-7,996 Lease

Liability

-4,004

Retained Earnings

-

+4,004 Interest Expense = -4,004



M10-13 (20 minutes) a. 7/1 Leased asset (+A) ……………………………….. 123,100 Lease liability (+L) ………………………. 123,100

$123,100 = 4,500 x 27.35548

b. 9/30 Depreciation expense (+E, -SE) ……………….. 3,078 Accumulated depreciation (+XA, -A) …. 3,078

$3,078 = $123,100 / (10 x 4).

9/30 Lease liability (-L) ……………………………….. 2,038 Interest expense (+E, -SE) ……………………… 2,462 Cash (-A) …………………………………… 4,500

$2,462 = $123,100 x (.08/4); $2,038 = $4,500 - $2,462.

12/31 Depreciation expense (+E, -SE) ……………….. 3,078 Accumulated depreciation (+XA, -A) …. 3,078

12/31 Lease liability (-L) ……………………………….. 2,079 Interest expense (+E, -SE) ……………………… 2,421 Cash (-A) …………………………………… 4,500

$2,421 = ($123,100 - $2,038) x (.08/4); $2,079 = $4,500 - $2,421. c.

+ Cash (A) - - Lease Liability (L) + 4,500 9/30 123,100 7/1

4,500 12/31 9/30 2,038 12/31 2,079

+ Leased Asset (A) - + Interest Expense (E) - 7/1 123,100 9/30 2,462

12/31 2,421

- Accumulated Depreciation (XA) + + Depreciation Expense (E) - 3,078 9/30 9/30 3,078 3,078 12/31 12/31 3,078



d. Balance Sheet Income Statement


+

Noncash Assets -

Contra Assets


+ Earned Capital


Income

Signed a capital lease.

+123,100 Leased Asset

-

= +123,100

Lease Liability

- =


-

+3,078 Accumulated Depreciation =

-3,078

Retained Earnings

-

+3,078 Deprec. Expense = -3,078

Made quarterly lease payment.

-4,500 Cash

-

=

-2,038 Lease

Liability

-2,462

Retained Earnings

-

+2,462 Interest Expense = -2,462


-

+3,078 Accumulated Depreciation

=

-3,078 Retained Earnings

-

+3,078 Deprec. Expense

= -3,078

Made quarterly lease payment.

-4,500 Cash

-

=

-2,079 Lease

Liability


-

+2,421 Interest Expense

= -2,421

e. 7/1 No entry 9/31 Rent expense (+E, -SE) ………………………… 4,500 Cash (-A) …………………………………… 4,500 12/31 Rent expense (+E, -SE) ………………………… 4,500 Cash (-A) …………………………………… 4,500

The amount of rent expense recognized if the lease is treated as an operating lease is $9,000 ($4,500 + $4,500). However, if the lease is treated as a capital lease, interest and depreciation are recognized. The total expense for 2010 is $11,039 ($2,462 + $2,421 + $3,078 + $3,078). The capital lease method tends to report higher expense in the early periods of the lease.



M10-14 (15 minutes) a. Capital leases record both the leased asset and the lease liability on the face

of the balance sheet. Operating leases, by contrast, do not record either the leased asset or the lease liability. They are, as a result, a common technique to achieve off-balance-sheet financing. Concerning the income statement, capital leases result in depreciation of the leased asset and interest expense on the lease liability. Operating leases record only rent expense.

b. Analysts frequently add the present value of the operating lease payments to

both assets and liabilities, thus capitalizing the operating lease. This adjustment improves the interpretation of measures of financial leverage and operating performance. If Yum’s operating lease commitments in total are substantial, they could have a significant impact on the assessment of financial leverage. Yum indicates no individual lease is material. However, the total commitment could be substantial.

M10-15 (20 minutes) a. Present value of expected operating lease payments for Southwest Airlines

using a financial calculator, I/YR=7:

Year ($ millions)

Operating Lease Payment

Present Value

2009 ........................ $ 400 $ 374

2010 ........................ 335 293

2011 ........................ 298 243

2012 ........................ 235 179

2013 ........................ 195 139

After 2013 ............... 876 521

Average life ............ 4.5 years * $1,749

* $876 ÷ $195/year = 4.5 years.



M10-15—continued. The calculations of the present value of each payment follow:

N I/YR PV PMT FV 1 7 374 0 400

N I/YR PV PMT FV 2 7 293 0 335

N I/YR PV PMT FV 3 7 243 0 298

N I/YR PV PMT FV 4 7 179 0 235

N I/YR PV PMT FV 5 7 139 0 195

The present value of payments after Year 5 follows:

N I/YR PV PMT FV 4.5 7 731 195 0

N I/YR PV PMT FV 5 7 521 0 731

b. The capitalization of these operating leases increases Southwest’s total

liabilities by 18% to $11.580 million ($9.831 million + $1.749 million). M10-16 (15 minutes) a. American Express is reporting $13 million in pension expense for 2008. b. Expected returns are an offset to service and interest costs and serve to

reduce reported pension expense. c. “Expected” refers to the use of long-term average returns for the investment

portfolio. Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income.



M10-17 (15 minutes) a. Yum Brands is reporting $36 million of pension expense for 2008.

b. Expected returns are an offset to service and interest costs and serve to reduce reported pension expense.

c. “Expected” refers to the use of long-term average returns for the investment portfolio. Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income.

