Analyzing, Interpreting and Capitalizing Operating Leases

Analyzing, Interpreting and Capitalizing Operating Leases

Question 1

Analyzing, Interpreting and Capitalizing Operating Leases
Assume YUM! Brands, Inc., reports the following footnote relating to its capital and operating leases in its 2010 10-K report ($ millions).

Future minimum commitments under non-cancelable leases are set forth below. At December 25, 2010, and December 26, 2009, the present value of minimum payments under capital leases was $245 million and $228 million, respectively.

Commitments ($ millions)	Capital	Operating
2011	$ 27	$ 422
2012	27	367
2013	65	339
2014	23	378
2015	23	280
Thereafter	276	1,964
	$ 441	$ 3,750

(a) Confirm that the implicit rate on YUM!’s capital leases is 8.36%.

N	Amount	IRR
0	Answer	??
1	Answer
2	Answer
3	Answer
4	Answer
5	Answer
6	Answer
7	Answer
8	Answer
9	Answer
10	Answer
11	Answer
12	Answer
13	Answer
14	Answer
15	Answer
16	Answer
17	Answer

Using a 8.36% discount rate and rounding the remaining lease life to three decimal places, compute the present value of YUM!’s operating leases. (Use a financial calculator or Excel to compute. Do not round until your final answers. Round each answer to the nearest whole number.)

($ millions)	Present Value
Year 1	Answer
Year 2	Answer
Year 3	Answer
Year 4	Answer
Year 5	Answer
After 5	Answer
Total*	Answer

* (Use subsequent rounded answers for calculation.)

Which of the following statements best describes the adjustments we might consider to YUM!’s balance sheet and income statement from the information in part (a)?

-Rent expense is replaced with depreciation and interest expense is added to nonoperating expense. There is no effect on the balance sheet.

-YUM’s total assets and total liabilities are increased by the present value of the capitalized leases. There is no effect on the income statement.

-YUM’s total assets and total liabilities are increased by the present value of the capitalized leases. In its income statement, rent expense is replaced with depreciation, and interest expense is added to nonoperating expense.

-YUM’s total assets and total liabilities are increased by the present value of the capitalized leases. In its income statement, rent expense is replaced with depreciation.

(b) YUM! reported total liabilities of $6,103 million for 2010. Would the adjustment from part (a) make a substantial difference to YUM!’s total liabilities?

-Yes, YUM!’s liabilities would increase, but there would be no effect on assets.

-Yes, YUM!’s assets and liabilities would be substantially higher following the adjustments suggested.

-Yes, YUM!’s assets would increase, but there would be no effect on its liabilities.

-No, adjustments are not required. So, there is no effect on YUM!’s balance sheet.

Question 2

Interpreting the Income Tax Expense Footnote
The income tax footnote to the financial statements of FedEx Corporation follows.

The components of the provision for income taxes for the years ended May 31 were as follows:

($ millions)	2007	2006	2005
Current provision
Domestic
Federal	$ 829	$ 719	$ 634
State and local	72	79	65
Foreign	174	132	103
	1,075	930	802
Deferred provisions (benefit)
Domestic
Federal	90	151	67
State and local	27	13	(4)
Foreign	7	(1)	(1)
	124	163	62
Provision for income taxes	$ 1,199	$ 1,093	$ 864

(a)What is the amount of income tax expense reported in FedEx’s 2007, 2006, and 2005 income statements?
2007 Income Tax Expense = $??? million
2006 Income Tax Expense = $??? million
2005 Income Tax Expense = $??? Million

(b) What percentage of total tax expense is currently payable in each year?

Round your answers to the nearest percent.
2007 ??%
2006 ??%
2005 ??%

Which of the following statements best describes why the percentages of total tax expense are different each year?

-Differences in the percentage of income tax expense that is currently payable arise because tax laws change frequently.

-Differences in the percentage of income tax expense that is currently payable arise solely because of fluctuations in the amount of taxable income.

-Differences in the percentage of income tax expense that is currently payable arise because companies typically defer tax payments in periods of reduced cash flow.

-Differences in the percentage of income tax expense that is currently payable arise because of fluctuation in the amount of deferred income tax assets or liabilities.

-Deferred tax liabilities arise in periods of higher taxable income.

-Companies use an accelerated depreciation method for tax purposes that results in a lower taxable income in the earlier years of the assets life vis-à-vis net income on the financial accounting books, which reflect straight-line depreciation for GAAP purposes.

-Deferred tax liabilities generally arise because companies defer the payment of taxes in periods of low cash flow.

-Restructuring accruals provide the best example of an event that gives rise to an increase in deferred tax liabilities.

