Acct 328 Exam 2

depreciation period

(asset/liability accounting) One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the period of depreciation. If the lease agreement transfers ownership of the asset to Delta (criterion 1) or contains a bargain-purchase option (criterion 2), Delta depreciates the aircraft consistent with its normal depreciation policy for other aircraft, *using the economic life of the asset*. On the other hand, if the lease does not transfer ownership or does not contain a bargain-purchase option, then Delta *depreciates it over the term of the lease*. In this case, the aircraft reverts to ILFC after a certain period of time.

effective-interest method

(asset/liability accounting) Throughout the term of the lease, Delta uses the __ to allocate each lease payment between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obligation. When applying the effective-interest method to capital leases, Delta must use the same discount rate that determines the present value of the minimum lease payments

asset and liability recorded

(asset/liability accounting) Under the capital lease method, Delta treats the lease transaction as if it purchases the aircraft in a financing transaction. That is, Delta acquires the aircraft and creates an obligation. Therefore, it records a capital lease as an asset and a liability at the lower of *(1) the present value of the minimum lease payments (excluding executory costs)* or *(2) the fair value of the leased asset at the inception of the lease*. The rationale for this approach is that companies should not record a leased asset for more than its fair value.

future tax rates

(tax rate consideration) What happens if tax rates are expected to change in the future? In this case, a company should use the *enacted tax rate* expected to apply. Therefore, a company must consider presently enacted changes in the tax rate that become effective for a particular future year(s) when determining the tax rate to apply to existing temporary differences. If new rates are not yet enacted for future years, you should use the current rate. In determining the appropriate enacted tax rate for a given year, companies must use the *average tax rate*

revision of future tax rates

(tax rate consideration) When a change in the tax rate is enacted, companies should record its effect on the existing deferred income tax accounts immediately. A company reports the effect as an adjustment to income tax expense in the period of the change

NOL accounting (net operating losses)

A __ occurs for tax purposes in a year when tax-deductible expenses exceed taxable revenues. An inequitable tax burden would result if companies were taxed during profitable periods without receiving any tax relief during periods of net operating losses. Under certain circumstances, therefore, the federal tax laws permit taxpayers to use the losses of one year to offset the profits of other years. Companies accomplish this income-averaging provision through the carryback and carryforward of net operating losses. Under this provision, a company pays no income taxes for a year in which it incurs a net operating loss.

loss carryforward

A company may forgo the loss carryback and use only the __ option, offsetting future taxable income for up to 20 years. If a carryback fails to fully absorb a net operating loss, or if the company decides not to carry the loss back, then it can carry forward the loss for up to 20 years. Because companies use carryforwards to offset future taxable income, the tax effect of a loss carryforward represents future tax savings. Realization of the future tax benefit depends on future earnings, an uncertain prospect

lease players

A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. In return for the use of the property, the lessee makes rental payments over the lease term to the lessor. Who are the lessors that own this property? They generally fall into one of three categories: 1. Banks. 2. Captive leasing companies. 3. Independents.

incremental borrowing rate

A lessee, like Delta, generally computes the present value of the minimum lease payments using its incremental borrowing rate. This rate is defined as: "The rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease." To determine whether the present value of these payments is less than 90 percent of the fair value of the property, Delta discounts the payments using its incremental borrowing rate. Determining the incremental borrowing rate often requires judgment because the lessee bases it on a hypothetical purchase of the property.

depreciation concept

Although Delta computes the amounts initially capitalized as an asset and recorded as an obligation at the same present value, the depreciation of the aircraft and the discharge of the obligation are independent accounting processes during the term of the lease. It should depreciate the leased asset by applying conventional depreciation methods: straight-line, sum-of-the-years'-digits, declining-balance, units of production, etc. The FASB uses the term "amortization" more frequently than "depreciation" to recognize intangible leased property rights. We prefer "depreciation" to describe the write-off of a tangible asset's expired services

income statement presentation

Circumstances dictate whether a company should add or subtract the change in deferred income taxes to or from income taxes payable in computing income tax expense. For example, a company adds an increase in a deferred tax liability to income taxes payable. On the other hand, it subtracts an increase in a deferred tax asset from income taxes payable. *[ Income taxes payable/refundable +- Changes in deferred income taxes = total income tax expense or benefit ]*

valuation allowance

Companies recognize a deferred tax asset for all deductible temporary differences. However, based on available evidence, a company should reduce a deferred tax asset by a __ if it is more likely than not that it will not realize some portion or all of the deferred tax asset. "More likely than not" means a level of likelihood of at least slightly more than 50 percent. Simultaneously establishes a valuation allowance to recognize the reduction in the carrying amount of the deferred tax asset; then you evaluate this allowance account at the end of each accounting period. Should consider all available evidence, both positive and negative, to determine whether, based on the weight of available evidence, it needs a __.