M10-18 (15 minutes) a. A&F maintains a defined contribution plan for the benefit of its employees.

b. Contributions are expensed when made.

c. Only the unpaid contribution, if any, appears on the A&F balance sheet. M10-19 (15 minutes) a. Target maintains only a defined contribution plan for the benefit of its

employees.

b. Contributions are expensed when made.

c. Only the unpaid contribution, if any, appears on Target’s balance sheet. d. First, employees who do not meet the unspecified eligibility requirement will

not be covered. Second, their investment is tied to whether the employees leave the contributions undiversified. Third, matching contributions can be reduced or eliminated in bad times.



M10-20 (15 minutes) a.

($millions) Payment Obligation

Present Value (i=6%)

2009 …………… $245 $231 2010 …………… 216 192 2011 …………… 157 132 2012 …………… 146 116 2013 …………… 143 107 Thereafter ……. 2,950 1,245

Total …………… $3,857 $2,023

Average Life: $2,950/$143 = 20.6 years. The calculations of the present value of each payment follow:

N I/YR PV PMT FV 1 6 231 0 245

N I/YR PV PMT FV 2 6 192 0 216

N I/YR PV PMT FV 3 6 132 0 157

N I/YR PV PMT FV 4 6 116 0 146

N I/YR PV PMT FV 5 6 107 0 143


N I/YR PV PMT FV 20.6 6 1,666 143 0

N I/YR PV PMT FV 5 6 1,245 0 1,666

b.

($millions) Balance Sheet Income Statement


+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income

To capitalize operating leases

+2,023 Leased Asset

= +2,023

Lease Liability

-

=



M10-20—continued. c. Recognition of the operating leases would affect the current ratio. Recording

the lease asset would increase noncurrent assets by $2,023 million, but recording the lease liability would increase current liabilities by $231 million, and noncurrent liabilities by $1,792 million ($2,023 - $231).

d. (in $millions)

Leased asset (+A) ……………………………….. 2,023 Lease liability (+L) ………………………. 2,023

+ Leased Asset (A) - - Lease Liability (L) + 2,023 2,023

e. Yes. The present value of the operating leases of $2,023 million represent over 45% of Target’s operating cash flow in 2008.

M10-21 (15 minutes) a. The use of contract manufacturers removes the manufacturing assets and

related liabilities from Nike’s balance sheet.

Because sales are unaffected, PPE turnover is increased by the removal of assets. The effect on net operating profit after taxes (NOPAT) is uncertain; depreciation is removed (interest on the liabilities incurred to purchase the manufacturing assets is also removed, but this is a nonoperating expense and, therefore, does not affect NOPAT), but Nike will pay a higher price for its manufactured goods in order to provide the manufacturer with a return on its investment. If the contract manufacturer is more efficient than Nike, however, the price increase is mitigated. Profitability will increase if the turnover effect more than offsets the negative effect on NOPAT and profit margin, which is likely.

b. Executory contracts are not recognized under GAAP. As a result, the use of contract manufacturers achieves off-balance-sheet financing. This is one motivating factor for their use.



M10-22 (20 minutes) a, b, c.

Year Book value

Tax basis (after depreciation deduction) Temporary difference

Tax rate

Deferred tax liability

2010 $300,000 $173,000 $127,000 40% $50,800

2011 $200,000 $173,000 - ($100,000 - $31,000) = $104,000 $96,000 40% $38,400

2012 $100,000 $104,000 - ($100,000 - $31,000) = $35,000 $65,000 40% $26,000

d. Because the deferred tax liability is reversing in years 2011, 2012 and 2013, part

of the deferred tax liability should be classified as a current liability each year. The amounts are presented in the following table.

Year Deferred tax liability Long-term amount –

reversing beyond one year Current portion – reversing

within one year

2010 $50,800 $38,400 $12,400

2011 $38,400 $26,000 $12,400

2012 $26,000 $0 $26,000



EXERCISES E10-23 (20 minutes) a. All of Fortune Brands’ leases are classified as operating. GAAP requires

companies to provide a table of projected lease payments for both operating and capital leases (for example, see the Verizon lease footnote example in E10-24). Because no capital leases are included in the Fortune Brands footnote, we know that it only has operating leases.

b. Neither the leased asset nor the lease obligation is reported on the balance

sheet for an operating lease. As a result, total assets and total liabilities are reduced. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. During the life of the lease, however, the two will not be equal. Even if depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease.

c.

Year ($ millions)


Present Value

2009 ........................ $ 57.8 $ 54

2010 ........................ 45.4 40

2011 ........................ 35.1 29

2012 ........................ 26.3 20

2013 ........................ 22.4 16

After 2013 ............... 18 12

Average life ............ 1 year * $171

* Average life =$18/$22.4 = 0.8 rounded up to 1 The lease effect on the D/E ratio changes from $7,420/$4,672 = 1.59 to ($7,420 + $171)/$4,672 = 1.62. This is not a major change.



E10-24 (20 minutes) a. According to Verizon’s lease footnote, it has both capital and operating leases.

Only the capital leases are reported on-balance sheet in the amount of $390 million ($63 million in current liabilities and $327 million as long-term liabilities). This is not the total obligation to its lessors. Verizon also has a significant amount of leases that it has classified as operating. In fact, the minimum lease payments under operating leases are over 14 times that for capital leases! These operating leases are not reported on-balance-sheet.

b. Neither the leased asset nor the lease obligation is reported on the balance sheet for an operating lease. As a result, total assets and total liabilities are reduced. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. During the life of the lease, however, the two will not be equal. Even if depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease.