Question 3

Analyzing and Interpreting Footnote on Operating and Capital Leases
Assume Verizon Communications, Inc., provides the following footnote relating to its leasing activities in its 10-K report. The aggregate minimum rental commitments under noncancelable leases for the periods shown at December 31, 2010, are as follows:

Years (dollars in millions)	Capital Leases	Operating Leases
2011	$ 83	$ 1,449
2012	71	1,226
2013	67	966
2014	63	796
2015	46	477
Thereafter	143	1,947
Total minimum rental commitments	473	$ 6,861
Less interest and executory costs	(122)
Present value of minimum lease payments	351
Less current installments	(46)
Long-term obligation at December 31, 2010	$ 305

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(b) What effect does the failure to capitalize operating leases have on Verizon’s balance sheet? Over the life of its leases, what effect does this lease classification have on net income?

-Total assets and total liabilities are lower than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be equal to the interest and depreciation expense that the company would record under capital leases.

-Total assets and total liabilities are lower than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be greater than the interest and depreciation expense that the company would record under capital leases.

-There is no effect on the balance sheet and income statement as a result of the classification of leases.

-Total assets and total liabilities are higher than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be equal to the interest and depreciation expense that the company would record under capital leases.

(c) Compute the present value of Verizon’s operating leases, assuming an 8.06% discount rate and rounding the remaining lease term to 3 decimal places. (Use a financial calculator or Excel to compute. Do not round until your final answers. Round each Present Value answer to the nearest whole number.)

($ millions)	Present Value
Year 1	??Answer
Year 2	?Answer
Year 3	?Answer
Year 4	?Answer
Year 5	?Answer
After 5	?Answer
Total*	?Answer

* (Use subsequent rounded answers to compute the Total.)

Which of the following statements best describes how we might use this additional information in our analysis of the company?

-To assess the company’s financial condition and performance, we might add the present value of its operating leases to both operating assets and nonoperating liabilities. No adjustment is necessary for the income statement.

-To assess the company’s financial condition and performance, we might add the present value of its operating leases to both operating assets and nonoperating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability.

-To assess the company’s financial condition and performance, we might add the sum of the contractual payments under the operating leases to both assets and nonoperating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability.

-Verizon’s balance sheet and income statement are prepared in accordance with GAAP. No adjustments are necessary to evaluate the financial condition of the company.

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Question 4

Analyzing and Interpreting Pension Disclosures
Assume General Mills reports the following pension footnote in its 10-K report.

Defined Benefit Pension Plan ($ millions)	2010	2009
Change in Plan Assets
Fair value at beginning of year	$ 4,097.8	$ 3,620.3
Actual return on assets	181.1	625.9
Employer contributions	14.2	10.6
Plan participant contributions	3.6	2.8
Divestitures/acquisitions	—	2.4
Benefit payments	(182.0)	(164.2)
Fair value at end of year	$ 4,114.7	$ 4,097.8
Change in Projected Benefit Obligation
Benefit obligation at beginning of year	$ 3,257.5	$ 2,916.4
Service cost	80.1	73.1
Interest cost	176.7	185.6
Plan amendment	1.9	0.2
Curtailment/other	(0.6)	(0.4)
Plan participant contributions	3.6	2.8
Actuarial loss (gain)	(147.1)	244.0
Benefits payments	(182.0)	(164.2)
Projected benefit obligation at end of year	$ 3,190.1	$ 3,257.5

Estimated benefit payments, which reflect expected future service, as appropriate, are expected to be paid from fiscal 2011-2020 as follows:

(in millions)	Defined Benefit Pension Plans
2011	$ 176.3
2012	182.5
2013	189.8
2014	197.5
2015	206.6
2016-2020	$ 1,187.3

(a) Which of the statements below best describes what is meant by service cost and interest cost?

-Service cost represents the additional pension benefits earned by employees during the current year but paid to employees in the future. Interest cost is the expense we incur on funds borrowed by the pension plan.

-Service cost represents the wages earned by employees managing the pension plan during the current year. Interest cost is an expense that accrues on the pension obligation during the year.

-Service cost represents the wages earned by employees managing the pension plan during the current year. Interest cost is the expense we incur on funds borrowed by the pension plan.

-Service cost represents the additional pension benefits earned by employees during the current year but paid to employees in the future. Interest cost is an expense that accrues on the pension obligation during the year.

(b) What is the total amount paid to retirees during fiscal 2010?
Answer ?? $million

What is the source of funds to make these payments to retirees?

-pension obligations

-pension assets

-pension liabilities

-operating cash flows

(d) Which of the following statements best describes what are the plan amendment adjustments, and how they differ from actuarial gains and losses?

