Dmp3e Ch10 Solutions 022810 Final

7/27/2019 Dmp3e Ch10 Solutions 022810 Final

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Chapter 10

Reporting and Analyzing Leases,Pensions, and Income Taxes

Learning Objectives coverage by question

Mini-exercises

Exercises Problems Cases

LO1 Define off-balance-sheetfinancing and explain its effects onfinancial analysis.

20, 21 47

LO2 Account for leases using theoperating lease method or the capitallease method.

12, 13, 14 23, 24, 25, 27 33, 36 47

LO3 Convert off-balance-sheetoperating leases to the capital lease

method.

15 25, 26, 2733, 34, 35,

36, 45

47

LO4 Explain and interpret thereporting for pension plans.

16, 17, 18, 19 29, 30 37, 38 46

LO5 Analyze and interpret pensionfootnote disclosures.

16, 17, 18, 19 28, 29, 30 37 46

LO6 Describe and interpretaccounting for income taxes.

22 31, 3239, 40, 41,

42, 43, 4448

Cambridge Business Publishers, 2011

Solutions Manual, Chapter 10 10-1


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QUESTIONS

Q10-1. Under an operating lease, the lessor retains the usual risks and rewards ofowning the property. In accounting for an operating lease, the lesseedoesnt record either the leased asset or the lease liability on the balancesheet, and normally charges each lease payment to rent expense. Incontrast, a capital lease transfers to the lessee substantially all of the risksand rewards relating to the ownership of the property. Accordingly, thelessee accounts for a capital lease by recording the leased property as anasset and establishing a liability for the lease obligation. The leased asset issubsequently depreciated, and interest expense is accrued on the leaseliability.

Q10-2. The leasing footnote is reasonably complete to allow for capitalization ofoperating leases for analysis purposes. Despite the quality of the leasingdisclosures, on-balance-sheet treatment is, arguably, a more direct form of

communication from the company and, as a result, is more easilyinterpreted by users of its financial statements.

Q10-3. Yes, over the term of the lease the rent expense on an operating lease willbe equal to the sum of the interest and depreciation on a capital lease. Onlythe timing of the expense recognition changes. Expense is ultimatelyrelated to the cash flows required to discharge the obligation. Those cashflows are the same whether or not the lease is capitalized.

Q10-4. Under defined contribution plans, companies make contributions to theplans which, together with earnings on the amounts invested, provide thesole source of funding for payments to retirees. Under defined benefit

plans, the obligations are defined with payment to be made in the futurefrom general corporate funds. These plans may or may not be fully funded.Since the companys obligation is extinguished upon payment for a definedcontribution plan, the accounting is relatively simple: record an expensewhen paid or accrued. Defined benefit plans present a number ofcomplications in that the liability is very difficult to estimate and involves anumber of critical assumptions. In addition, companies lobbied for (and theFASB agreed to) various mechanisms to smooth the impact of pensioncosts on reported earnings. These smoothing mechanisms furthercomplicate the accounting for defined benefit plans vis--vis definedcontribution plans.

Q10-5. Although the accounting can get complicated, a net pension asset will bereported if the fair market value of the plan assets exceeds the planobligation. Otherwise, a net liability will be reported on the balance sheet torepresent the underfunding of the pension obligation.

Q10-6. Service cost, interest cost and the expected return on plan investments (areduction of the pension cost) are the basic components of pensionexpense. Companies might also report amortization of deferred gains andlosses.


Financial Accounting, 3rd Edition10-2


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Q10-7. The use of expected returns and the deferral of unexpected gains andlosses act to smooth corporate earnings by removing the effects of swingsin the market values of investments and variation in pension liabilitiesresulting from changes in actuarial assumptions or plan amendments.

Q10-8. For a capital lease, the initial value of the lease asset and the lease

obligation are determined by calculating the present value of the minimumlease payments. The minimum lease payments include those paymentsthat are not subject to options or contingencies, including any guaranteedresidual value.

Q10-9. Retirement benefits are normally expensed in the period in which they areearned by the employee, not when they are paid. Some benefits arecalculated for periods of employment prior to the inception of a pensionplan or prior to a plan amendment. The cost of these benefits (called priorservice costs) is expensed by amortizing the cost over the averageexpected future period of employee service.

Q10-10. The amount of the accumulated benefit obligation in excess of the fair valueof the plan assets must be reported as a minimum pension liability. If theaccrued pension liability that is reported in the balance sheet is smallerthan the minimum liability, then an additional pension liability, equal to thedifference, must be reported.

Q10-11.A tax payment would be recorded as deferred taxes under two situations.First, if the company is required to make a tax payment (based on thehigher taxable income reported on the tax return) but not record thatpayment as tax expense, a deferred tax asset is recorded. Deferred taxassets result from those situations where an expense is recognized andrecorded in the income statement, but is not deductible on the companys

tax return in the current period. This produces higher income on the taxreturn and tax payments that are higher than tax expense. The excesspayment is recorded as an increase (debit) to a deferred tax asset.

The second situation arises when a deferred tax liability reverses. In thissituation, tax expense has been recognized in excess of tax payments inprior years. When the tax return catches up with the income statement,the tax deferral reverses and the deferred tax liability is reduced (debited).In either situation, the deferred tax account (either asset or liability) isdebited and cash is credited.




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MINI EXERCISES

M10-12 (15 minutes)

a. i.1/1 No entry

12/31 Rent expense (+E, -SE) . 12,000Cash (-A) 12,000

ii.1/1 Leased asset (+A) .. 57,198

Lease liability (+L) 57,198

$57,198 = $12,000 x 4.76654

12/31 Depreciation expense (+E, -SE) ... 9,533

Accumulated depreciation (+XA) 9,533$9,533 = $57,198 / 6.

12/31 Lease liability (-L) 7,996Interest expense (+E, -SE) . 4,004

Cash (-A) 12,000

$4,004 = $57,198 x .07; $7,996 = $12,000 - $4,004.

b.+ Cash (A) - - Lease Liability (L) +

12,000 12/31 57,198 1/112/31 7,996

+ Leased Asset (A) - + Interest Expense (E) -

1/1 57,198 12/31 4,004

- Accumulated Depreciation (XA) + + Depreciation Expense (E) -

9,533 12/31 12/31 9,533

c.Balance Sheet Income Statement

Transaction CashAsset +

NoncashAssets -

ContraAssets

= Liabilities + Contrib.Capital +EarnedCapital Revenues - Expenses =

NetIncome

Signed acapitallease.

