FINANCIAL

STATEMENT
ANALYSIS &
VALUATION
Peter Easton
7eMcAnally
Mary Lea
Steve Crawford
Greg Sommers
 Module 10
Analyzing Leases, Pensions, and Taxes

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 Learning Objective 10-1
Analyze and interpret lease disclosures.

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 Leases

 A lease is a contract between the owner of an asset (the lessor) and

the party desiring to use that asset (the lessee)
 Since this is a private contract between two willing parties, it is
governed only by applicable commercial law, and can include whatever
provisions the parties negotiate
 Leases generally provide for the following terms
 Lessor grants the lessee unrestricted right to use the asset during the lease term
 Lessee agrees to maintain the asset and make periodic payments to the lessor
 Title to the asset remains with the lessor, who usually takes physical possession of the
asset at lease-end unless the lessee negotiates the right to purchase the asset at
its market value or other predetermined price

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 Leases as a Financing Vehicle
 Leases are a financing vehicle like a bank loan with advantages
1. Leases often require less equity investment by the lessee
 Leases usually require the first lease payment be made up front

 For a 60-month lease, up front payment is 1/60 (1.7%) investment,

compared to 20%–30% equity investment required by a bank
2. Lease terms can be structured to meet both parties’ needs
 Allow variable payments to match the lessee’s seasonal cash inflows

 Have graduated payments for start-up companies

3. Leases can be utilized for vehicles, equipment, and real estate

 These advantages have made leasing a popular form of financing

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 Lease Reporting
Microsoft
 Companies report all leases on the balance sheet as both assets and
lease
 When companies describe their leases in notes, they distinguish between
operating leases and finance leases

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 Lease Balance Sheet Reporting
Microsoft
 On its balance sheet, Microsoft reports assets relating to both operating
and finance leases

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 Lease Balance Sheet Reporting
Microsoft
 Microsoft reports the lease liabilities on its 2022 balance sheet

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 Lease Accounting
 The first step in lease accounting is to determine whether a lease is operating
or financing
 Finance leases meet one or more of the following criteria
 Transfer of ownership The lease transfers ownership of the underlying asset to the lessee
by the end of the lease term
 Purchase option The lease grants the lessee an option to purchase the underlying asset
that the lessee is reasonably certain to exercise
 Lease term The lease term is for a major part of the remaining economic life of the
underlying asset
 Present value The present value of the sum of the lease payments and any residual value
guaranteed by the lessee equals or exceeds substantially all of the fair value of the
underlying asset
 Specialized asset The underlying asset is so specialized that it is expected to have no
alternative use at the end of the lease term
 Any lease of 12 months or more, not classified as a finance lease, is classified
as an operating lease
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 Lease Accounting and the Balance Sheet

 The balance sheet presents lease liabilities and right-of-use assets

separately (not the net amount)
 Finance lease assets are typically included in PPE, and lease liabilities are
included with debt
 Operating lease assets and liabilities are each reported in a separate line
item if material
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 Lease Liabilities
 Footnotes disclose a schedule of future lease payments
 For Microsoft in 2022

 Total forecasted operating lease payments are $15,004 M

 Microsoft’s balance sheet includes liabilities of $13,717 M which includes
the portion maturing in the next year
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 Calculating Present Value
of Operating Lease Payments
Discount rate = 2.09%

Total lease payments PV of lease payments

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 Imputed Discount Rate for Leases

 We use 2.09% to determine the PV of Microsoft’s operating leases.

 But where did that rate come from?
 In Excel, we can use the IRR function to estimate the implicit discount
rate that Microsoft used for its leases

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 Lease Accounting and the Income Statement

 Total expense over the lifetime of the lease equals the total remaining
lease payments plus total amortization of any up-front costs
 Assume a company
 Executes a five-year lease requiring annual payments of $22,463
 Pays $5,000 of initial direct costs prior to commencing the lease

 The PV of the lease payments at 4% is $100,000 and the company

recognizes a lease liability for that amount
 The company recognizes a right-of-use asset of $105,000 ($100,000 PV
of the lease payments + $5,000 up-front costs)
 The total lease cost under both operating and finance leases is
$22,463 × 5 years + $5,000 upfront costs = $117,314
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 Lease Accounting and the Income Statement

