Lecture 9 - Long-Term Leases and Pension Obligations

Long-Term Leases

Leases are similar to borrowing money. Sometimes you have to record it in the same way.

Usually, there’s nothing on the books when you sign the lease. Then record the lease expenses as incurred.

If it’s a big capital lease, like an airplane, and the lease covers the length of the useful life (ex. 20 years), you may be required to record it as if you purchased it:
Dr. Leased Equipment
--- Cr. Lease Obligation

When you make a lease payment,
Dr. Lease Obligation
Dr. Interest expense
--- Cr. Cash

We won’t go through how you make the calculations for the amounts of the lease obligation and the interest.

At the end of the year, depreciate it:
Dr. Depreciation expense leased equipment
--- Cr. Accumulated depreciation on leased equipment

Guidelines and criteria for using capital leasing approach
- how much of the useful life of the asset does the lease cover
- do you have the option to purchase the underlying property at a low rate

Pension Obligations

Defined contribution vs. Defined benefit plan (per ERISA)

Defined benefit plan – employer says to employee: after you retire, assuming you’ve been with the firm for 20 year, we’ll pay you a retirement benefit of 80% of the highest salary you received with the firm. Employer bears the risk of adverse investments. PBGC (pension benefit guarantee corp) guarantees/insures the pension fund.

Defined contribution plan – you and the employer or both (optionally) make contributions to a fund (some tax benefits). When you retire, you can take those funds as a lump sum or an annuity. Employee bears the risk of adverse investment yield. No long term liability for the firm. No need for special accounting.

With Defined benefit plans we need special accounting for the firm’s liability. You must estimate the retirement cost of current employees incurred this year (via actuarial methods).
Dr. Pension Expense
--- Cr. Liability for pensions
Dr. Pension Liability
--- Cr. Cash

If this balances out, you’ll have zero net liability. That would be a “fully funded” pension plan. If not, it’s unfunded pension liability.

Many companies are going from defined benefit plans to defined contribution plans.

Another type of expense on the books that should be recorded today rather than when it’s paid out later – medical expenses to be covered after retirement. Year’s ago, it wasn’t on the books until it was incurred. Now, it’s accounted for like pension plans.
Dr. Post Ret. Med Expense
--- Cr. Liability for Post Ret. Exp
Dr. Liability for Post Ret. Exp
--- Cr. Cash

These expenses can be hugely significant. Many companies canceled/discontinued these plans.