EE10-25 (25 minutes)

a. Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. The present value is computed as follows:

Year ($ 000s)



2009 ......................... $ 851,412 $ 795,713

2010 ......................... 803,071 701,434

2011 ......................... 731,808 597,375

2012 ......................... 645,215 492,235

2013 ......................... 556,031 396,445

>Thereafter ............. 2,132,053 1,342,833

Average life ............ 4 years* $4,326,035

* $2,132,053 ÷ $556,031/year = 3.834 rounded to 4 years.

The present value of Staples’ operating leases is computed to be $4.326 billion. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. Staples’ liabilities are 58% higher following this adjustment (adjusted liabilities are $7.442 billion + $4.326 billion = $11.768 billion).



E10-25—continued.

The calculations of the present value of each payment follow:

N I/YR PV PMT FV 1 7 795,713 0 851,412

N I/YR PV PMT FV 2 7 701,434 0 803,071

N I/YR PV PMT FV 3 7 597,375 0 731,808

N I/YR PV PMT FV 4 7 492,235 0 645,215

N I/YR PV PMT FV 5 7 396,445 0 556,031


N I/YR PV PMT FV 4 7 1,883,394 556,031 0

N I/YR PV PMT FV 5 7 1,342,833 0 1,883,394

b.

($ 000s) Balance Sheet Income Statement


+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income

To capitalize operating leases.

+4,326,036 Leased Asset

= +4,326,036

Lease Liability

-

=

c. 2008 Leased asset (+A) ……………………………... 4,326,036 Lease liability (+L) ……………………… 4,326,036

2009 Depreciation expense (+E, -SE) ……….……. 432,604 Accumulated depreciation (XA, -A) ..… 432,604

Interest expense (+E, -SE) ……..………..…… 302,823 Lease liability (-L) ……………………..………. 548,589 Cash (-A) ………………………………….. 851,412 d.

+ Leased Asset (A) - - Lease liability (L) +

2008 4,326,036 4,326,036 2008 2009 548,589


432,604 2009 2009 432,604

+ Cash (A) - + Interest Expense (E) -

851,412 2009 2009 302,823



E10-26 (25 minutes) Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. The present value is computed as follows:

Year ($ millions)

Operating Lease Payment ---Net


2009 ......................... $ 450 $ 421

2010 ......................... 414 362

2011 ......................... 375 306

2012 ......................... 338 258

2013 ......................... 306 218

>2013 ...................... 2,421 1,292

Average life ............ 7.912 years* $2,857

* $2,421 ÷ $306/year = 7.912 years


N I/YR PV PMT FV 1 7 421 0 450

N I/YR PV PMT FV 2 7 362 0 414

N I/YR PV PMT FV 3 7 306 0 375

N I/YR PV PMT FV 4 7 258 0 338

N I/YR PV PMT FV 5 7 218 0 306


N I/YR PV PMT FV 7.912 7 1,812 306 0

N I/YR PV PMT FV 5 7 1,292 0 1,812

The present value of Yum’s net operating leases is computed to be $2,857 million. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. YUM!’s liabilities are 43% higher following this adjustment (adjusted liabilities are $6.635 billion + $2.857 billion = $9.492 billion).



E10-27 (25 minutes)

a. Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. The present value is computed as follows:

Year ($ millions)

Operating Lease Payment --- Net


2009 ......................... $ 312.4 $ 292

2010 ......................... 264.4 231

2011 ......................... 228.9 187

2012 ......................... 192.1 147

2013 ......................... 163.9 117

>2013 ...................... 692.3 415


* $692.3 ÷ $163.9/year = 4.224 years.


N I/YR PV PMT FV 1 7 292 0 312.4

N I/YR PV PMT FV 2 7 231 0 264.4

N I/YR PV PMT FV 3 7 187 0 228.9

N I/YR PV PMT FV 4 7 147 0 192.1

N I/YR PV PMT FV 5 7 117 0 163.9


N I/YR PV PMT FV 4.225 7 582 163.9 0

N I/YR PV PMT FV 5 7 415 0 582

The present value of Nike’s operating leases is computed to be $1,370 million. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities.



E10-27—continued.

b.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income To capitalize operating leases.

+1,389 Leased Asset

= +1,389

Lease Liability

-

=

c. 1. Leased asset (+A) ……………………………. 1,389 Lease Liability (+L) ……………………. 1,389 2. Depreciation expense (+E, -SE) ………….… 139 Accumulated depreciation (+XA, -A)... 139 3. Lease liability (-L) …………………………… 215.2 Interest expense (+E, -SE) ……………….… 97.2 Cash (-A) …………………..……………. 312.4 d.

+ Leased Asset (A) - - Lease Liability (L) +

1 1,389 1,389 1 3 215.2


139 2 2 139

+ Cash (A) - + Interest Expense (E) -

312.4 3 3 97.2

E10-28 (20 minutes) a. Service cost is the increase in the pension obligation resulting from employees

working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation.

b. Payments to retirees are made from the pension investment account. There is a corresponding reduction in the pension obligation.

c. The funded status is the pension obligation less the fair market value of the pension investments. In this case $923 million (pension obligation) – $513 million (pension investments) = $410 million underfunded amount.

d. A $410 million net pension liability is reported in the balance sheet.



