Changes Ahead - A New Lease Standard

April 29th, 2013

Changes Ahead - A New Lease Standard

           

          The main objective of financial statements is to provide faithful representation of company's position. However, there are some accounting practices, such as lease transactions, that have always been criticized by both the Financial Accounting Standard Board(FASB) and the International Accounting Standard Board (IASB). The FASB and the IASB have been working together to develop a new approach that will allow rights and obligations (assets and liabilities) to be properly represented on the balance sheet.  The boards are developing proposals after considering responses to their Discussion Paper and their 2010 Exposure Draft. The goal of this article is to provide information regarding the status of the proposed lease standard, the basic changes in lease accounting due to proposed lease standard, the likely effective date of new standard, and implementation issues.

            The FASB announced lease re-exposure on April 10th 2013. The board agreed unanimously to re-expose their revised proposal for a lease standard for a 120 day comment period.  The boards plan to issue the new proposed accounting standard by the second quarter of 2013.

            The existing lease standard requires the lessee to expense periodic rent on his or her income statement on a straight-line basis. The lessor records the periodic rental income as revenue on his or her income statement. In other words, the operational lessee only records the rent expense on the income statement and discloses future lease payments in disclosure notes.

             The boards proposed a right-of-use model for all leases, eliminating all operating leases. In other words, the proposed new lease standard requires the lessee to include all long-term leases initially on the balance sheet. The lessee would measure the lease liability based on the present value of the lease payment over the period, using discount rate at the lease inception. The lessees must classify their leases into two categories: insignificant or significant portion of the leased asset to be consumes. For leases that require the lessee to own an insignificant portion of the leased asset, such as land or a building, the lessee must categorize the lease as a straight-line basis. Under straight-line basis, the lessees would recognize lease expense on a straight-line basis. For leases that require the lessee to own a significant portion of the leased asset, such as equipment, the lessee must recognize an interest expense or an amortization expense. Thus, the proposed new standard will affect both the income statement and the balance sheet.

            Under the proposed lease standard, lessors must classify  leases into two categories: operating lease accounting or the receivable and residual approach. The lessor will use the operating lease accounting if the lessee uses an insignificant of the lease asset. However, if the lessee uses a significant portion of the leased asset, then the lessor will use the receivable and residual approach. With the receivable and residual approach, the lessor “sells” part of the lease asset to the lessee, and the lessor classifies the “sold” asset as receivable. The lessor will record the unsold portion of the asset as residual. With this approach, the lessor must recognize profits and losses upfront on the portion that is “sold.” This means that the residual amount will be deferred profit and a part of the carrying value.

            The implementation of the proposed new lease standard may be difficult for companies. The proposed new standard will affect the decision making process for lessees. The lessee may consider buying the asset, instead of leasing it. The cost of upgrading software, training employees, and hiring experts to train may be an additional cost for companies. The lessee could violate the debt covenants due to the increase in liabilities. This violation may cause the agency problems. 

            The goal of financial statements is to provide a faithful representation of a company's financial position. The information provided in the financial statements should be transparent. The proposed new lease standard seems to address the user’s need for transparency.

Pension Funding - Will Your Plan Provide Benefits?

April 29th, 2013
Pension Funding - Will Your Plan Provide Benefits?

Pensions are promises made by the employers to pay to their workers a set of benefits after they retire. The U.S. GAAP (Generally Accepted Accounting Principles) requires that these promises be present in a company's financial statements as a liability. The pension fund deficit continues to grow for the one hundred largest corporate pension plans according to the Milliman report (issued by an actuarial consulting firm). Furthermore, despite the record contributions of $61.5 billion from the one hundred largest companies, there will still not be enough money to offset pension liabilities. The goal of this article is to provide information regarding the status of the pension fund deficit, the assumptions that affects the funding status, and the factors that affects the corporate pension measurements.

