Chapter 15 In a Set of Financial Statements, What Information Is Conveyed about Other Noncurrent Liabilities?

Reporting a Liability for Leased Property

Question: Notes and bonds payable serve as the predominant source of long-term financing in the United States. Virtually all companies raise significant sums of money by incurring debts of this type. However, a quick perusal of the balance sheets of most well-known companies finds a broad array of other noncurrent liabilities, some of staggering size.

• Sears Holdings Corporation disclosed long-term capital lease obligations of $597 million as of January 29, 2011.
• Southwest Airlines Co. reported deferred income tax liabilities of approximately $2.5 billion on December 31, 2010.
• Alcoa Inc. at December 31, 2010, lists $2.6 billion in liabilities (slightly under 12 percent of the company’s total) labeled as accrued postretirement benefitsPromises such as pension payments, health care insurance coverage, and life insurance benefits made by employers to eligible employees to be received after the individuals reach a specified retirement age. (other than pensions).

These noncurrent liabilities represent large amounts of debts that are different from traditional notes and bonds. Some understanding of these balances is necessary to comprehend the information being conveyed in a set of financial statements. The reporting of liabilities such as those above is explored in depth in upper-level financial accounting courses. However, a basic level of knowledge is essential for every potential decision maker, not just those individuals who chose to major in accounting in college.

Lease liabilities will be explored first in this chapter. To illustrate, assume that the Abilene Company needs an airplane to use in its daily operations. Rather than buy this asset, Abilene leases one from a business that owns a variety of aircraft. The lease is for seven years at an annual cost of $100,000. A number of reasons might exist for choosing to lease rather than buy. Perhaps Abilene is able to negotiate especially good terms for the airplane because of the company’s willingness to commit to such a long period of time.

On the day that the lease is signed, should Abilene report a liability and, if so, is the amount just the first $100,000 installment, the $700,000 total of all payments, or some other figure? When a company leases an asset, how is the related liability reported?

 

Answer: The liability balance to be reported by the Abilene Company cannot be determined based purely on the information that is provided. When a lesseeA party that pays cash for the use of an asset in a lease contract. (the party that will make use of the asset) signs a lease agreement, the transaction is recorded in one of two ways based on the terms of the contract.

Possibility One—An Operating LeaseA rental agreement where the benefits and risks of ownership are not conveyed from the lessor to the lessee.. Abilene might have obtained the use of this airplane through an operating lease, a rental arrangement. If so, the liability recognized when the contract is signed is $100,000, only the amount due immediately. Upon payment, the reported debt is reduced to zero despite the requirement that six more installments have to be paid. In financial accounting, the future payments on an operating lease are viewed as a commitment rather than a liability. Thus, information about those payments is disclosed in the notes to the financial statements but not formally reported.

Possibility Two—A Capital LeaseA rental agreement where the benefits and risks of ownership are conveyed from the lessor to the lessee so that both the asset and liability are reported initially by the lessee at the present value of the cash payments; for accounting purposes, it exists when one of four established criteria are met.. This transaction could also have met specific criteria for classification as a capital lease. That type of lease is viewed as the equivalent of Abilene buying the airplane. The initial liability recognized by Abilene is the present value of the $700,000, the entire amount of cash to be paid over these seven years. The present value is determined by the mathematical removal of a reasonable rate of interest.

Does a Lessee Prefer to Report an Operating or Capital Lease?

Question: The previous answer raises a number of immediate questions about lease accounting. Probably the first of these relates to the practical goal of officials who want to produce financial statements that make their company look as financially healthy as possible. A lease agreement can be reported as (a) an operating lease with only the initial payment recorded as a liability or (b) a capital lease where the present value of all payments (a much larger number) is shown as the liability.

Officials for the lessee must surely prefer to classify all leases as operating leases to reduce the reported debt total. In financial accounting, does a lessee not have a bias to report operating leases rather than capital leases?

 

Answer: The answer to this question is obviously “Yes.” If an option exists between reporting a larger liability (capital lease) or a smaller one (operating lease), officials for the lessee are inclined to take whatever measures necessary to classify each contract as an operating lease. This is not a choice such as applying FIFO or LIFO. The reporting classification is based on the nature of the agreement.

Thus, Abilene Company will likely attempt to structure the contract for this airplane to meet any designated criteria for an operating lease. Financial accounting is supposed to report events and not influence them. However, at times, authoritative reporting standards impact the method by which companies design the transactions in which they engage.

