Accounting Theory Final

CHAPTER 17

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CHAPTER 20

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CHAPTER 21A

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Explain the following concepts: (a) bargain purchase option and (b) bargain renewal option.

A bargain purchase option is a lease purchase option in which the lessee can buy the asset for a price that is significantly lower than the underlying asset's expected fair value at the date the option becomes exercisable, thus making the exercise of the option reasonably certain. A bargain renewal option is essentially the same conceptually as a bargain purchase option, except the option is to renew the lease as opposed to purchasing the asset. That is, a bargain renewal option is an option in which the price of renewal at which the lessee can buy the asset is significantly lower than the underlying asset's expected fair value at the date the option becomes exercisable, thus making the exercise of the option reasonably certain. A bargain purchase option and a bargain renewal option have similar impacts on the initial classification and measurement of the lease. With respect to classification, the existence of a bargain purchase option is one way a lease can meet the finance/sales-type lease classification criteria. In the case of a bargain renewal option, the additional lease term that would be added by exercising the option should be included in the lease term when assessing whether or not the lease meets the lease term test. The present value of the option price would also be used in assessing whether the lease met the present value test. For measurement purposes, the present value of both a bargain purchase option and a bargain renewal option should be included in the initial value of the lease liability and right-of-use asset.

What is the purpose of a cash flow hedge?

A cash flow hedge is used to hedge exposures to cash flow risk, which is exposure to the variability in cash flows. The cash flows received on the hedging instrument (derivative) will offset the cash flows received on the hedged item. Generally, the hedged item is a transaction that is planned some time in the future (an anticipated transaction).

Differentiate between a defined contribution pension plan and a defined benefit pension plan. Explain how the employer's obligation differs between the two types of plans.

A defined-contribution plan specifies the employer's contribution to the plan usually based on a formula, which may consider such factors as age, length of service, employer's profit, or compen¬sation levels. A defined-benefit plan specifies a determinable pension benefit that the employee will receive at a time in the future. The employer must determine the amount that should be contributed now to provide for the future promised benefits. In a defined-contribution plan, the employer's obligation is simply to make a contribution to the plan each year based on the plan formula. The benefit of gain or risk of loss from assets con¬tributed to the plan is borne by the employee. In a defined-benefit plan, the employer's obligation is to make sufficient contributions each year to provide for the promised future benefits. Therefore, the employer is at risk to the extent that contributions will not be adequate to meet the promised benefits.

Describe the accounting for actuarial gains and losses.

Actuarial gains or losses arise from (1) asset gains or losses (when the expected return is different than the actual return on plan assets) and (2) a liability gain or loss (when actuarial assumptions do not coincide with actual experiences related to computation of the projected benefit obligation.) In the period that they arise, these gains and losses are not recognized as part of pension expense, but are recognized as increases or decreases in other comprehensive income. In subsequent periods, these amounts are amortized into periodic pension expense over the remaining service lives of the employees, using corridor amortization.

What are the major differences between postretirement healthcare benefits and pension benefits?

Additionally, although healthcare benefits are generally covered by the fiduciary and reporting standards for employee benefit funds under ERISA, the stringent minimum vesting, participation, and funding standards that apply to pensions do not apply to healthcare benefits.

What is the role of an actuary relative to pension plans? What are actuarial assumptions?

An actuary's role is to ensure that the company has established an appropriate funding pattern to meet its pension obligations, to make predictions and assumptions about future events and conditions that affect pension costs, and to assist the accountant in measuring facets of the pension plan that must be reported (costs, liabilities and assets). In order to determine the company's pension obligation, the actuary must first determine the expected benefits that will be paid in the future. To accomplish this requires the actuary to make actuarial assumptions, which are estimates of the occurrence of future events affecting pension costs, such as mortality, withdrawals, disable¬ment and retirement, changes in compensation, and changes in discount rates to reflect the time value of money.

What is meant by the term "underlying" as it relates to derivative financial instruments?

An underlying is a special interest rate, security price, commodity price, index of prices or rates, or other market-related variable. Changes in the underlying determine changes in the value of the derivative. Payment is determined by the interaction of the underlying with the face amount and the number of shares, or other units specified in the derivative contract (these elements are referred to as notional amounts).

Explain how cash-basis accounting for pension plans differs from accrual-basis accounting for pension plans. Why is cash-basis accounting generally considered unacceptable for pension plan accounting?

