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    Module 9 Module 9 Document Transcript

    • Module 9 Reporting and Analyzing Off-Balance-Sheet Financing QUESTIONS Q9-1. 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 not record either the leased asset nor 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. Q9-2. 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. Q9-3. 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. Q9-4. 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. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 1
    • Q9-5. 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. Q9-6. 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. Q9-7. 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. Q9-8. A variable interest entity can be any form of business organization. VIEs are typically used to securitize assets or to provide project financing. The “primary beneficiary” is the party which realizes most of the benefits from the VIE and bears most of the VIE’s risks of failure. It is this entity that will be required to consolidate the VIE on its balance sheet, thus increasing its assets and liabilities. Examples include trusts used to securitize receivables and other assets, as well as entities used to acquire real estate, manufacturing assets, etc. for the use by another entity. Q9-9. Fin 46 requires consolidation of variable interest entities (VIEs) with their primary beneficiary. The consolidation process brings together the balance sheets and income statements of the two entities, thus resulting in on-balance sheet financing. ©Cambridge Business Publishers, 2006 2 Financial Accounting for MBAs, 2nd Edition
    • MINI-EXERCISES M9-10 (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. M9-11 (20 minutes) a. Present value of expected operating lease payments for Southwest Airlines Year Operating Lease Discount Factor ($ millions) Payment (i=0.07) Present Value 1................... $ 283 0.935 $ 265 2................... 273 0.873 238 3................... 219 0.816 179 4................... 202 0.763 154 5................... 190 0.713 135 >5................. 1,328 5.383 729* Average life. 6.99 years $1,700 * $190 x 5.383 x 0.713 = $729 b. The capitalization of these operating leases increases Southwest’s total liabilities by 35% to $6,526 million ($4,826 million + $1,700 million). M9-12 (15 minutes) a. American Express is reporting $105 million in pension expense for 2003. b. Expected returns are an offset to service and interest costs and serve to reduce reported pension expense. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 3
    • 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. M9-13 (15 minutes) a. Yum Brands is reporting $40 million of pension expense for 2003 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. M9-14 (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. M9-15 (15 minutes) a. Target 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 Target’s balance sheet. M9-16 (15 minutes) a. Dow Chemical has established these Variable Interest Entities (VIE’s) to own assets that it is leasing on operating leases. The reference to the residual value guarantee suggests that these are “synthetic real estate leases.” This particular VIE structure has been used by numerous companies in order to gain off-balance sheet treatment of the operating ©Cambridge Business Publishers, 2006 4 Financial Accounting for MBAs, 2nd Edition
    • lease for financial reporting purposes while, at the same time, gaining the tax benefits of ownership. b. Since the leases are classified as “operating,” neither the leased asset nor the lease liability appear on the balance sheet. The leases are, thus, off-balance sheet financing. c. Fin 46 requires consolidation of the VIE by its “primary beneficiary,” that entity which enjoys most of the benefits form the VIE’s activities and bears most of the risk if it performs poorly. Consolidation will combine the balance sheets of the two entities. As a result, the leased asset and related financing will appear on Dow’s balance sheet, thus negating the off-balance sheet treatment that Dow presently enjoys. M9-17 (15 minutes) a. The use of contract manufacturers removes the manufacturing assets and related liabilities from Reebok’s balance sheet. b. Since sales are unaffected, asset turnover is increased by the removal of assets. The effect on 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 Reebok 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 Reebok, however, the price increase is mitigated. RNOA will increase if the turnover effect more than offsets and the negative effect on NOPAT margin, which is likely. c. 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. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 5
