Module 6
Assets, Taxes & Postretirement Benefits
A. Measurement of the Carrying Amount of Long-Lived Assets
Assets can be tangible items such as inventories and buildings or intangible items
such as patents and trademarks. The previous two chapters—on receivables and
inventories—examined current assets. Current assets represent a large part of total assets
for many companies. Recall that a current asset is expected to be converted into cash
within one year or within the operating cycle, whichever is longer. This chapter
concentrates on operating assets expected to yield their economic benefits (or service
potential) over a period longer than one year. Such assets are called long-lived assets.
Long-lived assets represent a significant percentage of total assets in industries
such as oil exploration and refining, automobile manufacturing, and steel. Exhibit 10.1
shows the asset portion of Exxon Mobil Corporation’s balance sheet in both dollar and
common-size terms at December 31, 2012. Notice that long-lived assets (Property, plant,
and equipment) comprise 68.0% of total assets. Firms have latitude in how much detail
they provide about separate long-lived asset components.
Expected benefit approaches recognize that assets are valuable because of the
future cash inflows they are expected to generate. Consequently, these approaches
measure various definitions of future cash inflows that are expected to be generated by
the asset. One example of an expected benefit approach is discounted present value.
Under it, the value of an item of manufacturing equipment is measured by estimating the
discounted present value of the stream of future net operating cash inflows it’s expected
to generate over its operating life. Another example of an expected benefit approach is
the cash inflow that the asset would bring if it were sold instead of being used in
operations. Under this variant of the expected benefit approach, long-lived assets are
reported at their net realizable value—the amount that would be received if the assets
were sold in the used asset market. Under both approaches, the income statement effect is
the change in the value of the asset.
Economic sacrifice approaches to asset measurement focus on the amount of
resource expenditure necessary to acquire it. One example of an economic sacrifice
approach is historical cost (the dominant GAAP measurement method)—that is, the
historical amount spent to buy the asset constitutes the past sacrifice incurred to bring the
asset into the firm. Another example of an economic sacrifice approach involves
measuring the current (or replacement) cost of the asset. Under a replacement cost
(sometimes called current cost) approach, assets are carried at their current purchase cost
—the expenditure (sacrifice) needed today to buy the asset. Under both of these
approaches, depreciation expense is recognized on the income statement. However, under
replacement cost, a firm also recognizes in other comprehensive income holding gains
(losses) for increases (decreases) in replacement costs. Depreciation expense is then
based on the revised replacement cost amounts.
Accounting numbers are widely used in contracts such as loan agreements,
incentive compensation plans, and union contracts (see Chapter 7). Because of these uses,
parties whose transactions are explicitly or implicitly tied to accounting numbers expect
them to be neutral (unbiased) and free from error (accurate). Recall from Chapter 1 that
these characteristics are ingredients of faithful representation.2 If the numbers are easily
manipulated or inaccurate, then cautious decision makers would be reluctant to enter into
contracts using such “soft” numbers. The reason is that manipulation by one party could
circumvent the contract terms. In addition, contracting parties desire timely and cost
effective accounting so that contracts can be monitored and enforced. Auditors also
prefer that financial statement numbers have certain characteristics. One is that the
numbers be verifiable. Verifiability means the numbers should arise from readily
observable, corroborative facts rather than from subjective beliefs. Verifiable numbers
are important to auditors because of the many lawsuits arising from audited financial
statements. Auditors believe that verifiable data help provide a defense in court, reducing
potential litigation losses.
The economic sacrifice approach that uses replacement cost—that is, the
estimated current cost of replacing the asset (alternative 3)—has also been disqualified on
the basis of concerns similar to those expressed for net realizable values. Because of the
practical considerations discussed above, historical cost (less accumulated depreciation)
has become the primary method for reporting long-lived assets in the United States.
However, it also can have serious limitations. First, depreciation is an allocation of
historical cost to time periods. Except by coincidence, the net book value amount at a
point in time—original cost less accumulated depreciation—does not reflect the expected
benefit of the asset. Long-lived assets typically last for many years, and the expected
benefits might increase rather than decrease. U.S. GAAP prohibits upward adjustments to
long-lived assets. Second, because the financial statements do not reflect replacement
costs or present values, analysts may have difficulty making meaningful comparisons of
old firms to new firms in the same industry or comparing firms across industries. This
problem is exacerbated if a firm does not modernize and innovate. Under historical cost,
the return-on-asset ratio increases as the book value of the asset declines from
depreciation.
Avoidable interest is the product of cumulative weighted average expenditures on
the constructed asset times the interest rate. Let’s first illustrate the computation of
cumulative weighted average expenditures. The computation measures the timing of the
dollar expenditures over the construction period. The earlier in the period the expenditure
takes place, the more days that the expenditure needs to be financed— and the more
interest is incurred. For example, assume that expenditures of $1,000,000 are incurred
evenly over the 2014 year that construction took place. Here, cumulative weighted
average expenditures are simply $1,000,000/2 5 $500,000.
However, capitalization is restricted to interest arising from actual borrowings
from outsiders. To see the financial statement effect of this restriction, let’s assume that
Canyon had not borrowed from a bank but had instead issued more common stock and
used the proceeds to finance construction. Also assume that Canyon had absolutely no
interestbearing debt outstanding. Equity funds are not “free”—stockholders expect to
earn a return and will replace management if it doesn’t materialize! Despite this, GAAP
does not allow Canyon to calculate an artificial interest charge on the equity financing
and capitalize this “imputed interest” as a part of the cost of the building. So, the way the
construction is financed can alter the cost capitalized under GAAP when a company
initially has no outstanding debt. Treating equity that is issued to finance construction as
“free” (when there is no interestbearing debt outstanding) is consistent with the
traditional accounting model. That is, GAAP does not recognize the imputed cost
associated with capital provided by stockholders. These funds are treated as if they are
free. So, the cost of equity capital is ignored under GAAP in both income determination
and asset costing.
The way incurred costs are allocated between land and building affects the
amount of income that will be reported in future periods. Land is a permanent or
nonwasting asset, so it’s not depreciated. A factory building has a finite life and is
depreciated over future years. For financial reporting purposes, the manner in which costs
are allocated between, say, land and building, is guided by which one (land or building)
generated the cost. For tax purposes, the incentives for allocating costs between land and
building asset categories are completely different because the objective of most firms is
to minimize tax payments, not to “correctly” allocate costs. The higher the costs allocated
to land for tax purposes, the higher the future taxable income becomes because land
cannot be depreciated. Aggressive taxpayers seek to minimize the amount of joint
expenditures allocated to nondepreciable assets such as land. Similarly, taxpayers would
prefer not to capitalize interest payments for tax purposes because the benefits of the
deduction would be spread over the depreciable life of the asset rather than being
deductible immediately. However, U.S. income tax rules generally parallel financial
reporting rules and require cost allocations between land and buildings that are similar to
U.S. GAAP rules. The same is true for interest capitalization—U.S. tax rules closely
parallel GAAP rules and therefore require avoidable interest to be capitalized for tax
purposes.
When one firm purchases an intangible asset—for example, a valuable trademark
—from another firm, few new accounting or reporting issues arise. The acquired
intangible asset is recorded at the arm’s-length transaction price. If the intangible asset is
purchased with other assets, then the purchase price must be allocated among assets
based on relative fair values as shown on pages 550–551. Most acquired intangible assets
are amortized (depreciated) over their expected useful lives (discussed in more detail later
in the chapter). We refer to these intangibles as amortizable intangible assets. However,
some intangible assets such as brand names have indefinite lives and are not amortized.
