Chapter 10.

Commitments and Contingent Liabilities, Deferred Tax

Liabilities, and Retirement Obligations

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Difficulty Rating for Exercises and Problems:

Easy: none
Medium: E10.13; E10.14; E10.15; E10.16; E10.17
P10.21; P10.22: P10.24; P10.30
Difficult: E10.18; E10.19; E10.20
P10.23; P10.25; P10.26; P10.27; P10.28; P10.29

QUESTIONS
Q10.1 Contingent Liability Accounting. Under U.S. GAAP, a company must
disclose the existence of any lawsuit that is likely to result in a financial loss;
however, the company does not have to include the legal liability on its balance
sheet until a payout is probable and the amount of the settlement can be
reasonably estimated. According to a CFO Magazine study (April, 2006), 47
percent of U.S. public companies report being sued but less than five percent
reported a legal liability on their balance sheet. Despite the magnitude of
Mercks potential losses, the company had not, as of year-end 2005, set aside
any reserves for the potential Vioxx-related litigation liability. Noteworthy,
however, is the fact that Mercks credit rating was dropped a notch by S&P as a
result of the litigation.

Q10.2 Debt Covenants and Going-Concern Exceptions. When a company violates

a debt covenant, several outcomes may occur:
The lender will allow the borrower to renegotiate the loan agreement,
usually resulting in higher borrowing fees to the borrower.
The lender will call for immediate repayment of the debt.

The first outcome is quite common, but when a borrower is already in financial
distress (like Sea Container), a lender will usually opt for the second outcome
to preserve as much of the loan principal as possible. When a lender calls for
immediate loan repayment, a voluntary Chapter 11 bankruptcy filing by the
borrower is a common outcome. It appears that Sea Containers auditors
foresee a bankruptcy filing as a likely eventuality in this case, and consistent
with their responsibility to shareholders, implicitly notified shareholders of this
possibility.

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Solutions Manual, Chapter 10 10-1
Q10.3 Pension Accounting and Debt Covenants. Most companies (possibly even
EDS) have explicit language in their debt agreements that prevent a debt
covenant from being violated by a mandatorily-imposed accounting policy
change like the proposed FASB pension accounting standard. For those
companies whose debt agreements do not contain such language, they will
need to take some action, such as:
Seek a waiver of the covenant violation;
Renegotiate the actual debt covenant to reflect the new accounting
standard; or,
Attempt to boost shareholders equity by raising new equity capital.

Q10.4 Accounting for Pending Lawsuits. Bausch & Lomb will be required to
disclose the existence of the product recall and product removal in its
footnotes, along with the existence of the collateral litigation. The company will
also have some type of income statement disclosure relating to the product
recall, which might take the form of an inventory write-down for the value of its
ReNu contact lense solution and possibly even an impairment loss taken on its
South Carolina plant which produces the ReNu product.

In response to the news announcement of the product recall, Bausch & Lombs
share price declined 25 percent, from $60 to $45 per share.

Q10.5 Interpreting Deferred Income Tax Assets. Although Microsoft defers a portion
of the sales price of its software when sold, to be matched with the future cost
of providing technical support services and the cost of future free upgrades, the
IRS generally requires companies to report their revenue on a cash basis.
Thus, while Microsoft would declare all of the revenue associated with a
software sale immediately for tax purposes (since such transactions are paid
for at the time of sale), some of the revenue would be deferred and recognized
in a subsequent period for accounting purposes. This effectively forces
Microsoft to prepay its income taxes to the IRS relative to the time when the
income taxes are considered due for accounting purposes.