+57,198LeasedAsset

- = +57,198LeaseLiability

- =

Depreciationon leasedasset.

-

+9,533AccumulatedDepreciation

=-9,533

RetainedEarnings

-

+9,533Deprec.Expense

= -9,533

Made annualleasepayment.

-12,000Cash

- =

-7,996Lease

Liability

-4,004RetainedEarnings

-

+4,004InterestExpense

= -4,004




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M10-13 (20 minutes)

a.7/1 Leased asset (+A) .. 123,100

Lease liability (+L) . 123,100$123,100 = 4,500 x 27.35548

b.9/30 Depreciation expense (+E, -SE) .. 3,078

Accumulated depreciation (+XA, -A) . 3,078$3,078 = $123,100 / (10 x 4).

9/30 Lease liability (-L) .. 2,038Interest expense (+E, -SE) 2,462

Cash (-A) 4,500$2,462 = $123,100 x (.08/4); $2,038 = $4,500 - $2,462.

12/31 Depreciation expense (+E, -SE) .. 3,078Accumulated depreciation (+XA, -A) . 3,078

12/31 Lease liability (-L) .. 2,079Interest expense (+E, -SE) 2,421

Cash (-A) 4,500$2,421 = ($123,100 - $2,038) x (.08/4); $2,079 = $4,500 - $2,421.

c.

+ Cash (A) - - Lease Liability (L) +4,500 9/30 123,100 7/1

4,500 12/31 9/30 2,03812/31 2,079

+ Leased Asset (A) - + Interest Expense (E) -7/1 123,100 9/30 2,462

12/31 2,421

- Accumulated Depreciation (XA) + + Depreciation Expense (E) -3,078 9/30 9/30 3,0783,078 12/31 12/31 3,078




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d.Balance Sheet Income Statement

Transaction CashAsset +

NoncashAssets -

ContraAssets

= Liabilities + Contrib.Capital +EarnedCapital Revenues - Expenses =

NetIncom

Signed acapital lease.

+123,100LeasedAsset

- =+123,100

LeaseLiability

- =


-

+3,078AccumulatedDepreciation =


-

+3,078Deprec.Expense = -3,078

Made quarterlyleasepayment.

-4,500Cash

- =

-2,038Lease

Liability-2,462

RetainedEarnings

-

+2,462InterestExpense = -2,462


-

+3,078AccumulatedDepreciation

=-3,078

RetainedEarnings

-+3,078Deprec.Expense

= -3,078

Made quarterlyleasepayment.

-4,500Cash

- =

-2,079Lease

Liability


-+2,421InterestExpense

= -2,42

e.

7/1 No entry

9/31 Rent expense (+E, -SE) 4,500Cash (-A) 4,500

12/31 Rent expense (+E, -SE) 4,500Cash (-A) 4,500

The amount of rent expense recognized if the lease is treated as an operatinglease is $9,000 ($4,500 + $4,500). However, if the lease is treated as a capitallease, interest and depreciation are recognized. The total expense for 2010 is$11,039 ($2,462 + $2,421 + $3,078 + $3,078). The capital lease method tends toreport higher expense in the early periods of the lease.




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M10-14 (15 minutes)

a. Capital leases record both the leased asset and the lease liability on the faceof the balance sheet. Operating leases, by contrast, do not record either theleased asset or the lease liability. They are, as a result, a common technique to

achieve off-balance-sheet financing. Concerning the income statement, capitalleases result in depreciation of the leased asset and interest expense on thelease liability. Operating leases record only rent expense.

b. Analysts frequently add the present value of the operating lease payments toboth assets and liabilities, thus capitalizing the operating lease. Thisadjustment improves the interpretation of measures of financial leverage andoperating performance. If Yums operating lease commitments in total aresubstantial, they could have a significant impact on the assessment offinancial leverage. Yum indicates no individual lease is material. However, thetotal commitment could be substantial.

M10-15 (20 minutes)

a. Present value of expected operating lease payments for Southwest Airlinesusing a financial calculator, I/YR=7:

Year($ millions)

Operating LeasePayment Present Value

2009......................... $ 400 $ 374

2010......................... 335 293

2011......................... 298 243

2012......................... 235 179

2013......................... 195 139

After 2013................ 876 521

Average life............. 4.5 years * $1,749

* $876 $195/year = 4.5 years.




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M10-17 (15 minutes)

a. Yum Brands is reporting $36 million of pension expense for 2008.

b. Expected returns are an offset to service and interest costs and serve toreduce reported pension expense.

c. Expected refers to the use of long-term average returns for the investmentportfolio. Expected returns are used in the computation of pension expense,rather than actual returns, in order to smooth reported income.

M10-18 (15 minutes)

a. A&F maintains a defined contribution plan for the benefit of its employees.

b. Contributions are expensed when made.

c. Only the unpaid contribution, if any, appears on the A&F balance sheet.

M10-19 (15 minutes)

a. Target maintains only a defined contribution plan for the benefit of its

employees.b. Contributions are expensed when made.

c. Only the unpaid contribution, if any, appears on Targets balance sheet.d. First, employees who do not meet the unspecified eligibility requirement will

not be covered. Second, their investment is tied to whether the employeesleave the contributions undiversified. Third, matching contributions can bereduced or eliminated in bad times.




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M10-20 (15 minutes)a.

($millions) PaymentObligation

Present Value(i=6%)

2009 $245 $2312010 216 192

2011 157 1322012 146 1162013 143 107Thereafter . 2,950 1,245

Total $3,857 $2,023

Average Life: $2,950/$143 = 20.6 years.

The calculations of the present value of each payment follow:

N I/YR PV PMT FV

1 6 231 0 245

N I/YR PV PMT FV2 6 192 0 216

N I/YR PV PMT FV3 6 132 0 157

N I/YR PV PMT FV4 6 116 0 146

N I/YR PV PMT FV5 6 107 0 143

The present value of payments after Year 5 follows:

N I/YR PV PMT FV20.6 6 1,666 143 0

N I/YR PV PMT FV5 6 1,245 0 1,666

b.($millions) Balance Sheet Income Statement

Transaction CashAsset +NoncashAssets =

Liabil-ities +

Contrib.Capital +

EarnedCapital Revenues - Expenses =

NetIncome

To capitalizeoperating leases

+2,023LeasedAsset

=+2,023Lease

Liability- =




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M10-20continued.

c. Recognition of the operating leases would affect the current ratio. Recordingthe lease asset would increase noncurrent assets by $2,023 million, butrecording the lease liability would increase current liabilities by $231 million,and noncurrent liabilities by $1,792 million ($2,023 - $231).

d. (in $millions)Leased asset (+A) .. 2,023

Lease liability (+L) . 2,023

+ Leased Asset (A) - - Lease Liability (L) +2,023 2,023

e. Yes. The present value of the operating leases of $2,023 million represent over45% of Targets operating cash flow in 2008.