If the previous example is judged to be an operating lease, Abilene only reports an initial liability of $100,000 although legally bound by the agreement to pay a much larger amount. The term off-balance sheet financingDescription used for an obligation where an amount of money must be paid that is larger than the figure reported on the balance sheet; for a lessee, an operating lease provides an example of off-balance sheet financing. is commonly used when a company is obligated for more money than the reported debt. Operating leases are one of the primary examples of “off-balance sheet financing.”

As mentioned at the start of this chapter, Sears Holdings Corporation reports noncurrent liabilities of about $597 million on January 29, 2011, in connection with capital leases. However, that obligation seems small in comparison to the amount to be paid by the company on its operating leases. As the notes to those financial statements explain, Sears has numerous operating leases (for the use of stores, office facilities, warehouses, computers and transportation equipment) that will require payment of over $5.3 billion in the next few years. Most of the debt for this additional $5.3 billion is “off the balance sheet.” In other words, the obligation is not included in the liability section of the company’s balance sheet. For an operating lease, the reported liability balance does not reflect the total obligation, just the current amount that is due.

Differentiating an Operating Lease from a Capital Lease

Question: For a lessee, a radical difference in reporting exists between operating leases and capital leases. Company officials prefer to report operating leases so that the amount of liabilities appearing on the balance sheet is lower. What is the distinction between an operating lease and a capital lease?

 

Answer: In form, all lease agreements are rental arrangements. One party (the lessor) owns legal title to property while the other (the lessee) rents the use of that property for a specified period of time. However, in substance, a lease agreement may go beyond a pure rental agreement. Financial accounting has long held that a fairly presented portrait of an entity’s financial operations and economic health is only achieved by looking past the form of a transaction to report the actual substance of what is taking place. “Substance over form” is a mantra often heard in financial accounting.

Over thirty years ago, U.S. GAAP was created (by FASB) to provide authoritative guidance for the financial reporting of leases. An official pronouncement released at that time states that “a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee.” In simple terms, this standard means that a lessee can obtain such a significant stake in leased property that the transaction more resembles a purchase than it does a rental. If the transaction looks like a purchase, the accounting should be that of a purchase.

When the transaction is more like a purchase, it is recorded as a capital lease. When the transaction is more like a rental, it is recorded as an operating lease.

• Capital lease. The lessee gains substantially all the benefits and risks of ownership. Although legal form is still that of a lease arrangement, the transaction is reported as a purchase at the present value of the future cash flows.
• Operating lease. The lessee does not obtain substantially all the benefits and risks of ownership. The transaction is reported as a rental arrangement.

Criteria for a Capital Lease

Question: A capital lease is accounted for as a purchase because it so closely resembles the acquisition of the asset. An operating lease is more like a rent. The lessee normally prefers to report all such transactions as operating leases to reduce the amount of debt shown on its balance sheet. How does an accountant determine whether a contract qualifies as a capital lease or an operating lease?

 

Answer: In establishing reporting guidelines in this area, FASB created four specific criteria to serve as the line of demarcation between the two types of leases. Such rules set a standard that all companies must follow. If any one of these criteria is met, the lease is automatically recorded by the lessee as a capital lease. In that case, both the asset and liability are reported as if an actual purchase took place.

Not surprisingly, accountants and other company officials study these four criteria carefully. They hope to determine how the rules can be avoided so that most of their new contracts are viewed as operating leases. Interestingly, in recent years, official groups here and abroad have been examining these rules to decide whether U.S. GAAP and IFRS will be revised so that virtually all leases are reported as capital leases. At this time, the final outcome of those deliberations remains uncertain. However, a serious limitation on the use of the operating lease category seems likely in the next few years.

