978-0324651140 Chapter 11 Lecture Note

Unlock access to all the studying documents.

View Full Document

11–

Notes

CHAPTER 11

LIABILITIES: OFF-BALANCE-SHEET FINANCING, RETIREMENT

BENEFITS, AND INCOME TAXES

I. Learning Objectives

1. Understand (a) why and how firms structure financing to keep debt off the

balance sheet, and (b) how standard setters have refined the concept of an

accounting liability to reduce the number of off balance-sheet financing

obligations.

2. Understand the accounting issues in measuring and recognizing the cost of

retirement benefits (such as pension benefits and health care benefits) and

in reporting on the balance sheet an asset for overfunded benefits and a

liability for underfunded benefits.

3. Understand why firms may recognize revenues and expenses for financial

reporting in a period different from that used for tax reporting and the

effect of such differences on the measurement of income tax amounts on

the income statement and the balance sheet.

II. Organization of Class Sessions

Some instructors may find the material in this chapter to be too

advanced for the first financial accounting course. We attempt to cover

leases and income taxes at a minimum because of the importance of these

topics. We want our students exposed to issues in accounting for

retirement benefits but seldom have enough class time to do this topic

justice.

III. Lecture Outline

1. Understand (a) why and how firms structure financing to keep debt

off the balance sheet, and (b) how standard setters have refined the

concept of an accounting liability to reduce the number of off–

balance- sheet financing obligations..

Begin the discussion by asking why firms might desire to keep debt off

their balance sheets. Most students see the link between the amount of a

firm’s debt and its perceived riskiness. Keeping debt off of the balance

Notes 11–

sheet may make the firm appear less risky and lower its cost of financing.

Then ask: How should an analyst view such off-balance sheet

arrangements? Some students will take a conservative position and argue

that all such commitments should appear as liabilities when assessing a

firm’s risk. Other students will argue that the probability of the firm

having to make a future cash payment should dictate whether or not to

include such commitments among liabilities. GAAP tends to emphasize

the latter view, although the pronouncements by the FASB on off-balance

financing are not fully consistent in this regard. Both the FASB and IASB

seem to understand the implications of attempts to structure transfers of

assets and other transactions to keep debt off the balance sheet. A goal in

formulating appropriate reporting standards is to reflect the economic

effect of such arrangements and the trend in recent standards is to

recognize more obligations as liabilities that were previously off-balance-

sheet. When we can devote at least one hour of class time to this topic, we

use Problem 11.37. This problem provides an excellent basis for class

discussion. The solution to this problem provides suggested approaches to

teaching it. (Questions 11.2, 11.4, and 11.5 and Exercises 11.19 and 11.20)

You can delay this discussion until Chapter 13 and integrate it with

discussion of variable interest entities, but that chapter is chock full

already. You might consider the benefits of bring the VIE discussion to

here.

2. Understand the accounting issues in measuring and recognizing

the cost of retirement benefits (such as pension benefits and health

care benefits) and in reporting on the balance sheet an asset for

overfunded benefits and a liability for underfunded benefits.

We seldom have sufficient class time to do this topic justice. The one

concept we try to communicate is the need to recognize the cost of retiree

benefits as an expense during employees’ working years, rather than when

the firm provides these benefits during retirement. The matching

convention provides the theoretical rationale for this accounting.

Recognizing the expense requires recognition of a liability as well.

Measuring this liability requires estimates of the present value of the

amount payable, which in turn requires information about employee

turnover, mortality, provisions of the benefit arrangement, and other

factors. Questions 11.8 and 11.21 permit discussion of the accounting

issues. The web site for this book includes additional discussion of the

accounting for retirement benefits for instructors desiring to explore this

topic in greater depth

Express that the IFRS requires employers to recognize the funded

status of a defined benefit pension plan as

11–

Notes

A. An asset (pension plan is overfunded)

B. Liability (pension plan is underfunded).

Considering the Exhibit 11.4 provided in the text, calculate the

underfunded pension and off-setting entries in other comprehensive

income.

3. Understand why firms may recognize revenues and expenses for

financial reporting in a period different from that used for tax

reporting and the effect of such differences on the measurement of

income tax amounts on the income statement and the balance sheet.

We find that deferred tax accounting causes students more difficulty

than any other topic in the course. When APB Opinion No. 11 was in

effect, we used the matching convention to help students understand the

logic of deferred tax accounting. The balance sheet orientation of FASB

Statement No. 109 complicates the accounting, particularly with its

emphasis of using changes in deferred tax assets and deferred tax

liabilities to measure the deferred portion of income tax expense. The use

of the valuation allowance for deferred tax assets further complicates the

accounting. Having taught the topic from both an income statement

perspective and a balance sheet perspective, we have concluded that the

income statement approach works best for the introductory accounting

course. We, therefore, follow this approach in Chapter 11. Although the

balance sheet approach is procedurally correct, it tends to cloud the

conceptual understanding of deferred tax accounting. We have placed the

discussion of the balance sheet approach on the web site for this book for

instructors wishing to explore this topic from that perspective or who want

to explore the more advanced issues, such as change in tax rates, which

require such a balance sheet approach.

We discuss the conceptual basis for deferred tax accounting by asking

students a series of questions:

A. Why might firms choose to use different methods of accounting of

financial reporting and income tax reporting?

B. Why does using the income taxes payable on a particular year’s taxable

income as the measure of income tax expense for that year create a poor

matching of expenses with revenue? The Burns Company example in

the text (Exhibit 11.11) illustrates in Column 9 the strange pattern of

income for a company doing precisely the same thing each year.

Notes 11–

As is true in all financial reporting expense must equal expenditure

(other than transactions with owners), so total income tax expense must

equal total cash expenditures for income taxes. Thus, the concern in

deferred tax accounting is not ultimately with the amount of income tax

expense but with when firms should recognize it. At this point, we place

Exhibit 11.11 from the text on the board or projected on a screen. Using

the amounts in Columns (8) and (10), show how deferred tax accounting

provides for a better matching of income tax expense with income before

income taxes.

Questions 11.6 and 11.14 to 11.18 permit a discussion of the issues of

deferred tax accounting without getting bogged down in numbers.

Exercises 11.26, 11.27, and 11.28, are straightforward illustrations of the

concepts of deferred tax accounting. Problems 11.34 to 11.36 draw from

income tax disclosures of actual companies and will be challenging to most

students.