M10-21 (15 minutes)

a. The use of contract manufacturers removes the manufacturing assets andrelated liabilities from Nikes balance sheet.

Because sales are unaffected, PPE turnover is increased by the removal ofassets. The effect on net operating profit after taxes (NOPAT) is uncertain;depreciation is removed (interest on the liabilities incurred to purchase themanufacturing assets is also removed, but this is a nonoperating expenseand, therefore, does not affect NOPAT), but Nike will pay a higher price for itsmanufactured goods in order to provide the manufacturer with a return on itsinvestment. If the contract manufacturer is more efficient than Nike, however,the price increase is mitigated. Profitability will increase if the turnover effectmore than offsets the negative effect on NOPAT and profit margin, which islikely.

b. Executory contracts are not recognized under GAAP. As a result, the use ofcontract manufacturers achieves off-balance-sheet financing. This is one

motivating factor for their use.




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M10-22 (20 minutes)

a, b, c.

YearBookvalue

Tax basis (after depreciation deduction)Temporarydifference

Taxrate

Deferredtax liability

2010 $300,000 $173,000 $127,000 40% $50,800

2011 $200,000 $173,000 - ($100,000 - $31,000) = $104,000 $96,000 40% $38,400

2012 $100,000 $104,000 - ($100,000 - $31,000) = $35,000 $65,000 40% $26,000

d. Because the deferred tax liability is reversing in years 2011, 2012 and 2013, partof the deferred tax liability should be classified as a current liability each year.The amounts are presented in the following table.

Year Deferred tax liabilityLong-term amount

reversing beyond one yearCurrent portion reversing

within one year

2010 $50,800 $38,400 $12,400

2011 $38,400 $26,000 $12,400

2012 $26,000 $0 $26,000




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EXERCISES

E10-23 (20 minutes)

a. All of Fortune Brands leases are classified as operating. GAAP requirescompanies to provide a table of projected lease payments for both operating andcapital leases (for example, see the Verizon lease footnote example in E10-24).Because no capital leases are included in the Fortune Brands footnote, we knowthat it only has operating leases.

b. Neither the leased asset nor the lease obligation is reported on the balancesheet for an operating lease. As a result, total assets and total liabilities arereduced. Over the life of the lease, total rent expense under operating leases willbe equal to the interest and depreciation expense that would have beenrecorded under capital leases. Profit is unaffected by this classification. Duringthe life of the lease, however, the two will not be equal. Even if depreciation is

computed on a straight-line basis, interest is accrued based on the balance ofthe lease obligation which is higher in the earlier years of the lease. As a result,depreciation plus interest will exceed rent expense during the early years of thelease life and will be less toward the end of the lease.

c.Year($ millions)

Operating LeasePayment Present Value

2009......................... $ 57.8 $ 54

2010......................... 45.4 40

2011......................... 35.1 292012......................... 26.3 20

2013......................... 22.4 16

After 2013................ 18 12

Average life............. 1 year * $171

* Average life =$18/$22.4 = 0.8 rounded up to 1

The lease effect on the D/E ratio changes from $7,420/$4,672 = 1.59 to($7,420 + $171)/$4,672 = 1.62. This is not a major change.




14/40

E10-24 (20 minutes)

a. According to Verizons lease footnote, it has both capital and operating leases.Only the capital leases are reported on-balance sheet in the amount of $390million ($63 million in current liabilities and $327 million as long-term liabilities).This is not the total obligation to its lessors. Verizon also has a significant

amount of leases that it has classified as operating. In fact, the minimum leasepayments under operating leases are over 14 times that for capital leases! Theseoperating leases are not reported on-balance-sheet.

b. Neither the leased asset nor the lease obligation is reported on the balancesheet for an operating lease. As a result, total assets and total liabilities arereduced. Over the life of the lease, total rent expense under operating leases willbe equal to the interest and depreciation expense that would have beenrecorded under capital leases. Profit is unaffected by this classification. Duringthe life of the lease, however, the two will not be equal. Even if depreciation iscomputed on a straight-line basis, interest is accrued based on the balance ofthe lease obligation which is higher in the earlier years of the lease. As a result,

depreciation plus interest will exceed rent expense during the early years of thelease life and will be less toward the end of the lease.

EE10-25 (25 minutes)

a. Our analysis might capitalize (add to both assets and liabilities) the presentvalue of the expected operating lease payments. The present value is computedas follows:

Year($ 000s) Operating LeasePayment Present Value(i=7%)2009.........................

$ 851,412 $ 795,7132010.........................

803,071 701,4342011.........................

731,808 597,3752012.........................

645,215 492,2352013.........................

556,031 396,445>Thereafter.............

2,132,053 1,342,833

Average life............. 4 years* $4,326,035* $2,132,053 $556,031/year = 3.834 rounded to 4 years.

The present value of Staples operating leases is computed to be $4.326 billion. Wemight consider adjusting its balance sheet by adding this amount to both assetsand liabilities. Staples liabilities are 58% higher following this adjustment (adjustedliabilities are $7.442 billion + $4.326 billion = $11.768 billion).




15/40

E10-25continued.

The calculations of the present value of each payment follow:N I/YR PV PMT FV1 7 795,713 0 851,412

N I/YR PV PMT FV

2 7 701,434 0 803,071

N I/YR PV PMT FV3 7 597,375 0 731,808

N I/YR PV PMT FV4 7 492,235 0 645,215

N I/YR PV PMT FV5 7 396,445 0 556,031

The present value of payments after Year 5 follows:N I/YR PV PMT FV

4 7 1,883,394 556,031 0

N I/YR PV PMT FV5 7 1,342,833 0 1,883,394

b.($ 000s) Balance Sheet Income Statement


Liabil-ities +

Contrib.Capital +


NetIncome

To capitalizeoperating leases.