deferred tax liability

Created when income tax expense is greater than taxes payable; represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year. This computation indicates that income tax expense has two components—*current tax expense* (the amount of income taxes payable for the period) and deferred tax expense. *Deferred tax expense* is the increase in the deferred tax liability balance from the beginning to the end of the accounting period.

implicit interest rate

However, there is one exception to this rule. If (1) Delta knows the implicit interest rate computed by ILFC and (2) it is less than Delta's incremental borrowing rate, then Delta must use ILFC's implicit rate. What is the interest rate implicit in the lease? It is the discount rate that, when applied to the minimum lease payments and any unguaranteed residual value accruing to the lessor, causes the aggregate present value to equal the fair value of the leased property to the lessor. The purpose of this exception is twofold. First, the implicit rate of ILFC is generally a more realistic rate to use in determining the amount (if any) to report as the asset and related liability for Delta. Second, the guideline ensures that Delta does not use an artificially high incremental borrowing rate that would cause the present value of the minimum lease payments to be less than 90 percent of the fair value of the aircraft. Use of such a rate would thus make it possible to avoid capitalization of the asset and related liability

accounting by the lessee

If Delta Airlines (the lessee) capitalizes a lease, it records an asset and a liability generally equal to the present value of the rental payments. ILFC (the lessor), having transferred substantially all the benefits and risks of ownership, recognizes a sale by removing the asset from the balance sheet and replacing it with a receivable. Lessee JE - [Dr Leased Equipment, Cr Lease Liability] Lessor JE - [Dr Lease Receivable, Cr Equipment] Delta does not capitalize the lease, it does not record an asset, nor does ILFC remove one from its books. When Delta makes a lease payment, it records rental expense; ILFC recognizes rental revenue.

arguments against capital leases

Many companies believe that capital leases negatively impact their financial position: Their debt to total equity ratio increases, and their rate of return on total assets decreases. As a result, the business community resists capitalizing leases. Whether this resistance is well founded is debatable. From a cash flow point of view, the company is in the same position whether accounting for the lease as an operating or a capital lease. Managers often argue against capitalization for several reasons. First, capitalization can more easily lead to violation of loan covenants. It also can affect the amount of compensation received by owners (for example, a stock compensation plan tied to earnings). Finally, capitalization can lower rates of return and increase debt to equity relationships, making the company less attractive to present and potential investors

executory costs

Like most assets, leased tangible assets incur insurance, maintenance, and tax expenses—called __—during their economic life. If ILFC retains responsibility for the payment of these "ownership-type costs," it should exclude, in computing the present value of the minimum lease payments, a portion of each lease payment that represents __. They do not represent payment on or reduction of the obligation. Many lease agreements specify that the lessee directly pays executory costs to the appropriate third parties. In these cases, the lessor can use the rental payment without adjustment in the present value computation.

income tax accounting objectives

One objective of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year. A second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events already recognized in the financial statements or tax returns

permanent differences

Some differences between taxable income and pretax financial income are permanent. Permanent differences result from items that (1) enter into pretax financial income but never into taxable income, or (2) enter into taxable income but never into pretax financial income. Congress has enacted a variety of tax law provisions to attain certain political, economic, and social objectives. Some of these provisions exclude certain revenues from taxation, limit the deductibility of certain expenses, and permit the deduction of certain other expenses in excess of costs incurred. A corporation that has tax-free income, nondeductible expenses, or allowable deductions in excess of cost, has an effective tax rate that differs from its statutory (regular) tax rate. Since permanent differences affect only the period in which they occur, they do not give rise to future taxable or deductible amounts. As a result,* companies recognize no deferred tax consequences*

advantages of leasing

The growth in leasing indicates that it often has some genuine advantages over owning property, such as: 1) 100% financing at fixed rates 2) protection against obsolescence 3) flexibility 4) less costly financing 5) tax advantages 6) off-balance-sheet financing

loss carryback

Through use of a __, a company may carry the net operating loss back two years and receive refunds for income taxes paid in those years. The company must apply the loss to the earlier year first and then to the second year. It may carry forward any loss remaining after the two year carryback up to 20 years to offset future taxable income

lease accounting problems

To avoid leased asset capitalization, companies design, write, and interpret lease agreements to prevent satisfying any of the four capitalized lease criteria. Companies can easily devise lease agreements in such a way, by meeting the following specifications: 1) Ensure that the lease does not specify the transfer of title of the property to the lessee 2) Do not write in a bargain-purchase option 3) set the lease term at something less than 75% of the estimate economic life of the leased property 4) Arrange for the present value of the minimum lease payments to be less than 90% of the FV of the leased property.

