Leases and Pensions ROSS SCHOOL OF BUSINESS Winter 2006 Module 9 Accounting 501 Jefferson P. Williams Accounting for Leases Lease - a contract whereby an owner (lessor) grants the use of property to a second party (lessee) for rental payments Some leases are recorded simply as if one party is renting property from another. Other leases are recorded as liabilities and assets when the lease contract is signed. Operating and Capital Leases Capital lease - a lease that transfers substantially all the risks and benefits of ownership to the lessee They are accounted for as if they were installment sales which provide for the payment over time along with interest. The leased item must be recorded as if it were sold by the lessor and purchased by the lessee. Operating and Capital Leases Operating lease - a lease that should be accounted for by the lessee as ordinary rent expenses --- any lease other than a capital lease Examples include rental of an apartment or rental of a car on a daily basis. Operating and Capital Leases Differences in accounting for operating and capital leases: Operating - treat as rental expense Rent Expense xxx Cash xxx Capital - treat as if the lessee borrowed the money and purchased the leased asset Leased property xxxx Capital lease liability xxxx Differences in Income Statements The major difference in the income statements for a capital lease and an operating lease is the timing of the expenses. A capital lease tends to bunch heavier charges in the early years. These charges are the amortization of the lease plus the interest factor. An operating lease records the payments directly as expenses, generally in a straight-line manner. For comparable leases, the total expenses are the same. Criteria for Capital Leases Before GAAP established criteria for leases to be classified as capital leases, many companies were keeping ?off balance sheet financing? by treating their noncancellable leases as monthly rentals. These leases created assets and liabilities that the companies were not recognizing. Criteria for Capital Leases Under GAAP, a capital lease exists if one or more of the following conditions are met: Title to the leased property is transferred to the lessee by the end of the lease term. An inexpensive purchase option is available to the lessee at the end of the lease. The lease term equals or exceeds 75% of the estimated economic life of the property. At the start of the lease, the present value of minimum lease payments is at least 90% of the property?s fair value. Pensions and Other Postretirement Benefits Pension - payments to former employees after they retire, usually in the form of reduced wages Other postretirement benefits - benefits provided to retired workers in addition to a pension, such as life and health insurance Pensions and Other Postretirement Benefits Pensions and other postretirement benefits are considered to be liabilities when earned by employees, because accrual accounting requires that expenses are to be matched with associated revenues. These benefits must be recognized when they are earned by the employees, usually many years before they are disbursed. The obligations are reported as unpaid liabilities on the balance sheet. Pensions and Other Postretirement Benefits Because of the long time frame involved, present value techniques must be used to measure the obligations. To calculate the present values, firms must estimate employee life expectancy, future work lives, ages at retirement, and levels of future pension payments to retirees. The firm must also choose an interest rate to be used in the present value computations. Pensions and Other Postretirement Benefits Companies do not just accrue huge pension liabilities each year. Money must also be set aside each year to fund the liabilities. This ensures that cash will be available to meet pension obligations upon retirement of employees. Congress provides tax incentives to companies that contribute cash to pension fund trusts that are separate from the firms? assets and are controlled by trustees. Pensions and Other Postretirement Benefits Jones Corporation?s pension expense for the year is $350,000. Jones pays $200,000 of the pension expense into a pension fund. How is this transaction recorded? Pensions and Other Postretirement Benefits Jones Corporation?s pension expense for the year is $350,000. Jones pays $200,000 of the pension expense into a pension fund. How is this transaction recorded? Pension expense 350,000 Cash 200,000 Accrued pension liability 150,000 Pensions and Other Postretirement Benefits Accounting for other postretirement benefits is essentially the same as accounting for pensions. However, Congress does not allow tax incentives to payments for these benefits. Most companies do not fund other postretirement benefits, so the entire amount is usually recorded as a liability.
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