E10-29 (20 minutes) a. Service cost is the increase in the pension obligation resulting from employees


b. The “actual” return on pension investments is ($1,527 million in 2008 (this causes the decrease in the pension investment account).

c. Actuarial losses (gains) generally arise as a result of decreases (increases) in the discount rate used to compute the pension obligation (PBO). Because the PBO is the present value of expected future payouts to retirees, a decrease in the discount rate results in an increase in the PBO. This decrease is called an actuarial loss.

d. Payments to retirees are made from the pension investment account. There is a corresponding reduction in the pension obligation.

e. Xerox contributed $299 million to its pension plans in 2008.

f. Xerox paid $657 million to its retirees in 2008.

g. The funded status is the pension obligation less the fair market value of the pension investments. In this case $8,495 million – $6,923 million = $1,572 million underfunded amount.

h. A $1,572 million net pension liability is reported on the balance sheet. E10-30 (20 minutes) a. Service cost is the increase in the pension obligation resulting from employees


b. Payments to retirees are made form the pension investment account. There is a corresponding reduction in the pension obligation.

c. The funded status is the pension obligation less the fair market value of the pension investments. In this case $30,394 million – $27,791 million = $2,603 million underfunded amount.

d. A $2,603 million net pension liability is reported on the balance sheet.



E10-31 (15 minutes) a.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income To record income tax

expense

=

+920.1 Taxes

Payable

-300.6 Deferred

Taxes

-619.5 Retained Earnings

- +619.5 Income Tax

Expense

= -619.5

b. Deferred income taxes (-L) ……………….….….… 300.6 Income tax expense (+E, -SE) ……………..…..… 619.5 Income taxes payable (+L) …………………. 920.1

c. An expense of $619.5 million is recorded in the income statement, thereby

reducing both net income and retained earnings. Liabilities are increased by $619.5 million, $920.1 million in income taxes payable less the decrease of $300.6 million in deferred income taxes.

E10-32 (15 minutes) a.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income

a. To record income tax expense.

=

+93 Taxes

Payable +1,248 Deferred

Taxes


- +1,341 Income Tax

Expense

= -1,341

b.

Income tax expense (+E, -SE) …..…….. 1,341 Deferred income taxes (+L) ……. 1,248 Taxes payable (+L) ….…………… 93

c. An expense of $1,341 million is recorded in the income statement, thereby

reducing both net income and retained earnings. Deferred tax liabilities are increased (or deferred tax assets are reduced) by $1,248 million, and tax payable liability was increased by $93 million.

d. The refund is most likely due to one of two sources: (1) a loss recorded in an

earlier period for financial reporting purposes that was not recognized until 2004 for tax reporting purposes (e.g., a restructuring loss) or (2) a tax loss carryforward.



PROBLEMS P10-33 (60 minutes) a. Rent expense (+E, -SE) ………………………………. 208,085,000 Cash (-A) ……………………………………………. 208,085,000 b. Outback would report a lease liability of $1,074,521,000 at December 31, 2008 if

the operating leases were capitalized.

($ 000s)

Year Operating Lease Payment Present Value at Dec. 31, 2008

(i=8%)

2009 ………… 175,367 162,377

2010 ………… 167,613 143,701

2011 ………… 156,382 124,141

2012 ………… 148,186 108,921

2013 ………… 139,902 95,215

>2013 ………. 831,160 436,696

831,160/139,902=5.94 yrs. $1,071,051


N I/YR PV PMT FV 1 8 162,377 0 175,367

N I/YR PV PMT FV 2 8 143,701 0 167,613

N I/YR PV PMT FV 3 8 124,141 0 156,382

N I/YR PV PMT FV 4 8 108,921 0 148,186

N I/YR PV PMT FV 5 8 95,215 0 139,902


N I/YR PV PMT FV 5.94 8 641,650 139,902 0

N I/YR PV PMT FV 5 8 436,696 0 641,650



P10-33—continued. c. In 2009, Outback would report interest expense of $85,684,000 ($1,071,051,000

x .08) and depreciation expense of $107,105,100 ($1,071,051,000/10) instead of rent expense of $175,367,000.

These costs ($85,684,000 and $107,105,100) would replace the otherwise

reported rent expense of $175,367,000 on the 2009 income statement. In the early years of a lease the higher interest expense causes the capitalization of leases to increase expenses compared to the rent expense. This situation reverses in the later years of the lease.

d. These transactions/entries are reflected in the financial statement effects

template below.

($000s) Balance Sheet Income Statement


+

Noncash Assets -

Contra Assets


+ Earned Capital


Income

2009 Depreciation expense.

-

+107,105* Accumulated Depreciation

=


-

+107,105

Deprec. Expense

= -107,105

2009 Lease payment. -175,367

Cash

-

=

-89,683

Lease Liability

-85,684** Retained Earnings

-

+85,684 Interest Expense

= -85,684

*Accumulated depreciation is a contra asst, so assets are reduced. **$1,071,051 x 0.08 e. In the statement of cash flows, the rent expense on operating leases is

classified as an operating cash flow. Although the total cash flow is the same, if the lease is treated as a capital lease, then part of the lease payment (the interest) is classified as operating and the remainder (the principal) is classified as a financing cash flow. Depreciation on the lease is deducted in the computation of income but added back in the operating section of the cash flow statement because it is not a cash flow.