Cash-basis accounting recognizes pension cost as being equal to the amount of cash paid by the employer to the pension fund in any period; pension funding serves as the basis for expense recognition under the cash basis. Accrual-basis accounting recognizes pension cost as it is incurred and attempts to recognize pension cost in the same period in which the company receives benefits from the services of its employees. Frequently, the amount which an employer must fund for pension purposes during a particular period is unrelated to the economic benefits derived from the pension plan in that period. Cash-basis accounting recognizes the amount funded as periodic pension cost and the amount funded may be discretionary and vary widely from year to year. Funding is a matter of financial manage¬ment, based on working capital availability, tax considerations, and other matters unrelated to accounting considerations.

What is the meaning of "corridor amortization"?

Corridor amortization occurs when the accumulated OCI (G/L) balance gets too large. The gain or loss is too large when it exceeds the arbitrarily selected FASB criterion of 10% of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets. The excess gain or loss balance may be amortized using any systematic method but the amortization cannot be less than the amount computed using the straight-line method over the average remaining service-life of active employees expected to receive benefits.

Where are gains and losses related to cash flow hedges involving anticipated transactions reported?

Derivatives used in cash flow hedges are accounted for at fair value on the balance sheet but gains or losses are recorded in equity as part of other comprehensive income.

Describe the accounting procedures involved in applying the finance lease method by a lessee.

For a finance lease, the lessee records a right-of-use asset and lease liability at commencement of the lease. The lessee then recognizes interest expense on the lease liability over the life of the lease using the effective interest method and records amortization expense on the right-of-use asset generally on a straight line basis. A lessee therefore reports both interest expense and amortization of the right to use asset on the income statement. As a result, the total expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement. The lessee continues to amortize the right-of-use asset and decrease the principal of the lease liability until both are reduced to zero at the end of the lease. The right-of-use asset should be amortized over the lease term, unless there is a bargain-purchase option or ownership of the asset transfers to the lessee at the end of the lease. If either of these criteria are met, then the lessee amortizes the right-of-use asset over the economic life of the asset.

What are the main distinctions between a traditional financial instrument and a derivative financial instrument?

For a traditional financial instrument, an investor generally must pay the full cost, while derivatives require little initial investment. In addition, the holder of a traditional security is exposed to all risks of ownership, while most derivatives are not exposed to all risks associated with ownership in the underlying. For example, the intrinsic value of a call option only can increase in value. Finally, unlike a traditional financial instrument, the holder of a derivative could realize a profit without ever having to take possession of the underlying. This feature is referred to as net settlement and serves to reduce the transaction costs associated with derivatives.

Identify the lease classifications for lessors and the criteria that must be met for each classification. What is the relevance of revenue recognition criteria for lessor accounting for leases?

From the standpoint of the lessor, leases will (with few exceptions) be classified for accounting purposes as either (a) operating leases or (b) sales-type leases. A sales-type lease meets one or more of the following five tests: 1. The lease transfers ownership, 2. The lease contains a bargain-purchase option, 3. The lease term is a major part of the remaining economic life of the underlying asset (i.e. equal to 75% or more of the estimated economic life of the property), 4. The present value of the lease payments equals or exceeds substantially all of the underlying asset's fair value (i.e. 90% of the fair value of the property), 5. The asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. If none of the above five tests are met, the lease will be treated as an operating lease. The FASB concluded that by meeting any one of the lease classification tests, the lessor transfers control of the leased asset and therefore satisfies a performance obligation, which is required for revenue recognition under the FASB's recent standard on revenue. That is, if the lessee takes ownership or consumes a substantial portion of the underlying asset over the lease term, the lessor has in substance transferred control of the right-of-use asset and the lessor has a sales-type lease. On the other hand, if the lease does not transfer control of the asset over the lease term, the lessor generally uses the operating approach in accounting for the lease.

Bradley Co. is expanding its operations and is in the process of selecting the method of financing this program. After some investigation, the company determines that it may (1) issue bonds and with the proceeds purchase the needed assets, or (2) lease the assets on a long-term basis. Without knowing the comparative costs involved, answer these questions: (c) How will the balance sheet be different if Bradley Co. leases the assets rather than purchasing them?

Given the new reporting standard on leasing the financial statement effects of a long-term noncancelable lease versus the purchase of the asset are somewhat similar. That is assets under a long term lease are capitalized at the present value of the future lease payments and this value is probably equivalent to the purchase price of the assets. On the liability side, the bond payable amount would be equivalent to the present value of the future lease payments. In summary, the amounts presented in the balance sheet would be quite comparable. The description of the leased asset (right-of-use asset) and related liability would however be different than under a bond financing as would the general classifications; the specific labels (leased assets and lease liability) would be different.

Describe the effect on the lessee of a "bargain purchase option" on accounting for a finance lease transaction.

