Deck 10: Reporting and Analyzing Leases, Pensions, and Income Taxes

Question 1

Operating leases appear as assets on the lessee's balance sheet.

Answer 1

False

Question 2

Failure to capitalize leases has very little effect on a company's return on equity (ROE) ratio.

Answer 2

True

Question 3

The defined contribution plan and the defined benefit plan both recognize pension expense at the accrual of the liability.

Answer 3

False

Question 4

The increase in pension obligation due to an employee working an additional year for the employer will cause the net pension liability on the balance sheet to increase but have no direct effect on the income statement.

Question 5

Leases are often a better financing vehicle than traditional bank loans because leases often require less equity investment.

Question 6

Failure to recognize leases as capital leases rather than operating leases results in understated profit for a company in the early year's a lease.

Question 7

Operating leases increase interest expense in the income statement, while decreasing net cash flows in the cash flow statement, compared with capital leases.

Question 8

GAAP permits companies to choose to report pension income based either on actual investment returns of pension investments or on expected returns.

Question 9

Companies are required to report total pension assets and total pension liabilities on their balance sheets.

Question 10

Off-balance-sheet financing instruments are not reported on the financial statements or the footnotes to those statements.

Question 11

IFRS classifies more leases as finance leases that are reported on the balance sheet than those capitalized under U.S. GAAP.

Question 12

Both IFRS and U.S. GAAP require companies to report the funded status of defined benefit pension plans on the balance sheet.

Question 13

How are operating leases reported in the lessee's financial statements?
I. As an asset that is depreciated, similar to the company's other assets
II. As a footnote disclosure
III. As either a short-term or long-term liability, depending on the length of the lease

A) I and II
B) II and III
C) I only
D) II only

Question 14

GAAP identifies two different approaches in reporting leases by the lessee: capital lease method and the operating lease method.
Which option best describes the financial statement effects of leasing on the financial statements of the lessee?

A)
B)
C)
D)

Question 15

Which of the following is not a factor that changes a company's pension obligation during the year?

A) Service cost
B) Benefits paid
C) Interest cost
D) Contributions to the pension plan

Question 16

Which of the following is not a benefit of utilizing operating leases for the lessee?

A) Lease liability is not reported on the balance sheet
B) Measures of leverage are improved
C) NOPAT is higher
D) Net operating asset turnover is higher

Question 17

Failure to capitalize leased assets and liabilities when they should be capitalized results in a number of distortions in the ROE disaggregation analysis.
Which of the following is not a distortion?

A) Reported expense is lower in the early years of a capital lease relative to an operating lease, but is higher in later years.
B) Net operating asset turnover is overstated due to the non-reporting of leased assets.
C) Financial leverage is understated.
D) All of the above are distortions.

Question 18

Festival Corp. disclosed the following lease information in its 2016 annual report (in millions).
What lease liability does Festival's report on its balance sheet at December 31, 2016?

A) $21,644
B) $25,356
C) $47,000
D) Present value of operating lease payments, which must be calculated because it is not provided in the footnote above.

Question 19

Which of the following is a requirement under IFRS but not under U.S. GAAP?

A) Companies must report the funded status of their defined benefit pension plans on the balance sheet.
B) Companies must calculate the unfunded status as the PBO less the fair value of the plan assets and add back actuarial gains.
C) Companies must include interest cost as part of pension expense.
D) Companies must report current period pension expense on the income statement.

Question 20

Rosebud Corp. reported the following items in the 2016 pension footnote.
How much is the company's pension expense for the year?

A) $ 4,212
B) $ 1,252
C) $ 328
D) $ 452

Question 21

Rosebud Corp. reported the following items in the 2016 pension footnote.
How much is the increase in the company's pension obligation during the year?

A) $1,308
B) $1,432
C) $ 552
D) $2,108

Question 22

For a defined benefit plan, which of the following is correct?

A) The plan defines the contribution the employer is to make, with no promise concerning the ultimate payout to employees.
B) The plan requires that the pension expense and the cash funding amount be the same.
C) The plan requires that the employee bears the risk of loss or benefit of gain from assets contributed to the plan.
D) The plan defines the benefits that the employee will receive at retirement.