Instead, they are evaluated annually for impairment (decline in value). We refer to these
types of intangibles as indefinite-lived intangible assets. Goodwill is another type of
intangible asset, which represents the difference between the total fair value of an
acquired business and the fair value of its identifiable net assets.
The major types of cash outflows most likely to result in intangibles creation
(R&D, advertising costs, and so forth) are immediately expensed. When past outflows
successfully create intangible assets, these outflows have already been expensed and
there are usually few remaining future outflows to capitalize! Consequently, the balance
sheet carrying amount for intangible assets is often far below the value of the property
right. As software development companies proliferated in the 1980s, authoritative
accounting guidance was ultimately issued for software development costs.7 This GAAP
applies the previously described R&D rules to the particular circumstances faced by
companies developing computer software products. Specifically, prior to establishing the
technological feasibility of a computer software product, a company expenses all R&D
costs incurred to develop it. After technological feasibility is established, additional costs
incurred to ready the product for general release to customers are supposed to be
capitalized. Capitalization of additional costs ceases when the final product is available
for sale. The costs incurred before technological feasibility is established can be
considerable; because feasibility may not be ensured until late in the expenditure cycle,
there may be few costs left to capitalize. Accordingly, the intangible software asset may
be recorded at an amount far lower than its value to the software development firm, just
as in other (nonsoftware) R&D settings.
Even though the potential assets associated with R&D expenditures are not
recognized under GAAP, research indicates that investors treat the expenditures as if they
are assets. One study examined the relationship between R&D expenditures and both
future earnings and share values.9 The study found that a $1 increase in R&D
expenditures results in a cumulative $2 profit increase over a seven-year period.
Furthermore, a $1 increase in R&D expenditures leads to a $5 increase in the market
value of a firm’s shares, on average. So, R&D expenditures are related to future benefits,
and logic suggests that a causal relationship exists. Another study developed statistically
reliable estimates of unrecorded R&D asset costs.10 These estimates were then used to
adjust reported earnings and book values to reflect capitalization of R&D. The adjusted
numbers that reflected R&D capitalization (and subsequent amortization) were strongly
associated with stock prices and returns and, thus, were value-relevant to investors. So,
investors’ behavior suggests that the adjusted numbers are measuring R&D benefits. A
recent study suggests that not all R&D is created equal. R&D appears to have the most
impact on future earnings in industries where patents and other legal mechanisms are
most effective in protecting R&D.11 Given the above academic research, analysts should
consider carefully R&D expenditures in their evaluations of companies though they are
not on the balance sheet.
Analysts can recast financial statements using required GAAP disclosures. For
example, firms are required to disclose separately total expensed R&D costs.13 Similarly,
authoritative accounting literature requires disclosure of unamortized software assets,
amortization and write-downs of the assets in each period, and all costs that are expensed
prior to technological feasibility.14 Analysts can use these disclosures to reconstruct what
asset and amortization amounts would be if GAAP allowed full capitalization. (Analysts
can create their own estimation procedures or use the methods in the article cited in
footnote 10.) Unfortunately, disclosures of marketing and advertising expenditures are
voluntary and therefore do not consistently permit a similar adjustment approach for
trademarks or brands. So, it’s harder to undo the limitations of GAAP for these
unrecorded intangible assets
B. Asset Impairment
As mentioned early in this chapter, due to verifiability concerns, long-lived assets
are carried at depreciated historical cost instead of net realizable value. However, the
concept of faithful representation (see Chapter 1, page 18) outweighs verifiability
concerns when there is evidence that the carrying value of long-lived asset exceeds the
expected future economic benefits. When a long-lived asset is considered to be impaired,
the carrying value is reduced to its fair value, and the new value is then depreciated over
its remaining useful life.
The GAAP steps for evaluating indefinite-lived intangible assets for impairment
are more straightforward than the steps discussed above.21 Indefinite-lived intangible
assets must be evaluated for impairment annually or more frequently if the firm observes
events such as those discussed in Stage A for tangible assets. U.S. GAAP allows a two-
step evaluation process where firms first assess qualitative factors to determine whether it
is necessary to perform a quantitative impairment test. If based on this qualitative
evaluation, management believes that it is more likely than not that an indefinite-lived
intangible asset has been impaired, then it must go to the second step and perform a
quantitative assessment by calculating the fair value of the intangible asset. If the book
value of the asset exceeds the fair value, then the asset is considered impaired. The firm
then reduces the book value of the asset to its estimated fair value and records a loss. As
is the case with tangible assets and amortizable intangible assets, the book value of the
asset cannot be increased later if the fair value recovers.
We build on our prior discussions by analyzing the excerpts of Krispy Kreme
Doughnuts’ 2011 annual report provided in Exhibit 10.7. During the first part of the last
decade, Krispy Kreme Doughnuts enjoyed rapid sales growth and expansion. However,
subsequently, its profits declined, and some stores were no longer profitable. The top
schedule summarizes the impairment charges from 2009 to 2011. The schedule shows
that Krispy Kreme recorded new impairment charges on its long-lived assets of $3,437
thousand for the year ended January 30, 2011. The paragraph below the schedule
describes the company’s impairment review and measurement process. Note that this
process is consistent with our earlier discussion of the GAAP guidance for impairments.
When an electric utility builds a nuclear plant or an oil company constructs an
offshore drilling rig, regulatory authorities require public welfare and safety expenditures
at the end of the asset’s life. Nuclear plants must be decontaminated and drilling rigs
must be disassembled. This costs money. And by law, these expenditures must take
place. So, when certain types of assets are built, a liability simultaneously arises for
future expenditures. Historically, there were not generally accepted accounting principles
to guide the accounting for these required outflows at the end of an asset’s life, so no
liability appeared on firms’ books. But current GAAP requires firms to record a liability
when certain assets are placed into service.24 Here’s how the rules work. Firms are
required to estimate the expected present value of the outflows that will occur when
assets are eventually retired. These outflows are discounted using a credit-adjusted risk-
free rate. The liability’s discounted present value is recorded along with an increase in the
carrying amount of the related long-lived asset.
Firms constantly experience changing market conditions such as the emergence of
new competing products or the development of more efficient distribution systems. In
responding to these innovations, firms often seek to dispose of groups of assets that are
no longer suited to the new environment they face. When firms actively try to sell some
of the assets they currently own, these asset groups generally should be classified in the
balance sheet as “held for sale” if they are expected to be sold within one year.26 When
assets are held for sale, they are reported at the lower of book value or fair value less
costs to sell.
Segregating the assets held for sale on the balance sheet and separately disclosing
their operating results on the income statement are designed to help analysts better
understand past firm performance and assess future prospects. For example, in evaluating
the efficiency of past asset utilization using the return-on-assets ratio, assets that are
destined for sale should be excluded from the rate-of-return denominator and their profit
or loss contribution should be excluded from the numerator. This exclusion provides a
better measure of expected future performance based on assets expected to remain in the
firm. The disclosure rules provide guidance on when certain assets should be segregated
on the balance sheet, which alerts analysts to items that should be omitted from rate-of-
return calculations.29 Similarly, income forecasts are enhanced insofar as the income or
loss from the asset groups that have been or are about to be sold are isolated “below the
line” and are no longer factored into the analysts’ forecast.
