10-1 Chapter 10 – Liabilities: Off-Balance-

sheet Financing, Leases, Deferred

Income Taxes, Retirement Benefits,
and Derivatives

FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
10th Edition

Clyde P. Stickney and Roman L. Weil

10-2
Learning Objectives

1. Understand (a) why firms attempt to structure debt financing to

keep debt off the balance sheet and (b) how standard setters
have refined the concept of an accounting liability to reduce
off-balance-sheet financing abuses.
2. Distinguish between operating leases and capital leases on the
bases of ther economic characteristics, accounting criteria, and
financial statement effects.
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.
4. Understand the accounting issues related to retiree benefit plans.
5. Learn the basics about derivative instruments and hedging.
10-3 Chapter Outline

1. Off-balance sheet financing

2. Leases
3. Income tax accounting and deferred taxes
4. Pension benefits and other deferred compensation
5. Health care and other benefits
6. Derivative instruments
7. An international perspective
Chapter Summary
8. Appendix 10.1: Effects on the cash flow statement
of transactions involving liabilities
10-4 1. Off-Balance Sheet Financing
 Off-balance sheet financing is any means that secures the use
of assets for the firm without having to recognize an off-
setting liability.
 If the liability is not recognized, then the double-entry system
does not allow for the recognition of the asset either, but this
is a tradeoff that some managers are willing to make.
 Off-balance-sheet financing can affect key financial ratios,
especially the financing ratios that use total debt as a
denominator, showing them to be lower (and more favorable)
than they would be if the financing were recognized.
a. Rationale for off-balance sheet financing
b. Structuring off-balance sheet financing
10-5 1.a. Rationale for Off-Balance
Sheet Financing

1. It lowers the cost of borrowing if lenders are not aware of the

unrecorded liabilities.
 This rationale assumes that lenders can be fooled by off-
balance-sheet methods.
 Standard-setting bodies have required increased
disclosures of such methods in recent years.
2. It avoids violating some debt covenants; that is, restrictions
specified in the debt agreement to protect the lender. These
restrictions are sometimes stated in the form of financial
ratios which may be effected by whether or not the liability is
recorded.
10-6 1.b. Structuring Off-Balance
Sheet Financing
Off-balance-sheet financing fall into one of two categories that accounting
does not recognize as liabilities:
1. Executory contracts are promises to pay at a future date for future
benefits
 These may be legally binding and give both parties valuable rights.

 Standard accounting would recognize a liability as benefits are

received, not when the contract is signed.
2. Contingent obligations are obligations that arise only if a specified set of
conditions are met.
 Standard accounting would recognize a liability as the contingent
events occur rather than when the contract is signed.
10-7 2. Leases

 Firms may lease (or rent) assets instead of

purchasing them.
 A true lease would give the lessee (the one paying
for use of the asset) flexibility.
 Some leases are so inflexible that they are
tantamount to a purchase. They may be non-
cancelable, long-term and impose on the lessee all
costs of operating.
 Private automobile leases are typically so restrictive
as to be the economic equivalent of a purchase.
 A true automobile lease would be more like what is
called renting a car.
10-8 2. Leases (Cont.)
 Because of the possibility that leases may be used as
a form of off-balance sheet financing, GAAP calls
for leases to be capitalized under certain conditions.
 Capitalizing a lease means to recognize the lease as
if it were a purchase and thus recognize both the
leased asset and the lease liability. The lease asset
may be depreciated over time and the lease liability
may be amortized as payments are made.
 If the lease is not capitalized, it may be treated as a
true lease (or operating lease). In this case, a lease
expense would be recognized as payments were
made but no asset or long-term liability would be
recognized.
10-9 2. Leases (Cont.) -- Conditions
 GAAP required that a lease be capitalized if any one
of the following conditions are met:
1. Transfer of ownership to lessee at end of lease
2. Transfer at “bargain purchase” option
3. Lease extends for 75% of the asset’s life
4. PV of lease payments is 90% of fair market value
 Of course, if management wants the lease to be
treated as an operating lease, they will structure the
lease terms to avoid all four of these criteria.
 In such cases, the last requirement (90% of fair
market value) is considered the most restrictive.
10-10 2. Leases -- Accounting For
 Operating lease or true lease:
 Neither the leased asset nor the lease liability are
recorded
 Lease expense is recognized as cash payments are
made or adjusting entries are required
 Capital lease:
 Both a lease asset (leasehold) and a lease liability
are recognized for the PV of the lease obligations
 As payments are made or adjusting entries
required:
 The asset may be depreciated
 The liability is amortized
10-11 Exhibit 10.1
Example of Lease Obligation Amortization
Amortization Schedule for $45,000 lease liability, accounted for as
a capital lease, repaid in three annual payments of $19,709 with
interest at 15% compounded annually.

Interest expense col 3 amt

Lease liability col 5 amt
Cash col 4 amt

lease liab. interest reduction lease liab.

beginning expense cash in lease end of
year of year at 15% payment liability year
(1) (2) (3) (4) (5) (6)
1 $45,000 $6,750 $19,709 $12,959 $32,041
2 32,041 4,806 19,709 14,903 17,138
3 17,138 2,571 19,709 17,138 0
10-12 3. Income Tax Accounting and
Deferred Taxes

 Terms
 Book income is income before income taxes for
financial reporting purposes
 Taxable income is the amount of income on
which the income tax is based
 The two may be different because of:
 The timing of recognition may be different, or
 Some revenues or expenses may have special
tax treatments
10-13 3. Income Tax Accounting and
Deferred Taxes (Cont.)