Question 23

The December 31, 2016 10-K filing for Great Golf Company provides the following footnote information for purchase obligations for the next five years:
Unconditional Purchase Obligations
During the normal course of its business, the Company enters into agreements to purchase goods and services, including purchase commitments for production materials, endorsement agreements with professional golfers and other endorsers, employment and consulting agreements, and intellectual property licensing agreements pursuant to which the Company is required to pay royalty fees. It is not possible to determine the amounts the Company will ultimately be required to pay under these agreements as they are subject to many variables including performance-based bonuses, reductions in payment obligations if designated minimum performance criteria are not achieved, the Company's sales levels, and severance arrangements. As of December 31, 2016, the Company has entered into many of these contractual agreements with terms ranging from one to six years. The minimum obligation that the Company is required to pay under these agreements is $158,436,000 over the next six years. In addition, the Company also enters into unconditional purchase obligations with various vendors and suppliers of goods and services in the normal course of operations through purchase orders or other documentation or that are undocumented except for an invoice. Such unconditional purchase obligations are generally outstanding for periods less than a year and are settled by cash payments upon delivery of goods and services and are not reflected in this total. Future purchase commitments as of December 31, 2016, are as follows (in thousands):
No amounts are listed on Great Golf's balance sheet for commitments and contingencies. On its 2016 balance sheet, Great reported total liabilities and stockholders' equity of $1,275,272,000 and total stockholders' equity of $482,562,000.
If Great Golf reported the unconditional purchase obligations in its balance sheet, how would its debt-to-equity ratio change? (Ignore discounting.)

A) It would increase by 0.328
B) It would increase by 0.164
C) It would not change
D) Not enough information is provided to answer

Question 24

With respect to estimate changes in pension assumptions, an investment return increase will have what probable effect?

A) A decrease in the expected return on plan assets
B) A decrease in pension expense
C) Both A and B are correct.
D) None of these choices is correct.

Question 25

Use the following information to answer questions below
Caroline Company began operations in 2015. The company reported $128,000 of depreciation expense on its income statement in 2015 and $84,000 in 2016. On its tax returns, the company deducted $192,000 for depreciation in 2015 and $112,000 in 2016. The 2016 tax return shows a tax obligation (liability) of $132,000 based on a 40% tax rate.

-What is the temporary difference between the book value of depreciable assets and the tax basis of these assets at the end of 2015?

A) $12,800
B) $60,000
C) $32,000
D) $64,000

Question 26

Use the following information to answer questions below
Caroline Company began operations in 2015. The company reported $128,000 of depreciation expense on its income statement in 2015 and $84,000 in 2016. On its tax returns, the company deducted $192,000 for depreciation in 2015 and $112,000 in 2016. The 2016 tax return shows a tax obligation (liability) of $132,000 based on a 40% tax rate.

-What is the temporary difference between the book value of depreciable assets and the tax basis of these assets at the end of 2016?

A) $60,000
B) $92,000
C) $24,000
D) $ 4,000

Question 27

Use the following information to answer questions below
Caroline Company began operations in 2015. The company reported $128,000 of depreciation expense on its income statement in 2015 and $84,000 in 2016. On its tax returns, the company deducted $192,000 for depreciation in 2015 and $112,000 in 2016. The 2016 tax return shows a tax obligation (liability) of $132,000 based on a 40% tax rate.

-How much deferred tax liability will Caroline report at the end of 2015?

A) $32,000
B) $25,600
C) $12,800
D) $51,200

Question 28

Use the following information to answer questions below
Caroline Company began operations in 2015. The company reported $128,000 of depreciation expense on its income statement in 2015 and $84,000 in 2016. On its tax returns, the company deducted $192,000 for depreciation in 2015 and $112,000 in 2016. The 2016 tax return shows a tax obligation (liability) of $132,000 based on a 40% tax rate.

-What is Caroline's deferred tax liability at the end of 2016?

A) $36,800
B) $28,000
C) $88,000
D) $24,000

Question 29

Use the following information to answer questions below
Caroline Company began operations in 2015. The company reported $128,000 of depreciation expense on its income statement in 2015 and $84,000 in 2016. On its tax returns, the company deducted $192,000 for depreciation in 2015 and $112,000 in 2016. The 2016 tax return shows a tax obligation (liability) of $132,000 based on a 40% tax rate.

-What is Caroline's income tax expense for 2016?

A) $ 76,800
B) $143,200
C) $ 44,800
D) $ 99,200

Question 30

Which of the following is a significant item that is not recognized in the accounts and the financial statements?
I. Expected postretirement benefit obligation
II. Accumulated postretirement benefit obligation
III. Postretirement benefit plan assets

A) I and II
B) II and III
C) I only
D) I, II, and III

Question 31

Which one of the following statements is required by IFRS for reporting of leases, but not required for GAAP reporting?