C. Depreciation
Productive assets such as buildings, equipment, and machinery eventually wear
out. Assets including patents, which have a finite economic life, ultimately expire.
Consequently, the cost of these assets must be apportioned to the periods in which they
provide benefits. The systematic expensing and write-down of a tangible long-lived asset
is called depreciation. For intangible assets, the allocation of costs to periods is referred
to as amortization. For mineral deposits and other wasting assets, the assignment of
expired costs to periods is called depletion. For simplicity, we refer collectively to any of
these allocations of costs to periods as the depreciation process. In financial reporting, the
cost to be allocated to periods through the depreciation process is the asset’s original
historical cost minus its expected salvage value. The objective is to spread the original
cost over the period of asset use; depreciation is not intended to track the asset’s
declining market value. Realistically, the asset’s end-of-period book value (its original
cost minus cumulative depreciation) would approximate its market value only by sheer
coincidence. We stress this absence of correspondence between accounting measures of
depreciation and value decrement because GAAP accounting depreciation, as we have
said, is a process of cost allocation, not asset valuation.
The straight-line (SL) depreciation method simply allocates cost minus salvage
value evenly over the asset’s expected useful life. The units-of-production (UP)
depreciation method is similar to SL but allocates cost minus salvage over the expected
units to be produced instead of the expected useful life. We compute a per unit rate
instead of an annual rate of depreciation. To illustrate the method, we assume that 20,000
units are expected to be produced, and actual production follows the pattern given in
Exhibit 10.8. Note that the amount of SL depreciation is constant, but UP depreciation
does not follow a consistent pattern. In both cases, total depreciation expense equals
$10,000 over the five-year period. The units-of-production method is often used in
extractive industries. For example, the cost ofLexploring and drilling for oil would be
capitalized and then depreciated on the basis of expected barrels of oil. The depreciation
rate for the double-declining balance (DDB) method is double the straight-line rate (in
Exhibit 10.8, 20% per year for SL, 40% per year for DDB). Applying a constant DDB
depreciation percentage to a declining balance will produce a book value at the end of the
asset’s economic life that is above or below the salvage value. To depreciate down to an
asset’s expected salvage value using DDB, two steps can be employed.
This adjustment process relies on several assumptions. First, the adjustment
assumes that the useful life differences are artificial and do not reflect real differences in
expected asset longevity. Second, it assumes that the salvage value proportions are
roughly equivalent for all firms in the industry, and third, the dollar breakdown within the
asset categories (e.g., buildings versus leasehold improvements) are similar across the
firms being compared. If these assumptions are incorrect, the average age computation
for one firm cannot legitimately be applied to the other’s asset base to estimate “adjusted”
depreciation. However, if these assumptions hold, the adjusted numbers should make a
comparison between Whole Foods and other firms in the industry more accurate. In
Chapter 13, we illustrate another adjustment approach for depreciation differences that
uses data from the deferred income tax footnote.
D. Exchanges of Nonmonetary Assets
Occasionally firms will exchange one nonmonetary asset such as inventory or
equipment for another nonmonetary asset. Unless certain exceptions in the following
discussion apply, the recorded cost of a nonmonetary asset acquired in exchange for some
other nonmonetary asset is the fair value of the asset that was given up. Any resulting
gain or loss on the transaction is recognized. Each company received cash, and the stage
was therefore set for potentially recognizing revenues and income on these deals. These
deals sometimes generated upfront income. Even if they didn’t generate income, they did
increase revenues—an important factor “since investors focused on revenue in new
industries that often had little earnings to show for themselves.”
For firms to use the revaluation method, they need reliable measurements, which
often require the help of professional appraisers. When firms have reliable measurements
and elect the revaluation method, the Accumulated depreciation account is typically
removed and the revalued amount becomes the new book value.40 If the asset is
originally written-up, the amount of the write-up is credited to an owners’ equity account
called Revaluation surplus (equivalent to Accumulated other comprehensive income in
U.S. GAAP). Subsequent write-downs are debited to this account until it is depleted. Any
additional write-downs are debited as revaluation losses. If assets are originally written-
down, the amount of the write-down is debited as a revaluation loss. Subsequent write-
ups are credited as revaluation loss reversals through net income to the degree they
reverse prior write-downs. Any additional write-ups are credited to Revaluation surplus.
Depreciation in subsequent periods is based on the revaluation net book value
(€35,000,000). If the building has an expected remaining useful life of 20 years at the
time of the revaluation, annual depreciation on the income statement will be €1,750,000
(that is, €35,000,000y20). While revaluations are not mandatory, if a company does
voluntarily revalue assets, all assets of a similar class (nature or function) must be
revalued. Furthermore, once assets are revalued, regular reassessments are required to
keep the valuations up to date. Most firms do not choose the revaluation method for their
tangible assets. This is not surprising given the cost of appraisals and estimating fair
values. However, some firms use it for specific classes of assets with significant amounts
of land. Given that firms can use the revaluation method for all, some, or none of its
tangible assets, comparability across firms can be an issue.
Another area in which U.S. GAAP and IFRS rules for tangible long-lived assets
potentially diverge is accounting for investment property.41 Long-lived investment
property consists of assets such as land, buildings, and equipment that are held to earn
rentals, for capital appreciation, or for both. To understand how these differ from other
long-lived assets under IFRS, investment properties are assets that are not used to
produce or supply goods or services, nor are they held for sale in the ordinary course of
business (as inventories are). They are distinct from the company’s operating assets.42
When investment properties are initially acquired, they are measured at cost.
Subsequently, however, firms have the choice under IAS 40 to carry investment
properties at either amortized historical cost or fair value. The method selected must be
applied to all investment properties. So, a firm would not be allowed to use the fair value
method for investment land while simultaneously measuring buildings held for
investment at cost. However, comparability across firms will still be affected because
firms have the choice of cost or fair value. Firms choosing the cost method still have to
disclose fair values, and this disclosure would allow analysts to adjust historical cost
method financial statements.
IAS 36, “Impairment of Assets,” provides the guidelines for impairments of long-
lived tangible and intangible assets other than investment property measured at fair
value.46 For tangible assets and amortizable intangible assets, events that require an
impairment review are similar to the U.S. GAAP events mentioned in Stage A on page
558. However, Stage C differs in that an impairment loss occurs if the carrying value
exceeds the recoverable amount, defined as the higher of the asset’s fair value (less costs
to sell) and its value in use, which is the discounted net cash flows identified in Stage B.
Because of the use of discounted instead of undiscounted net cash flows, IFRS guidelines
could trigger an impairment loss that would not be triggered by GAAP. In addition, in the
event of a write-down, IFRS guidance would reduce the carrying value to the higher of
the discounted cash flows or fair value less selling costs, whereas GAAP would reduce
the carrying value to fair value (see Stage E on page 559). Consequently, we would
expect to see more frequent, but smaller, impairments under IFRS than under GAAP.
IFRS rules also permit reversals of previously recognized impairment losses when there
has been a change in the estimates that were previously used to measure the loss. The
reversal increases net income.
E. Understanding Income Tax Reporting and Note Disclosures
A temporary difference results when a revenue (gain) or expense (loss) enters into
the determination of book income in one period but affects taxable income in a different
(earlier or later) period. A brief summary of common temporary differences is provided
in Exhibit 13.1. Temporary differences are so named because they eventually reverse.