+4,326,036LeasedAsset

=+4,326,036

LeaseLiability

- =

c.2008 Leased asset (+A) ... 4,326,036Lease liability (+L) 4,326,036

2009 Depreciation expense (+E, -SE) .. 432,604Accumulated depreciation (XA, -A) .. 432,604

Interest expense (+E, -SE) .... 302,823Lease liability (-L) ... 548,589

Cash (-A) .. 851,412

d.

+ Leased Asset (A) - - Lease liability (L) +2008 4,326,036 4,326,036 20082009 548,589

- Accumulated Depreciation (XA) + + Depreciation Expense (E) -432,604 2009 2009 432,604

+ Cash (A) - + Interest Expense (E) -851,412 2009 2009 302,823




16/40




17/40

E10-26 (25 minutes)

Our analysis might capitalize (add to both assets and liabilities) the present value ofthe expected operating lease payments. The present value is computed as follows:

Year

($ millions)

Operating Lease

Payment ---Net

Present Value

(i=7%)2009.........................

$ 450 $ 4212010.........................

414 3622011.........................

375 3062012.........................

338 2582013.........................

306 218>2013.......................

2,421 1,292

Average life............. 7.912 years* $2,857

* $2,421 $306/year = 7.912 years

The calculations of the present value of each payment follow:N I/YR PV PMT FV1 7 421 0 450

N I/YR PV PMT FV2 7 362 0 414

N I/YR PV PMT FV3 7 306 0 375

N I/YR PV PMT FV4 7 258 0 338

N I/YR PV PMT FV5 7 218 0 306


7.912 7 1,812 306 0

N I/YR PV PMT FV5 7 1,292 0 1,812

The present value of Yums net operating leases is computed to be $2,857 million.We might consider adjusting its balance sheet by adding this amount to bothassets and liabilities. YUM!s liabilities are 43% higher following this adjustment(adjusted liabilities are $6.635 billion + $2.857 billion = $9.492 billion).




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E10-27 (25 minutes)

a. Our analysis might capitalize (add to both assets and liabilities) the presentvalue of the expected operating lease payments. The present value is computedas follows:

Year($ millions) Operating LeasePayment --- Net Present Value(i=7%)2009.........................

$ 312.4 $ 2922010.........................

264.4 2312011.........................

228.9 1872012.........................

192.1 1472013.........................

163.9 117>2013.......................

692.3 415

Average life............. 4.224 years* $1,389

* $692.3 $163.9/year = 4.224 years.

The calculations of the present value of each payment follow:N I/YR PV PMT FV1 7 292 0 312.4

N I/YR PV PMT FV2 7 231 0 264.4

N I/YR PV PMT FV3 7 187 0 228.9

N I/YR PV PMT FV4 7 147 0 192.1

N I/YR PV PMT FV5 7 117 0 163.9


4.225 7 582 163.9 0

N I/YR PV PMT FV5 7 415 0 582

The present value of Nikes operating leases is computed to be $1,370 million. Wemight consider adjusting its balance sheet by adding this amount to both assetsand liabilities.




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E10-27continued.

b.

Balance Sheet Income Statement


Liabil-ities +

Contrib.Capital +


NetIncome

To capitalize

operating leases.

+1,389

LeasedAsset

=

+1,389

LeaseLiability

- =

c.1. Leased asset (+A) . 1,389

Lease Liability (+L) . 1,389

2. Depreciation expense (+E, -SE) . 139Accumulated depreciation (+XA, -A)... 139

3. Lease liability (-L) 215.2Interest expense (+E, -SE) . 97.2

Cash (-A) ... 312.4

d.+ Leased Asset (A) - - Lease Liability (L) +

1 1,389 1,389 13 215.2

- Accumulated Depreciation (XA) + + Depreciation Expense (E) -139 2 2 139

+ Cash (A) - + Interest Expense (E) -312.4 3 3 97.2

E10-28 (20 minutes)

a. Service cost is the increase in the pension obligation resulting from employeesworking another year for the company. Interest cost is the accrual of interest onthe (discounted) pension obligation.

b. Payments to retirees are made from the pension investment account. There is acorresponding reduction in the pension obligation.

c. The funded status is the pension obligation less the fair market value of thepension investments. In this case $923 million (pension obligation) $513million (pension investments) = $410 million underfunded amount.

d. A $410 million net pension liability is reported in the balance sheet.




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E10-29 (20 minutes)


b. The actual return on pension investments is ($1,527 million in 2008 (thiscauses the decrease in the pension investment account).

c. Actuarial losses (gains) generally arise as a result of decreases (increases) inthe discount rate used to compute the pension obligation (PBO). Because thePBO is the present value of expected future payouts to retirees, a decrease inthe discount rate results in an increase in the PBO. This decrease is called anactuarial loss.

d. Payments to retirees are made from the pension investment account. There is acorresponding reduction in the pension obligation.

e. Xerox contributed $299 million to its pension plans in 2008.

f. Xerox paid $657 million to its retirees in 2008.

g. The funded status is the pension obligation less the fair market value of thepension investments. In this case $8,495 million $6,923 million = $1,572 millionunderfunded amount.

h. A $1,572 million net pension liability is reported on the balance sheet.

E10-30 (20 minutes)


b. Payments to retirees are made form the pension investment account. There is acorresponding reduction in the pension obligation.

c. The funded status is the pension obligation less the fair market value of thepension investments. In this case $30,394 million $27,791 million = $2,603million underfundedamount.

d. A $2,603 million net pension liabilityis reported on the balance sheet.




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E10-31 (15 minutes)a.



Liabil-ities +

Contrib.Capital +

EarnedCapital

Revenues - Expenses = NetIncomeTo record income tax

expense=

+920.1

TaxesPayable

-300.6Deferred

Taxes

-619.5RetainedEarnings -

+619.5Income Tax

Expense

= -619.5

b.Deferred income taxes (-L) ... 300.6Income tax expense (+E, -SE) .... 619.5

Income taxes payable (+L) . 920.1

c. An expense of $619.5 million is recorded in the income statement, thereby

reducing both net income and retained earnings. Liabilities are increased by$619.5 million, $920.1 million in income taxes payable less the decrease of$300.6 million in deferred income taxes.

E10-32 (15 minutes)a.



Liabil-ities +

Contrib.Capital +


NetIncome

a. To record incometax expense.