The income statement will reflect the total lease cost of $117,314
differently for operating and finance leases
 Operating lease Lease expense of $23,463 ($117,314 / 5 years) is
recognized each period as rent expense
 Finance lease Lease expense includes interest on the lease liability
plus straight-line amortization of the right-of-use asset
 For year 1: lease expense $100,000 × 4% + $105,000/5 = $25,000
 Amortization of the right-of-use asset is included in income from operations (similar to
depreciation expense relating to PPE assets)
 Interest expense will be reported after operating income
 Operating profit will be higher than by the amount of interest expense recognized as
nonoperating
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 Lease Income Statement Reporting: Microsoft

 Microsoft discloses the following about the income statement effects of

their leases

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 Leases and Statement of Cash Flows

The statement of cash flows will be impacted by the lease classification of

in a similar manner to the income statement
 Operating lease Cash flow from operating activities includes the entire
lease payment
 Finance lease The lease payments include payment of accrued interest
and reduction of the principal balance of the lease liability
 The interest portion is included in net income and, therefore, in net cash flows from
operating activities
 The portion representing payment of principal is considered a financing activity
 Net cash flows from operating activities will be higher for finance leases by the amount
of the payment allocated to reduction of the lease liability

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 Summary of Lease Accounting and Reporting
 For both operating and financing leases, the balance sheet treatment is
identical
 However, the income statement and statement of cash flows presentation
depends on the lease classification

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 Analyst Adjustments 10.1

 Analysts can separate operating lease payments into operating and

nonoperating components by using information in the lease notes
 For Microsoft for 2022

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 Analyst Adjustments 10.1

 Microsoft reports operating lease liabilities of $13,717 and a weighted

average discount rate of 2.09% for operating leases.
 We adjust the operating lease payments reported in the income
statement
 The $287 million of imputed interest expense is treated as nonoperating
 The remaining $2,174 million is treated as operating

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 Learning Objective 10-2
Analyze and interpret pension disclosures.

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 Post-Retirement Benefit Plans
 Companies frequently offer post-retirement plans for employees
 There are two general types of plans

1. Defined contribution plan This plan requires the company to make

periodic contributions to an employee’s account (usually with a third-
party trustee like a bank)
 Many plans require an employee matching contribution
 Following retirement, the employee makes periodic withdrawals from the account
 A tax-advantaged 401(k) account is a typical example
 Under a 401(k) plan, the employee makes contributions that are exempt from federal
taxes until they are withdrawn by the employee after retirement

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 Post-Retirement Benefit Plans

2. Defined benefit plan This plan requires the company make periodic
payments to a third party, which then makes payments to an employee
after retirement
 Payments usually based on years of service and employee’s salary
 The company may or may not set aside sufficient funds to cover these obligations
(federal law sets minimum funding requirements)
 As a result, defined benefit plans can be over- or underfunded
 All pension investments are retained by the third party until paid to employees
 In the event of bankruptcy, employees have the standing of a general creditor, but
usually have additional protection in the form of government pension benefit
insurance

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 Accounting for Defined Contribution Plans

 The financial statement implications and the accounting for defined

contribution plans is similar to a simple accrual of wages payable
 When the company becomes liable to make its contribution, it accrues the liability and
related expense
 Later, when the company makes the payment, its cash and the liability are reduced

 The amount of the liability is certain, and the company’s obligation is fully
satisfied once payment has been made

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 Accounting for Defined Benefit Plans
 For a defined benefit plan the company promises to pay retirees based
on a formula that includes the employee’s final salary level and years of
service, both of which are unknown
 Estimating the amount of the liability is difficult and prone to error
 While companies typically set aside some cash to fund promised payments, usually it
is only the minimum contribution required by law
 This makes it uncertain whether there will be sufficient funds available to make
required payments to retirees
 The accounting for defined benefit plans is subjective, amounts are
uncertain, and companies frequently revise their estimates.
 Footnote disclosures are often lengthy and difficult to decipher
 Nonetheless, it is possible to use the disclosures to assess how a defined benefit plan
impacts company performance and financial condition
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 Projected Benefit Obligations―Overview

 The projected benefit obligation (PBO) is the present value of the

estimated benefit payments to retirees
 The estimate of the PBO involves a number of estimates that include:
 Number of employees who will reach retirement age while employed with the
company
 Salary levels at retirement—this requires an estimate of wage inflation.
 Years of service at retirement
 Years over which annual payments will be made—this requires an estimate of life span

