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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
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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
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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.
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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.