That is, a revenue (or expense) item that causes book income to be more (less) than
taxable income when it is initially recorded— called an originating temporary difference
—will eventually reverse. These reversals cause book income to be less (more) than
taxable income in future periods and are called reversing temporary differences.
To illustrate the issues related to interperiod tax allocation, consider the most
common temporary book/tax difference: depreciation expense. For tax purposes, value-
maximizing firms try to minimize the discounted present value of their future tax
payments. Assuming tax rates do not change, each dollar of tax deduction today is more
valuable than a dollar of tax deduction in the future. This time-value-of-money principle
is why most firms use accelerated depreciation for tax purposes. But many of these same
firms use straight-line depreciation for financial reporting purposes. This creates a
temporary difference between book income and taxable income.
The easiest way to record income tax expense here would be to treat the taxes
payable each year (Column [c] of Exhibit 13.4) as the reported book income tax expense.
Exhibit 13.5 and Figure 13.2 show what would happen if this were done. As you can
readily see in the exhibit and figure, this approach causes the effective tax rate to increase
from 32.7% in 2014 to 37.3% in 2018, while after-tax earnings would decline from
$13,467 in 2014 to $12,533 in 2018 (Column [d] of Exhibit 13.5). This occurs even
though pretax book income ($20,000) and the statutory tax rate (35%) are stable over the
five-year period.
Columns (a) and (b) of Exhibit 13.6 repeat information from earlier exhibits.
Column (a) shows the amount of tax that must be paid each year and column (b) shows
the difference between book depreciation and tax depreciation each year. Now consider
what happens in 2014. Mitchell must pay $6,533 in taxes, which was determined as
taxable income of $18,667 times the 35% tax rate. But book pre-tax income was $20,000
(Exhibit 13.4). The $1,333 difference between taxable income and book pre-tax income
was because of the different depreciation methods used in the books and in the tax return.
So now we ask the question, will there ever be a tax payment on the additional $1,333 of
book pre-tax income recognized in 2014? The answer is yes because tax depreciation will
be less than book depreciation in the later years of the asset’s life, causing taxable income
to exceed pre-tax book income when that happens. So, in 2014 there is an increase in a
deferred tax liability to reflect the future tax payment on future taxable income
corresponding to 2014 pre-tax book income. This increase in the deferred tax liability
increases 2014 income tax expense accordingly.
This constant effective tax rate at exactly the 35% statutory tax rate resulted from
a combination of factors. First, we applied interperiod tax allocation, or deferred tax
accounting, rather than basing income tax expense on the amount of taxes to be paid in a
given year. Second, we assumed the statutory tax rate itself was constant at 35%. (We
have already mentioned that if the tax rate changes, the effective tax rate will be affected,
and we will illustrate how that happens later in the chapter.) Third, we assumed there
were no permanent differences. Permanent differences cause the effective tax rate to
deviate from the statutory tax rate because they affect book pre-tax income without a
corresponding effect on income tax expense or vice versa. In either case, when there are
permanent differences and we divide income tax expense by book pre-tax income, we no
longer get 35%. For example, suppose that in any year we examined, Mitchell also had
$5,000 of municipal bond interest. This interest is never subject to tax, so there should be
no income tax expense associated with it. Because the income is not subject to tax,
currently payable taxes are unaffected. And because the municipal bond interest does not
create a temporary difference, there is no change in any deferred tax asset or liability. So
there is no effect on income tax expense as a result of this income. However, pre-tax
book income would be $5,000 higher, so the effective tax rate would be $7,000y($20,000
1 $5,000) 5 28%. If this level of municipal bond interest were constant across years, the
effective tax rate would still be constant due to the interperiod tax allocation, but it would
be constant at 28%. If the level of municipal bond interest were changing over time, the
effective tax rate would change as well.
The Mitchell Corporation example illustrates a situation in which pre-tax book
income initially exceeds taxable income, creating a deferred tax liability. But temporary
differences can go in the opposite direction as well. In many circumstances, taxable
income initially exceeds pre-tax book income, thereby giving rise to deferred tax assets.
To illustrate how a deferred tax asset arises, let’s assume that in December 2014 Paul
Corporation leases an office building it owns to another company for $100,000. The lease
covers all of 2015 and specifies that the tenant pay the $100,000 to Paul Corporation
immediately on signing the lease in 2014. On an accrual basis, rental income will be
earned entirely in 2015, the period covered by the lease.
There is no guarantee a firm will be profitable in the future. And, if a firm does
not generate any taxable income, it may not be able to realize the tax benefits represented
by the deferred tax assets it recorded. That is, those benefits can only be realized through
reduced tax payments if there are tax payments to be reduced. For this reason, GAAP
requires firms to assess the likelihood that deferred tax assets may not be fully realized in
future periods. If management believes the probability of future taxable income being
sufficient to realize fully its deferred tax assets is more than 50%, then deferred tax assets
can be recognized in their entirety. However, if management’s assessment indicates that
it is more likely than not that some portion of the benefit will not be realized, then a
deferred tax asset valuation allowance isLrequired. GAAP states that this valuation
allowance “shall be sufficient to reduce the deferred tax asset to the amount that is more
likely than not to be realized.”
The guidance on how to assess whether a valuation allowance is necessary
requires firms to consider all available information, both positive and negative. The
guidance notes, however, that for start-up companies, the full assortment of information
normally examined is likely not to be available. In particular, there may not be a history
of profitable operations to suggest the firm will be profitable in the future. The guidance
goes on to say that forming a conclusion that a valuation allowance is not necessary
would be difficult when there is negative evidence, such as losses in recent periods,
particularly if there was no taxable income in any prior years to which those losses could
be carried back.
It is not unusual to see a valuation allowance at a profitable company, although
this might seem counterintuitive. If a firm has deferred tax assets in a particular tax
jurisdiction, it will have to generate taxable income in that jurisdiction to realize the value
of the deferred tax assets. So if, for example, a company has a European subsidiary that
has no history of profits, it might need a valuation allowance even if the U.S. parent is
profitable overall. The decisions to establish a deferred tax asset valuation allowance and,
if so, what amount to record are subjective assessments. Readily observable criteria do
not exist, and the dollar amounts involved can be very large, so the potential for abuse is
clear. For an example of how large a valuation allowance can be relative to the rest of the
financial statements, we consider Ford Motor Company’s 2011 valuation allowance
reversal. In January 2012, Ford issued a press release disclosing its earnings results for
2011.
In general, U.S. GAAP requires firms to classify deferred tax assets or deferred
tax liabilities as current or noncurrent according to how the asset or liability giving rise to
the temporary difference is classified. For example, a deferred tax asset related to
doubtful accounts on accounts receivable (a current asset) would be classified as current,
whereas a deferred tax liability for temporary differences on depreciation of fixed assets
would be classified as noncurrent. A temporary difference is related to an asset or
liability if reduction of that asset or liability causes the temporary difference to reverse.
The term reduction includes amortization, sale, or other realization of an asset and
amortization, payment, or other satisfaction of a liability. If a deferred tax asset or
liability is not related to an asset or liability (e.g., a deferred tax asset related to a net
operating loss carryforward), it is classified according to the expected reversal date of the
temporary difference. In the case of Unfortunato’s $87,500 deferred tax asset related to
its net operating loss carryforward, the portion expected to be realized in the coming year
would be classified as current and the remainder would be classified as noncurrent.
