2011
112. What is off-balance-sheet financing? How are they structured? How are they treated under U.S. GAAP
and IFRS.
OFF-BALANCE-SHEET FINANCING
Off-balance-sheet financing refers to obtaining cash, goods, or services without a formal borrowing
arrangement that U.S GAAP or IFRS recognizes as a liability on the balance sheet. The following explores the
rationale for off-balance-sheet financing, transaction structures that typically achieve off-balance-sheet
financing, and the responses of standard-setting bodies that require firms to recognize an increasing number and
variety of off-balance-sheet financing arrangements.
RATIONALE FOR OFF-BALANCE-SHEET FINANCING
Managers frequently cite these reasons, among others, for using off-balance sheet financing:
STRUCTURING OFF-BALANCE-SHEET FINANCING
Liabilities are present obligations of an entity to transfer assets or provide services to other entities in the future
as a result of past transactions and events. Many off-balance-sheet financings fall into one of two categories
that accounting typically does not recognize as liabilities: executory contracts and contingent obligations.
Executory Contracts
These are the accounting issues:
TREATMENT OF OFF-BALANCE-SHEET FINANCING ARRANGEMENTS UNDER U.S. GAAP AND
IFRS
U.S. GAAP and IFRS provide guidance for deciding whether a given financing arrangement appears as a
liability on the balance sheet or is disclosed in the notes. Many financing arrangements are complex, and the
authoritative guidance tends to relate to specific financing arrangements (for example, transfers of receivables,
TRANSFER OF RECEIVABLES IN EXCHANGE FOR CASH
A transfer of receivables is a common form of financing that sometimes achieves off- balance-sheet financing.
In more complicated financing arrangements, firms sell batches of receivables to a legally separate entity whose
sole purpose is to hold the receivables and issue claims on their cash flows. Common terminology refers to such
an entity as a special purpose entity, or SPE, or a variable interest entity, or VIE and to the firm that sells the
113. Describe the accounting for pension plan benefits.
RETIREMENT BENEFITS
Many employers provide retirement benefits to their employees, including pensions, health insurance, and life
insurance. U.S. GAAP and IFRS have similar provisions, although both standard-setting bodies currently have
projects underway to make changes in the required accounting.
RECOGNITION OF PENSION EXPENSE
The employer must recognize the cost of pension plans as an expense in some period. An important conceptual
question is whether the employer should recognize this cost as an expense:
U.S. GAAP and IFRS require firms to recognize the cost of pension plans as an expense during the years when
employees render services.
PENSION PLAN STRUCTURE AND DEFINITIONS
The structure of a typical pension plan is as follows:
The employer sets up a pension plan that is legally separate from the employer. The pension plan specifies the
eligibility of employees, the types of promises to employees, the method of funding, and the pension plan
administrator. Some employers promise to contribute a certain amount to the pension plan each period for each
employee (usually based on an employee’s salary), without specifying the benefits the employee will receive
during retirement. The amounts employees eventually receive depend on the investment performance of the
pension plan. Common terminology refers to such plans as defined contribution pension plans. In most defined
The typical benefit formula for a defined benefit plan takes into account both the employee’s length of service
and salary. For example, the employer might promise to pay an employee during retirement an annual pension
equal to a stated percentage (say, 2%) of the average annual salary during the employee’s five highest-paid
working years. In this example, an employee with 40 years of service receives an annual pension equal to 80%
of that employee’s average salary during the five highest-paid working years.
U.S. GAAP defines the primary measurement of the pension liability of the pension plan as the projected
benefit obligation (PBO)—the present value of the amount the pension plan expects to pay to employees during
retirement based on accumulated service but using the level of salary expected to serve as a basis for computing
pension benefits. IFRS uses similar measurement methods and terminology.
Projected Benefit Obligation (PBO) at Beginning of the Period
+ Increase in PBO for Interest
+ Increase in PBO for Current Employee Service (service cost)
+/– Actuarial Gains and Losses
– Payments to Retirees
= Projected Benefit Obligation (PBO) at End of the Period
The projected benefit obligation changes during a period for several reasons:
114. Describe the accounting for employer sponsored defined benefit pension plans.
EMPLOYER (SPONSOR) ACCOUNTING FOR A DEFINED BENEFIT PENSION PLAN
The funded status of a defined benefit pension plan on the employer’s balance sheet mirrors the overfunded or
underfunded status on the books of the pension plan on each balance sheet date. Differences between pension
assets and pension liabilities relate to funding policies of the employer, investment performance, changes in
actuarial assumption, and changes in the pension benefit formula. Pension plans measure and report pension
assets at fair values and measure and report pension liabilities using a current market interest rate for
high-quality, fixed-income investments. Thus, the amounts reported on the balance sheet of the employer and of
the pension fund reflect value changes as they occur.