=

+93TaxesPayable

+1,248Deferred

Taxes


-+1,341Income Tax

Expense

= -1,341

b.Income tax expense (+E, -SE) .... 1,341

Deferred income taxes (+L) . 1,248Taxes payable (+L) . 93

c. An expense of $1,341 million is recorded in the income statement, thereby

reducing both net income and retained earnings. Deferred tax liabilities areincreased (or deferred tax assets are reduced) by $1,248 million, and taxpayable liability was increased by $93 million.

d. The refund is most likely due to one of two sources: (1) a loss recorded in anearlier period for financial reporting purposes that was not recognized until2004 for tax reporting purposes (e.g., a restructuring loss) or (2) a tax losscarryforward.




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PROBLEMS

P10-33 (60 minutes)

a. Rent expense (+E, -SE) . 208,085,000Cash (-A) . 208,085,000

b. Outback would report a lease liability of $1,074,521,000 at December 31, 2008 ifthe operating leases were capitalized.

($ 000s)

Year Operating Lease PaymentPresent Value at Dec. 31, 2008

(i=8%)

2009 175,367 162,377

2010 167,613 143,701

2011 156,382 124,141

2012 148,186 108,921

2013 139,902 95,215

>2013 . 831,160 436,696

831,160/139,902=5.94 yrs. $1,071,051

The calculations of the present value of each payment follow:N I/YR PV PMT FV

1 8 162,377 0 175,367

N I/YR PV PMT FV2 8 143,701 0 167,613

N I/YR PV PMT FV3 8 124,141 0 156,382

N I/YR PV PMT FV4 8 108,921 0 148,186

N I/YR PV PMT FV5 8 95,215 0 139,902


5.94 8 641,650 139,902 0

N I/YR PV PMT FV5 8 436,696 0 641,650




23/40

P10-33continued.

c. In 2009, Outback would report interest expense of $85,684,000 ($1,071,051,000x .08) and depreciation expense of $107,105,100 ($1,071,051,000/10) instead ofrent expense of $175,367,000.

These costs ($85,684,000 and $107,105,100) would replace the otherwisereported rent expense of $175,367,000 on the 2009 income statement. In theearly years of a lease the higher interest expense causes the capitalization ofleases to increase expenses compared to the rent expense. This situationreverses in the later years of the lease.

d. These transactions/entries are reflected in the financial statement effectstemplate below.

($000s) Balance Sheet Income Statement

Transaction CashAsset +NoncashAssets - ContraAssets

= Liabilities + Contrib.Capital + EarnedCapital Revenues - Expenses = NetIncome

2009Depreciationexpense. -

+107,105*AccumulatedDepreciation

=-107,105RetainedEarnings

-+107,105

Deprec.Expense

= -107,10

2009 Leasepayment. -175,367

Cash- = -89,683

LeaseLiability

-85,684**RetainedEarnings

-

+85,684InterestExpense

= -85,684

*Accumulated depreciation is a contra asst, so assets are reduced.**$1,071,051 x 0.08

e. In the statement of cash flows, the rent expense on operating leases isclassified as an operating cash flow. Although the total cash flow is the same,if the lease is treated as a capital lease, then part of the lease payment (theinterest) is classified as operating and the remainder (the principal) isclassified as a financing cash flow. Depreciation on the lease is deducted inthe computation of income but added back in the operating section of thecash flow statement because it is not a cash flow.




24/40

P10-34 (40 minutes)

a. All of Abercrombie & Fitchs leases are classified as operating. U.S. GAAPrequires companies to provide a table of projected lease payments for bothoperating and capital leases. Because no capital leases are included in theAbercrombie & Fitch footnote, we know that it only has operating leases.

Because operating leases are not capitalized on the balance sheet, neither theleased asset, nor the lease obligation, appear on-balance-sheet.

b. Total assets and total liabilities are lower than the balance that would have beenreported had the leases been capitalized. Over the life of the lease, total rentexpense under operating leases will be equal to the interest and depreciationexpense that would have been recorded under capital leases. Profit is unaffectedby this classification. During the life of the lease, however, the two will not beequal. Even if depreciation is computed on a straight-line basis, interest isaccrued based on the balance of the lease obligation, which is higher in theearlier years of the lease. As a result, depreciation plus interest will exceed rent

expense during the early years of the lease life and will be less toward the end ofthe lease.

c. Using a 10% discount rate, the present value of A&Fs operating leasespayments is computed as follows:

Year($ 000s)

Operating LeasePayment

Present Value(i=10%)

2009......................... $314,587 $285,988

2010......................... 318,845 263,509

2011......................... 305,830 229,773

2012......................... 287,772 196,551

2013......................... 267,951 166,376

>2013....................... 1,302,139 616,821

Average life............. 4.86 years* $1,759,018

* $1,302,139 $267,951/year = 4.86 years.




25/40

P10-34continued.


N I/YR PV PMT FV2 10 263,509 0 318,845

N I/YR PV PMT FV3 10 229,773 0 305,830

N I/YR PV PMT FV4 10 196,551 0 287,772

N I/YR PV PMT FV5 10 166,376 0 267,951

The present value of payments after Year 5 follows:

N I/YR PV PMT FV4.86 10 993,396 267,951 0

N I/YR PV PMT FV5 10 616,821 0 993,396

d.

($ 000s) Balance Sheet Income Statement


Liabil-ities +

Contrib.Capital +


NetIncome


+1,759,018LeasedAsset

=+1,759,018

LeaseLiability

- =

e. ($ 000s)2/3/08 Leased asset (+A) .. 1,759,018

Lease liability (+L) . 1,759,018

2009 Depreciation expense (+E, -SE) 175,902Accumulated depreciation (+XA, -A) . 175,902

$175,902 = $1,759,018 / 10

Lease liability (-L) . 138,685Interest expense (+E, -SE) .. 175,902

Cash (-A) 314,587$175,902 = $1,759,018 x 0.10.




26/40

P10-34continued.

f. ($ 000s)

+ Cash (A) - - Lease Liability (L) +

1,759,018 1

314,587 3 3 138,685


1 1,759,018 3 175,902


175,902 2 2 175,902

The interest expense is the same as the depreciation charge because interest isat 10% and depreciation is over 10 years.

g. The effect of a failure to report the leased assets and related lease obligation on-balance-sheet understates fixed commitments. It will leave gross margin largelyunaffected if we assume that the leases are approximately at the midpoint oftheir lives, on average. The debt to equity ratio is increased by capitalizing theleases. Capitalization of the leases would increase the asset base, which would,in turn, lower asset turnover. Hence turnover rates are overstated by the failureto capitalize the leases. Overall these two factors offset each other leaving ROEonly marginally affected. Our conclusion of how A&F is achieving its ROE islikely to be altered because A&F has lower turnover and higher financialleverage than was apparent based on the published (unadjusted) financialstatements.