We have not said much about permanent differences yet, other than to define
them. Permanent differences are items (either revenue/gain or expense/loss) that are
included in book pre-tax income but not taxable income, or vice versa. It is not just a
difference in when the item is reported, but whether it is reported at all, ever. For
example, municipal bond interest income is never included in taxable income but it is
part of pre-tax book income, so it represents a permanent difference. The reason we have
not said much about permanent differences yet is because our approach to determining
income tax expense implicitly deals with permanent differences. Income tax expense
should include the income tax consequences of any amounts included in pre-tax book
income, regardless of when those tax consequences are realized in cash through higher or
lower tax payments. An item included in pre-tax book income that will never be included
in taxable income has no tax consequences ever and so it should not affect income tax
expense. By summing the income tax currently payable and the change in deferred tax
assets and liabilities, we properly incorporate the fact that there are no tax consequences
for items included in pre-tax income but not taxable income.
Income tax note disclosures provide financial statement users with a wealth of
information. If you understand these disclosures, you’ll be able to extract useful insights
about a firm’s past performance, future prospects, and tax planning strategies. To
illustrate, let’s look at the income tax note from the annual report of Deere & Company
for the year ended October 31, 2012, shown in Exhibit 13.14. To make the discussion
easier to follow, we divided the note into Panels (a) through (d) and numbered key lines
or sections in these panels.
The reconciliation in Exhibit 13.14(b) is required under GAAP.10 It shows why
the debit to income tax expense in the 2010–2012 period was different from the U.S.
federal statutory corporate tax rate of 35% times pre-tax book income. For example, the
$1,659 million debit to income tax expense in the previous entry is not equal to 35% of
Deere’s reported 2012 pre-tax income of $4,734.4 million 3 35% 5 $1,657.0 million,
although in this particular year the difference is quite small. The reconciliation [Item ➃ in
Exhibit 13.14(b)] explains what caused the divergence. The reconciliation is useful to
analysts because it provides information about the firm’s tax planning and policies. It is
also useful to assess the quality of earnings and for forecasting future income tax
expense. A large year-to-year decrease in effective tax rates translates into an increase in
bottom-line earnings that may not be sustainable. The divergence between the statutory
tax rate (the 35% tax rate set forth in U.S. federal tax laws) and the effective tax rate
(measured by book tax expense divided by book pre-tax income) arises from a number of
sources.
Recall from our earlier discussion of valuation allowances that a change in the
valuation allowance is reflected immediately in income tax expense, even though there is
no corresponding amount in pre-tax book income. Therefore, changes in the valuation
allowance cause the effective tax rate to deviate from the 35% statutory tax rate and
create a reconciling item in the tax rate reconciliation. Deere’s income tax rate
reconciliation in Exhibit 13.14(b) shows the company’s income tax expense was $200
million higher in 2012 than it otherwise would have been because of a change in the
valuation allowance. This amount is approximately equal to the $211Lmillion difference
between the valuation allowance reported at October 31, 2012, and October 31, 2011
(285 2 74, from Exhibit 13.4(c), item ➇). The fact that these two amounts are not
identical could be explained by changes in exchange rates used to translate valuation
allowances related to foreign operations
Finally, federal tax laws provide tax credits (dollar for dollar credit against tax
burden otherwise owed) for certain types of expenditures. By reducing income tax
expense without altering pre-tax book income, these tax credits reduce the effective tax
rate below the statutory rate. Deere’s reconciliation shows adjustments for two tax
credits. The company received a tax credit for wind energy production in 2010 ($30
million). It also received research and development tax credits in all three years
presented. The amount of the credits totaled $10Lmillion in 2012.
Notice that the $426 million increase in Deere’s net deferred tax assets (net debits
to these accounts) in Exhibit 13.14(c) does not equal the $92 million debit to Deferred tax
assets and liabilities shown in the journal entry on page 770 to record Deere’s 2012 tax
expense, taxes payable, and deferred taxes. The discrepancy is partially explained by
intraperiod income tax allocation, discussed briefly in Chapter 2. Recall that all income
statement items shown below Income from continuing operations and any direct charges
or credits to stockholders’ equity are shown net of any related income tax effects.
Accordingly, tax effects (including deferred tax effects) that arise from discontinued
operations, extraordinary items, direct charges or credits to stockholders’ equity for prior
period adjustments, or other comprehensive income items are not included in Deere’s tax
journal entry on page 770. This journal entry is limited to income tax effects that relate to
income from continuing operations. Deere reported no discontinued operations and no
extraordinary items in 2012. However, Deere’s Statement of Changes in Stockholders’
Equity (not shown) reveals four items of Other comprehensive income— retirement
benefits adjustment, cumulative translation adjustment, unrealized loss on derivatives,
and unrealized gain on investments. Generally, all of these items except for the
translation adjustment would be shown net of deferred tax effect. Deere reported an
increase in accumulated other comprehensive loss of $623.8 million in fiscal 2012 related
to the three items that are shown net of deferred tax effect. We can estimate the pre-tax
amount related to these items as $623.8 million/(1 2 0.35) 5 $959.7 million and the tax
effect to be $959.7 million 3 0.35 5 $335.9 million. This tax effect would increase the
deferred tax asset during the year. So, it explains essentially the entire $334 million
difference between the $426 million that net deferred tax assets increased and the $92
million increase in net deferred tax assets that is explained by the deferred tax provision.
The deferred tax asset also would have been affected by any revaluation of foreign
deferred tax assets and liabilities for changes in exchange rates, although we do not have
sufficient information to determine those amounts.
We have seen that deferred tax assets and liabilities reverse eventually. However,
we almost never see a deferred tax asset or liability balance of zero in a balance sheet.
Why? Because even though individual deferred tax assets and liabilities reverse, as they
do, they are replaced by new deferred tax assets and liabilities that arise. Whether a
company’s overall deferred tax position is growing or shrinking is likely to be related to
whether the company itself is growing or shrinking. Consider once again the Mitchell
Company example from earlier in the chapter. Mitchell acquired a machine and
depreciated it over a five-year period using straight-line depreciation for financial
reporting and sum-of-the-years-digits for tax purposes. Suppose Mitchell bought one of
these machines every year and its profits reflected the expanding production capacity as
Mitchell went from one machine to two to three and so on. But as soon as a machine
reached five years old, it was no longer usable and Mitchell disposed of it. So, after five
years, Mitchell would be in a “steady state” with five machines operating. Each year it
would acquire a new machine but dispose of an old one. After some years, suppose
Mitchell stopped replacing machines so that the company would shrink in size.
It is often said that generating deferred tax liabilities increases cash flow. This
statement is not actually true. Using tax accounting methods that accelerate deductions or
delay income recognition increases cash flow, at least in the early years. This strategy
may or may not also create deferred tax liabilities, but it is the tax strategy, not whether a
deferred tax liability is created, that affects cash flow. Let’s return to the Mitchell
Corporation example yet again. In 2014, Mitchell would have reported the income
statement and cash flow statement shown in the first column of ExhibitL13.16. Note that
in the cash flow statement depreciation and the deferred portion of the income tax
provision are both added back to net income to derive cash flow from operating activities.
