Problem 1
Explaining and Interpreting Leases
On January 1, Borman Company, a lessee, entered into three noncancellable leases for new equipment indentified as: Lease J, Lease K, and Lease L. None of the three leases transfers ownership of the equipment to Borman at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, is 75% of the excess of the fair vale of the equipment to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by the lessor. The following additional information is distinct for each lease:
* Lease J does not contain a bargain purchase option; the lease term is equal to 80% of the estimated economic life of the equipment.
* Lease K contains a bargain purchase option; the lease term is equal to 50% of the estimated economic life of the equipment.
* Lease L does not contain a bargain purchase option; the lease term is equal to 50% of the estimated economic life of the equipment.
(A) Leases J and K are capital leases
Required:
a. Explain how Borman Company should classify each of these three leases. Discuss the rationale for your answer.
Leases are classified as either capital leases or operating leases. The payments made under an operating lease are recorded as rent expense in the income statement. The capital lease is recorded on the balance sheet with an asset entry and a liability. In order to qualify as an operating lease, a lease must not meet any of the following criteria:
1. The term of the lease is 75% or more of the estimated useful life of the asset.
2. The purchase agreement of the lease is less than market value.
3. The ownership of the asset is transferred to the lessee at the end of the term.
4. The present value of the payment of the lease is 90% or higher than the market value of the asset.
Given these criteria, Borman Company should classify lease J as a capital lease because the lease term is 80% of the useful life of the equipment, lease K should also be a capital lease because it contains a purchase option, however, lease L does not meet any of the four criteria so it can be classified as an operating lease.
b. Identify the amount, if any, Borman records as a liability at inception of the lease for each of the three leases.
For lease J, Borman should record as a liability the present value of minimum lease payments over the term of the lease minus any maintenance and/or insurance paid or any other "executory costs". The amount of liability recorded for lease K is the same as lease J but for lease K, the amount in the 'bargain purchase option' should be added to the minimum lease payment. Lease L has no liability amount to record at inception.
c. Assuming that Borman makes the minimum lease payments on a straight-line basis, describe how Borman should record each minimum lease payment for each of these three leases.
Lease J - The lease payments made by Borman would be allocated against the liability and interest expense, making periodic reductions to both in the balance sheet.
Lease K - The lease payments made by Borman would be allocated against the liability and interest expense, making periodic reductions to both in the balance sheet.
Lease L - The lease payments are allocated against rent expense in the income statement
d. Assess accounting practice in accurately portraying the economic reality for each lease.
Leases J and K classifications as capital leases means that they are already being presented and captured for analysis. This also means that they may negatively affect some ratios such as debt covenants which could serve as incentive to some managers to classify a portion of their leases as operating leases.
To get the true financial position of a company, an analyst may find it necessary to reclassify certain operating lease to capital lease.
Problem 1.2
Analyzing Environmental Liability Disclosures
The U.S. government actively seeks the identification and cleanup of sites that contain hazardous materials. The Environmental Protection Agency (EPA) identifies contaminated sites under the Comprehensive Environmental Response Compensation and Liability Act (CERCLA). The government will force parties responsible for contaminating the site to pay for cleanup whenever possible. Also, companies face lawsuits for persons injured by environmental pollution. Potentially responsible parties include current and previous owners and operators of hazardous waste disposal sites, parties who arranged for disposal of hazardous materials at the site, and parties who transported the hazardous materials to the site. Potentially responsible parties should accrue a contingent environmental liability if the outcome of pending or potential action is probable to be unfavorable and a reasonable estimate of costs can be made. Amounts for environmental liabilities can be large. For example, Exxon paid damages totaling $5 billion for the highly publicized Exxon Valdez tanker accident. Estimates to clean up sites identified by the EPA range as high as $500 billion to $750 billion. The "superfund" sites are sites with the highest priority for cleanup under CERCLA. Estimates to clean up these sites alone total $150 billion. The responsible parties face additional lawsuits as well and these potential losses are not included in these totals.
Required:
a. Discuss why environmental liabilities are especially difficult to measure.
Environmental liabilities are especially difficult to measure due to the unexpected nature and extreme uncertainty found in environmental exposure when dealing with property damage, cleanup costs, third party bodily damage, damages to natural resources, etc. The timing of an environmental disaster is impossible to predict as is the degree or size of the disaster.
b. Discuss how you would adjust the financial analysis of companies that are predisposed to environmental legal action but have not accrued any contingent loss amounts. For example, how might you adjust your beliefs about the financial position of Union Carbide and it competitors following the Bhopal tragedy?