27/40

P10-35 (40 minutes)

a. Best Buy reports $265 million of capital leases in its liabilities of which $59million due in 2010 is reported as a current liability. The $8,600 of operatingleases are not reported in the balance sheet nor are the related leased assets.

b. Total assets and total liabilities are lower than the balance that would havebeen reported had the leases been capitalized. Over the life of the lease, totalrent expense under operating leases will be equal to the interest anddepreciation expense that would have been recorded under capital leases. Profitis unaffected by this classification. In any given year of the lease, however, thetwo will not be equal. If depreciation is computed on a straight-line basis,interest is accrued based on the balance of the lease obligation, which is higherin the earlier years of the lease. As a result, depreciation plus interest willexceed rent expense during the early years of the lease life and will be lesstoward the end of the lease.

c. Using a 10% discount rate, the present value of Best Buys operating leasespayments is computed as follows:

($ millions)Year



1...............................$ 1,097 $ 997

2...............................1,045 864

3...............................964 724

4...............................900 615

5...............................846 525

>5.............................3,748 1,809

Average life.............4.43 years* $5,534

* $3,748 $846/year = 4.43 years.




28/40

P10-35continued.

The calculations of the present value of each payment follow:N I/YR PV PMT FV1 10 997 0 1,097

N I/YR PV PMT FV

2 10 864 0 1,045

N I/YR PV PMT FV3 10 724 0 964

N I/YR PV PMT FV4 10 615 0 900

N I/YR PV PMT FV5 10 525 0 846


4.43 10 2,914 846 0

N I/YR PV PMT FV5 10 1,809 0 2,914

d.



Liabil-ities +

Contrib.Capital +


NetIncome


+5,534Leased Asset

=+5,534

LeaseLiability

- =

e. 20091. Leased asset (+A) . 5,534

Lease liability (+L) .. 5,53420102. Depreciation expense (+E, -SE) . 553

Accumulated depreciation (+XA, -A) .. 553$572 = $5,716 / 10

3. Lease liability (-L) .. 544Interest expense (+E, -SE) .. 553

Cash (-A) 1,097$572 = $5,716 x 0.10




29/40

P10-35continued.

f.+ Cash (A) - - Lease Liability (L) +

5,534 1.1,097 3. 3. 544


1. 5,534 3. 553


553 2. 2. 553

The interest expense is the same as the depreciation charge because interest is

at 10% and depreciation is over 10 years.

g. The effect of a failure to report the leased assets and related lease obligation on-balance-sheet understates fixed commitments. It will leave gross margin largelyunaffected if we assume that the leases are approximately at the midpoint oftheir lives, on average. The debt to equity ratio is increased. Capitalization of theleases would increase the asset base, which would, in turn, lower assetturnover. Hence turnover rates are overstated by the failure to capitalize theleases. Overall these two factors offset each other leaving ROE only marginallyaffected. Our conclusion of how Best Buy is achieving its ROE is likely to bealtered because Best Buy has lower turnover and higher financial leverage than

was apparent based on the published (unadjusted) financial statements.

P10-36 (5 minutes)

a. Leased asset (+A) 74,520Lease liability (+L) . 74,520

b. Prepaid rent (+A) .. 1,000Cash (-A) 1,000




30/40

P10-37 (50 minutes)

a. $177 million expense

b. The expected return is computed as the beginning fair market value of thepension plan assets multiplied by the long-term expected return on theseinvestments. For 2009, this is computed as $11,879 8.5% = $1010, slightly lessthan the reported amount of $1,059 million. The plan investment reported anactual loss of $2,306 million. U.S. GAAP permits the use of the expected long-term rate of return in order to smooth earnings. If actual returns were to beused, corporate profits would fluctuate greatly with swings in investmentreturns. The logic behind using the long-term rate is that investment returnsare expected to fluctuate around this average and its use more accuratelycaptures the average cost of the pension plan. It is similar to the logic ofreporting held-to-maturity bond investments at historical cost rather thancurrent market value.

c. The pension liability is increased by the service and interest costs and

decreased by any payments made to plan participants. The actuarial loss (gain)relates to the effects on the pension obligation of changes in assumptions usedto compute it, such as the discount rate or the rate of expected wage inflation.The pension plan assets are increased (decreased) by investment gains (losses),are increased by company contributions and are decreased by benefits paid toplan participants.

d. The funded status is the excess (deficiency) of the pension obligation overplan assets. If plan assets exceed pension obligation, the funded status ispositive or overfunded. If pension obligations exceed the fair market value ofplan assets, the funded status is negative or underfunded. The funded status ofthe FedEx pension plan is $(238) at the end of 2009. Pension obligations are

$11,050 million and pension assets are $10,812 million. FedEx should report itsnet funded status as a net pension liability of $238 million on its balance sheet.

e. Because the pension obligation is the present value of expected pensionpayments, an increase in the discount rate decreases the present value reportedon the balance sheet. The effect on the income statement is more difficult topredict. The interest cost component of pension expense is the product of thebeginning of the year pension obligation and the discount rate. In 2009, theeffect of an increase in the discount rate is to apply a higher discount rate to alower pension obligation. These two effects are offsetting, but usually result inlower interest cost.

f. The estimated wage inflation rate is used to project future benefit payments.Decreasing the estimated inflation rate decreases the pension obligationbecause a lower amount of payments to plan participants is projected.Decreasing the expected wage inflation rate decreases the pension obligationreported on the balance sheet and, consequently, the interest component ofpension expense. It is an income-increasing action.




31/40

P10-38 (5 minutes)

a. Pension expense (+E, -SE) 16,000Cash (-A) ... 16,000

16,000 = 400,000 x .04.

b. Bartov would report a net liability of $450,000 ($625,000 - $175,000) in its 2010balance sheet.