Criteria to Qualify as a Capital Lease (only one must be met):

1. If the lease contract specifies that title to the property will be conveyed to the lessee by the end of the lease term, it is a capital lease. If legal ownership is to be transferred from lessorA party that receives cash for granting the use of owned property to a lessee through a lease contract. to lessee, the entire series of payments is simply a method devised to purchase the asset. From the beginning, the property was being acquired.
2. If the contract allows the lessee to buy the property at a specified time at an amount sufficiently below expected fair value (so that a purchase is reasonably assured), it is a capital lease. The availability of this bargain purchase option indicates, once again, that the true intention of the contract is the conveyance of ownership. The transaction is the equivalent of a purchase if the option price is so low that purchase by the lessee can be anticipated.
3. If the lease contract is for a term that is equal to 75 percent or more of the estimated life of the property, it is a capital lease. This criterion is different from the first two where the transaction was just a disguised purchased. Here, the lessee will never gain ownership. However, the lease is for such an extensive portion of the asset’s life that the lessee obtains a vast majority of its utility. Although the 75 percent standard is an arbitrary benchmark, no doubt can exist that the lessee will be the primary beneficiary of the property.
4. The fourth criterion is too complicated to cover in an introductory textbook. The general idea is that the lessee is paying approximately the same amount as would have been charged to buy the asset. Paying the equivalent of the purchase price (or close to it) indicates that no real difference exists between the nature of the lease transaction and an acquisition.

The Financial Reporting of an Operating Lease

Question: The Abilene Company has agreed to pay $100,000 per year for seven years to lease an airplane. Assume that legal title will not be received by Abilene and no purchase option is mentioned in the contract. Assume also that the life of the airplane is judged to be ten years and the payments do not approximate the fair value of the item.

The contract is signed on December 31, Year One, with the first annual payment made immediately. Based on the description of the agreement, none of the four criteria for a capital lease have been met. Thus, Abilene has an operating lease. What financial accounting is appropriate for an operating lease?

 

Answer: None of the four criteria for a capital lease is met in this transaction:

1. Legal ownership is not conveyed to the lessee.
2. No bargain purchase option is included in the contract.
3. The life of the lease is less than 75 percent of the life of asset (seven years out of ten years or 70 percent).
4. Payments do not approximate the acquisition value of the asset.

Thus, Abilene is just renting the airplane and agrees on an operating lease. The first annual payment was made immediately to cover the subsequent year.

Because the first payment has been made, no liability is reported on Abilene’s balance sheet although the contract specifies that an additional $600,000 in payments will be required over the subsequent six years. In addition, the airplane itself is not shown as an asset by the lessee. The operating lease is viewed as the equivalent of a rent and not a purchase.

During Year Two, as time passes, the future value provided by the first prepayment gradually becomes a past value. The asset balance is reclassified as an expense. At the end of that period, the second payment will also be made.

Initial Recording of a Capital Lease

Question: One slight change can move this contract from an operating lease to a capital lease. Assume all the information remains the same in the previous example except that the airplane has an expected life of only nine years rather than ten. With that minor alteration, the life of the lease is 77.8 percent of the life of the asset (seven years out of nine years). The contract is now 75 percent or more of the life of the asset. Because one of the criteria is now met, this contract must be viewed as a capital lease. The change in that one estimation creates a major impact on the reporting process. How is a capital lease reported initially by the lessee?

 

Answer: As a capital lease, the transaction is reported in the same manner as a purchase. Abilene has agreed to pay $100,000 per year for seven years, but no part of this amount is specifically identified as interest. According to U.S. GAAP, if a reasonable rate of interest is not explicitly paid each period, a present value computation is required to split the contractual payments between principal (the amount paid for the airplane) and interest (the amount paid to extend payment over this seven-year period). This accounting is not only appropriate for an actual purchase when payments are made over time but also for a capital lease.

Before the lessee computes the present value of the future cash flows, one issue must be resolved. A determination is needed of the appropriate rate of interest to be applied. In the previous discussion of bonds, a negotiated rate was established between the investor and the issuing company. No such bargained rate exists in connection with a lease. According to U.S. GAAP, the lessee should use its own incremental borrowing rate. That is the interest rate the lessee would be forced to pay to borrow this same amount of money from a bank or other lending institution.As explained in upper-level accounting textbooks, under certain circumstances, the lessee might use the implicit interest rate built into the lease contract by the lessor. Assume here that the incremental borrowing rate for Abilene is 10 percent per year. If the company had signed a loan to buy this airplane instead of lease it, the assumption is that the lender would have demanded an annual interest rate of 10 percent.

Abilene will pay $100,000 annually over these seven years. Because the first payment is made immediately, these payments form an annuity due. As always, the present value calculation computes the interest at the appropriate rate and then removes it to leave the principal: the amount of the debt incurred to obtain the airplane. Once again, present value can be found by table (in the following link or included at the end of this book), by formula, or by Excel spreadsheet.On an Excel spreadsheet, the present value of a $1 per period annuity due for seven periods at an assumed annual interest rate of 10 percent is computed by typing the following data into a cell: =PV(.10,7,1,,1).