 The company uses these assumptions to estimate the amount that will be
paid to employees from retirement until the end of their lives
 This amount is discounted (at an assumed rate called the “settlement
rate”) to yield the present value of the future pension benefits to be paid
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 Defined Benefit Plans on the Balance Sheet

 On the balance sheet companies report the funded status for pension and
other post-employment obligations
Funded Status = Projected benefit obligation − Pension plan
assets
 Pension plan assets This is an investment portfolio with debt and
equity securities
 The portfolio provides a return that will fund future payments to retirees
 Each period the investment account increases with investment income (interest,
dividends, and gains) and as the company contributes additional cash to the portfolio
 The investment account decreases with investment losses and as cash is paid to
retirees
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 Defined Benefit Plans on the Balance Sheet
 Projected benefit obligation (PBO) This represents the present value
of the company’s estimated future payments to retirees
 A company must estimate required future payments
 Following factors make it difficult to project future payments (companies
hire actuarial advisors to do this)
 Payments often do not occur for many decades into the future
 Number of eligible employees is uncertain
 Employees’ longevity with the company is unknown
 Payments depend on employees’ final salary levels, which must be estimated

 A company computes the present value of the future cash outflows

to determine the projected benefit obligation
 PBO liability decreases when the company pays benefits to retirees
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 Defined Benefit Plans on the Balance Sheet
 Funded status The balance sheet reports the funded status―the
difference between the projected benefit obligation (PBO) and the
market value of the plan assets
 If the plan assets > PBO, the pension plan is overfunded and a net asset
is reported on the balance sheet
 If PBO > plan assets, the plan is underfunded and the balance sheet
reports a liability for the unfunded amount

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 Sufficiency of Plan Assets
 For 2023 FedEx reported domestic and international pension plans along
with postretirement healthcare plans with a negative funded status

 Employees and analysts are keenly interested in the likelihood that the
company will be able to pay its pension obligations
 This negative funded status is cause for some concern
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 Sufficiency of Plan Assets
 Funded status is not the only measure we can use to assess the
company’s ability to pay its pension obligations
 Companies provide a schedule of expected benefit payments for the
next five years and for the five-year period thereafter

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 Sufficiency of Plan Assets
 The analysis question is whether the pension plan assets will generate
investment returns sufficient to cover the required pension payments

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 Sufficiency of Plan Assets

 The bottom line is that the cash for benefit payments must come from
the pension plan assets
 Either the plan assets must generate sufficient returns to fund
benefit payments, or the company must make additional contributions
to the pension plan assets
 Severely underfunded plans might not have sufficient assets to cover
the projected payments to retirees
 In this case, the company might need to use operating cash flow, or
worse, borrow to cover its pension benefit obligations

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 Defined Benefit Plans on the Income Statement
 A useful way to think about the income statement effects of pensions is
to recall the accounting equation
Assets = Liabilities + Equity
 As liabilities increase, holding assets constant, equity must decrease (an
expense)
 As liabilities fall, equity must increase (income)
 Several items cause the funded status liability to increase or
decrease―these items create pension expense

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 Defined Benefit Plans on the Income Statement

 Service cost
 Pension benefits based on years of service and salary levels at retirement
 As employees work another year, their cumulative years of service increase as does
their salary level―this increases the benefits due to them at retirement
 Funded status increases and the related expense is called service cost since it relates
to the service provided to the company by employees that year

 Interest cost
 The PBO is computed as the present value of the expected benefit payments
 Each year, the liability increases by the interest accrued on the PBO liability, computed
using the discount rate―this expense is called interest cost

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 Defined Benefit Plans on the Income Statement

 Investment returns
 If a pension investment portfolio generates a positive investment return, plan assets
increase and the funded status liability decreases―this creates income (reduces
expense)
 If the pension investment portfolio reports a loss, plan assets decrease and the funded
status liability increases, resulting in additional pension expense

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 Defined Benefit Plans on the Income Statement