Both of these items are noncash components of net income and therefore must be
reversed in the operating activities section of the cash flow statement.
F. Income Tax Measuring and Reporting Uncertain Tax Positions
Uncertainty abounds in tax law, and whether a tax position will ultimately be
upheld often is unclear because of ambiguity in the law or conflicting court decisions. An
uncertain tax position is a tax position that may, as a result of such ambiguity, be
challenged by taxing authorities. If the firm is not successful in defending its position
either in discussions with the taxing authority or in court, the amount and timing of the
firm’s tax payments ultimately will differ from what the firm envisioned. For example,
since 2005, firms have been permitted to deduct a portion of their profits from certain
domestic production activities. (That portion currently stands at 9%.) Gibson &
Associates, an engineering and construction firm, took the deduction, claiming that some
of its activities fell within the law’s definition of production activities. The IRS disagreed
and challenged. The parties went to tax court. From the time Gibson first claimed the
deduction until the case was resolved, the company had an uncertain tax position because
it would not know with certainty what the amount and timing of its tax payments would
be until the court ruled or the parties settled.
GAAP sets out a two-step process to determine how much benefit may be
recognized from an uncertain tax position and correspondingly how much a firm should
report in its tax contingency reserve as a liability for unrecognized tax benefits. Step 1
involves a recognition threshold. A firm must determine whether the uncertain tax
position meets the threshold of “more likely than not” that it will be able to sustain its
position based solely on technical merits.18 The term “more likely than not” means a
likelihood of more than 50%. The more-likely-than-not recognition threshold is a positive
assertion by management of the belief that the firm is entitled to the economic benefits
associated with the tax position (e.g., the firm is entitled to a deduction taken on its tax
return).
Doyle Company reports pre-tax book income of $10,000 that includes a $1,000
expense that is also deducted on the company’s tax return. The tax law is unclear as to
whether the deduction is permitted now or at any point in the future, so taking the
deduction leads to an uncertain tax position. Assuming Doyle has no other uncertain tax
positions, no book-tax differences, and a tax rate of 40%, this deduction results in a $400
uncertain tax benefit. Management’s assessment is that it is 65% likely the deduction will
be sustained based on the technical merits.
To see how this entry records a $250 uncertain tax benefit, first consider the
$4,000 in taxes Doyle will pay currently. That amount is computed assuming the item in
question is fully deductible. The $4,000 amount would also be the income tax provision
for the year if it were certain Doyle’s tax position would be sustained. In contrast, if the
deduction were known to be impermissible, Doyle’s income tax expense would have
been $11,000 3 40% 5 $4,400. So, any tax provision between $4,000 and $4,400 must be
recording a portion of the uncertain tax benefit. By recording a Tax contingency reserve
of $150, along with the $4,000 of income tax payable, Doyle records income tax expense
of $4,150. The result is that income tax expense is $4,400 2 $4,150 5 $250 lower than in
the nondeductible scenario, so a $250 uncertain tax benefit has been recorded.
Uncertain tax positions can sometimes arise because of uncertainty about the
timing of the deductibility of an expense under the tax code. Assume now that Doyle
Company’s $1,000 deduction fails to meet the more-likely-than-not condition. That is,
the full deduction taken in the current period’s tax return is unlikely to be sustained upon
review. However, it is certain based on current tax law that this expenditure would be
amortizable (deductible) for tax purposes over a five-year period. In other words, Doyle
is certain it will eventually get to deduct $1,000, but it believes it is unlikely to sustain its
position that the entire deduction may be taken immediately. Under GAAP, Doyle
subtracts only $200 of the expenditure ($1,000y5) when it computes the taxable income
amount to be used to determine the current portion of its income tax expense. That is
because only $200 is sufficiently certain to be deductible in the current year that it may
enter into Doyle’s computation of the current portion of income tax expense. So, the
current portion of Doyle’s income tax expense is ($11,000 2 $200) 3 40% 5 $4,320.
In 2012, Deere took uncertain tax positions that resulted in a $46 million increase
in the tax contingency reserve. In addition, the tax reserve related to tax positions
previously taken increased by $31 million, consisting of $54 million in increases and $23
million in decreases, $9 million of which was because the statute of limitations expired,
meaning the taxing authorities could no longer challenge those positions. The foreign
exchange amount arises because the tax contingency reserves from foreign subsidiaries
are denominated in other currencies. When the exchange rate with the U.S. dollar
changes, these reserves, in U.S. dollar terms, are revalued to reflect the current exchange
rate.
G. Extracting Analytical Insights from Note Disclosures
Tax notes provide useful information beyond taxes. Information about deferred
tax assets and liabilities, in particular, can help assess earnings quality and enhance
interfirm comparisons. This is because, generally, all firms will select tax policies that
minimize the present value of their tax payments, even though their financial reporting
choices might differ substantially. As a result, firms’ tax choices are likely to be more
similar to each other than their financial reporting choices, providing a useful benchmark
for assessing quality and comparing firms.
Companies must disclose details about individual temporary differences that give
rise to the deferred tax asset and deferred tax liability balances on the balance sheet.
Scrutiny of the details comprising deferred taxes can reveal important analytical insights
about the actions management has taken to boost short-term earnings. To illustrate, refer
to Exhibit 13.18, which contains excerpts from the Year 2 income tax note for ChipPAC
Inc. This excerpt identifies major elements of the deferred tax asset and liability balances.
Notice that the deferred income taxes attributable to book-versus-tax depreciation
differences (highlighted area) went from a $92 thousand debit balance (asset) in Year 1 to
a $10.870 million credit balance (liability) in Year 2, an increase of $10.962 million.
Some portion of this increase is likely due to acquisitions of new property, plant, and
equipment during the year that were depreciated at a faster rate for tax purposes than for
book purposes. (ChipPAC’s cash flow statement reveals that $93.174 million was spent
in Year 2 for acquisition of property and equipment.) However, fixed asset growth
explains only a small part of the increase.
A financial statement reader can glean important information from changes in
deferred tax balances, as demonstrated in Exhibit 13.18. It was possible to infer that
depreciable lives were extended because of the relatively large increase in deferred taxes
arising from book-versustax depreciation differences. As we saw, ChipPAC clearly
disclosed this change in estimated useful lives. GAAP requires disclosure of a change in
an accounting estimate only if the impact of the change is material.19 Unfortunately,
widely accepted guidelines for assessing materiality do not exist. Consequently, firms
that are not as candid as ChipPAC could conceivably decide to extend asset lives and not
disclose the change. Their motive could be to manipulate or smooth income, and they
would justify nondisclosure by contending that the impact of the change is immaterial.
Because materiality guidelines are subjective, careful scrutiny of the income tax note
provides analysts a way to detect subtle changes in accounting estimates that affect
bottom-line earnings but are not separately disclosed. This avenue is especially useful to
auditors. A detailed examination of deferred income tax balances provides auditors
evidence for evaluating management’s candor.
H. Rights and Obligations in Pension Contracts
A pension plan is an agreement by an organization (sponsor) to provide payments
— called a pension—to employees when they retire, either in a series of payments (an
annuity) or as a one-time “lump-sum” distribution. In the United States, the plan sponsor
makes contributions to a pension trust—a legal entity that invests and holds the assets for
the employee’s benefit—over the employee’s career. The retiree then receives pension
payments from the trust during retirement. In most instances, these company pension
payments supplement payments from government-sponsored pension plans— such as
Social Security in the United States. A pension plan represents a valuable benefit to
employees. Employers create these plans as a way to attract and retain a qualified
workforce. Because pensions benefit firms in the form of higher productivity from
employees, the cost of a worker’s pension plan is treated as an expense over that worker’s
period of employment.