    • EXERCISES E9-18 (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 (see the Verizon lease footnote example in E9-19). Since 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. E9-19 (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 $241 million ($54 million in current liabilities and $187 million as long-term liabilities). This is not the total obligation to its Lessors. Verizon also has a significant amount of leases that it has classified as operating. In fact, the minimum lease payments under operating leases are over 13 times that for capital leases! These operating leases are not reported on-balance sheet. b. Neither the leased asset nor the lease obligation is reported on the balance sheet for an operating lease. As a result, total assets and total liabilities are reduced. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. During the life of the lease, however, the two will not be equal. Even if depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation which is higher in the earlier years of the lease. As a ©Cambridge Business Publishers, 2006 6 Financial Accounting for MBAs, 2nd Edition
    • result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 7
    • E9-20 (25 minutes) Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. Assuming a 7% discount rate, the present value is computed as follows: Year Operating Lease Discount Factor ($ 000s) Payment (i=0.07) Present Value 1................... $ 504,964 0.934579 $ 471,929 2................... 484,450 0.873439 423,137 3................... 451,712 0.816298 368,732 4................... 421,610 0.762895 321,644 5................... 395,472 0.712986 281,966 >5................. 2,336,640 4.707* 1,327,214** Average life. 5.91 years $3,194,648 * Present value of an annuity of 5.91 periods @ 7% ** $395,472 x 4.707 x 0.712986 = $1,327,214 The present value of Staples’ operating leases is computed to be $3.194 billion. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. Staples’ liabilities are 212% higher following this adjustment (adjusted liabilities are $2.840 billion + $3.194 billion = $6.034 billion). E9-21 (25 minutes) Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. Assuming a 7% discount rate, the present value is computed as follows: Year Operating Lease Discount Factor ($ millions) Payment (i=0.07) Present Value 1................... $ 298 0.935 $ 279 2................... 270 0.873 236 3................... 231 0.816 188 4................... 209 0.763 160 5................... 187 0.713 133 >5................. 1,091 4.767* 636** Average life. 6.00 years $1,632 * Present value of an annuity of 6 periods @ 7% ** $187 x 4.767 x 0.713 = $636 The present value of Yum’s operating leases is computed to be $1,632 million. We might consider adjusting its balance sheet by adding this amount ©Cambridge Business Publishers, 2006 8 Financial Accounting for MBAs, 2nd Edition
    • to both assets and liabilities. YUM!’s liabilities are 136% higher following this adjustment (adjusted liabilities are $4.500 billion + $1.632 billion = $6.132 billion). E9-22 (25 minutes) Our analysis might capitalize (add to both assets and liabilities) the present value of the expected operating lease payments. Assuming a 7% discount rate, the present value is computed as follows: Year Operating Lease Discount Factor ($ 000s) Payment (i=0.07) Present Value 1................... $ 45,685 0.934579 $ 42,696 2................... 35,203 0.873439 30,748 3................... 27,728 0.816298 22,634 4................... 21,264 0.762895 16,222 5................... 16,891 0.712986 12,043 >5................. 12,753 0.711* 8,563** Average life. 0.76 years $132,906 * Present value of an annuity of 0.76 years @ 7% ** $16,891 x 0.711 x 0.712986 = $8,563 The present value of Reebok’s operating leases is computed to be $132.906 million. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. E9-23 (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 $629 million (pension obligation) – $438 million (pension investments) = $191 million underfunded amount. d. A $51 million net pension asset is reported on the balance sheet. This is due to the fact that the actuarial loss ($230 million) and prior service cost ($12 million) is not recognized on-balance sheet. As a result , $242 million ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 9
    • of the pension obligation used to compute the funded status is not recognized, thus increasing the net pension liability/asset by that amount and resulting in a net pension asset. E9-24 (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. The “actual” return on pension investments is $1.15 billion in 2003 (this causes the increase in the pension investment account). The expected return (not the actual return) of $940 million impacts Xerox’ profitability in 2003. c. Actuarial losses generally arise as a result of reductions in the discount rate used to compute the pension obligation (PBO). Since the PBO is the present value of expected future payouts to retirees, a reduction in the discount rate results in an increase in the PBO. This increase 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 $672 million to its pension plans in 2003. f. Xerox paid $861 million to its retirees in 2003. g. The funded status is the pension obligation less the fair market value of the pension investments. In this case $8,971 million – $7,301 million = $1,670 million underfunded amount. h. A $174 million net pension asset is reported on the balance sheet. This is largely due to the fact that the actuarial loss ($1,870 million) and prior service cost ($24 million) is not recognized on-balance sheet. As a result of these factors and the transition asset, $1,844 million of the pension obligation used to compute the funded status is not recognized, thus increasing the net pension liability/asset by that amount and resulting in a net pension asset. E9-25 (20 minutes) ©Cambridge Business Publishers, 2006 10 Financial Accounting for MBAs, 2nd Edition