Present value of an annuity due of $1 per year for seven years at a 10 percent annual interest rate is $5.35526. The present value of seven payments of $100,000 is $535,526.

present value = $100,000 × 5.35526 present value = $535,526

After the present value has been determined, the recording of the capital lease proceeds very much like a purchase made by signing a long-term liability.

A comparison at this point between the reporting of an operating lease and a capital lease is striking. The differences are not inconsequential. For the lessee, good reasons exist for seeking an operating lease rather than a capital lease.

Accounting for a Capital Lease over Time

Question: In a capital lease, property is not bought but is accounted for as if it had been purchased. When the contract is signed in the previous example, Abilene records both the leased airplane and the liability at the present value of the required cash payments. What reporting takes place subsequent to the initial recording of a capital lease transaction?

 

Answer: As with any purchase of an asset having a finite life where payments extend into the future, the cost of the asset is depreciated, and interest is recognized in connection with the liability. This process remains the same whether the asset is bought or obtained by capital lease.

Depreciation. The airplane will be used by Abilene for the seven-year life of the lease. The recorded cost of the asset is depreciated over this period to match the expense recognition with the revenue that the airplane helps generate. Assuming the straight-line method is applied, annual depreciation is $76,504 (rounded) or $535,526/seven years.

Interest. The principal of the lease liability during Year Two is $435,526. That balance is the initial $535,526 present value less the first payment of $100,000. The annual interest rate used in determining present value was 10 percent so interest expense of $43,553 (rounded) is recognized for this period of time—the liability principal of $435,526 times this 10 percent annual rate. As in the chapter on bonds and notes, the effective rate method is applied here.

The Reporting of Deferred Tax Liabilities

Question: At the beginning of this chapter, mention was made that Southwest Airlines reported deferred income taxes at the end of 2010 as a noncurrent liability of $2.5 billion. Such an account balance is not unusual. The Dow Chemical Company listed a similar debt of almost $1.3 billion on its December 31, 2010, balance sheet while Marathon Oil Corporation showed approximately $3.6 billion. What information is conveyed by these huge account balances? How is a deferred income tax liability created?

 

Answer: The reporting of deferred income tax liabilitiesA balance sheet account indicating that the current payment of an income tax amount has been delayed until a future date; companies often seek to create this deferral so that tax dollars can be used in the interim to increase net income. is, indeed, quite prevalent. One recent survey found that approximately 70 percent of businesses included a deferred tax balance within their noncurrent liabilities.Matthew Calderisi, senior editor, Accounting Trends & Techniques, 63rd edition (New York: American Institute of Certified Public Accountants, 2009), 279. Decision makers need to have a basic understanding of any account that is so commonly encountered in a set of financial statements.

In the earlier discussion of LIFO, the disparity between financial accounting principles and income tax rules was described. In the United States, financial information is presented based on the requirements of U.S. GAAP (created by FASB) whereas income tax reporting is determined according to the Internal Revenue Code (written by Congress). At many places, these two sets of guidelines converge. If a grocery store sells a can of tuna fish for $6 in cash, the revenue is $6 on both the reported financial statements and the income tax return. However, at a number of critical junctures, the recognized amounts can be quite different.

Where legal, companies frequently exploit these differences for their own benefit by delaying tax payments. The deferral of income taxes is usually considered a wise business strategy because the organization is able to use its cash for a longer period of time and, hence, generate additional revenues. When paid, the money is gone, but until then, it can be used to raise net income. For example, if an entity earns a 10 percent return on assets and manages to defer a tax payment of $700 million for one year, the increased profit is $70 million ($700 million × 10 percent).

Businesses commonly attempt to reduce their current taxable income by moving reported gains and revenue into the future. That is one prevalent method for deferring tax payments. Southwest, Dow Chemical, and Marathon likely used this approach to create a portion of the deferred tax liabilities they are reporting. Revenue or a gain might be recognized this year for financial reporting purposes although deferred until an upcoming time period for tax purposes. Consequently, the payment of tax on this income is pushed into that future year. As long as the tax laws are obeyed, such deferral is legal.

