Financial Accounting, Chapter 15.4 - YouTube

Hello, my name is Leah Kratz and I'm one of the co-authors of your financial

accounting textbook. By now I hope you've had a chance to look through and read, as

well as think about our chapter on other non-current liabilities. There are a lot

of things that show up in this chapter that companies engage in and I hope that

you have a chance to talk about them with your professor. Talk about them with

your classmates and think about what these represent. Again, we want you to be

able to look at a set of financial statements and understand what it is

you're seeing and what those items represent. Hopefully you've had a chance

to think about your top five most important things from the

chapter. Here's a list of my top five. Compare them to yours, see what you think.

Where are they different and where are they the same? Here we go.

For me, the fifth most important thing is the concept of off-balance-sheet

financing. Now, this is a term that we talked about when we learned the

historic rules for accounting for operating leases. Although we no longer

use this method for accounting for operating leases, you may still encounter

off-balance sheet financing in other areas of accounting. So I wanted you to

be familiar with the terminology. Off-balance-sheet financing is when a

company has an obligation, but for some reason or another they are not required

by FASB to report that on their balance sheet. As you would imagine,

companies love this. They have the ability to finance their operations but

not show the obligation on their books. And although FASB has changed the

accounting regulations for operating leases to where they have to report that

obligation, again, it is still something that you may encounter at some point in

the future. So I wanted you to be familiar with it. Again, my pick for

number five is off-balance sheet financing.

For me, the fourth most important thing in the chapter is the debt-to-equity

ratio. Now, this is a ratio that's very easy to compute.

You take your total liabilities and you divide it by your total equity. This

ratio will give you a lot of information about how individuals in the

organization are making decisions and what their strategy is. Because of that, a

lot of individuals will use this ratio to evaluate the organization and make

decisions such as investing or lending money to the organization. What the debt-

to-equity ratio is communicating, is how the company is obtaining their assets.

Are they obtaining their assets through debt or are they obtaining those assets

through capital investments or through operations? Now, a company that uses debt

to finance their operations, that can be considered a very wise strategy because

they're using someone else's money to make money. At the same time, this does

present risk because all of the money that's borrowed has to be repaid and it

has to be repaid with interest. So if a company is unable to make those payments

they can be forced into bankruptcy. Again, the debt-to-equity ratio does

communicate a lot about the organization, about the decisions they've made, and how

they're going to go about financing their operations. Because it's so

important and because it's used so frequently by individuals that are

making decisions, I place this as number four.

For me, the third most important thing in chapter 15 is the idea of the

uncertainty that surrounds some of our numbers that are reported on a balance

sheet. There is no better representation of this uncertainty than the amounts

that are reported with post-retirement benefits. Post-retirement benefits are

the amounts that companies are obligated to pay on behalf of their former

employees. Examples would be things like health insurance, retirement benefits, and

such. These amounts are really uncertain to calculate and to know, because they're

so far in the future. Also, we don't know how long we'll be paying these benefits

because a lot of them are based on how long the individuals live. We can't

possibly know how long someone's going to live. We also can't know how the costs

are going to change over time. Because of this, the numbers are very uncertain. At

the same time, these are very large numbers and very important numbers and

individuals like to see them reported. So for that reason, accountants do try to

make the best estimates they can and they use the services of individuals

like actuaries to help estimate the amounts. The present value of those

amounts are calculated and are then reported on the balance sheet. But again,

there's a lot of uncertainty surrounding that and because of that concept of

uncertainty, I wanted to share that as number three most important thing in

chapter 15.

This brings us to number two on my list. Number two item for this chapter for me

is the concept of deferred income taxes. Deferred income taxes are shown on the

balance sheet and they represent an amount of tax that is owed at some point

in the future. Now, companies actually prefer having deferred income taxes. The

reason is because income has been earned for financial reporting, but for some

reason, something in the tax code is allowing that income to be recognized

but paid for tax purposes at some point in the future. And as you can imagine,

companies like that. If they have a tax bill of a million dollars and they have

the option of paying it today or paying it in two years, they certainly would

want to pay that in two years because in that time period they could use those

funds and earn money off of that and make that money work for them before

they have to pay it to the IRS. So again, these are very legitimate situations

where a company has earned the revenue for financial reporting, but because of

some rule in the tax code, the actual tax bill on that income is deferred until

some point in the future. Companies do enjoy this benefit and when you see that

on a balance sheet you know that that obligation for that tax is at some point

in the future. For me, deferred income taxes was number two on our list.

And that brings us to the first most important thing from chapter 15. For me,

the most important thing was the idea of accounting for leases. As we saw, we have

a couple different methods for accounting for leases. FASB has

recently updated the rules for lease accounting regulations and we'll explore

those here.

The first option an organization has for accounting for leases is a finance

lease. A finance lease is really more like a purchase than a rental agreement.

All of the rights and obligations of that property are going to transfer, and

because of that, we're going to record it very similar to a purchase. All of the

lease payments are computed and the present value of those payments are

calculated. At that point a right-of-use asset is placed on the balance sheet for

that amount as well as a corresponding liability. Over time, that asset is going

to be amortized similar to it would be if it hadn't purchased it outright. Also

the liability will be repaid with interest.

Now the FASB has identified five criteria that could qualify a lease

agreement as financing and if any one of those criteria are met, the lease

agreement is considered a financing lease.

The other option an organization has for recording the lease is an operating

lease. Now operating leases have changed significantly in the last couple years

as FASB has updated the lease accounting regulations. If any of the

five criteria are not met, if none of the criteria are met, then the lease, by

default, is an operating lease. But the FASB has determined that there does

need to be an asset and a corresponding liability on the books. Even for

operating leases. So similar to a finance lease, the the present value of the cash

payments is computed and a rate of these assets is recorded as well as a liability.

Under an operating lease, there's going to be a standard lease expense amount

every period. The interest on the obligation is computed and subtracted

from that lease payment. The difference is going to go to amortization expense.

So, over time, as payments are made, the amount of interest that's reported goes

down and the amount of amortization expense that's reported increases over

the life of the lease agreement. Because lease accounting is so prevalent and

it's so popular for many different companies, I place this as number one for

chapter 15. I hope you've had a chance to enjoy chapter 15. To read it to think

about it, and to really examine what you thought was most important. I hope you're

learning a lot. I hope you're coming along in your financial accounting

knowledge, and by now you're really able to look at a set of financial statements

and understand quite a lot of the things that are going on within the

organization. I hope this excites you and I hope it

makes you want to keep learning more.