A) Leases must be capitalized if the leased asset's risks and rewards are transferred to the lessee
B) Lease accounting is more principles based than rules based
C) Capitalizing a lease requires that the lessee depreciate the leased asset
D) Operating lease payments are reported as rent expense

Question 32

Festival Corp. disclosed the following footnote in its 2016 annual report related to its leasing activities.
The Company leases various buildings, computer and other equipment, and storage space under operating leases which expire on various dates through January 2037. Rent expense on these leases as well as other month to month rentals was $27,210, $19,081, and $15,012, for 2016, the 2015, and 2014, respectively.
A. What effect, if any, do operating leases have on Festival's 2016 balance sheet and income statement?
B. Would operating leases be considered an on or off-balance-sheet form of financing?

Question 33

Complete Foods Markets reports lease information in its 2016 annual report (in thousands). Excerpts follow:
The present values of future minimum obligations for capital leases shown above are calculated based on interest rates determined at the inception of the lease, or upon acquisition of the original lease.
What economic liability is omitted from Complete Foods' balance sheet? Describe the effect on assets, liabilities and equity if this liability was included on Complete Foods' balance sheet.

Question 34

La Grange Supply Company disclosed the following footnote regarding operating leases in its 2016 annual report:
Minimum rental commitments under non-cancelable operating leases are as follows:
La Grange Supply has an 8% discount rate.
If the operating lease is treated as a capital lease, by how much will total liabilities increase?

Question 35

Monongahela Corporation includes the following in its 2016 annual report (in thousands).
On an ongoing basis, we evaluate our estimates, including those related to the value of deferred acquisition costs, incentive compensation, income taxes, pension benefits and contingencies and litigation. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Our actual results may differ from these estimates under different assumptions or conditions.
A. What estimates does the company make when accounting for capital leases?
B. What estimates does the company make when accounting for defined benefit pensions?

Question 36

Pacific Northwest Sporting Goods reported annual depreciation on a newly acquired asset for 2016 in the amount of $80,000 using the straight-line method. For tax purposes, the company used the following schedule of depreciation expense:
Year 1: $144,000
Year 2: $116,000
Year 3: $ 92,000
Year 4: $ 84,000
Year 5: $ 64,000
Year 6: $ 56,000
Year 7: $ 48,000
Year 8: $ 36,000
Annual income before depreciation expense for each year is steady at $440,000 and the income tax rate is 35%. Show the financial statement effects relating to taxes in years 3 to 5 assuming taxes are paid at the same time they are accrued using the following template:

Question 37

Sweets Corp. reported the following items in the 2016 pension footnote. Use the information to calculate the pension expense for the year.

Question 38

Andersen Laboratories' 2016 annual report includes the following excerpt about its defined benefit plans (in millions):
A. What is service cost?
B. What is interest cost?
C. What pension payments did Andersen Labs' retired employees receive during the year?

Question 39

The following pension information was disclosed by Starbright International (000's):
Employee Benefit Plans
The company sponsors defined contribution retirement plans covering substantially all of its domestic employees and certain employees of its foreign subsidiaries. Contributions are determined at the discretion of the Board of Directors. Aggregate amounts charged to operations under the plans in 2016, 2015, and 2014 were $55,740, $58,400, and $46,576, respectively. In addition, certain foreign subsidiaries are required to provide benefits pursuant to government regulations.
A. How does Starbright account for its contributions to its retirement plan?
B. How is Starbright's obligation to its retirement plan reported on its balance sheet?

Question 40

The income tax footnote to the financial statements of Cucumber, Inc. for the year ending December 31, 2016 is as follows.
A. How much income tax expense is reported in Cucumber, Inc.'s income statement for 2016?
B. How much of the income tax expense is payable in cash in 2016?
C. Provide an example to explain how the deferred tax expenses could be positive in 2016?

Question 41

The following is an excerpt from Regina Company's 2016 annual report (in millions):
A. What is an operating lease?
B. Why does Regina include operating leases on its balance sheet?

Question 42

The following pension information was disclosed by Package Delivery Service (PDS):
A. Identify possible reasons that PDS might have decreased its discount rate in 2016.
B. What effect(s) did these changes have on PDS' income statement and balance sheet?