Taxable income is reduced in the current period (revenue is moved out) but increased at a later time (the revenue is moved back into taxable income). Because a larger tax will have to be paid in the subsequent period, a deferred income tax liability is created. To illustrate, assume that a business reports revenue of $10,000 on its Year One income statement. Because of tax rules and regulations, assume that this amount will not be subject to income taxation until Year Six. The $10,000 is referred to as a temporary tax differenceA revenue or expense reported for both financial accounting and income tax purposes but in two different time periods; leads to the recognition of deferred income taxes.. It is reported for both financial accounting and tax purposes but in two different time periods.

If the effective tax rate for this business is 40 percent, it reports a $4,000 ($10,000 × 40 percent) deferred income tax liability on its December 31, Year One, balance sheet. The revenue was earned in Year One, so the related expense and liability are also recorded in Year One. This amount will be paid to the government but not until Year Six when the revenue becomes taxable. The revenue is recognized now according to U.S. GAAP but in a later year for income tax purposes. Although, net income is higher in the current year than taxable income, taxable income will be higher in the future by $10,000. Most important, payment of the $4,000 income tax is delayed until Year Six.

Simply put, a deferred income tax liabilityMany companies also report deferred income tax assets that arise because of other differences in U.S. GAAP and the Internal Revenue Code. For example, Southwest Airlines included a deferred income tax asset of $214 million on its December 31, 2010, balance sheet. Accounting for such assets is especially complex and will not be covered in this textbook. Some portion of this asset balance, although certainly not all, is likely to be the equivalent of a prepaid income tax where Southwest was required to make payments by the tax laws in advance of recognition according to U.S. GAAP. is created when an event occurs now that will lead to a higher amount of income tax payment in the future.

The Installment Sales Method and Deferred Income Taxes

Question: Assume that the Hill Company buys an asset (land, for example) for $150,000. Later, this asset is sold for $250,000 during Year One. The earning process is substantially complete at that point. Hill reports a gain on its Year One income statement of $100,000 ($250,000 less $150,000). Because of the terms of the sales contract, this money will not be collected from the buyer until Year Five. The buyer is financially strong and should be able to pay at the required times. Hill’s effective tax rate for this transaction is 30 percent.

Officials for Hill are pleased to recognize the $100,000 gain on this sale in Year One because it makes the company looks better. However, they prefer to wait as long as possible to pay the income tax especially since no cash has yet been collected. How can the recognition of income for tax purposes be delayed, thereby creating the need to report a deferred income tax liability?

 

Answer: According to U.S. GAAP, this $100,000 gain is recognized on Hill Company’s income statement in Year One based on accrual accounting. The earning process is substantially complete and the amount to be collected can be reasonably estimated. However, if certain conditions are met, income tax laws permit taxpayers to report such gains using the installment sales method.The installment sales method can also be used for financial reporting purposes but only under very limited circumstances. In simple terms, the installment sales method allows a seller to delay reporting a gain for tax purposes until cash is collected. In this illustration, no cash is received in Year One, so no taxable income is reported. The tax will be paid in Year Five when Hill collects the cash. Thus, as shown in Figure 15.10 "Year One—Comparison of Financial Reporting and Tax Reporting", the income is reported now on the financial statements but not until Year Five for tax purposes.

The eventual tax to be paid on the gain will be $30,000 ($100,000 × 30 percent). How is this $30,000 reported in Year One if payment to the government is not required until Year Five?

• First, because of the matching principle, the income tax expense of $30,000 must be recorded in Year One. The $100,000 gain is reported on the income statement in that year; therefore, any related expense is recognized in the same period. That is the basic premise of the matching principle.
• Second, the $100,000 gain creates a temporary difference. The amount will become taxable when the cash is collected in Year Five. At that time, a tax payment of $30,000 is required. Accountants have long debated whether this liability is created when the income is earned (Year One) or when the payment is to be made (Year Five). Legally, the company does not owe any money to the government until the Year Five income tax return is filed. However, reporting guidance provided by U.S. GAAP holds that recognition of the gain in Year One is the event that creates the probable future sacrifice. Thus, the liability is recognized immediately; a deferred income tax liability must be reported.

Consequently, the adjusting entry shown in Figure 15.11 "December 31, Year One—Recognition of Deferred Income Tax on Gain" is prepared at the end of Year One so that both the expense and the liability are properly reported.