    • 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 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 $41,043 million – $42,841 million = $1,798 million overfunded amount. d. A $8,366 million net pension asset is reported on the balance sheet. This is largely due to the fact that the actuarial loss ($5,079 million) and prior service cost ($1,512 million) is not recognized on-balance sheet. As a result of these factors and the transition asset, $6,588 million of the pension obligation used to compute the funded status is not recognized, thus increasing the net pension liability/asset by that amount and resulting in a net pension asset. E9-26 (25 minutes) 1. Total loans receivable amount to $275 billion at the end of 2002. Of this amount, $137 billion (50%) is reported on GM’s balance sheet. One-half of its portfolio has been securitized via Variable Interest Entities (VIE’s). The securitization process involves the purchase of these loans by the VIE which funds the purchase by selling bonds to the market. The bonds are collateralized by the loans receivable and these loans provide the cash flows to repay the bonds. 2. Prior to Fin 46, the activities of these VIE’s were off-balance sheet. Once the receivables were sold, neither the receivables nor the related financing were reported on-balance sheet. In addition to off-balance sheet treatment of the sale, companies also realized a lower financing cost as the receivables were, presumably, bankruptcy protected. Fin 46 was proposed following the Enron scandal, and others. It requires all VIE’s to be consolidated with their “primary beneficiary,” that entity which enjoys the residual benefits of the VIE’s activities and bears the risks in the event of failure. Consolidation means that the assets and liabilities of the VIE will be combined with those of the primary beneficiary, thus negating the beneficial effects of off-balance sheet financing. GM indicates that consolidation will result in the reporting on its balance sheet of $1.1 billion of ACO-related receivables and $17.5 billion of FIO-related receivables. GM does not disclose the additional ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 11
    • liabilities that will be recorded on its balance sheet as a result of the consolidation. Since these VIEs are highly leveraged, it is reasonable to assume that the additional liabilities will be similar in magnitude to the additional assets that it records. 3. GM reports that “management is considering restructuring alternatives to ensure the continued non-consolidation of such assets,” presumably to preserve the benefits of off-balance sheet financing. ©Cambridge Business Publishers, 2006 12 Financial Accounting for MBAs, 2nd Edition
    • PROBLEMS P9-27 (40 minutes) a. All of Abercrombie & Fitch’s leases are classified as operating. GAAP requires companies to provide a table of projected lease payments for both operating and capital leases (see the Verizon lease footnote example in Exercise 9-19). Since no capital leases are included in the Abercrombie & Fitch footnote, we know that it only has operating leases. Since 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 to be nearly $600 million follows: Year Operating Lease Discount Factor ($ 000s) Payment (i=0.10) Present Value 1................... $120,313 0.909091 $109,375 2................... 121,316 0.826446 100,261 3................... 118,695 0.751315 89,177 4................... 112,899 0.683013 77,112 5................... 99,381 0.620921 61,708 >5................. 316,724 2.620* 161,674** Average life. 3.19 years $599,307 * Present value of an annuity of 3.19 years @ 10% ** $99,381 x 2.62 x 0.620921 = $161,684 Each of the next 5 years projected lease payment is discounted individually. Then, the payments due after 5 years represent a 3.19 year annuity based on the year 5 payment amount. The present value of this annuity is, then, discounted from year 5 to the present using the formula ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 13
    • rather than the table since the annuity life is in fractional years. The sum of the present values is approximately $600 million. d. Failure to report the leased assets and related lease obligation on-balance sheet has overstated asset turnover and understated financial leverage. Profit margins will be largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. Since the turnover and leverage effect offset one another, ROE is largely unaffected. Our conclusion of the underlying source of the ROE performance, however, is significantly affected as we can now see that A&F is achieving its ROE with lower turnover and higher financial leverage than was apparent based on our review of the published (unadjusted) financial statements. P9-28 (40 minutes) a. All of Best Buy’s leases are classified as operating. GAAP requires companies to provide a table of projected lease payments for both operating and capital leases (see the Verizon lease footnote example in Exercise 9-19). Since no capital leases are included in the Best Buy footnote, we know that it only has operating leases. Since operating leases are not capitalized on the balance sheet, neither the leased asset nor the lease obligation appears 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. ©Cambridge Business Publishers, 2006 14 Financial Accounting for MBAs, 2nd Edition