P10-34 (40 minutes)

a. All of Abercrombie & Fitch’s leases are classified as operating. U.S. GAAP requires companies to provide a table of projected lease payments for both operating and capital leases. Because no capital leases are included in the Abercrombie & Fitch footnote, we know that it only has operating leases. Because operating leases are not capitalized on the balance sheet, neither the leased asset, nor the lease obligation, appear on-balance-sheet.

b. Total assets and total liabilities are lower than the balance that would have been reported had the leases been capitalized. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. During the life of the lease, however, the two will not be equal. Even if depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation, which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease.

c. Using a 10% discount rate, the present value of A&F’s operating leases payments is computed as follows:

Year ($ 000s)



2009 ........................ $314,587 $285,988

2010 ........................ 318,845 263,509

2011 ........................ 305,830 229,773

2012 ........................ 287,772 196,551

2013 ........................ 267,951 166,376

>2013 ...................... 1,302,139 616,821

Average life ............ 4.86 years* $1,759,018

* $1,302,139 ÷ $267,951/year = 4.86 years.



P10-34—continued. The calculations of the present value of each payment follow:

N I/YR PV PMT FV 1 10 285,988 0 314,587

N I/YR PV PMT FV 2 10 263,509 0 318,845

N I/YR PV PMT FV 3 10 229,773 0 305,830

N I/YR PV PMT FV 4 10 196,551 0 287,772

N I/YR PV PMT FV 5 10 166,376 0 267,951


N I/YR PV PMT FV 4.86 10 993,396 267,951 0

N I/YR PV PMT FV 5 10 616,821 0 993,396

d.

($ 000s) Balance Sheet Income Statement


+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income

To capitalize operating leases.

+1,759,018 Leased Asset

= +1,759,018

Lease Liability

-

=

e. ($ 000s) 2/3/08 Leased asset (+A) ………………………………….. 1,759,018 Lease liability (+L) …………………………. 1,759,018 2009 Depreciation expense (+E, -SE) ………………… 175,902 Accumulated depreciation (+XA, -A) ……. 175,902

$175,902 = $1,759,018 / 10

Lease liability (-L) …………………………………. 138,685 Interest expense (+E, -SE) ………….……………. 175,902 Cash (-A) ……………………………………… 314,587

$175,902 = $1,759,018 x 0.10.



P10-34—continued. f. ($ 000s)

+ Cash (A) - - Lease Liability (L) +

1,759,018 1 314,587 3 3 138,685

+ Leased Asset (A) - + Interest Expense (E) -

1 1,759,018 3 175,902


175,902 2 2 175,902

The interest expense is the same as the depreciation charge because interest is at 10% and depreciation is over 10 years. g. The effect of a failure to report the leased assets and related lease obligation on-

balance-sheet understates fixed commitments. It will leave gross margin largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. The debt to equity ratio is increased by capitalizing the leases. Capitalization of the leases would increase the asset base, which would, in turn, lower asset turnover. Hence turnover rates are overstated by the failure to capitalize the leases. Overall these two factors offset each other leaving ROE only marginally affected. Our conclusion of how A&F is achieving its ROE is likely to be altered because A&F has lower turnover and higher financial leverage than was apparent based on the published (unadjusted) financial statements.



P10-35 (40 minutes) a. Best Buy reports $265 million of capital leases in its liabilities of which $59

million due in 2010 is reported as a current liability. The $8,600 of operating leases are not reported in the balance sheet nor are the related leased assets.

b. Total assets and total liabilities are lower than the balance that would have been

reported had the leases been capitalized. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. In any given year of the lease, however, the two will not be equal. If depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation, which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease.

c. Using a 10% discount rate, the present value of Best Buy’s operating leases

payments is computed as follows:

($ millions) Year



1 .............................. $ 1,097 $ 997

2 .............................. 1,045 864

3 .............................. 964 724

4 .............................. 900 615

5 .............................. 846 525

>5 ............................ 3,748 1,809


* $3,748 ÷ $846/year = 4.43 years.



P10-35—continued.


N I/YR PV PMT FV 1 10 997 0 1,097

N I/YR PV PMT FV 2 10 864 0 1,045

N I/YR PV PMT FV 3 10 724 0 964

N I/YR PV PMT FV 4 10 615 0 900

N I/YR PV PMT FV 5 10 525 0 846


N I/YR PV PMT FV 4.43 10 2,914 846 0

N I/YR PV PMT FV 5 10 1,809 0 2,914

d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income

To capitalize operating leases. +5,534

Leased Asset =

+5,534 Lease

Liability

-

=

e. 2009 1. Leased asset (+A) ………………………………. 5,534 Lease liability (+L) ……………………….. 5,534 2010 2. Depreciation expense (+E, -SE) ………………. 553 Accumulated depreciation (+XA, -A) ….. 553

$572 = $5,716 / 10

3. Lease liability (-L) ……………………………….. 544 Interest expense (+E, -SE) …………………….. 553 Cash (-A) …………………………………… 1,097

$572 = $5,716 x 0.10



P10-35—continued.

f. + Cash (A) - - Lease Liability (L) +

5,534 1. 1,097 3. 3. 544 + Leased Asset (A) - + Interest Expense (E) -

1. 5,534 3. 553


553 2. 2. 553

The interest expense is the same as the depreciation charge because interest is at 10% and depreciation is over 10 years. g. The effect of a failure to report the leased assets and related lease obligation on-

balance-sheet understates fixed commitments. It will leave gross margin largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. The debt to equity ratio is increased. Capitalization of the leases would increase the asset base, which would, in turn, lower asset turnover. Hence turnover rates are overstated by the failure to capitalize the leases. Overall these two factors offset each other leaving ROE only marginally affected. Our conclusion of how Best Buy is achieving its ROE is likely to be altered because Best Buy has lower turnover and higher financial leverage than was apparent based on the published (unadjusted) financial statements.