Under both U.S. GAAP and IFRS, the following formula calculates the Net Pension Expense (or Credit) for a
defined benefit pension plan,:
Interest Cost (the increase in the obligation because of the passage of time)
+ Service Cost (the increase in the obligation because of an additional year of employee service)
– Expected Return on Pension Investments
+/– Amortization of Performance and Actuarial Gains and Losses
+/– Amortization of Prior Service Cost
Including interest cost as a positive amount and the expected return on pension investments as a negative
amount illustrates the extent to which expected earnings from pension investments cover the increase in the
pension liability caused by the passage of time. If the expected return is large enough, the firm will report a
115. Discuss the interpretation of retirement benefit disclosures.
INTERPRETING RETIREMENT BENEFIT DISCLOSURES
Firms report extensive information about their retirement plans in notes to the financial statements. Firms
cannot currently apply the fair value option to retirement plan obligations. If those provisions did apply, firms
would report unamortized items in net income as they arose.
116. Describe the accounting for income taxes for financial reporting purposes.
INCOME TAXES
MEASUREMENT OF INCOME TAX EXPENSE
The difference between pretax book income and taxable income arises from two factors.
The basis for both U.S. GAAP and IFRS requirements for income tax accounting for financial reporting
purposes.focuses on two financial reporting objectives: recognizing the amount of taxes payable in the current
year and recognizing deferred tax assets and deferred tax liabilities for the future income tax consequences of
temporary differences. A temporary difference that implies a future tax deduction gives rise to a deferred tax
asset, and a temporary difference that implies a future increase in income tax payable gives rise to a deferred tax
liability. The accountant computes income tax expense using pretax amounts for financial reporting, not the
amounts on income tax returns. Note that permanent differences never reverse, never affect cash outflows for
income taxes, and therefore never affect income tax expense for any period.
ILLUSTRATION OF TEMPORARY DIFFERENCES
One purpose of the income statement is to assist a user of financial reports to understand why income behaves
over time as it does. When operations remain the same year after year and tax rates do not change, the user of
financial reports will expect net income to remain the same. If income tax expense equaled income taxes
payable, reported earnings would vary from year to year simply because temporary differences cause book
income before taxes to differ from taxable income.
117. Describe the complexities of permanent and temporary differences on the financial reporting requirements
for income taxes.
FINANCIAL REPORTING REQUIREMENTS FOR INCOME TAXES
A firms income tax expense each period equals pretax book income multiplied by the income tax rate. Income
tax expense for a firm also equals income taxes currently payable plus the change in the deferred tax liability.
The deferred tax liability changed each year by the amount of the tax effect of the temporary differences
between depreciation for financial reporting and depreciation for tax reporting.
U.S. GAAP and IFRS require a more complex procedure for accounting for income taxes. The principal
complexities are as follows:
Thus, the Deferred Tax Asset or Deferred Tax Liability accounts on the balance sheet can change each period
because of the following factors:
118. Discuss the accounting for income taxes and the disclosure of income taxes in the financial statements.
ACCOUNTING FOR INCOME TAXES
Accounting for income taxes recognizes and measures the tax effects of temporary differences between book
and taxable income. In measuring income tax expense, U.S. GAAP and IFRS require recognition of the tax
effect when temporary differences originate. Any difference between income tax expense and income taxes
payable for a given reporting period results in a deferred tax asset or deferred tax liability. The notes to the
financial statements provide information on the components of book income before taxes, the current and
deferred portions of income tax expense, a reconciliation between income taxes at the statutory rate and the
effective rate, and the components of deferred tax assets and deferred tax liabilities.
DISCLOSURE OF INCOME TAXES IN THE FINANCIAL STATEMENTS
Notes to the financial statements provide additional information about income tax expense and deferred tax
assets and deferred tax liabilities. Firms report four items of information:
The effective tax rate equals income tax expense divided by book income before income taxes. This section
gives the reasons the effective tax rate differs from the 35% statutory federal income tax rate. The reasons
generally fall into one of two categories: (1) income tax rate differences, and (2) permanent differences.
Firms recognize the fair value of acquired IPR&D as an asset and then amortize it over the expected period of