    • c. Using a 10% discount rate, the present value of Best Buy’s operating leases payments is computed to be nearly $2.75 billion as follows: Year Operating Lease Discount Factor ($ millions) Payment (i=0.10) Present Value 1................... $ 472 0.909 $ 429 2................... 459 0.826 379 3................... 417 0.751 313 4................... 376 0.683 257 5................... 361 0.621 224 >5................. 2,698 5.095* 1,142** Average life. 7.47 years $2,744 * Present value of an annuity of 7.47 years @ 10% ** $361 x 5.095 x 0.621 = $1,142 Each of the next 5 years projected lease payment is discounted individually. Then, the payments due after 5 years represent a 7.47 year annuity based on the year 5 payment amount. The present value of this annuity is, then, discounted from year 5 to the present using the formula rather than the table since the annuity life is in fractional years. The sum of the present values is approximately $2.75 billion. d. Failure to report the leased assets and related lease obligation on-balance sheet has overstated asset turnover and understated financial leverage. Profit margins will be largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. Since the turnover and leverage effect offset one another, ROE is largely unaffected. Our conclusion of the underlying source of the ROE performance, however, is significantly affected as we can now see that Best Buy is achieving its ROE with lower turnover and higher financial leverage than was apparent based on our review of the published (unadjusted) financial statements. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 15
    • P9-29 (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 $206 million. This is not the total obligation to its Lessors. FedEx also has a significant amount of leases that it has classified as operating. In fact, the minimum lease payments under operating leases are over 47 times that for capital leases! These operating leases are not reported on-balance sheet. b. We can impute the discount rate FedEx uses to compute the present value of its capital leases by trial and error. It appears that the company is using a 3.5% discount rate as follows: Year Operating Lease Discount Factor ($ millions) Payment (i=0.035) Present Value 1................... $12 0.96618 $12 2................... 12 0.93351 11 3................... 12 0.90194 11 4................... 12 0.87144 10 5................... 12 0.84197 10 >5................. 253 14.73769* 149** Average life. 21.08 years $203 * Present value of an annuity of 21.08 years @ 3.5% ** $12 x 14.73769 x 0.84197 = $149 c. Using a 3.5% discount rate, the present value of FedEx’s operating leases payments is computed to be nearly $11.75 billion as follows: Year Operating Lease Discount Factor ($ millions) Payment (i=0.035) Present Value 1................... $1,501 0.96618 $1,450 2................... 1,235 0.93351 1,153 3................... 1,162 0.90194 1,048 4................... 1,053 0.87144 918 5................... 1,028 0.84197 866 >5................. 8,791 7.28177* 6,303** Average life. 8.55 years $11,738 * Present value of an annuity of 8.55 years @ 3.5% ** $1,028 x 7.28177 x 0.84197 = $6,303 Each of the next 5 years projected lease payment is discounted individually. Then, the payments due after 5 years represent a 8.55 year ©Cambridge Business Publishers, 2006 16 Financial Accounting for MBAs, 2nd Edition
    • annuity based on the year 5 payment amount. The present value of this annuity is, then, discounted from year 5 to the present using the formula rather than the table since the annuity life is in fractional years. The sum of the present values is approximately $11.75 billion. d. Failure to report the leased assets and related lease obligation on-balance sheet has overstated asset turnover and understated financial leverage. Profit margins will be largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. Since the turnover and leverage effect offset one another, ROE is largely unaffected. Our conclusion of the underlying source of the ROE performance, however, is significantly affected as we can now see that FedEx is achieving its ROE with lower turnover and higher financial leverage than was apparent based on our review of the published (unadjusted) financial statements. e. FedEx reports $206 million of capitalized leases on its balance sheet. Another $11.75 billion of leased assets and related lease obligations is off- balance sheet as operating leases. Less than 2% of FedEx’s leases are reported on-balance sheet. f. There is a significant amount of assets that are required in order for FedEx to conduct its business that are not reported on-balance sheet. In addition, the true extent of FedEx’s obligations is significantly understated. In the case of FedEx, therefore, it does not appear that the balance sheet does an adequate job. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 17
