Exam 3 Conceptual Questions

29. What are "initial direct costs" and how are they accounted for by lessees and lessors?

Initial direct costs are the incremental costs of a lease that would not have been incurred had the lease not been executed. For the lessee, some costs that are included in the right-of-use asset are commissions, legal fees from the execution of the lease, lease documentation preparation costs incurred after the execution of the lease, and consideration paid for a guarantee of residual value by an unrelated third party. For operating leases, the lessor should defer initial direct costs and amortize them as expenses over the term of the lease. In a sales-type lease transaction, the lessor expenses the initial direct costs at lease commencement (in the period in which it recognizes the profit on the sale). An exception is when there is no selling profit or loss on the transaction, in which case the initial direct costs are deferred and recognized over the lease term.

21. 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.

4. The meaning of the term "fund" depends on the context in which it is used. Explain its meaning when used as a noun. Explain its meaning when it is used as a verb.

When the term "fund" is used as a noun, it refers to assets accumulated in the hands of a funding agency for the purpose of meeting pension benefits when they become due. When the term "fund" is used as a verb, it means to pay over to a funding agency (as to fund future pension benefits or to fund pension cost).

2. State how each of the following items is reflected in the financial statements. a. Change from FIFO to LIFO method for inventory valuation purposes. b. Charge for failure to record depreciation in a previous period. c. Litigation won in current year, related to prior period. d. Change in the realizability of certain receivables. e. Write-off of receivables. f. Change from the percentage-of-completion to the completed-contract method for reporting net income.

(a) Change in accounting principle; retrospective application is generally not made because it is impracticable to determine the effect of the change on prior years. The FIFO inventory amount is therefore generally the beginning inventory in the current period. (b) Correction of an error and therefore prior period adjustment; adjust the beginning balance of retained earnings. (c) Increase income for litigation settlement, assuming it was not accrued. (d) Change in accounting estimate; currently and prospectively. Part of operating section of income statement. (e) Reduction of accounts receivable and the allowance for doubtful accounts. (f)Change in accounting principle; retrospective application to prior period financial statements

9. Identify the five components that comprise pension expenses. Briefly explain the nature of each component.

**9. The five components of pension expense are: (1) Service cost—the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. (2) Interest cost—the increase in the projected benefit obligation as a result of the passage of time. (3) Actual return on plan assets—the reduction in pension cost for actual investment income from plan assets and the change in the market value of plan assets. (4) Amortization of prior service cost—the cost of retroactive benefits granted in a plan amendment (including initiation of a plan). (5) Gains and losses—a change in the value of either the projected benefit obligation or the plan assets resulting from experience different from that assumed or expected or from a change in an actuarial assumption. Note: Regarding return on plan assets, the final component is expected rate of return. We are assuming above that an adjustment is made to the actual return to determine expected return.

2. 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: a. What are the possible advantages of leasing the assets instead of owning them? b. What are the possible disadvantages of leasing the assets instead of owning them? c. How will the balance sheet be different if Bradley Co. leases the assets rather than purchasing them?

. (a) Possible advantages of leasing for the lessee: 1. Leasing may be more flexible in that the lease agreement may contain less restrictive provisions than the bond indenture. 2. Leasing permits 100% financing of assets, as the lease is often signed without requiring any money down from the lessee. 3. Leasing may permit more rapid changes in equipment, reduce the risk of obsolescence, and pass the risk in residual value to the lessor or a third party. 4. Leasing may have favorable tax advantages. (b) Assuming that funds are readily available through debt financing, there may not be great advantages (in addition to the above-mentioned) to signing a noncancelable, long-term lease. One additional advantage of leasing is its availability when other debt financing is unavailable. (c) 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.

6. 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.

6. 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.

15. Discuss and illustrate how a correction of an error in previously issued financial statements should be handled.

A correction of an error in previously issued financial statements should be handled as a prior-period adjustment. Thus, such an error should be reported in the year that it is discovered as an adjustment to the beginning balance of retained earnings. In addition, if comparative statements are presented, the prior periods affected by the error should be restated. The disclosures need not be repeated in the financial statements of subsequent periods. As an illustration, assume that credit sales of $40,000 were inadvertently overlooked at the end of 2019. When the error was discovered in a subsequent period, the appropriate entry to record the correction of the error would have been (ignoring income tax effects): Accounts Receivable..................................................................................... 40,000 Retained Earnings................................................................................. 40,000

2. 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-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 contributed to the plan is borne by the employee. In a defined-benefit plan, the employer's obligationis 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.

What is a short-term lease? Describe lessee accounting for a short-term lease.

A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less. Rather than recording a right-of-use asset and lease liability, lessees may elect to expense lease payments as incurred.

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

An asset gain occurs when the actual return on the plan assets is greater than the expected return on plan assets while an asset loss occurs when the actual return is less than the expected return on the plan assets. A liability gain results from unexpected decreases in the pension obligation and a liability loss results from unexpected increases in the pension obligation.

7. Unlike the other major financial statements, the statement of cash flows is not prepared from the adjusted trial balance. From what sources does the information to prepare this statement come, and what information does each source provide?

Comparative balance sheets, a current income statement, and certain transaction data all provide information necessary for preparation of the statement of cash flows. Comparative balance sheets indicate how assets, liabilities, and equities have changed during the period. A current income statement provides information about the amount of cash provided from operating activities. Certain transactions provide additional detailed information needed to determine whether cash was provided or used during the period.