If a bargain-purchase option exists, the lessee must increase the present value of the lease payments by the present value of the option price. This is the case for both classification and initial measurement of the lease liability and right-of-use asset. A bargain purchase option also affects the period over which the right-of-use asset is amortized, since the lessee amortizes the asset over its economic life rather than the term of the lease. If the lessee fails to exercise the option, the lessee will recognize a loss to the extent of the book value of the right-of-use asset in the period that the option expired.

What factors must be considered by the actuary in measuring the amount of pension benefits under a defined benefit plan?

In measuring the amount of pension benefits under a defined-benefit pension plan, an actuary must consider such factors as mortality rates, employee turnover, interest and earnings rates, early retirement frequency, and future salaries.

From a lessee perspective, distinguish between a finance lease and an operating lease.

Lessees generally have two possible lease accounting methods: (a) the finance method and (b) the operating method. Under both methods, the lessee records a right-of-use asset and a related lease liability. However, the subsequent treatment of the right-of-use asset and lease liability differs under each method. For a finance lease, the lessee recognizes interest expense on the lease liability over the life of the lease using the effective interest method and records amortization expense on the right-of-use asset generally on a straight line basis. A lessee therefore reports both interest expense and amortization of the right to use asset on the income statement. In an operating lease the lessee also measures interest expense using the effective interest method. However the lessee amortizes the right-of-use asset, such that the total lease expense is the same from period to period. In other words for operating leases, only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement typically on a straight-line basis. To determine which method to apply, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset (i.e. if control transfers to the lessee). If the lease meets one of five classification tests to determine whether the arrangement is effectively a purchase of the underlying asset, the lease is treated as a finance lease. Otherwise, if none of the tests are met, the lessee is deemed to only obtain the right to use the asset (not ownership of the asset itself), and accounts for the lease as an operating lease.

How does an "asset gain or loss" develop in pension accounting? How does a "liability gain or loss" develop in pension accounting?

Liability gains and losses are unexpected gains or losses from changes in the projected benefit obligation. Liability gains (resulting from unexpected decreases) and liability losses (resulting from unexpected increases) are recognized in other comprehensive income. The accumulated gains and losses are then amortized to expense over the remaining service lives of active employees expected to receive benefits.

What are "liability gains and losses," and how are they accounted for?

Liability gains and losses are unexpected gains or losses from changes in the projected benefit obligation. Liability gains (resulting from unexpected decreases) and liability losses (resulting from unexpected increases) are recognized in other comprehensive income. The accumulated gains and losses are then amortized to expense over the remaining service lives of active employees expected to receive benefits.

Boey Company reported net income of $25,000 in 2018. It had the following amounts related to its pension plan in 2018: Actuarial liability gain $10,000; Unexpected asset loss $14,000; Accumulated other comprehensive income (G/L) (beginning balance), zero. Determine for 2018 (a) Boey's other comprehensive income, and (b) comprehensive income.

OCI 2018 Actuarial Liability Gain 10,000 -Asset Loss 14,000 =Other Comprehensive Loss 4,000 Computation of comprehensive income Net Income 25,000 +Other Comprehensive Loss 4,000 =Comprehensive income 21000

What are the major differences between postretirement healthcare benefits and pension benefits?

PENSIONS Funding: generally funded Benefit: Well-defined and level dollar amount Beneficiary: Retiree Benefit Payable: Monthly Predictability: Variables are reasonably predictable HEALTHCARE BENEFITS Funding: generally not funded Benefit: Generally uncapped and great variability Beneficiary: Retiree, spouse, other Benefit Payable: as needed and used Predictability: Utilization difficult to predict.

Paul Singer indicated that "all leases must now be capitalized on the balance sheet." Is this statement correct? Explain.

Paul Singer is for the most part correct. As long as the lease has a lease term of over 12 months, Paul is correct that the lease must be recognized on the balance sheet of the lessee. However, the new lease standard allows for a short-term lease exception. Under the short-term lease exception for lessees, rather than recording a right-of-use asset and lease liability, lessees may elect to expense the lease payments as incurred. In this case, the lease is not capitalized on the balance sheet as Paul suggested.

What are postretirement benefits other than pensions?

Postretirement benefits other than pensions include healthcare and other welfare benefits provided to retirees, their spouses, dependents, and beneficiaries. The other welfare benefits include life insurance offered outside a pension plan, dental care as well as medical care, eye care, legal and tax services, tuition assistance, day care, and housing activities.

Explain the difference between service cost and prior service cost.

Service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. Actuaries compute service cost at the present value of the new benefits earned by employees during the year. Prior service cost is the cost of retroactive benefits granted in a plan amendment or initiation of a pension plan. The cost of the retroactive benefits is the increase in the projected benefit obligation at the date of the amendment.