 Actuarial adjustments
 Computing PBO requires estimates about future payments, pension investment
portfolio returns, and discount rates
 Companies can, and often do, change these estimates, which affects the PBO and
the funded status
 Wage inflation If a company increases its inflation assumption, estimated salaries at
retirement will be higher and the pension liability increases, resulting in higher expense
 Years of benefit payments If the company assumes a longer period for benefit payments
to retirees, the pension liability increases, resulting in higher expense
 Discount rate While a higher discount rate reduces the present value of the PBO, the annual
interest cost is at a higher rate but accrued on a lower PBO. The net effect on the pension
liability is, therefore, indeterminate.
 Investment returns Investment returns on plan assets offset pension expense. So as
investment returns increase, pension expense decreases

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 Pension Expense Smoothing

 FASB made concessions to gain support for the pension standard

 Companies expressed concern over recognizing the full PBO as a liability on the
balance sheet and preferred the “net” funded status
 Companies were also concerned about the increase in volatility of reported earnings
that would result if changes in plan assets and the PBO were reflected in current
earnings
 To allay these concerns, the FASB agreed to a mechanism that would
smooth pension expense: companies could include two items in
comprehensive income (and AOCI) instead of net income (and retained
earnings)
1. Large investment gains and losses on pension assets
2. Changes in the PBO that arise from changes in actuarial assumptions

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 Pension Expense Smoothing
 Bottom line: as long as the total deferred gains or losses are not
excessive, they remain on the balance sheet in AOCI
 Details of the deferral mechanism:
 Instead of recognizing actual returns on pension assets in the income statement,
companies recognize an expected return that represents the long-term rate of
return the company expects to earn
 Only amortization of excess deferred gains or losses recognized in current
income
 For most companies, pension expense is computed as follows

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 Pension Expense Smoothing
 Pension plan assets and PBO are updated each year as follows:

 We see that benefits are paid from the pension plan assets, and the
payments reduce both the plan assets and the PBO liability

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 Fair Value Accounting for Pensions
 The use of expected returns and the deferral actuarial gains and losses
smooths pension expense and dampens earnings volatility
 While most companies take this approach, some companies choose to
recognize gains and losses in current earnings
 Verizon, IBM, Honeywell, FedEx, UPS and AT&T now do so
 At FedEx gains and losses are significant

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 Footnote Disclosure—Key Assumptions
 Companies must disclose rates and assumptions used
to estimate PBO and pension expense

 Analysts assess reasonableness of assumptions and track changes in

assumptions
 Changes in assumptions have the following general effects on pension
expense

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 Three Important Analysis Implications

1. To what extent will the company’s pension plans compete with investing
and financing needs for the available cash flows?
 Federal law (Employee Retirement Income Security Act) sets minimum standards
for pension contributions
 If investment returns are insufficient, companies must make up the shortfall
that compete for available operating cash flows with other investing and financing
activities
 Companies might need to postpone capital investment
 Analysts must be aware of funding requirements when projecting future cash flows

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 Analysis Implications

2. In what ways has the company’s choice of estimates affected its

profitability?
 Accounting for pensions requires many assumptions
 Each assumption affects reported profit, and analysts must be aware of
changes in these assumptions and their effects on profitability
 An increase in reported profit due to a change in an assumption, might not be
related to core operating activities and, further, might not be sustainable
 Analysts must consider such changes in estimates as they evaluate reported
profitability

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 Analysis Implications

3. Should pension costs and funded status be treated as operating or

nonoperating?
 Under GAAP, companies report the service cost component of pension cost in the
same line item as other compensation costs
 The other components of pension expense are presented in the income statement
separately and outside of operating income
 GAAP defines the PBO as the “actuarial present value . . . of all benefits attributed by
the pension benefit formula to employee service rendered before that date”
 Thus, we treat the funded status liability as an operating item

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 Other Post-Employment Benefits (OPEB)

 In addition to pension benefits, many companies provide healthcare and

insurance benefits to retired employees
 These other post-employment benefits (OPEB) present reporting
challenges similar to pension accounting
 Companies often provide these benefits on a “pay-as-you-go” basis―rare
for companies to make contributions in advance for OPEB
 As a result, this liability, called accumulated post-employment
benefit obligation (APBO), is largely, if not totally, unfunded
 Companies report unfunded APBO as a liability
 Companies report annual service costs and accrued interest costs as expenses each
year
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 Analyst Adjustments 10.2