In Year Five, when the cash is received from the sale, Hill will report the $100,000 gain on its income tax return. The resulting $30,000 payment to the government eliminates the deferred income tax liability. However, as shown in Figure 15.11 "December 31, Year One—Recognition of Deferred Income Tax on Gain", the income tax expense was reported back in Year One when the original sale was recognized for financial reporting purposes.

Liability for Postretirement Benefits

Question: According to the information provided at the beginning of this chapter, Alcoa reported a $2.6 billion liability at the end of 2010 for accrued postretirement benefits. What constitutes a postretirement benefit?

 

Answer: In a note to the 2010 financial statements, Alcoa explains part of this liability as follows:

“Alcoa also maintains health care and life insurance benefit plans covering eligible U.S. retired employees and certain retirees from foreign locations. Generally, the medical plans pay a percentage of medical expenses, reduced by deductibles and other coverages. These plans are generally unfunded, except for certain benefits funded through a trust. Life benefits are generally provided by insurance contracts. Alcoa retains the right, subject to existing agreements, to change or eliminate these benefits.”

Postretirement benefits cover a broad array of promises that companies make to their employees to boost morale and keep them from seeking other jobs. According to this note disclosure, Alcoa provides two of the most common: health care insurance and life insurance. Based on stipulations as to eligibility, Alcoa helps its employees by paying a portion of these insurance costs even after they have retired. Alcoa apparently continues to provide these payments as a reward for years of employee service.

Determining a Liability for Postretirement Benefits

Question: Assume that one of the employees for the Michigan Company is currently thirty-four years old and is entitled to certain postretirement benefits starting at the age of sixty-five. The company has promised to continue paying health care and life insurance premiums for all retirees as long as they live.Health care and life insurance benefits paid by an employer while an employee is still working do not pose an accounting issue. The costs are known and can be expensed as incurred. These expenses are matched with the revenues being generated by the employees at the current time. For this employee, no postretirement benefits will be paid for the next thirty-one years (65 less 34). After that, an unknown payment amount will begin and continue for an unknown period of time. In one of the opening chapters of this book, the challenge presented to accountants as a result of future uncertainty was discussed. Probably no better example of uncertainty can be found than postretirement benefits. Payments may continue for decades and neither their amount nor their duration is more than a guess.

The employee is helping the company generate revenues currently so that, as always, the related expense should be recognized now according to the matching principle. Although this obligation might not be paid for many years, both the expense and related liability are recorded when the person is actually working for the company and earning these benefits.

How is the amount of this liability possibly determined? An employee might retire at sixty-five and then die at sixty-six or live to be ninety-nine. Plus, estimating the cost of insurance (especially medical insurance) over several decades into the future seems to be a virtually impossible challenge. The skyrocketing cost of health care is difficult to anticipate months in advance, let alone decades. The dollar amount of the company’s obligation for these future costs appears to be a nebulous figure at best. In this textbook, previous liabilities have been contractual or at least subject to a reasonable estimation prior to recognition. How is the liability calculated that will be reported by a company for the postretirement benefits promised to its employees?

 

Answer: As shown by the Alcoa example, postretirement benefits are estimated and reported according to U.S. GAAP while employees work. Because of the length of time involved and the large number of variables (some of which, such as future health care costs, are quite volatile), a precise determination of this liability is impossible. In fact, this liability might be the most uncertain number found on any set of financial statements. Apparently, reporting a dollar amount for postretirement benefits, despite its inexactness, is more helpful than omitting the expense and liability entirely. However, decision makers need to understand that these reported balances are no more than approximations.

The actual computation and reporting of postretirement benefits is more complicated than can be covered adequately in an introductory financial accounting textbook. An overview of the basic steps, though, is useful in helping decision makers understand the information that is provided.

To arrive at the liability to be reported for postretirement benefits that are earned now but only paid after retirement, the Michigan Company takes two primary steps. First, an actuaryAn individual who mathematically computes the likelihood of future events. calculates an estimation of the cash amounts that will eventually have to be paid as a result of the terms promised to employees. “An actuary is a business professional who analyzes the financial consequences of risk. Actuaries use mathematics, statistics, and financial theory to study uncertain future events, especially those of concern to insurance and pension programs.”http://www.math.purdue.edu/academic/actuary/what.php?p=what. In simpler terms, an actuary is a mathematical expert who computes the likelihood of future events.