            According to the Milliman report, decreasing discount rates are the cause for the increasing pension deficits. The discount rates for the year 2012 fell to a record low of 4.02%, a decrease of 0.76%, which forced the 2012 deficit to be $388.8 billion. This represents an increase of $61.5 billion from the year 2011. The pension expense for these companies was also at a record high. The total pension expense for 2012 was $55.8 billion, an increase of $17.8 billion from the year 2011. The investment return among the largest plans increased from 5.9% to 11.7%, which was almost double from the  year 2011 . The largest corporations have already announced their plan to make a contribution to the fund relief. AT&T and Ford have announced their plan to contribute $9.5 and $5.0 billion, respectively, for 2013. Boeing, Chevron, Exxon-Mobil, and Lockheed-Martin have indicated that they will contribute at least $1 billion to their pension funds.

             The calculation of the pension liability contains various factors. The calculation includes the expected salary at retirement of the current employee and the number of years he or she has served. The calculation also accounts for how long retirees are likely to live . The discount rate also plays a crucial role in the calculation. The higher the discount rate the lower the pension liability. The pension funding status is affected by the investment performance of the plan asset. They have an inverse relationship: the higher the return on the invested securities, the lower the pension liability.

Despite the anxious report of 2012, 2013 already looks like a good start for the corporate pension fund. Standard & Poor's 500,  a stock market index based on the market capitalization of 500 leading publicly traded companies,  has gained a return of 9.56% from December 31, 2012 to April 22, 2013. A partner in Mercer, retirement consulting firm, stated that the pension obligation has decreased back to the obligation of 2011. Nonetheless, he is concerned about the volatility of the stock market, which could pull the pension obligation back on balance to the 2012 amount. The Milliam firm found that a 0.27% increase in the discount rate and the increase in the stock market decreased the pension liabilities for the hundred largest pension funds in 2012 by almost $106 billion.

Federal Reserve said in October that the interest rate will remain low, near zero, until mid-2015, which means the discount rate will not fluctuate significantly. If the market continues to grow, then the deficits will soon be minimal. However, the slowing economic growth of the U.S, the holding interest rate by Fed, and the steady increase in the unemployment rate may make the market volatile and cause pension liabilities to increase.

Getting Familiar with 401(K).

What is 401(K) Plan?

401(K) is the employer sponsor plan (defined contribution plan) that allows individuals to contribute cash (a maximum of $17,500 for 2013), share in stock options, or reduce salary compensation. Individuals can control how much money they invest into 401(K). Usually, the contributions to 401(K) are divided into stocks, bonds, and money market mutual fund investments. In the salary reduction form of 401(K), individuals agree to have their employer withdraw a certain percentage of their salary income. The contribution made by employers from the salary income of the employees is invested into their 401(K). However much money a person invests is tax deferred, with the limit being $17,500. Individuals do not have to pay taxes until the amount is withdrawn. But if taxpayers decide to withdraw from their 401(K) before the age of 59 ½, then they are subject to additional 10% penalty taxes.

Benefits:

            In most cases, the employer matches the amount that an individual contributed in 401(K) plan. For example, if a taxpayer has contributed 5% of his total salary, then the employer will contribute another 5%. This is called 100% match from the employer. Getting a loan from the 401(K) retirement system is another way for taxpayer escaping from the penalty of 10%. When someone takes a loan, the interest paid made will go back into his 401(K) contribution. For example, if a taxpayer takes a loan of $1,000 from 401(K) retirement system, then he will pay interest of $100. Then the excess amount paid, a $100, will go into his contribution of 401(K) plan, which means a taxpayer is paying interest to himself. However, if a taxpayer goes into default on his loan payment, then the loan is considered as distribution and is subject to a 10% penalty. The 401(K) plan is protected against job changes. If a taxpayer ever decides to change his job, then the amount contributed to his 401(K) plan can be carried to his new place of employment. In addition to this, , money invested in the 401(K) is not subject to bankruptcy  This simply means employees are protected from creditors.

Practical Implication:

Suppose Wilbur makes $50,000 per year once he graduates. He should try to contribute the maximum$17,500 to his 401(K). In this way, he will benefit financially. The $17,500 will be pre-taxed money. Suppose his employer will match 3% of his salary, and his employer matches 50 cents for every dollar for the next 2% of his salary. Then, his total amount of contribution to his 401(K) will be $17,500 + $50,000*.03 + $50,000*.02*.50 = $19,500. Also, in the case of a financial emergency, he should utilize his 401(K). He should take the loan from his 401(K), so that he will pay interest to himself. This contribution in 401(K) will also help him decrease his marginal tax rate, which could give him additional savings.