Defined contribution plans specify the amount of cash that the employer puts into
the plan trust. No explicit promise is made about the size of the periodic benefits the
employee will receive during retirement. Rather, the promise is the amount of
contributions the employer will make periodically. The employee exchanges service for
this promise. The employee is generally given a variety of alternative investment funds
(broad stock funds, growth stock funds, bond funds, etc.), and the ultimate size of the
payments the employee will receive depends on the success of these investments.
The common types of defined contribution plans are money purchase, profit
sharing, and 401(k). In a money purchase plan, the employer contributes a fixed
percentage of an employee’s salary to the pension plan. The employer must make this
contribution whether it is having a good year or a bad year. In a profit-sharing plan, the
employer contributes to the plan only when profits exceed a predetermined threshold.
The contribution may then be allocated to participants on the basis of salary or seniority.
In a 401(k) plan, the employer makes a contribution only if the employee voluntarily
contributes to a pension plan. The terms of the plan specify the matching percentage
(often 50%) and the maximum annual employer contribution or the maximum percentage
of salary eligible for matching. Some 401(k) plans have very generous terms; others are
somewhat miserly. Because of the fixed commitments associated with money purchase
plans, they consistently result in cash outflows for the firm whereas the cash outflows for
the other types of defined contribution plans vary from year to year.
A defined benefit plan is quite different. These agreements specify the formula
that determines the annual benefit amount (lifetime annuity) to be paid out to the
employee during retirement rather than the annual amount that will be contributed to the
plan. The annual pension benefit typically depends on each employee’s years of service
and salary. For example, a defined benefit plan may specify that an employee will receive
an annual pension equal to 3% (called a generosity factor) of his or her salary at
retirement for each year of service. An employee with 25 years of service and an annual
salary at retirement of $60,000 would receive an annual pension benefit of $45,000 (25
years of service 3 3% for each year 3 the ending salary of $60,000). Because the pension
payout formula is specified in advance in a defined benefit plan, the employer bears the
investment risk instead of the employee. 1 However, the employee bears the risk that the
firm will go bankrupt and default on unfunded pension liabilities. Determining how much
cash must be contributed to the fund to provide the annual pension benefit of $45,000 is
complex and may be expensive to compute. These amounts must be computed using
assumptions and procedures described later in the chapter.2 The tax treatment for defined
benefit plans is similar to that for defined contribution plans. The employer receives tax
deductions for amounts contributed to the pension trust, and the employee does not pay
tax until pension payments are received during retirement. Also, the parties involved in a
defined benefit plan are the same as those in a defined contribution plan. However, under
a defined benefit plan, employees receive in exchange for service the promise of a
lifetime annuity instead of the promise of contributions to a trust.
I. Accounting Issues Related to Defined Benefit Pension Plans
The accounting problem is further complicated by the presence of the pension
trust assets. In a defined contribution plan the employee bears the risk associated with
pension investments. However, in a defined benefit plan the employer bears the risk. Just
as pension liabilities can change over time because actual experience differs from
expectations, pension asset returns can vary greatly from year to year. Consequently, the
accounting must incorporate asset returns and expected fluctuations in returns. In
December 1985, the Financial Accounting Standards Board (FASB) issued specified
measurement and disclosure requirements for defined benefit pension plans.5 The
disclosure aspects of these GAAP rules were amended in 1998 and again in 2003.6 In
2006, the FASB further revised both recognition and disclosure requirements.7 The
current authoritative accounting literature for pension measurement and reporting
requirements is found in the FASB ASC Topic 715, Compensation– Retirement Benefits.
Pension expense measurement for financial reporting includes several smoothing
features to make annual pension expense less volatile. These smoothing features were
included to respond to corporate lobbying and to acknowledge that short-term gains and
losses on pension assets and obligations may not result in cash inflows or outflows. These
gains and losses are omitted from pension expense. From 1986 to 2006, they also were
excluded from the balance sheet and were merely disclosed in notes. Since 2006, these
temporary gains and losses have been recognized in accumulated other comprehensive
income (AOCI)8 with a corresponding offset to a balance sheet pension asset or liability
account. Despite the numerous changes to pension accounting since 1985, the FASB still
views the existing GAAP as an interim measure and continues to study pension
presentation and measurement issues.
J. Financial Reporting for Defined Benefit Pension Plans
By working in 2014, Francie earns one year of pension benefits. Although the
pension is being earned when Francie’s salary is $182,000 per year, the pension payment
will be based on the highest annual salary at retirement, $200,000. To accrue the
appropriate amount of pension liability, Robie computes the expected pension benefit per
retirement year based on the $200,000. Under the formula, Francie will receive $10,000
(1 year 3 0.05 generosity 3 $200,000 highest salary) each year during retirement because
of her work in 2014. Based on her life expectancy, she will receive three payments. To
obtain the present value of these payments, we use a present value of an ordinary annuity
(pvoa) factor to discount the payments to the retirement date and a present value of an
amount (pv) factor to further discount the one year from the retirement date of December
31, 2015, to December 31, 2014, the balance sheet date. December 31, 2014 (as opposed
to January 1, 2014), is used here because Francie does not earn a pension benefit until she
has worked an entire year. The service cost for 2014 is $24,526 ($10,000 3 pvoa 3, 7% of
2.62432 3 pv 1, 7% of 0.93458). Because no obligation existed at the beginning of 2014,
his amount also is the cumulative pension liability at the end of 2014. The $24,526
present value of pension benefits earned to date is called the projected benefit obligation
(PBO). Note that the PBO calculation is based on service to date and future salaries.
A plan incurs interest on PBO until it is paid. Therefore, in 2015 in addition to
service cost, interest cost arises from the passage of time and increases both PBO and
pension expense. The Interest cost of $1,717 is computed by taking the PBO at the
beginning of the period (here $24,526) and multiplying it by the discount rate (here 7%).
We did not have interest cost in 2014 because the liability did not arise until December
31, 2014, when Francie completed a year of service. Exhibit 14.2 Panel (a) shows that the
beginning PBO of $24,526 is increased by service cost of $26,243 and interest cost of
$1,717 to obtain an ending balance of $52,486. Because both service cost and interest
cost increase PBO, they also increase pension expense for Robie Corporation [see Exhibit
14.2 Panel (b)].
Plan assets are invested in stocks and bonds that pay dividends and interest.
Furthermore, the stocks and bonds could appreciate in value. The dividends, interest, and
appreciation constitute the actual return on plan assets. At December 31, 2014, the
pension plan assets (held by the trust) had a balance of $24,526. The 2015 expected
return of $1,717 is computed by multiplying the beginning plan assets of $24,526 by the
expected long-term rate of return assumption of 7%. For this simplified example, recall
that we assume that the actual return equals the expected return (see page 830). We did
not have a return in 2014 because the plan did not have assets until the December 31,
2014, contribution. The actual return increases plan assets, and the expected return
decreases pension expense for Robie Corporation. Conceptually, the expected return on
plan assets offsets increases to PBO created by the service cost and interest cost
components.