 The difference between book and taxable income

are of two types:
1. Permanent differences are differences in what is
recognized or not. For example, a tax-free bond
gives book income but not taxable income.
2. Temporary differences are differences that will
equal out over a long time. For example, book
income may use straight line depreciation while
taxable income will use macrs, an accelerated
depreciation. Over time, both will depreciate the
same amount but at different rates.
10-14 3. Income Tax Accounting and
Deferred Taxes (Cont.)
 Two views of income taxes:
1. Income taxes are expenses and should be
matched or accrued like other expenses.
2. Income taxes are not expenses but are like other
taxes and should be recognized at the amount
paid in the current period.
 U.S. GAAP holds to the first view. Thus, a tax
deferral method saves taxes paid during the current
period but may not reduce tax expense.
 Critics of this view hold that tax expense is unlike
other expenses in that it does not give rise to the
potential for revenues.
10-15
3. Recording the Income Tax Expense
A firm which has temporary differences between tax-based income
and book income will record tax expense based on book income, pay
the IRS the amount of the tax and the difference generally
represents a liability. (See Exhibit 10.3)

Year 1 Income tax expense 32,000

Income tax payable 30,400
Deferred tax liability 1,600
In the future when the deferred taxes become due, the effect is
reversed reducing the deferred tax liability.

Year 4 Income tax expense 32,000

Deferred tax liability 2,240
Income tax payable 34,240
10-16 4. Pension Benefits and Other Deferred
Compensation

 Employers may provide benefits to workers after

their retirement.
 One reason is to build worker loyalty and good will.
 Also, at one time, such benefits were a non-cash
form of compensation.
 Present federal law now requires employers to
actually put away cash to cover the obligations of
pension benefits.
 The amount of cash and the recognition of an
expense are complex issues.
10-17
4. Pension Benefits (Cont.)

1. Employers set up a pension plan specifying

eligibility, promises, funding and an administrator.
2. Employer computes pension expense for each
period.
3. Employer transfers cash to a separate pension fund
each period.
4. If cumulative pension expenses exceed cumulative
pension funding, a pension liability appears on the
balance sheet, else a pension asset is recognized.
5. If the PV of pension commitments to employees
exceeds the assets of the fund, a pension liability
would also have to be recognized.
10-18
4. Pension Benefits (Cont.)

SFAS No. 87 defines two measures of pensions

liability:
1. Accumulated benefit obligation -- the present value
of amounts expected to be paid to employees during
retirement based on accumulated service and
current salary.
2. Projected benefit obligation -- the present value of
amounts expected to be paid to employees during
retirement based on accumulated service to date
but using the level of salary expected to serve as a
basis for computing pension benefits.
10-19
4. Pension Benefits (Cont.)

 The administrator of the pension fund should make

prudent and profitable investments of those funds.
 If the pension funds grows, this adds to the fund
since the fund is not an asset of the firm.
 Such growth does however ease the amount of cash
that the firm has to transfer to the fund in future
periods.
Fund assets at beginning of the period
+ Actual earnings on pension fund investments
+ Contributions from employer
- Payments to retirees
= Fund assets at end of the period
10-20
5. Health Care and Other Benefits

 Health care, insurance and other benefits resemble

pension plans in concept.
 The PV of such commitments, or health-care
benefits obligation, represents an economic
obligation of the employer.
 GAAP requires firms to recognize an expense for
these obligations and to recognize liabilities for any
under funded obligations.
 Firms may recognize the full liability in one year or
piecemeal over several years.
10-21 6. Derivative Instruments

 Firms face risks in carrying out business

operations:
1. The risk that customers will stop buying its
products and services,
2. The risk that raw material used in production will
increase in cost after the firm has committed to a
selling price,
3. The risk that currency exchange rates will change
after the firm has made commitments fixed in
terms of a foreign currency,
4. The risk that interest rates will change,
5. The risk that employees will quit or retire.
10-22 6. Derivative Instruments (Cont.)

 Many firms seek to avoid risk even if it is costly.

 Some financial firms specialize in helping firms
avoid risk through financial instruments which are
sold to the firm.
 In general, such a financial instrument substitutes
a fixed known cost for an unknown cost.
 These instruments are analogous to insurance.
 These instruments are as hedging when money is
involved and as derivative instruments when the
payoff is based on economic outcomes.
 GAAP requires firms to show the market value of
derivatives on their balance sheets.
10-23
7. An International Perspective

 Leases -- most industrial countries distinguish

between capital and operating leases although the
criteria may vary.
 Income tax accounting -- in general, countries that
allow separate rules for tax and financial reporting
allow deferred tax accounting.
 Retirement benefits -- most industrial countries
provide worker benefits and some are more
generous than in the U.S., however, most do not
provide the same detail of accounting disclosure.
10-24
Chapter Summary

 This chapter completes the discussion of liabilities.

 The point was made that liabilities cover some
obligations that are difficult to measure.
 Leases may represent a significant future obligation.
 Pensions certainly do.
 Taxes may give rise to future obligations when
aggressive deferral methods are practiced.
 The intent of this chapter was to acquaint the student
with many problems of liability accounting and to give
the student an appreciation of some liabilities that
appear on the balance sheet.
10-25 Appendix 10.1: Effects on Cash Flows of
Transactions Involving Liabilities
 Leases -- Capitalizing a lease results in a long-lived asset
(use of investing cash) and a liability (financing cash).
As the asset is depreciated and the liability amortized,
operating cash is effected. The two effects may not
cancel out because of differences between the
depreciation method and the amortization method.
 Pensions -- The pension is a separate legal entity and is
not an asset of the firm, so cash paid in by the employee
is not an investment.
 Derivatives -- changes in the valuation of the derivative
will effect operating cash.