If a company is predisposed to environmental legal action but has not accrued any contingent loss amounts, it would be better to include an amount in the company's loss reserves. The amount in the 'loss reserves' can be adjusted as more information is gathered. My beliefs about the financial position of Union Carbide and it's competitors following the Bhopal tragedy would be that it would continue a negative downturn as the losses due to envinronmental factors increased.
c. Identify three industries that you consider as likely to face significant environmental risk. Explain.
Gas and oil, aside from facing the usual risks to water and soil, this industry also faces risk of "fracking" which is blamed for sinkholes and earthquakes.
If not properly regulated, the mining industry has the potential of releasing substances that are harmful to the water, soil and air; not to mention the depletion of natural resources.
Logging is an industry that could face significant environmental risk because even though timber can be considered a renewable resource, clear-cut logging of old-growth/forests changes the biome for an extended period of time as it takes years and years for the new trees to replace the ones taken.
Problem 1.3
Analyzing Pension Plan Disclosures
Campbell Soup
Refer to the financial statements of Campbell Soup Company in Appendix A. The Note on Pension Plans and Retirement Benefits describes computation of pension expense, projected benefit obligation (PBO), and other elements of the pension plan (all amounts in millions).
Required:
a. Explain what the service cost of $22.1 for Year 11 represents.
This could be explained as the service cost/liability to the company created during 2011 or the benefit/credit employees get for their service in 2011.
b. What discount rate did the company assume for Year 11? What is the effect of Campbell's change from the discount rate used in Year 10?
The discount rate for year 11 was 8.75%
The discount rate for year 10 was 9.00%, the effect of the reduction in the discount rate from 9.00% to 8.75% led to the increase in the service cost for year 11.
c. How is the "interest on projected benefit obligation" computed?
Interest on projected benefit obligation (PBO) is computed by multiplying the beginning-period PBO by the discount rate of 8.75%.
d. Actual return on assets is $73.4. Does this item enter in its entirety as a component of pension cost? Explain.
This item enters as a component of pension cost because it shows the return on the investment.
e. Campbell shows an accumulated benefit obligation (ABO) of $714.4. What is this obligation?
The Accumulated Benefit Obligation (ABO) is the present value of the obligations that Campbell owes to people who have retired or are about to retire.
f. Identify the PBO amount and explain what accounts for the difference between it and the ABO.
The PBO is the 'projected benefit obligation' - this amount is a projection of what employees are expected to be earning when they retire. The difference between the ABO and the PBO is that the ABO is usually a smaller number because it is the amount that the employer is liable legally, for the present value of payments to be made in the future but they are based on current wages, where PBO is a projection based on the wages employees are expected to be earning at the time they retire. To reflect to true financial position of the retirement plan, the PBO number is used for the funded status on the balance sheet.
g. Has Campbell funded its pension expense at the end of Year 11?
It does not look like Campbell has funded its pension expense at the end of year 11.
CHECK
(b) Year 11 rate, 8.75%
Question 2.1
Compare and contrast the effects of LIFO and FIFO inventory costing methods on earnings in an inflationary period.
Last In First Out (LIFO) means the last items entered into the inventory (which may be at a higher price) would be the first to be taken out, increasing the COGS. This means the lower priced items would remain in the inventory decreasing the asset account.
First In First Out (FIFO) means the first items entered into the inventory (which may have been entered at a lower price) would be the first taken out decreasing the COGS. This means the higher priced items would remain in the inventory increasing the asset account.
In an inflationary period FIFO would reflect an increase in income thereby causing higher taxes. Companies are not allowed to swith from FIFO to LIFO depending on the economy, they must continue valuing their inventory using the same method.
Exercise 2.2 Part (1) only
Do the same calculations for your chosen company and incorporate results into your research paper
Analytical Measures of Plant Assets
Colgate
Refer to the financial statements of Colgate in Appendix A.
Required:
a. Compute the following analytical measures applied to Colgate for 2006:
(1) Average total life span of plant and equipment.
(2) Average age of plant and equipment.
(3) Average remaining life of plant and equipment.
PROBLEM 2.3
Restating Inventory from LIFO to FIFO
BigBook website uses LIFO inventory accounting. Notes to BigBook.Com's Year 9 financial statements disclose the following (it has a marginal tax rate of 35%):
Inventories Year 8 Year 9
Raw Materials 392,675 369,725
Finished Producs 401,342 377,104
794,017 746,829
Less LIFO Reserve (46,000) (50,000)
748,017 696,829
Required:
a. Determine the amount by which Year 9 retained earnings of BigBook.Com changes if FIFO is used.
b. Determine the amount by which Year 9 net income of BigBook.Com changes if FIFO is used for both Years 8 and 9.
c. Discuss the usefulness of LIFO to FIFO restatements in an analysis of BigBook.Com.