operating method (lessee)

Under the __, rent expense (and the associated liability) accrues day by day to the lessee as it uses the property. The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting, any commitments to make future payments. The lessee makes appropriate accruals or deferrals if the accounting period ends between cash payment dates. Sterling does not report the loader, as well as any long-term liability for future rental payments, on the balance sheet. Sterling reports rent expense on the income statement. And, as discussed later in the chapter, Sterling must disclose all operating leases that have noncancelable lease terms in excess of one year.

uncertain tax positions

Whenever there is a contingency, companies determine if the contingency is probable and can be reasonably estimated. If both of these criteria are met, the company records the contingency in the financial statements. These guidelines also apply to uncertain tax positions. They are tax positions for which the tax authorities may disallow a deduction in whole or in part. __ often arise when a company takes an aggressive approach in its tax planning. Examples are instances in which the tax law is unclear or the company may believe that the risk of audit is low. Uncertain tax positions give rise to tax benefits either by reducing income tax expense or related payables or by increasing an income tax refund receivable or deferred tax asset.

direct-financing leases

__ are in substance the financing of an asset purchase by the lessee. In this type of lease, the lessor records a lease receivable instead of a leased asset. The lease receivable is the present value of the minimum lease payments. Remember that "minimum lease payments" include: 1) Rental payments (excluding executory costs) 2) Bargain-purchase option 3) Guaranteed residual value 4) Penalty for failure to renew

pretax financial income

__ is a financial reporting term. It also is often referred to as income before taxes, income for financial reporting purposes, or income for book purposes. Companies determine pretax financial income according to GAAP. They measure it with the objective of providing useful information to investors and creditors.

deductible temporary differences

are temporary differences that will result in deductible amounts in future years, when the related book liabilities are settled; give rise to recording deferred tax assets

taxable temporary differences

are temporary differences that will result in taxable amounts in future years when the related assets are recovered; give rise to recording deferred tax liabilities

capitalization criteria

criteria applying to the lessee for capitalization: 1) Transfer of ownership test 2) Bargain-purchase option test (significantly under FV) 3) Economic life test (75%) 4) Recovery of investment test (90%)

classification of leases by the lessor

for accounting purposes, the lessor may classify leases as one of the following: 1) Operating leases 2) Direct-financing leases 3) Sales-type leases (involves dealer profit)

taxable income

is a tax accounting term. It indicates the amount used to compute income taxes payable. Companies determine taxable income according to the Internal Revenue Code (the tax code). Income taxes provide money to support government operations.

temporary difference

is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements, which will result in taxable amounts or deductible amounts in future years. *Taxable amounts* increase taxable income in future years; *Deductible amounts* decrease taxable income in future years.

originating temporary difference

is the initial difference between the book basis and the tax basis of an asset or liability, regardless of whether the tax basis of the asset or liability exceeds or is exceeded by the book basis of the asset or liability.

reversing temporary difference

on the other hand, occurs when eliminating a temporary difference that originated in prior periods and then removing the related tax effect from the deferred tax account.

capitalization of leases

opinion differs over how to report these transactions, the various views on __ are as follows: 1) do not capitalize any leased assets 2) capitalize leases that are similar to installment purchases 3) capitalize all long-term leases 4) capitalize firm leases where the penalty for nonperformance is substantial. The FASB apparently agrees with the capitalization approach when the lease is similar to an installment purchase: It notes that Delta should capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable. Noncancelable means that Delta can cancel the lease contract only upon the outcome of some remote contingency, or that the cancellation provisions and penalties of the contract are so costly to Delta that cancellation probably will not occur.

special accounting problems

the features of lease arrangements that cause unique accounting problems are: 1) Residual values 2) Sales-type leases (lessor) 3) Bargain-purchase options 4) Initial direct costs 5) Current versus noncurrent classification 6) Disclosure

accounting by the lessor

there are three important benefits available to the lessor: 1) interest revenue 2) tax incentives 3) high residual value (to resell)

deferred tax asset

when taxes payable (tax return) greater than income tax expense (income statement) due to temporary difference; represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year; a temporary difference also known as future deductible amount. The deferred tax benefit results from the increase in the deferred tax asset from the beginning to the end of the accounting period. The deferred tax benefit is a negative component of income tax expense

capital vs operating lease

while the total charges to operations are the same over the lease term whether accounting for the lease as a capital lease or as an operating lease, under the capital lease treatment the charges are higher in the earlier years and lower in the later years. The following differences occur if using a capital lease instead of an operating lease: 1) An increase in the amount of reported debt (both short-term and long-term) 2) An increase in the amount of total assets (specifically long-lived assets) 3) A lower income early in the life of the lease and, therefore, lower R/E