Question 43

The following is an excerpt from the Freight Train, Inc.'s 2016 annual report:
A. Calculate the debt-to-equity ratio for Freight Train, Inc. for 2016 and 2015.
B. Does Freight Train, Inc. include the net present value of operating leases in the debt reported on the balance sheet? Why or why not?
C. Recalculate the debt-to-equity ratio for Freight Train, Inc. for 2016 and 2015 under the assumption that leases were capitalized. Would capitalizing these leases significantly affect the company's debt to equity ratio? Is there a concern about the company's solvency?

Question 44

Festival Corp. disclosed the following lease information in its 2016 annual report related to its leasing activities.
A. What amount did Festival's report on its 2016 balance sheet related to leases?
B. Calculate the lease-related assets that are potentially missing from Festival's 2016 balance sheet. Assume a discount rate of 4%.

Question 45

The following is the leasing commitment information taken from Wharf Imports, Inc.'s 10-K report for March 31, 2016.
Wharf's total liabilities for 2016 are $640,168 thousand. What dollar adjustment(s) might you consider to Wharf's balance sheet for analysis purposes, given this information and assuming that Wharf's intermediate-term borrowing rate is 7%? Explain.

Question 46

DuPage Company is interested in leasing a machine and has identified the following possible lease that it may acquire.
Prior to making this decision and without the lease information, DuPage Company has the following amounts:
●Assets: $5,500,000
●Liabilities: $4,500,000
●Income before lease expenses: $750,000
●Income tax rate 35%
Prepare an independent analysis for the lease that includes the assets and liabilities sections of the balance sheet and an income statement, as well as a comparison of debt-to-equity ratios and return on asset ratios. Assume equity is $1,000,000 before considering the leases and $958,829 when considering the leases. Briefly summarize the effect on the two ratios.

Question 47

American Symbol Outfitters includes the following information about its operating leases in its fiscal 2016 annual report:
A. Calculate the present value of operating lease payments using a discount rate of 6%.
B. Assume that the leased equipment has a useful life of 8 years and no salvage value. Estimate the effect on profit before taxes of capitalizing these leases. Assume straight-line depreciation. Assume that rental expense in 2016 is the same as 2017 lease payments.
C. How would ROE and other financial ratios from the ROE decomposition be affected if these the company capitalized these operating leases?

Question 48

The following is an excerpt from the Freight Train, Inc. 2016 annual report:
A. Calculate the present value of operating lease payments using a discount rate of 7%.
B. Freight Train, Inc.'s net operating assets (NOA) were $ $55,230 million in 2016. If the operating leases were capitalized, what would net operating assets have been?

Question 49

M. A. Ivy Company reports the following in its 2016 annual report:
For 2015 and 2016, the Company incurred rent expense of $1,486 and $1,758 (in thousands), respectively.
A. Calculate the present value of operating lease payments using a discount rate of 4%.
B. M. A. Ivy Company's balance sheet reports total assets of $46,640,000 and total liabilities of $11,377,500. Calculate the change in the company's assets and liabilities with the operating leases being capitalized.
C. Assume that the leased equipment has a useful life of 12 years and no salvage value. Assume straight-line depreciation. Estimate the effect on net operating profit before tax in 2016, of capitalizing these operating leases.
D. Estimate the effect on interest expense of capitalizing these operating leases.

Question 50

The following pension information was disclosed by Bloomington, Inc. (in millions)
A. What is "service cost"? How does it affect Bloomington's total pension expense for the year?
B. Bloomington reports an actuarial loss of $327.6 million for 2016. What is this loss and how does Bloomington account for it?
C. How much did Bloomington contribute to the pension plan during 2016?
D. What amount of pension benefits were paid to former Bloomington employees during the year?
E. Explain the funded status of the pension plan in 2016 and compare it to the funded status in 2015. Are these amounts significant?

Question 51

The following pension information was disclosed by Worldwide Paper Inc. concerning its U.S. pension costs:
A. Briefly explain the following components of the company's pension expense for the year: service cost, interest cost, and actuarial loss.
B. Worldwide Paper reports an actual return on plan assets of $2,366 for 2016. Why is this different from the expected return of $1,506 million reported above?
C. What cash contribution did the company make to the pension plan during the year?
D. Comment on the three-year trend you observe for net pension expense. What explains the trend?

Question 52

What are deferred taxes? When do they arise?

Question 53

Discuss the concept of "income smoothing" that is built into GAAP as it relates to pensions.

Question 54

Discuss the various implications of the failure to capitalize operating assets when they should be capitalized.