With respect to Microsofts portfolio of trading securities, GAAP requires that

any unrealized gains (and losses) be taken to the income statement at the time
of statement preparation, whereas for income tax purposes, such gains and
losses are recognized in a subsequent period at the time of sale of the security.
Microsoft discloses a deferred income tax asset attributed to the accounting for
trading securities which suggests that the company experienced an unrealized
loss on its trading securities that was booked immediately for accounting
purposes, thereby reducing the accounting estimate of income taxes below the
amount of income taxes actually paid to the IRS currently. The tax benefit of the
realized loss wasnt obtained by the company until a subsequent period, when
it reduced the income taxes actually payable.
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Q10.6 Interpreting Deferred Income Tax Liabilities. For accounting purposes,
Coca-Cola Enterprises (CCE) accounts for its intangible assets by subjecting
the assets to an annual impairment test; where no impairment is found, no
write-down in value is taken. However, since CCE discloses a deferred income
tax liability relating to its intangible assets, the company must be taking an
annual amortization charge on these assets for income tax purposes. The
annual amortization charge lowers CCEs taxable income and lowers the
currently payable income taxes, creating the deferred income tax liability.

Since the deferred income tax liability declined over the two years, it would
suggest that CCE took an impairment charge against its intangible assets
during the second year.

Q10.7 Analyzing the Funding Status of Pension Plans. Coca-Cola Enterprises

(CCE) pension plans are underfunded in both years by $766 million and $683
million, respectively. Assuming no changes in the underlying pension plan
assumptions, the level of funding appears to have increased by $83 million.
However, the funding assumptions did change, specifically the discount rate on
the benefit obligations was lowered from 5.8 percent to 5.4 percent. This
change, ceterus paribus, would have caused CCEs pension obligation to
increase. Hence, the increase in the level of pension funding must have
actually been greater than $83 million.

Q10.8 Changing Pension Plan Assumptions. Johnson and Johnson (J&J) lowered
the discount rate used to calculate the present value of its projected benefit
obligation from 6.75 percent to 5.75 percent. The effect of this change, ceterus
paribus, would be to increase the present value of J&Js benefit obligation (i.e.,
make the liability larger).

The discount rates used to value the projected benefit obligation are often
linked to long-term market interest rates. During the period 2002 to 2004, the
U.S. Federal Reserve Bank lowered the banks lending rate to three percent,
which in turn, drove down long-term rates of interest in the U.S. J&J chose to
lower the discount rate on its pension obligation to reflect the lower interest rate
environment that characterized the U.S. debt market at that time.

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Solutions Manual, Chapter 10 10-3
Q10.9 Discounting Deferred Income Tax Liabilities. In order to discount a future
amount, it is necessary to know the timing of the future cash payment, as well
as the appropriate discount rate. In the case of deferred income taxes, neither
the timing nor the discount rate is known. In the case of timing, since the
payment of currently deferred income taxes requires knowledge of a companys
future earnings, which cannot be known with certainty, it is impossible to
identify exactly when currently deferred income taxes will become due (and,
hence, paid). With regard to the appropriate discount rate, there are no interest
costs associated with deferred income tax liabilities they represent, in effect,
an interestfree loan from the U.S. government. Thus, it is unclear whether
these liabilities should be discounted at alland consequently, they are not
discounted.

Q10.10 (Appendix B) Interest Rate Swaps.

1. Financial Effects:
Home Depot converted its 5.4 percent interest payment of $27 million into a
variable-rate interest payment of LIBOR plus 300 basis points, also on a
basis of $500 million in debt.

2. Home Depot loses if LIBOR exceeds 5.1 percent but gains if LIBOR is
below 5.1 percent.

3. A zero-sum game is when one party wins, and the other party suffers an
equivalent loss.

Q10.11 Underfunded Retirement Obligations and Firm Valuation. All obligations of

a firm, whether they are carried on-balance-sheet or off-balance-sheet, must be
considered when calculating firm value. To ignore the off-balance-sheet
liabilities will result in an overstatement of firm value. Hence, when calculating
the value of Johnson and Johnsons capital stock, the $1.588 billion in off-
balance-sheet pension obligations must be considered to correctly estimate the
equity value per share.