P10-36 (5 minutes) a. Leased asset (+A) ……………………………………… 74,520 Lease liability (+L) ………………………………. 74,520 b. Prepaid rent (+A) ……………………………………….. 1,000 Cash (-A) …………………………………………… 1,000



P10-37 (50 minutes)

a. $177 million expense

b. The expected return is computed as the beginning fair market value of the pension plan assets multiplied by the long-term expected return on these

investments. For 2009, this is computed as $11,879 8.5% = $1010, slightly less than the reported amount of $1,059 million. The plan investment reported an actual loss of $2,306 million. U.S. GAAP permits the use of the expected long-term rate of return in order to smooth earnings. If actual returns were to be used, corporate profits would fluctuate greatly with swings in investment returns. The logic behind using the long-term rate is that investment returns are expected to fluctuate around this average and its use more accurately captures the average cost of the pension plan. It is similar to the logic of reporting held-to-maturity bond investments at historical cost rather than current market value.

c. The pension liability is increased by the service and interest costs and decreased by any payments made to plan participants. The actuarial loss (gain) relates to the effects on the pension obligation of changes in assumptions used to compute it, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions and are decreased by benefits paid to plan participants.

d. The “funded status” is the excess (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive or overfunded. If pension obligations exceed the fair market value of plan assets, the funded status is negative or underfunded. The funded status of the FedEx pension plan is $(238) at the end of 2009. Pension obligations are $11,050 million and pension assets are $10,812 million. FedEx should report its net funded status as a net pension liability of $238 million on its balance sheet.

e. Because the pension obligation is the present value of expected pension payments, an increase in the discount rate decreases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. In 2009, the effect of an increase in the discount rate is to apply a higher discount rate to a lower pension obligation. These two effects are offsetting, but usually result in lower interest cost.

f. The estimated wage inflation rate is used to project future benefit payments. Decreasing the estimated inflation rate decreases the pension obligation because a lower amount of payments to plan participants is projected. Decreasing the expected wage inflation rate decreases the pension obligation reported on the balance sheet and, consequently, the interest component of pension expense. It is an income-increasing action.



P10-38 (5 minutes) a. Pension expense (+E, -SE) …………………………… 16,000 Cash (-A) …………………………………….…….. 16,000

16,000 = 400,000 x .04. b. Bartov would report a net liability of $450,000 ($625,000 - $175,000) in its 2010

balance sheet. P10-39 (20 minutes) a. $34,106,000 b. $36,470,000 is payable in cash and the remainder is deferred. c. Deferred tax liabilities are created when a company reports greater revenues

and/or lower expenses in the income statement than are reported on the tax return. An example is supplied by certain pension expenses deductible for books before being deductible for taxes.

d. Deferred tax assets arise when income is recognized for tax purposes before it

is recognized in the financial statements, such as can be case with advance payments from customers. Thus receipt of the cash will decrease the deferred tax asset. Alternatively, deferred tax assets may arise when the tax return defers expenses that are recognized in the financial statements. Examples include bad debt expense and warranty expense. A restructuring charge is an example of the latter. Restructuring charges are not recognized in the tax return until they are realized (cash paid or assets sold at a loss). Therefore, the payment of the cash or sale of the assets will decrease the deferred tax asset.



P10-40 (20 minutes)

a. In 2009, the temporary difference is $8,000. $8,000 x 40% = $3,200. In 2010, the temporary difference reverses and no liability would be reported. b. Income tax expense (+E, -SE) ………………….. 91,200 Income taxes payable* (+L) ………………. 88,000 Deferred income tax liability (+L) ……….. 3,200 * ($236,000 – $16,000) x 40% = $88,000.

Income tax expense (+E, -SE) …………………. 94,800 Deferred income tax liability (-L) ……………… 3,200 Income taxes payable* (+L) ……………… 98,000 * ($245,000 – $0) x 40% = $98,000. c. Income tax expense (+E, -SE) …………………. 80,200 Income taxes payable (+L)* ……………… 77,000 Deferred income tax liability (+L) ………. 3,200 * ($236,000 – $16,000) x 35% = $77,000. Income tax expense (+E, -SE) …………………. 94,800 Deferred income tax liability (-L) ……………… 3,200 Income taxes payable (+L)* ……………….. 98,000 * ($245,000 – $0) x 40% = $98,000.

The solution to part c depends on what the company knew, in 2009, about the

tax rate in 2010. In the journal entries above, the assumption is that the tax rate is 35% in 2009, but is supposed to change to 40% in 2010. However, if the change in the tax rate was not known, the following entries would be required:

c. Income tax expense (+E, -SE) …………………. 79,800 Income taxes payable (+L)* ……………… 77,000 Deferred income tax liability (+L) ** ……. 2,800 * ($236,000 – $16,000) x 35% = $77,000. ** $8,000 x 0.35 = $2,800 Income tax expense (+E, -SE) .......................................................................... 95,200 Deferred income tax liability (-L) .................................................................... 2,800 Income taxes payable* (+L) ................................................................................ 98,000 * ($245,000 – $0) x 40% = $98,000.