P10-39 (20 minutes)

a. $34,106,000

b. $36,470,000 is payable in cash and the remainder is deferred.

c. Deferred tax liabilities are created when a company reports greater revenuesand/or lower expenses in the income statement than are reported on the taxreturn. An example is supplied by certain pension expenses deductible forbooks before being deductible for taxes.

d. Deferred tax assets arise when income is recognized for tax purposes before itis recognized in the financial statements, such as can be case with advancepayments from customers. Thus receipt of the cash will decrease the deferred

tax asset. Alternatively, deferred tax assets may arise when the tax returndefers expenses that are recognized in the financial statements. Examplesinclude bad debt expense and warranty expense. A restructuring charge is anexample of the latter. Restructuring charges are not recognized in the taxreturn until they are realized (cash paid or assets sold at a loss). Therefore, thepayment of the cash or sale of the assets will decrease the deferred tax asset.




32/40

P10-40 (20 minutes)

a. In 2009, the temporary difference is $8,000. $8,000 x 40% = $3,200.In 2010, the temporary difference reverses and no liability would be reported.

b. Income tax expense (+E, -SE) .. 91,200

Income taxes payable* (+L) . 88,000Deferred income tax liability (+L) .. 3,200

* ($236,000 $16,000) x 40% = $88,000.

Income tax expense (+E, -SE) . 94,800Deferred income tax liability (-L) 3,200

Income taxes payable* (+L) 98,000

* ($245,000 $0) x 40% = $98,000.

c. Income tax expense (+E, -SE) . 80,200Income taxes payable (+L)* 77,000Deferred income tax liability (+L) . 3,200

* ($236,000 $16,000) x 35% = $77,000.

Income tax expense (+E, -SE) . 94,800Deferred income tax liability (-L) 3,200

Income taxes payable (+L)* .. 98,000

* ($245,000 $0) x 40% = $98,000.

The solution to part c depends on what the company knew, in 2009, about thetax rate in 2010. In the journal entries above, the assumption is that the tax rateis 35% in 2009, but is supposed to change to 40% in 2010. However, if thechange in the tax rate was not known, the following entries would be required:

c. Income tax expense (+E, -SE) . 79,800Income taxes payable (+L)* 77,000Deferred income tax liability (+L) ** . 2,800

* ($236,000 $16,000) x 35% = $77,000.** $8,000 x 0.35 = $2,800

Income tax expense (+E, -SE) ..................................... 95,200Deferred income tax liability (-L) ............................... 2,800

Income taxes payable* (+L) ............................... 98,000

* ($245,000 $0) x 40% = $98,000.

Either way, the amount of income tax expense is determined as a plug amount.




33/40

P10-41 (20 minutes)

a. Temporary differences

2009: $32,000 - $24,000 = $8,000;

2010: ($32,000 + $37,000) ($24,000 + $26,000) = $19,000.

b. Deferred tax liability

2009: $8,000 x 40% = $3,200; 2010: $19,000 x 40% = $7,600

c. $19,200 + ($7,600 $3,200) = $23,600d. Income tax expense (+E, -SE) 23,600

Income taxes payable (+L) ... 19,200Deferred tax liability (+L) .. 4,400

+ Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) +

(d) 23,600 19,200 (d) 4,400 (d)

P9-42 (20 minutes)

a. Temporary differences

2009: $140,000 - $130,000 = $10,000;2010: ($140,000 + $122,000) ($130,000 + $128,000) = $4,000.

b. Deferred tax liability

2009: $10,000 x 35% = $3,500; 2010: $4,000 x 35% = $1,400

c. $45,150 + ($1,400 $3,500) = $43,050

d. Income tax expense (+E, -SE) 43,050Deferred tax liability (-L) 2,100

Income taxes payable (+L) .. 45,150

+ Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) +

(d) 43,050 45,150 (d) (d) 2,100




34/40

P10-43 (15 minutes)

a. $12,000 x 40% = $4,800.

b. Because the source of the temporary difference is a noncurrent asset (PP&E),the deferred tax liability would be classified as a noncurrent liability.

c. $8,000 x 40% = $3,200.

P10-44 (20 minutes)

Assume that the tax rate increase in 2011 was not known until 2010.

a. Book

value

b. Tax

basis

Temporary

difference

c. Deferred

tax liability2009 $12,000 $0 $12,000 $4,200 ($12,000 x 0.35)2010 $6,000 $0 $6,000 $2,400 ($6,000 x 0.40)2011 $0 $0 $0 $0

d. 12/31/09Income tax expense (+E, -SE) .. 112,000

Deferred income tax liability (+L) 4,200Income taxes payable (+L)* .. 107,800

* $308,000 x 0.35 = 107,800.

12/31/10Income tax expense (+E, -SE) . 138,200Deferred income tax liability (-L) . 1,800

Income taxes payable (+L)* ... 140,000

* $400,000 x 0.35 = $140,000.

12/31/11

Income tax expense (+E, -SE) .. 165,600Deferred income tax liability (-L) 2,400

Income taxes payable (+L)* 168,000

* $420,000 x 0.40 = $168,000.

The expense is determined as a plug amount.




35/40

P10-45 (40 minutes)

a. According to FedExs lease footnote, it has both capital and operating leases.Only the capital leases are reported on-balance-sheet in the amount of $294million (FedEx also reports a lease asset on the balance sheet, but the assetwill appear at an amount lower than the lease liability). This amount is not the

total obligation to its lessors. FedEx also has a significant amount of leases thatit has classified as operating. In fact, the minimum lease payments underoperating leases are over 34 times that for capital leases. These operating leasesare not reported on-balance-sheet.

b. An Excel spreadsheet to calculate the interest rate (using the IRR function)would look something like the following:

A B C D E F G H I J K L M N O

1 N 0 1 2 3 4 5 6 7 8 9 10 11 12 13

2 Amount -294 164 20 8 119 2 2 2 2 2 2 2 2 1

3 IRR 4.453%

The Excel function =IRR(B2:O2) returns a value of 4.453% (which is >3%).

c. The present value of FedExs operating leases payments is computed asfollows:

Year($ millions)


Present Value(i=4%)

2010.........................$1,759 $ 1,691

2011.........................1,612 1,490

2012.........................1,451 1,290

2013.........................1,316 1,125

2014.........................1,166 958

>2014.......................7,352 5,246

Total$14,656 $11,800

Average Life: $7,352/$1,166 = 6.3 years.




36/40

P10-45continued.