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9-4 Financial Accounting for Executives & MBAs, 3 rd Edition
Q10.12 (Ethics Perspective) Multiple Sets of Books. As stated in the chapter, firms
are subject to separate reporting requirements for external financial reporting
and income tax reporting. Since GAAP and tax regulations differ in many
aspects, one set of books would not suffice. Unfortunately, neither financial
reporting nor tax reporting is typically adequate for internal decision-making
needs. Both external reporting and tax reporting are aimed at the organization
as a whole, while decision-making tends to be concerned at a division, team,
project, or product level, for example. It is only natural to expect that a different
set of information will be needed for this level of analysis. It is also
understandable that an organization will not wish to disclose this level of detail
since it likely contains proprietary information that could be of value to
competitors. While it can be argued that hiding information from the public with
the intent to deceive is certainly a breach of ethics, disclosing proprietary
information about the firm could also be argued to be an ethical breach.

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Solutions Manual, Chapter 10 10-5
 EXERCISES

E10.13 Calculating Deferred Income Taxes.

Yr 1 Yr 2 Yr 3 Yr 4
Deferred income tax liability $100 $200 $100 --
Present value factor @ 10% 0.91 0.83 0.75
$91 $166 $75
Sum of the present values $332

Sample Corporations tax deferral strategy creates implicit savings of $68 ($400
- $332) based on a time value of money of ten percent.

A growing balance in the deferred income tax liability account is likely to

indicate that the Sample Corporation is aggressively using the Internal
Revenue Code to postpone the taxation of its income, while reporting that
income currently to its shareholders. Investment professionals are likely to view
this situation positively because the strategy will enable the company to finance
itself partially using the deferred income tax paymentsessentially, an interest-
free form of financing. The strategy has a downside, however, and that involves
the ultimate payment of the deferred income taxesas the expression goes,
you cant avoid death or income taxes.

E10.14 Deferred Income Taxes and Changing Tax Rates.

Tax rate = 35 percent
Financial
IRS Reporting
Net income before income taxes $130,000 $160,000
tax rate .35 .35
Income tax $ 45,500 $ 56,000
Deferred income tax liability $ 10,500

Tax rate = 30 percent

Financial
IRS Reporting
Net income before income taxes $130,000 $160,000
tax rate .30 .30
Income tax $ 39,000 $ 48,000
Deferred income tax liability $9,000

The deferred income tax liability declined by $1,500 ($10,500 less $9,000)
when the tax rate declined by five percent. A reduction in the income tax rate
reduces the value of any future tax obligation, with the amount of the reduction
equal to the difference in pretax net income between IRS and financial
reporting ($30,000) times the change in the tax rate (five percent).
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9-6 Financial Accounting for Executives & MBAs, 3 rd Edition
E10.15 Reporting the Provision for Income Taxes.
Provision for income taxes (reported on the income statement) $7,172
Portion of provision actually paid $4,466
Portion of provision deferred to future periods $2,706

The negative $174 in deferred foreign income taxes suggests that the company
had a deferred foreign income tax asset which was used to offset currently due
taxes.

E10.16 Analyzing Retirement Fund Obligations.

J&Js retirement fund obligations were underfunded in both years, as
follows (in millions):

Yr 2 Yr 1
Underfunding $2,063 $1,816

Of the underfunding in Year 2, $475 million, or approximately 23

percent, was recognized on J&Js balance sheet. In Year 1, the amount
recognized was $288, or about 16 percent of the total amount of
underfunding.

The unreported underfunding amounted to $1.588 billion in Year 2 and

$1.528 billion in Year 1 and represents a real liability of the company. In
short, it is an example of an off-balance-sheet liability that investment
professionals must consider when valuing a company. Beginning with fiscal
year-end 2007, companies were required to fully disclose unfunded pension
liabilities on the consolidated balance sheet.

One approach adopted by some investment professionals is to

capitalize the unrecognized portion of the underfunded pension liability (e.g.,
$1.588 billion in Year 2) both as a liability (Underfunded Projected Benefit
Obligation) and as a component of shareholders equity (specifically, Other
Comprehensive Income). Since the amount of the underfunded liability must
be considered when valuing a company, this action ensures that this liability
is explicitly considered in the valuation process.

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Solutions Manual, Chapter 10 10-7
E10.17 Analyzing Retirement Fund Obligations.
Intels retirement fund obligations are unfunded in both years as
follows (in millions):

Yr 2 Yr 1
Underfunding $335 $263

Of the Year 2 underfunding, $190 million, or approximately 57 percent,

was recognized on Intels balance. For Year 1, $219 million, or 83 percent,
of the underfunded obligation was reported on Intels balance sheet.