Either way, the amount of income tax expense is determined as a plug amount.



P10-41 (20 minutes)

a. Temporary differences –

2009: $32,000 - $24,000 = $8,000;

2010: ($32,000 + $37,000) – ($24,000 + $26,000) = $19,000. b. Deferred tax liability –

2009: $8,000 x 40% = $3,200; 2010: $19,000 x 40% = $7,600 c. $19,200 + ($7,600 – $3,200) = $23,600 d. Income tax expense (+E, -SE)…………………… 23,600 Income taxes payable (+L) ...……………… 19,200 Deferred tax liability (+L) …………..……… 4,400 + Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) +

(d) 23,600 19,200 (d) 4,400 (d)

P9-42 (20 minutes)

a. Temporary differences –

2009: $140,000 - $130,000 = $10,000;

2010: ($140,000 + $122,000) – ($130,000 + $128,000) = $4,000. b. Deferred tax liability –

2009: $10,000 x 35% = $3,500; 2010: $4,000 x 35% = $1,400 c. $45,150 + ($1,400 – $3,500) = $43,050 d. Income tax expense (+E, -SE)…………………… 43,050 Deferred tax liability (-L) ………………………… 2,100 Income taxes payable (+L) ……………….. 45,150 + Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) +

(d) 43,050 45,150 (d) (d) 2,100



P10-43 (15 minutes)

a. $12,000 x 40% = $4,800. b. Because the source of the temporary difference is a noncurrent asset (PP&E),

the deferred tax liability would be classified as a noncurrent liability. c. $8,000 x 40% = $3,200. P10-44 (20 minutes) Assume that the tax rate increase in 2011 was not known until 2010. a. Book

value b. Tax basis

Temporary difference

c. Deferred tax liability

2009 $12,000 $0 $12,000 $4,200 ($12,000 x 0.35) 2010 $6,000 $0 $6,000 $2,400 ($6,000 x 0.40) 2011 $0 $0 $0 $0 d. 12/31/09 Income tax expense (+E, -SE) ..………………… 112,000 Deferred income tax liability (+L)………… 4,200 Income taxes payable (+L)* ……………..… 107,800 * $308,000 x 0.35 = 107,800. 12/31/10 Income tax expense (+E, -SE) …….…………… 138,200 Deferred income tax liability (-L) ….…………… 1,800 Income taxes payable (+L)* ……..………. 140,000 * $400,000 x 0.35 = $140,000. 12/31/11 Income tax expense (+E, -SE) ………………….. 165,600 Deferred income tax liability (-L) ……………… 2,400 Income taxes payable (+L)* ……………… 168,000 * $420,000 x 0.40 = $168,000. The expense is determined as a plug amount.



P10-45 (40 minutes) a. According to FedEx’s lease footnote, it has both capital and operating leases.

Only the capital leases are reported on-balance-sheet in the amount of $294 million (FedEx also reports a lease asset on the balance sheet, but the asset will appear at an amount lower than the lease liability). This amount is not the total obligation to its lessors. FedEx also has a significant amount of leases that it has classified as operating. In fact, the minimum lease payments under operating leases are over 34 times that for capital leases. These operating leases are not reported on-balance-sheet.

b. An Excel spreadsheet to calculate the interest rate (using the IRR function) would look something like the following:

A B C D E F G H I J K L M N O

1 N 0 1 2 3 4 5 6 7 8 9 10 11 12 13

2 Amount -294 164 20 8 119 2 2 2 2 2 2 2 2 1

3 IRR 4.453%

The Excel function =IRR(B2:O2) returns a value of 4.453% (which is >3%). c. The present value of FedEx’s operating leases payments is computed as

follows:

Year ($ millions)



2010 ........................ $1,759 $ 1,691

2011 ........................ 1,612 1,490

2012 ........................ 1,451 1,290

2013 ........................ 1,316 1,125

2014 ........................ 1,166 958

>2014 ...................... 7,352 5,246

Total ........................ $14,656 $11,800

Average Life: $7,352/$1,166 = 6.3 years.



P10-45—continued.


N I/YR PV PMT FV 1 4 1,691 0 1,759

N I/YR PV PMT FV 2 4 1,490 0 1,612

N I/YR PV PMT FV 3 4 1,290 0 1,451

N I/YR PV PMT FV 4 4 1,125 0 1,316

N I/YR PV PMT FV 5 4 958 0 1,166


N I/YR PV PMT FV 6.3 4 6,382 1,166 0

N I/YR PV PMT FV 5 4 5,246 0 6,382

d. Failure to report the leased assets and related lease obligation on-balance sheet

has overstated asset turnover ratios and understated financial leverage ratios. For example, the debt to equity ratio would increase from 0.78 ($10,618/$13,626) to 1.65 ([$10,618 + $11,800]/$13,626). Profit margins will not be affected significantly, if we assume that the leases are approximately at the midpoint of their lives, on average. Because the decreased turnover and increased leverage effects offset one another, ROE is unaffected. Our conclusion about how FedEx is achieving its ROE is altered, however, because it has lower turnover and higher financial leverage than is apparent based on a review of the published (unadjusted) financial statements.

e. To effectively conduct its business, FedEx requires a significant amount of

assets that are not reported on-balance-sheet. In addition, the true extent of FedEx’s obligations is substantially understated. In the case of FedEx, therefore, it appears that the balance sheet does not do an adequate job.

f. Lease reporting in the U. S. follows U.S. GAAP while lease reporting in France

would follow IFRS. U.S. GAAP does not capitalize operating leases. Operating leases are considered executory contracts. Executory contracts are promises to pay defined amounts in the future for future benefits. Such contracts are not recognized as liabilities. The assets supplying the services are also not recognized. The requirements necessary to recognize a lease as a capital lease are not as specific under IFRS and hence a lease that would not be considered a capital lease under U.S. GAAP might be considered a capital lease under IFRS. Specific requirements for capitalization are covered in advanced courses.