Morgan Handley and Tricia Holbrook are discussing the new leasing standard. Morgan believes the standard requires that the lessee use the implicit rate of the lessor in computing the present value of its lease liability. Tricia is not sure if Morgan is correct. Explain the discount rate that the lessee should use to compute its lease liability.

The discount rate used by the lessee in the present value test and for valuing the lease liability is the implicit interest rate used by the lessor. This rate is defined as the discount rate that, at the commencement of the lease, causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset. However, if it is impracticable for the lessee to determine the implicit rate of the lessor, the lessee should use its incremental borrowing rate. The incremental borrowing rate is the rate of interest the lessee would have to pay on a similar lease or incur to borrow over a similar term the funds necessary to purchase the asset.

Differentiate between "accounting for the employer" and "accounting for the pension fund."

The employer is the organization sponsoring the pension plan. The employer incurs the costs and makes contributions to the pension fund. Accounting for the employer involves: (1) allocating the cost of the pension plan to the proper accounting periods, (2) measuring the amount of pension obligation resulting from the plan, and (3) disclosing the status and effects of the plan in the financial statements. The pension fund or plan is the entity which receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the pension recipients. Accounting for the fund involves identifying receipts as contributions from the employer sponsor, income from fund investments, and computing the amounts due to individual pension recipients. Accounting for the pension costs and obligations of the employer is the topic of this chapter; accounting for the pension fund is not.

Identify the lease classification tests and how they are applied.

The five classification tests are the following: 1. Transfer of Ownership Test: if the lease transfers ownership of the asset to the lessee at the end of the lease term, it is a finance lease. 2. Lease Purchase Option Test: if it is reasonably certain that the lessee will exercise the option (i.e. it is a bargain purchase option), it is a finance lease. 3. Lease Term Test: when the lease term is a major part of the remaining economic life of the leased asset (often indicated by a guideline of 75% or more of the economic life of the asset), then the lease is a finance lease. 4. Present Value Test: if the present value of the lease payments (fixed payments + residual value guarantee + bargain-purchase option) is reasonably close to the fair value of the asset (often indicated by a guideline of 90% or more of the fair value of the asset), then the lease is a finance lease. 5. Alternative Use Test: if at the end of the lease term, the lessor does not have an alternative use for the asset, the lease is a finance lease.

Explain the difference in lessee income statement and balance sheet presentation for a finance versus an operating lease.

The income statement presentation differs between the operating and finance lease methods of accounting for the lessee. While both methods amortize the right-of-use asset and reduce the lease liability over the course of the lease, the accounts used and amounts recognized are different. Under the operating method, a lessee records the same amount for lease expense each period over the lease term, partially made up of interest expense from the lease liability and amortization expense on the right-of-use asset. While the total "Lease Expense" is composed of essentially two different components, only one expense account is used on the income statement to recognize those two components. In contrast, under the finance lease method, a lessee reports both interest expense and amortization of the right-of-use asset on the income statement. In addition, instead of a straight-line, constant expense period to period, the separate treatment of the right-of-use asset and lease liability leads to the total expense for the lease transaction being higher in the earlier years of the lease arrangement than at the end of the lease arrangement. The balance sheet presentation is similar between the two methods, in that both methods require the recognition of a lease liability and related right-of-use asset at the commencement of the lease. However, it is the subsequent amortization and reduction of lease liability and right-of-use asset that differs, as described in the income statement presentation above.

In computing the interest component of pension expense, what interest rates may be used?

The interest component is the interest for the period on the projected benefit obligation outstanding during the period. The assumed discount rate should reflect the rates at which pension benefits could be effectively settled (settlement rates). Companies should look to rates of return on high-quality fixed-income investments currently available whose cash flows match the timing and amount of the expected benefit payments.

What payments are included in the lease liability?

The lease liability is recorded at the present value of the lease payments. This includes the periodic rental payments made by the lessee, bargain-purchase option if any, and amounts probable to be owed under a residual value guarantee. The present value of the lease payments is recorded as a lease liability by the lessee.

Describe the accounting procedures involved in applying the operating lease method by a lessee.

The lessee records a right-of-use asset and lease liability at commencement of the lease. The lessee records the same amount for lease expense each period over the lease term (often referred to as the straight-line method). The straight-line amount to be recognized each period is computed by finding the total cost of the lease to the lessee and dividing the total cost by the number of periods in the lease term. To accomplish the goal of achieving a single operating cost that is constant from period to period, companies continue to use the effective interest method for amortizing the lease liability. However instead of reporting interest expense, a lessee reports interest on the lease liability as Lease Expense. In addition, the lessee no longer reports amortization expense related to the right-of-use asset. Instead it "plugs" in an amount that increases the Lease Expense amount so that it is constant from period to period. This plugged amount then reduces the right-of-use asset, such that both the asset and liability are amortized to zero at the end of the lease.