N I/YR PV PMT FV

2 4 1,490 0 1,612

N I/YR PV PMT FV3 4 1,290 0 1,451

N I/YR PV PMT FV4 4 1,125 0 1,316

N I/YR PV PMT FV5 4 958 0 1,166


6.3 4 6,382 1,166 0

N I/YR PV PMT FV5 4 5,246 0 6,382

d. Failure to report the leased assets and related lease obligation on-balance sheet

has overstated asset turnover ratios and understated financial leverage ratios.For example, the debt to equity ratio would increase from 0.78 ($10,618/$13,626)to 1.65 ([$10,618 + $11,800]/$13,626). Profit margins will not be affectedsignificantly, if we assume that the leases are approximately at the midpoint oftheir lives, on average. Because the decreased turnover and increased leverageeffects offset one another, ROE is unaffected. Our conclusion about howFedExis achieving its ROE is altered, however, because it has lower turnover andhigher financial leverage than is apparent based on a review of the published(unadjusted) financial statements.

e. To effectively conduct its business, FedEx requires a significant amount of

assets that are not reported on-balance-sheet. In addition, the true extent ofFedExs obligations is substantially understated. In the case of FedEx, therefore,it appears that the balance sheet does not do an adequate job.

f. Lease reporting in the U. S. follows U.S. GAAP while lease reporting in Francewould follow IFRS. U.S. GAAP does not capitalize operating leases. Operating

leases are considered executory contracts. Executory contracts are promises topay defined amounts in the future for future benefits. Such contracts are notrecognized as liabilities. The assets supplying the services are also notrecognized. The requirements necessary to recognize a lease as a capital leaseare not as specific under IFRS and hence a lease that would not be considered acapital lease under U.S. GAAP might be considered a capital lease under IFRS.Specific requirements for capitalization are covered in advanced courses.




37/40

CASES AND PROJECTS

C10-46 (50 minutes)

a. Dow Chemical is reporting net pension expense of $122 million for 2008.

b. The expected rate of return is computed as the beginning fair market value ofthe pension plan assets multiplied by the long-term expected return on theseinvestments. For 2008, expected return was $$1,232 on assets of $16,130 million.This implies an expected rate of return of 7.64% ($1,232/$16,130).

c. The pension liability is increased by the service and interest costs anddecreased by any payments made to plan participants. The actuarial loss (gain)relates to the effects on the pension obligation of changes in assumptions usedto compute it, such as the discount rate or the rate of expected wage inflation.

The pension plan assets are increased (decreased) by investment gains (losses),are increased by company contributions, and are decreased by benefits paid toplan participants.

d. The funded status is the excess (deficiency) of the pension obligation overplan assets. If plan assets exceed pension obligation, the funded status ispositive. If pension obligations exceed the fair market value of plan assets, thefunded status is negative. The funded status of the Dow Chemical pension planis $(4,000) million at the end of 2008. Pension obligations are $15,573 million andpension assets are $11,573 million. Thus, the pension is underfunded and thebalance sheet should show a net pension liability of $4,000 million.

e. Since the pension obligation is the present value of expected pensionpayments, a increase in the discount rate decreases the present value reportedon the balance sheet. The effect on the income statement is more difficult topredict. The interest cost component of pension expense is the product of thebeginning-of-the-year pension obligation and the discount rate. The effect of anincrease in the discount rate is to apply a higher interest rate to a lower pensionobligation. Interest expense on the pension liability will usually increase in thiscircumstance. However, the actuarial gain resulting from the lower liabilityamount may offset the higher interest cost.

f. An increase in expected return unambiguously increases profitability aspension cost is reduced. This result occurs because the long-term rate is usedto compute the dollar amount of expected return that is an offset in thecomputation of pension expense.

g. Inflation rates differ from country to country. For 2008, those rates are generallyhigher outside the U.S. where FedEx operates. Inflation is expected to increasein the U.S. and could exceed the rates in other countries implying relativelyhigher compensation levels.




38/40

C10-47 (40 minutes)

a. Deltas purchase commitments are not reported on the balance sheet becausethey are unexecuted contracts. When Delta receives the aircraft from Boeing,Delta will record a debit to PPE assets and a credit to accounts payable. Someof the aircraft appear to have prearranged financing in the form of a sale-leaseback arrangement. Thus, when the aircraft are delivered, they will then besold to a third-party lessor and then leased under a capital lease.

Boeing will record a sale, with a debit to accounts receivable and a credit tosales revenue. At the same time, it will record a debit to cost of goods sold and acredit to aircraft inventory.

b. Rent expense (+E, -SE) .. 850Cash (-A) . 850

c. The total liability on the balance sheet would be $501million plus a premium of$64 million. Of this amount, $92 million would be classified as a current liabilityleaving a noncurrent liability of $473 million.

d. Delta will record rent expense of $1,646 million less any sublease income.

e. Using a 10% discount rate, the present value of Deltas operating leasepayments is computed as follows:

Year($ millions)



2009......................... $1,646 $ 1,496

2010......................... 1,559 1,288

2011......................... 1,326 996

2012......................... 1,204 822

2013......................... 1,059 658

>2014....................... 5,664 2,626

Total $12,458 $7,886

Average Life: $5,664 $1,059/year = 5.35 years.




39/40

C10-47continued.


N I/YR PV PMT FV

2 10 1,288 0 1,559

N I/YR PV PMT FV3 10 996 0 1,326

N I/YR PV PMT FV4 10 822 0 1,204

N I/YR PV PMT FV5 10 658 0 1,059


5.35 10 4,230 1,059 0

N I/YR PV PMT FV5 10 2,626 0 4,230

Given Deltas liabilities total $44.140 billion before capitalizing operating leases,the $7.886 billion of operating leases adds about 17.9% to Deltas total liabilities,which is a material, if not a substantial increase.




40/40

C10-48 (30 minutes)

a. $6,822 ($126,904 $136,840) = $16,758

b. Income tax expense (+E, -SE) .. 16,758Deferred tax asset current (-A) ... 1,494*

Deferred tax asset noncurrent (-A) .. 8,442Income taxes payable (+L) ... 6,822

*$91,843 $90,349

c. The temporary difference due to depreciation was $13,392 / 0.35 = $38,263.

The tax basis of PP&E assets was $942,219 - $38,263 = $903,956.

d. Prepaid catalog expenses are capitalized and amortized for financial reportingpurposes. However, for tax reporting purposes, the costs are expensed whenpaid. Consequently, the tax deduction is recognized before the expense is

recognized in the income statement. The prepaid catalog expense of $36,424represents a temporary difference between financial and tax reporting. Theresulting deferred tax liability of $14,589 offsets the other current deferred taxassets in the balance sheet.

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