 Companies have leeway in cash they contribute to pension plans

 Volatility in funding levels potentially skews liquidity and coverage
ratios that include operating cash flow or cash
 Analysts might “level out” such cash flow effects by using an average
level of pension plan cash contributions each year

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 Analyst Adjustments 10.2
 At FedEx cash contributions to total assets exhibit volatility

 Determine the 5-year weighted average contribution is 1.12%

 Use the 1.12% average to determine an average cash contribution

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 Analyst Adjustments 10.2

 Note that cash contributions have no income statement effect

 Cash flow statement is impacted via operating cash flows
 Pension assets on the balance sheet are impacted by cash contribution
 Total tax expense remains unchanged – taxes paid and deferred taxes
are affected in the same amount but in the opposite direction

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 Learning Objective 10-3
Analyze and interpret income tax reporting.

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 GAAP vs. Internal Revenue Code

 When preparing financial statements for stockholders and other external

constituents, companies use GAAP
 When companies prepare their income tax returns, they prepare financial
statements using the Internal Revenue Code (IRC)
 These two sets of rules recognize revenues and expenses differently and
yield markedly different income measures
 In general, companies desire to report the lowest possible income to tax
authorities to reduce the tax liability and increase after-tax cash flow
 This practice is acceptable so long as the financial statements are
prepared in conformity with GAAP and tax returns are filed in accordance
with the IRC
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 Timing Differences
Create Deferred Tax Assets and Liabilities

 For financial reports (GAAP), companies typically use straight-line

depreciation
 For tax returns (IRC), companies use an accelerated method of
depreciation (meaning more depreciation is taken in the early years of
the asset’s life and less depreciation in later years)
 When a company uses an accelerated rate for tax purposes, taxable
income is lower in the asset’s early years
 As a result, tax payments are reduced and after-tax cash flow is
increased
 That excess cash can then be reinvested in the business to increase its
returns to stockholders
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 Timing Differences―Example
 Assume a company purchases an asset with a five-year life
 It uses straight-line method when reporting to stockholders (GAAP) and
uses accelerated depreciation for tax purposes (IRC)
 During the first 2.5 years, tax-depreciation is
higher than GAAP-depreciation
 In the last 2.5 years, this is reversed
 Taxable income and taxes are higher during
the last 2.5 years
 The same total amount of depreciation is
recognized under both methods over the asset’s five-year
life―only the timing differs
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 Illustration of Deferred Tax Liabilities
 As an example, assume the following:
 A company purchases a depreciable asset with a two-year life for $100
 For GAAP, it uses straight-line method, and depreciation expense is $50 per year
 For tax reporting (IRC) the company uses accelerated method and depreciation
deduction is $75 in Year 1 and $25 in Year 2
 Assume income before depreciation and taxes of $200 and that its tax rate is 40%

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 Illustration of Deferred Tax Liabilities

 The reduction in cash reflects the tax payment

 At the end of Year 1, the company knows that additional tax must be paid in
Year 2 because the financial reporting and tax reporting depreciation
schedules are set when the asset is placed in service
 Given these known amounts, the company accrues the deferred tax
liability in Year 1 in the same manner as it would accrue any estimated
future liability
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 Illustration of Deferred Tax Liabilities
 At the end of Year 2, the additional income tax is paid and the company’s
deferred tax liability is now satisfied

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 Illustration of Deferred Tax Assets

 Deferred tax assets arise when the tax payment is greater than the tax
expense for financial reporting purposes
 For example, restructuring accruals create deferred tax assets
 In the year a company approves a reorganization plan, it records restructuring
expense and accrues a restructuring liability to cover future severance payments and
asset write-downs
 For tax purposes, restructuring costs are not deductible until paid in cash and
losses on asset value are not deductible until the assets are sold
 The timing difference between the GAAP expense and the tax
deduction permitted by the IRC creates a deferred tax asset

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 Illustration of Deferred Tax Assets

 Another example of timing differences is net operating loss (NOL)

carryforwards
 The IRC permits companies to deduct taxable losses incurred in the current year from
taxable income earned in the future
 Companies can carry losses forward indefinitely to reduce taxes owing in the future
 These future taxes saved create a future economic benefit, which is the definition
of an asset
 Deferred tax assets arising from NOL carryforwards are significant on
many companies’ balance sheets