18. 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.

18. Stan Conner and Mark Stein were discussing the presentation format of the statement of cash flows of Bombeck Co. At the bottom of Bombeck's statement of cash flows was a separate section entitled "Noncash investing and financing activities." Give three examples of significant noncash transactions that would be reported in this section.

Examples of noncash transactions are (1) issuance of stock for noncash assets, (2) issuance of stock to liquidate debt, (3) issuance of bonds or notes for noncash assets, and (4) noncash exchanges of property, plant, and equipment.

6. 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.

3. Differentiate between investing activities, financing activities, and operating activities.

Investing activities generally involve long-term assets and include (1) lending money and collecting on those loans and (2) acquiring and disposing of investments and productive long-lived assets. Financing activities, on the other hand, involve liability and stockholders' equity items and include (1) obtaining cash from creditors and repaying the amounts borrowed and (2) obtaining capital from owners and providing them with a return on their investment. Operating activities include all transactions and events that are not investing and financing activities. Operating activities involve the cash effects of transactions that enter into the determination of net income.

4. 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.

23. Describe the reporting of pension plans for a company with multiple plans, some of which are underfunded and some of which are overfunded.

Multiple plans may be combined and shown as one amount on the balance sheet, only if they are in the same under or overfunded position. For example, if the company has two or more under-funded (overfunded) plans, the underfunded (overfunded) plans are combined and shown as one amount as a liability (asset) on the balance sheet. The FASB rejected the alternative of combining all plans and representing the net amount as a single net asset or net liability. The rationale: A company does not have the ability to offset the excess of one plan against underfunded obligations of another plan. Furthermore, netting all plans is inappropriate because offsetting assets and liabilities is not permitted under GAAP unless a right of offset exists.

*26. 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.

17. Elliott Corp. failed to record accrued salaries for 2019, $2,000; 2020, $2,100; and 2021, $3,900. What is the amount of the overstatement or understatement of Retained Earnings at December 31, 2022?

Retained earnings is correctly stated at December 31, 2022. Failure to accrue salaries in earlier years is a counterbalancing error that has no effect on 2022 ending retained earnings.

12. 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.

2. Of what use is the statement of cash flows?

Some uses of this statement are: Assessing future cash flows: Income data when augmented with current cash flow data provide a better basis for assessing future cash flows. Assessing reasons for differences between income and net cash flow from operations: Some believe that cash flow information is more reliable than income information because income involves a number of assumptions, estimates, and valuations. Assessing operating capability: Whether a company is able to maintain its operating capability, provide for future growth, and distribute dividends to the owners depends on whether adequate cash is being or will be generated. Assessing financial flexibility and liquidity: Cash flow data indicate whether a company should be able to survive adverse operating problems and whether a company might have difficulty in meeting obligations as they become due, paying dividends, or meeting other recurring costs. Providing information on cash and non-cash investing and financing activities: Cash flows are classified by their effect on balance sheet items; investing activities affect long-term assets while financing activities affect liabilities and stockholders' equity.

4. Identify and describe the approach the FASB requires for reporting changes in accounting principles.

The FASB believes that the retrospective approach provides financial statement users the most useful information. Under this approach, the prior statements are changed on a basis consistent with the newly adopted standard; any cumulative effect of the change for prior periods is recorded as an adjustment to the beginning balance of retained earnings of the earliest period reported.

5. 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.

11. 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.

11. 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.

13. Identify the amounts included in the measurement of the right-of-use asset.

The right-of-use asset is initially measured as the same amount as the lease liability (i.e. present value of lease payments), adjusted for initial direct costs, prepayments and lease incentives. Initial direct costs paid by the lessee will increase the initial value of the right-of-use asset. Similarly, prepaid rent paid by the lessee will increase the amount of the right-of-use asset recorded. Lease incentives granted to the lessee by the lessor will decrease the initial value of the right-of-use asset.

7. Lenexa State Bank has followed the practice of capitalizing certain marketing costs and amortizing these costs over their expected life. In the current year, the bank determined that the future benefits from these costs were doubtful. Consequently, the bank adopted the policy of expensing these costs as incurred. How should the bank report this accounting change in the comparative financial statements?

This is an example of a situation in which it is difficult to differentiate between a change in accounting principle and a change in estimate. In such a situation, the change should be considered a change in estimate, and accordingly, should be handled currently and prospectively. Thus, all costs presently capitalized and viewed as providing doubtful future values should

14. Explain how the amount of cash payments to suppliers is computed under the direct method.

To determine cash payments to suppliers, it is first necessary to find purchases for the year. To find purchases, cost of goods sold is adjusted for the change in inventory (increased when inventory increases or decreased when inventory decreases). After purchases are computed, cash payments to suppliers are determined by adjusting purchases for the change in accounts payable. An increase (decrease) in accounts payable is deducted from (added to) purchases to determine cash payments to suppliers.

12. How should consolidated financial statements be reported this year when statements of individual companies were presented last year?

Where individual company statements were reported in prior years and consolidated financial statements are to be prepared this year, the following reporting and disclosure practices should be implemented: (1) The financial statements of all prior periods presented should be restated to show the financial information for the new reporting entity for all periods. (2) The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it. (3) The effect of the change on income from continuing operations, net income, and earnings per share amounts should be disclosed for all periods presented.

12. 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.