At the end of the current year, Pociek Co. has prior service cost of $9,150,000. Where should the prior service cost be reported on the balance sheet?

The prior service cost arising in the year of the amendment (which increases the projected benefit obligation) is recognized by an offsetting debit to Other Comprehensive Income (PSC). In subsequent periods, the $9,150,000 will be amortized into periodic pension expense over the remaining service lives of the employees. This approach is consistent with the treatment for actuarial gains and losses.

What is service cost, and what is the basis of its measurement?

The prior service cost arising in the year of the amendment (which increases the projected benefit obligation) is recognized by an offsetting debit to Other Comprehensive Income (PSC). In subsequent periods, the $9,150,000 will be amortized into periodic pension expense over the remaining service lives of the employees. This approach is consistent with the treatment for actuarial gains and losses.

What is the purpose of a fair value hedge?

The purpose of a fair value hedge is to offset the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment.

In what situation will the unrealized holding gain or loss on inventory be reported in income?

The unrealized holding gain or loss on inventory should be reported as income when this inventory is designated as a hedged item in a qualifying fair value hedge. If the hedge meets the special hedge accounting criteria (designation, documentation, and effectiveness), the unrealized holding gain or loss is reported as income.

What are the main distinctions between a traditional financial instrument and a derivative financial instrument?

Traditional Financial Instrument (e.g., Trading Security) -Payment Provision: Stock price times the number of shares. -Initial Investment Settlement: Investor pays full cost. Deliver stock to receive cash. Derivative Financial Instrument (e.g., Call Option) -Payment Provision: Change in stock price (underlying) times number of shares (notional amount). -Initial Investment Settlement: Initial investment is less than full cost. Receive cash equivalent, based on changes in stock price times the number of shares.

Explain the difference in lessor income statement presentation for a sales-type versus operating lease.

Under a sales-type lease, lessors report in the income statement Sales Revenue and Cost of Goods Sold (and resultant gross profit) at commencement of the lease. During the lease term interest Revenue on the Lease Receivable is reported. Under an operating lease, lessors report Lease Revenue (generally when payments are received) and Depreciation Expense on the leased asset.

Explain the accounting involved in applying the operating lease method by a lessor.

Under the operating method, each rental receipt of the lessor is recorded as lease revenue. The underlying leased asset is still recognized on the balance sheet of the lessor and depreciated in the normal manner. In addition to depreciation, any other related costs to the lease arrangement (i.e. insurance, maintenance, taxes, etc.) are recorded in the period incurred.

What is meant by "prior service cost"? When is prior service cost recognized as pension expense?

When a defined-benefit plan is either initiated or amended, credit is often given to employees for years of service provided before the date of initiation or amendment. The cost of these retroactive benefits are referred to as prior service cost. Employers grant retroactive benefits because they expect to receive benefits in the future. As a result, prior service cost should not be recognized as pension expense entirely in the year of amendment or initiation. It is recognized as an adjustment to other comprehensive income. It should be recognized during the service periods of those employees who are expected to receive benefits under the plan. Consequently, prior service cost is amortized over the service life of employees who will receive benefits and is a component of net periodic pension expense each period.

Wonda Stone read somewhere that a residual value guarantee is used for computing the present value of lease payments for lease classification purposes but is treated differently when measuring its lease liability. Is Wonda correct in her interpretation? Explain.

Wonda Stone is correct in her interpretation. For purposes of lease classification, the present value of the guaranteed residual value is used in determining whether the present value (90%) test is met. However, the amount included in the measurement of the lease liability is only the amount that the lessee expects to owe under the residual value guarantee at the end of the lease. For example, if a lessee guarantees a residual value of $10,000, but it is also probable that the lessee does not expect to owe any additional money at the end of the lease, then the guaranteed residual value would not be included in the initial measurement of the lease liability.

Describe the following terms: (a) residual value, (b) guaranteed residual value, and (c) initial direct costs.

(a) Residual value is the expected value of the leased asset at the end of the lease term. (b) A guaranteed residual value is a guarantee made to a lessor that the value of the leased asset returned to the lessor at the end of a lease will be at least a specified amount. Any amounts guaranteed under a residual value guarantee should be included in the present value test. (c) Initial direct costs are incremental costs of a lease that would not have been incurred had the lease not been executed. Initial direct costs incurred by the lessee are included in the cost of the right-of-use asset but are not recorded as part of the lease liability.