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 Reporting Deferred Tax Assets and Liabilities

 In financial statement notes, companies must disclose components of

deferred tax liabilities and assets
 Deferred tax assets and liabilities are calculated as follows:
 Deferred tax asset = Future estimated tax deductible expense or loss ×
Estimated tax rate
 Deferred tax liability = Future estimated taxable income × Estimated tax
rate
 Both deferred tax assets and deferred tax liabilities are computed using the tax rates
that the company anticipates will apply in the future
 If the tax rates change, so do the reported deferred tax assets and
liabilities

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 Reporting Deferred Tax Assets and Liabilities
 Yum! reports the following
deferred tax note for 2022

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 Valuation Allowance for Deferred Tax Assets (DTA)
 Companies must establish a valuation allowance for DTA if the future
realization of the tax benefits is uncertain
 The allowance reduces reported assets and increases tax expense, which
reduces equity
 The valuation allowance can be reduced (reversed) by one of two events
1. The company writes off a deferred tax asset
 The asset is reduced to zero and the amount written off is subtracted from the deferred tax
valuation allowance.
 There is no effect on income from this write-off

 Occurs when net operating loss carryforwards (NOLs) expire before they can be used to
offset other profits

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 Valuation Allowance for Deferred Tax Assets (DTA)

2. The company determines that the DTA will be realized

 If the company decides that the realization of the DTA is more likely than not, it can
reverse the deferred tax asset valuation allowance.
 The DTA allowance is reduced, and tax expense is reduced by the same amount, thus
increasing net income

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 Valuation Allowance for Deferred Tax Assets (DTA)
 YUM!’s deferred tax
footnote includes a
valuation allowance in
both 2021 and 2022, and
the allowance decreased
in 2022
 The decrease in the
valuation allowance in
2022 had the following
effects
 YUM’s deferred tax assets
and net income both
increased by $13 M
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 Effects of Loss Carryforwards
 Tesla provides an example of the effect of loss carryforwards on net
income

 In 2022, Tesla used tax loss carryforwards of $13.57 B to reduce taxable

income and save the company approximately $3 B in taxes
 Tesla also reports that it had an additional $18 B of carryforwards
available to offset taxable income in 2023 and beyond
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 Disclosures for Income Taxes

 The GAAP tax expense reported on the income statement relates on

GAAP reported income that the company expects to pay to federal,
state, and municipal taxing authorities as well as foreign governments
 For YUM! in 2022:

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 Disclosures for Income Taxes
 Companies disclose the portion of income tax expense that is currently
payable and the amount that relates to deferred taxes

For YUM! in
2022

 Current tax expense from company’s tax returns―must be paid (in cash) or
installments during the year―remaining balance is included as a current
liability
 Deferred tax expense is the effect on tax expense from changes in deferred
tax liabilities and deferred tax assets
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 Disclosures for Income Taxes
 Companies required to reconcile the difference between the U.S. corporate
tax rate and the company’s effective tax rate (Tax expense/Pretax income)

For YUM! in
2022

 The reconciliation table provides valuable information about transitory items

that affect taxes and net income
 YUM reported a reduction in tax rate from Intercompany restructuring (11.3%)
and from Impact of tax law changes (3.8%)
 Tax reductions like these are not likely to recur in the foreseeable future
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 Analysis of Income Tax Disclosures

 An increase in deferred tax liabilities indicates that a company is

reporting higher GAAP income relative to taxable income and can
indicate the company is managing earnings upwards
 Tax notes reveal changes in the deferred tax asset valuation
account often triggered by the write-off of DTAs typically relating to NOLs
 Companies can (and do) increase their estimate on the recoverability of
deferred tax assets
 When they do, the valuation allowance is reduced increasing DTA and
increasing net income dollar-for-dollar
 The reconciliation can reveal important transitory items that might
impact forecasts of future tax rates

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 Analyst Adjustments 10.3

 The irregular pattern in the ratio of Valuation allowance to gross DTA

raises a concern that managers might be using the valuation allowance to
manage earnings
 Use the four-year weighted average of 5.06%

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 Analyst Adjustments 10.3
 A constant rate of 5.06% yields differences in the valuation account

 We adjust the income statement and balance sheet as follows:

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 FINANCIAL
STATEMENT ANALYSIS
& VALUATION
7e

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