Uncertainty requires assumptions for discount rates, expected return on plan
assets, and numerous other future events such as employee turnover and mortality. GAAP
requires that the same interest rate be used for computing both the service cost and the
interest cost components of pension expense. However, companies are free to choose
some other rate for computing the expected rate of return on pension plan assets, and
most do so. A firm could temporarily lower its pension expense by assuming a higher
than justified discount rate (which reduces the service cost component) or a higher than
justified expected rate of return (which increases the expected return component that is
deducted). A higher discount rate assumption also reduces PBO, thereby increasing
funded status. To avoid such manipulation, GAAP provides guidelines for the
assumptions.
The sample for Figure 14.3 includes all U.S. NYSE firms with available data for
expected long-run rate of return, discount rate, pension assets, and PBO. The sample size
ranges from a low of 798 firms in 2012 to a high of 932 firms in 2005. The top and
bottom lines in each graph represent the rates in the 90th and 10th percentiles,
respectively. The middle line is the median. The highest median discount rate of
approximately 6.3% occurred in 2008. From 2008 to 2012, discount rates fell
significantly to a low of 4.0%. As interest rates change, companies must recompute their
PBOs using the new rates. When interest rates decline, the resulting increase (decrease)
in PBO is called an actuarial loss (gain). The recent decline in rates coupled with low
asset returns have led to significant underfunding in both private and government pension
plans. In 2013, severely underfunded pensions were key factors in Chicago’s and Illinois’
bond rating downgrades and Detroit’s bankruptcy.
Uncertainty not only complicates the measurement of service cost and interest
cost but also means that actual outcomes will likely differ from expectations. For
example, the actual return (the interest, dividends, and appreciation obtained during the
year) on pension plan assets differs from the expected return, and actual turnover and pay
increases differ from actuarial assumptions. As we are about to show, these deviations
between expected and actual events if recognized immediately—would inject volatility
into the periodic measure of pension expense. Managers abhor earnings volatility because
of its potential negative effects on stock valuations and accounting-based contracts (see
Chapters 6 and 7) and, not surprisingly, strong sentiments for reducing this volatility
emerged early in the exposure draft stage of pre-Codification SFAS No. 87. Components
4 and 5 of the annual pension expense calculation are designed to smooth this volatility.
Our discussion now turns to each of these smoothing components of pension expense.
K. Postretirement Benefits Other Than Pensions
Many companies promise to provide health care and life insurance to employees
and their spouses during retirement. The intent of these benefits is to attract and retain a
highly qualified workforce just as pensions are intended to do. Also, the employment
contract and accounting issues are similar to those encountered for pensions. We discuss
the similarities and point out important differences in these benefits. Under accrual
accounting, an expense and liability should be recognized over the period of employment
as employees qualify for these other postretirement benefits (OPEB). Historically,
however, few companies with postretirement benefit plans made expense accruals.
Instead, “pay-as-you-go” accounting was employed—that is, as cash payments were
made to provide the health care benefit coverage to retired employees, the amount of the
cash outflow was charged to expense. No liability appeared on the books. Additionally,
few companies funded these OPEB plans as benefits were earned.
As a result of both of these circumstances, enormous unrecorded (off-balance
sheet) liabilities for postretirement benefits existed by the mid-1980s, but neither periodic
debits to expense nor credits to a liability account were made to reflect the continued
growth of these obligations. To correct for the lack of transparency with respect to OPEB
benefits, the FASB issued pre-Codification SFAS No. 106 in December 1990.36 To give
some idea of the size of these previously unrecorded postretirement benefit liabilities,
when General Motors (GM) adopted preCodification SFAS No. 106 in 1992, its liability
totaled $33.1 billion, and its after-tax charge to the income statement was $20.8 billion.
In 1992, GM’s pre-tax loss before this accounting change was $3.3 billion.
Retiree benefit plans cost also is reduced for a Net curtailment/settlement gain of
$(101 million). The gain is a direct result of ending post-65 retiree health care and life
insurance benefits for a significant portion of GE’s employees (see the paragraph above
Schedule 1 in Exhibit 14.6). Reductions in earned benefits reduce the Accumulated
postretirement benefit obligation (APBO) and AOCI—Prior service cost as a negative
plan amendment. However, curtailment losses (gains) also may be recognized for
amendments that prevent employees from earning benefits tied to future service. For
example, GE’s accruals for retiree life insurance may have been based on future salary
levels. Consequently, GE would recognize a gain. A loss related to faster recognition of
prior service cost could also occur. Settlement losses (gains) also may be recognized
when a company relieves itself of primary responsibility or significant risks associated
with the plan. Accounting for curtailments and settlements is complex, and we cannot
determine how GE calculated the amounts allocated to the Net curtailment/settlement
gain, OCI—Prior service cost, OCI—Net actuarial loss, or losses (gains) outside of
pension accounts.38 As we will see in subsequent schedules, most of the change is
viewed as a negative plan amendment, thereby reducing AOCI—Prior service cost.
GE’s other OPEB schedules are similar to its pension schedules. Schedule 2 gives
the assumptions for its OPEB plans. Note that instead of a salary growth assumption, the
schedule contains an assumption for health care cost trend rates. The cost trend includes
projected costs related to physician care, hospital care, prescription drugs, medical
equipment, and so on. Health care liabilities are rarely tied to salary at retirement. The
typical postretirement benefit plan promises employees full coverage (for example,
comprehensive postretirement health insurance) after a certain period of employment—
say, 10 years. In such circumstances, the actuarially determined service cost of the plan is
accrued over the first 10 years of the employee’s service. The liability attributed to
service to date is the accumulated postretirement benefit obligation (APBO). The health
care cost trend rate can have a dramatic effect on the estimated APBO. Consequently,
firms are required to make sensitivity disclosures regarding the effect of a 1% increase or
decrease in the health care trend rate assumption. In the disclosure following Schedule 3,
GE states that a 1% increase (decrease) could increase (decrease) it’s APBO by $1,017
million or 8.6% ($860 million or 7.3%).
Although the FASB issued pre-Codification SFAS No. 87 more than 25 years
ago, many of its sections remain controversial. Calculations are extremely complex, and
net income does not reflect immediately actual asset returns or PBO actuarial (gains)
losses as they arise. However, current GAAP requires the funded status of pension and
postretirement plans to be recognized as a liability or an asset on a firm’s balance sheet.
Management has discretion in choosing the rate of return assumption and the
measurement method for the market-related value. Allowing actual return to come
through net income instead of showing the unexpected portion in OCI would eliminate
the discretionary expected rate of return, but it would make net income more volatile.
Most managers and many accountants argue that such a move could reduce the predictive
power and faithful representation of net income.
Despite concerns about prior accounting, studies provide evidence that pension
and OPEB expense components found in notes are priced by the market.42 Additionally,
other studies suggest a positive relationship between stock prices and the funded status of
pension and OPEB plans disclosed in the notes (and not recognized on the balance sheet
prior to 2006). These studies also show that the perceived reliability of the pension and
OPEB amounts affects their relation with stock prices.43 Although the studies suggest
that the market finds the pension and OPEB information useful, the results are not always
consistent across years, and some results suggest that investors may not fully price the
impact of the pension disclosures.44 Regulators, analysts, preparers, and researchers will
continue to debate the appropriate recognition, disclosure, and valuation techniques for
pensions and OPEBs.