CASES AND PROJECTS C10-46 (50 minutes)

a. Dow Chemical is reporting net pension expense of $122 million for 2008.

b. The expected rate of return is computed as the beginning fair market value of the pension plan assets multiplied by the long-term expected return on these investments. For 2008, expected return was $$1,232 on assets of $16,130 million. This implies an expected rate of return of 7.64% ($1,232/$16,130).

c. The pension liability is increased by the service and interest costs and decreased by any payments made to plan participants. The actuarial loss (gain) relates to the effects on the pension obligation of changes in assumptions used to compute it, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions, and are decreased by benefits paid to plan participants.

d. The “funded status” is the excess (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive. If pension obligations exceed the fair market value of plan assets, the funded status is negative. The funded status of the Dow Chemical pension plan is $(4,000) million at the end of 2008. Pension obligations are $15,573 million and pension assets are $11,573 million. Thus, the pension is underfunded and the balance sheet should show a net pension liability of $4,000 million.

e. Since the pension obligation is the present value of expected pension payments, a increase in the discount rate decreases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning-of-the-year pension obligation and the discount rate. The effect of an increase in the discount rate is to apply a higher interest rate to a lower pension obligation. Interest expense on the pension liability will usually increase in this circumstance. However, the actuarial “gain” resulting from the lower liability amount may offset the higher interest cost.

f. An increase in expected return unambiguously increases profitability as pension cost is reduced. This result occurs because the long-term rate is used to compute the dollar amount of expected return that is an offset in the computation of pension expense.

g. Inflation rates differ from country to country. For 2008, those rates are generally higher outside the U.S. where FedEx operates. Inflation is expected to increase in the U.S. and could exceed the rates in other countries implying relatively higher compensation levels.



C10-47 (40 minutes)

a. Delta’s purchase commitments are not reported on the balance sheet because they are unexecuted contracts. When Delta receives the aircraft from Boeing, Delta will record a debit to PPE assets and a credit to accounts payable. Some of the aircraft appear to have prearranged financing in the form of a sale- leaseback arrangement. Thus, when the aircraft are delivered, they will then be sold to a third-party lessor and then leased under a capital lease.

Boeing will record a sale, with a debit to accounts receivable and a credit to sales revenue. At the same time, it will record a debit to cost of goods sold and a credit to aircraft inventory.

b. Rent expense (+E, -SE) ………………….. 850 Cash (-A) .……………………………… 850

c. The total liability on the balance sheet would be $501million plus a premium of

$64 million. Of this amount, $92 million would be classified as a current liability leaving a noncurrent liability of $473 million.

d. Delta will record rent expense of $1,646 million less any sublease income. e. Using a 10% discount rate, the present value of Delta’s operating lease

payments is computed as follows:

Year ($ millions)



2009 ........................ $1,646 $ 1,496

2010 ........................ 1,559 1,288

2011 ........................ 1,326 996

2012 ........................ 1,204 822

2013 ........................ 1,059 658

>2014 ...................... 5,664 2,626

Total ........................ $12,458 $7,886

Average Life: $5,664 ÷ $1,059/year = 5.35 years.



C10-47—continued.


N I/YR PV PMT FV 1 10 1,496 0 1,646

N I/YR PV PMT FV 2 10 1,288 0 1,559

N I/YR PV PMT FV 3 10 996 0 1,326

N I/YR PV PMT FV 4 10 822 0 1,204

N I/YR PV PMT FV 5 10 658 0 1,059


N I/YR PV PMT FV 5.35 10 4,230 1,059 0

N I/YR PV PMT FV 5 10 2,626 0 4,230

Given Delta’s liabilities total $44.140 billion before capitalizing operating leases, the $7.886 billion of operating leases adds about 17.9% to Delta’s total liabilities, which is a material, if not a substantial increase.



C10-48 (30 minutes) a. $6,822 – ($126,904 – $136,840) = $16,758 b. Income tax expense (+E, -SE) …………………….……. 16,758 Deferred tax asset – current (-A) …..…………………. 1,494* Deferred tax asset – noncurrent (-A) ……………….. 8,442 Income taxes payable (+L) …..……………………. 6,822

*$91,843 – $90,349 c. The temporary difference due to depreciation was $13,392 / 0.35 = $38,263.

The tax basis of PP&E assets was $942,219 - $38,263 = $903,956. d. Prepaid catalog expenses are capitalized and amortized for financial reporting

purposes. However, for tax reporting purposes, the costs are expensed when paid. Consequently, the tax deduction is recognized before the expense is recognized in the income statement. The prepaid catalog expense of $36,424 represents a temporary difference between financial and tax reporting. The resulting deferred tax liability of $14,589 offsets the other current deferred tax assets in the balance sheet.

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