To make a reasonable guess at the amount of postretirement benefits, the actuary has to make a number of difficult estimations such as the average length of time employees will live and the future costs of health care and life insurance (and any other benefits provided to retirees). For example, an actuary’s calculations might indicate that these costs will average $10,000 per year for the twenty years that an employee is expected to live following retirement.

The future payments to be made by the company are estimated by an actuary, but they are projected decades into the future. Thus, as the second step in this process, the present value of these amounts is calculated to derive the figure to be reported currently on the balance sheet. Once again, as in previous chapters, interest for this period of time is determined mathematically and removed to leave just the principal of the obligation as of the balance sheet date. That is the amount reported by the employer within noncurrent liabilities.

The Consequences of Having to Report a Liability

Question: Alcoa recognizes an accrued postretirement benefit liability on its balance sheet of $2.6 billion. This number is the present value of the estimated amounts that the company will have to pay starting when each employee retires. Except for the inherent level of uncertainty, this accounting seems reasonable. At one time decades ago, companies were not required to recognize this obligation. The liability was ignored and costs were simply expensed as paid. Only after advanced computer technology and sophisticated mathematical formulas became available was the reporting of this liability mandated. What is the impact of reporting postretirement benefits if the numbers can only be approximated?

 

Answer: Organizations typically prefer not to report balances that appear to weaken the portrait of their economic health and vitality. However, better decisions are made by all parties when relevant information is readily available. Transparency is a primary goal of financial accounting. Arguments can be made that some part of the problems that many businesses currently face are the result of promises that were made over past decades where the eventual costs were not properly understood.

As the result of the evolution of U.S. GAAP, decision makers (both inside and outside the company) can now better see the costs associated with postretirement benefits. Not surprisingly, once disclosed, some companies opted to cut back on the amounts promised to retirees. The note disclosure quoted previously for Alcoa goes on further to say, “All U.S. salaried and certain hourly employees hired after January 1, 2002 are not eligible for postretirement health care benefits. All U.S. salaried and certain hourly employees that retire on or after April 1, 2008 are not eligible for postretirement life insurance benefits” (emphasis added).

For the employees directly impacted, these decisions may have been understandably alarming. However, by forcing the company to recognize this liability, U.S. GAAP has helped draw attention to the costs of making such promises.

Vital Signs Studied in Connection with Liabilities

Question: In previous chapters, various vital signs have been examined—numbers, ratios, and the like—that assist decision makers in evaluating an entity’s financial condition and future prospects. In connection with liabilities, do specific vital signs exist that are frequently relied on to help assess the economic health of a business or other organization?

 

Answer: One vital sign that is often studied by decision makers is the debt-to-equity ratioA measure of a company’s use of debt for financing purposes; it is computed by dividing total liabilities by total stockholders’ equity.. This figure is simply the total liabilities reported by a company divided by total stockholders’ equity. The resulting number indicates whether most of a company’s assets have come from borrowing and other debt or from its own operations and owners. A high debt-to-equity ratio indicates that a company is highly leveraged. As discussed previously, that raises the level of risk but also increases the possible profits earned by stockholders. Relying on debt financing makes a company more vulnerable to bankruptcy and other financial problems but also provides owners with the chance for higher financial rewards.

Recent debt-to-equity ratios presented in Figure 15.12 "Recent Debt-to-Equity Ratios for Several Prominent Companies" for several prominent companies show a wide range of results. No single financing strategy is evident here. The debt-to-equity ratio indicates a company’s policy toward debt, but other factors are involved. For example, in some industries, debt levels tend to be higher than in others. Also, individual responses to the recent economic recession might have impacted some companies more than others.

Another method to evaluate the potential problem posed by a company’s debts is to compute the times interest earned (TIE)A measure of a company’s ability to meet obligations as they come due; it is computed by taking EBIT (earnings before interest and taxes) and dividing that number by interest expense for the period. ratio. Normally, debt only becomes a risk if interest cannot be paid when due. This calculation helps measure how easily a company has been able to meet its interest obligations through current operations.

Times interest earned begins with the company’s net income before both interest expense and income taxes are removed (a number commonly referred to as “EBIT” or “earnings before interest and taxes”). Interest expense for the period is then divided into this income figure. For example, if EBIT is $500,000 and interest expense is $100,000, the reporting company earned enough during the year to cover the required interest obligations five times.