-Actuarial gains and losses represent charges that the pension plan incurs from actuaries that it hires to perform various estimates while amendment adjustments are changes to the liability arising from amendments to the plan itself.

-Actuarial gains (losses) are decreases (increases) to the PBO resulting from changes in the assumptions used to estimate the pension or health care liability, while amendment adjustments are adjustments made in accounting for the plan as a result of those estimates.

-Actuarial gains and losses represent charges that the pension plan incurs from actuaries that it hires to perform various estimates, while amendment adjustments are adjustments made in accounting for the plan as a result of those estimates.

-Actuarial gains (losses) are decreases (increases) to the PBO resulting from changes in the assumptions used to estimate the pension or health care liability, while amendment adjustments are changes to the liability arising from amendments to the plan itself.

(e) General Mills projects payments to retirees of over $175 million per year. Which of the following statements best describes how it is able to contribute only $14.2 million to its pension plan?

-Federal law does not require companies to fund pension plans. Any contributions that General Mills makes are purely voluntary.

-The funding for payments to retirees comes from pension assets. General Mills’ plans are overfunded and investment returns currently provide the cash inflow.

-Contributions to pension plans are made mostly by employees. Any contributions that —General Mills makes are purely voluntary.

-The funding for payments to retirees comes from the pension assets. General Mills, therefore, does not need to contribute its own funds to the pension plan.

(f) Which of the following statements best describes the effect from a substantial decline in the financial markets on General Mills’ contribution to its pension plans?

-General Mills’ pension plans are not affected by fluctuations in the general financial markets. There would be no effect on General Mills.

-General Mills’ contributions to its pension plans are purely voluntary. Fluctuations in the general financial markets would, therefore, have no effect.

-Should pension investments decline as a result of a decline in the financial markets, –General Mills might be required to increase its cash contribution to the pension plan.

Any shortfall in contributions is covered by con

Question 5

Reformulation for Deferred Tax Asset Valuation Allowance

Under Armour Inc. reports total tax expense of $154,112 thousand on its income statement for year ended December 31, 2015, and paid cash of $99,708 thousand for taxes. The tax footnote in the company’s 10-K filing, reports the following deferred tax assets and liabilities information.

December 31 ($ thouands)	2015	2014
Deferred tax assets
Stock-based compensation	$ 41,960	$ 36,715
Allowance for doubtful accounts and other reserves	35,375	26,328
Accrued expenses	19,999	11,398
Foreign net operating loss carryforward	19,600	16,302
Deferred rent	13,991	11,005
Inventory obsolescence reserves	11,956	8,198
Tax basis inventory adjustment	10,019	5,845
U.S. net operating loss carryforward	9,217	4,733
Foreign tax credits	6,151	5,131
State tax credits, net of foreign impact	4,966	4,245
Deferred compensation	2,080	1,858
Other	6,346	4,592
Total deferred tax assets	181,660	136,350
Less: valuation allowance	(23,899)	(15,406)
Total net deferred tax assets	157,761	120,944
Deferred tax liability
Property, plant and equipment	(31,069)	(17,638)
Intangible asset	(22,820)	(7,010)
Prepaid expenses	(8,766)	(6,424)
Other	(627)	(612)
Total deferred tax liabilities	(63,282)	(31,684)
Total deferred tax assets, net	$ 94,479	$ 89,260

Use the above information along with the information below to answer the requirements.

$ thousands	2012	2013
Deferred tax asset	$ 66,007	$ 107,931
Valuation allowance	4,110	7,748

Use the four-year average valuation allowance to deferred tax assets (2012 through 2015) to reformulate the income statement for each of the four years 2012–2015. See Analyst Adjustments 10.3 for guidance in the reformulation process.

Compute four year average of valuation allowance/deferred tax assets

Round to one decimal place (ex: 0.2345 = 23.5%)

%__???

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Use rounded percentage for subsequent computations.
Round answers to the nearest whole number.
Use negative signs with answers to indicate adjustments that reduce account balances.

Income Statement Adjustments	2012	2013	2014	2015
Income tax expense	Answer	Answer	Answer	Answer
Net income	Answer	Answer	Answer	Answer

Reformulate the balance sheet for each of the four years 2012–2015.

Use rounded answers computed in part a. to complete the table below.
Use negative signs with answers to indicate adjustments that reduce account balances.

Balance Sheet Adjustments	2012	2013	2014	2015
Valuation allowance	Answer	Answer	Answer	Answer
Deferred tax assets	Answer	Answer	Answer	Answer
Total assets	Answer	Answer	Answer	Answer
Retained earnings	Answer	Answer	Answer	Answer

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Analyzing, Interpreting and Capitalizing Operating Leases

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