    • P9-30 (50 minutes) a. $149 million 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 2002, this is computed as $5,622 * 10.9% = $612, slightly less than the reported amount of $621 million. In sharp contrast to the $621 of expected positive return on plan investments that is used in the computation of pension expense for 2002, the plan investment reported an actual loss of $(191) million. 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 bonds 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 use 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 FedEx pension plan is $(717) at the end of 2002. Pension obligations are $6,227 million and pension assets are $5,510 million. In contrast to the net pension obligation indicated by the negative funded status, FedEx reports a net pension asset on its balance sheet in the amount of $228 million at the end of 2002. This is because some of the pension obligation relating to actuarial losses ($823 million) and unamortized prior service costs ($130 million) are not yet reflected on-balance sheet. These liabilities arose because of changes in the assumptions used to compute the pension obligation or changes in the pension plan itself. GAAP allows companies to recognize these changes gradually over a period of time. This is another of the smoothing mechanisms that have been built into GAAP that are designed to minimize the impact of pension plans on the balance sheet and the income statement. ©Cambridge Business Publishers, 2006 18 Financial Accounting for MBAs, 2nd Edition
    • e. Since the pension obligation is the present value of expected pension payments, a reduction in the discount rate increases 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 a reduction in the discount rate is to apply a lower discount rate to a higher pension obligation. These two effects are offsetting and it is not clear which will dominate. f. The estimated wage inflation rate is used in the computation of the expected costs of the pension obligation. Reducing the estimated inflation rate reduces the pension obligation as a lower amount of payments to plan participants is projected. Reduction of the expected wage inflation rate reduces the pension obligation reported on the balance sheet and, consequently, the interest component of pension expense. It is an income increasing action. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 19
    • P9-31 (50 minutes) a. Dow Chemical is reporting net pension income of $145 million for 2002. 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 2002, this is computed as $11,424 million * 9.25% = $1,056 million, slightly less than the reported amount of $1,105 million. In sharp contrast to the $1,105 million of expected positive return on plan investments that is used in the computation of pension expense for 2002, the plan investment reported an actual loss of $(1,230) million. 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 bonds 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 use 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 $(2,536) million at the end of 2002. Pension obligations are $12,097 million and pension assets are $9,561 million. In contrast to the net pension obligation indicated by the negative funded status, Dow Chemical reports a net pension asset on its balance sheet in the amount of $394 million at the end of 2002. This is because some of the pension obligation relating to actuarial losses ($2,796 million) and unamortized prior service costs ($132 million) are not yet reflected on- balance sheet. ©Cambridge Business Publishers, 2006 20 Financial Accounting for MBAs, 2nd Edition
    • These liabilities arose because of changes in the assumptions used to compute the pension obligation or changes in the pension plan itself. GAAP allows companies to recognize these changes gradually over a period of time. This is another of the smoothing mechanisms that have been built into GAAP that are designed to minimize the impact of pension plans on the balance sheet and the income statement. e. Since the pension obligation is the present value of expected pension payments, a reduction in the discount rate increases 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 a reduction in the discount rate is to apply a lower discount rate to a higher pension obligation. These two effects are offsetting and it is not clear which will dominate. f. The increase in expected return unambiguously increases profitability as pension cost is reduced. This is because the long-term rate is used to compute the dollar amount of expected return that is an off-set in the computation of pension expense. ©Cambridge Business Publishers, 2006 Solutions Manual, Module 9 21