The unreported portion of the underfunded obligation amounted to

$145 million, or 43 percent, in Year 2, and $44 million, or 17 percent, in Year
1. The off-balance-sheet portion of the underfunded retirement obligation is
generally recognized by investment professionals as an off-balance- sheet
obligation. Beginning in 2007, the full unfunded amount must be disclosed
on the balance sheet.

Given that most investment professionals regard the undisclosed

underfunded portion of any retirement obligation as part of a companys
debt, a common restatement procedure is to increase the company liabilities
(Underfunded pension obligation) and decrease shareholders equity,
specifically Other Comprehensive Income.

E10.18 (Appendix 10B) Analyzing Foreign Currency Hedges. If the settlement cost
of the forward foreign exchange contract is $20,300, the forward exchange rate
for three months must have been 9.85 Pesos to the U.S. dollar (200,000 P
$20,300).

If the dollar-peso exchange rate moves to 9.5 P:$1, The Arizona Company
would be required to pay $21,053 (200,000 P 9.5 P) to Sonora, Inc. for the
equipment, for a loss of $1,053 above the original purchase price of $20,000.
Purchasing a forward contract would have saved $753 ($1,053- $300).

If the dollar-peso exchange rate moves to 9.0 P:$1, The Arizona Company
would be required to pay $22,222 (200,000 P 9.0 P), for a loss of $2,222
above the original $20,000 purchase price. Purchasing the forward contract
would have saved $1,922 ($2,222 - $300).

This is an example of a fair-value hedge of an unrecognized firm commitment;

and thus, any gain or loss in the market value of the forward contract is
reflected in current net income.

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9-8 Financial Accounting for Executives & MBAs, 3 rd Edition
E10.19 (Appendix 10B) Analyzing Interest Rate Swaps. Under the original note, The
Phoenix Company agreed to pay LIBOR each year. There are two scenarios to
consider:

1. LIBOR is six percent for years 2 and 3.

2. LIBOR is ten percent for years 2 and 3.

Thus, the financing costs under each scenario would be as follows:

Interest Expense
LIBOR = 6% LIBOR = 10%
Year 1 (8%) $8,000 $8,000
Year 2 6,000 10,000
Year 3 6,000 10,000
Total $20,000 $28,000

Under the fixed-rate swap agreement, The Phoenix Company locks in the eight
percent rate for three years for total interest payments of $24,000. Thus, if
LIBOR goes to six percent, The Phoenix Company has lost $4,000 in excess
interest payments; however, if LIBOR goes to ten percent, The Phoenix
Company gains $4,000 from the swap in the form of reduced interest
payments.

This is an example of a fair value hedge of an existing, recognized liability; and

thus, any gain or loss in the market value of the swap would be taken to current
net income.

E10.20 (Appendix 10B) Analyzing Forward Commodity Contracts. The forward

price per gallon of wine was $160 ($3.2 million divided by 20,000 gallons). If the
actual purchase price per gallon was $170, The Portet Wine Company would
suffer a loss of $200,000 [20,000 x ($170 - $160)]. In short, the decision was
not a good one.

This is an example of a cash flow hedge of a forecasted transaction; and thus,

any gain or loss on the market value of the commodity contract would be
reflected in Other Comprehensive Income on the balance sheet and not on the
income statement.

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Solutions Manual, Chapter 10 10-9
 PROBLEMS

P10.21 Legal Proceedings: Patent Infringement

1. Decline in revenue: 70% x $3.3 billion = $2.31 billion
Estimated 2005 revenue: $19.4 - $2.31 = $17.09 billion
Decline in net income: 60% x $2.31 = $1.386 billion
Estimated 2005 net income: $2.4 - $1.386 = $1.014 billion
The decline in revenue is only twelve percent, but the potential loss in net
income is huge almost 58 percent!

2. If patent protection on Plavix is lost, BMS should take an impairment charge

against its intangible assets, recognizing a parallel impairment loss on its
income statement. The value of the impairment would likely be $84 million
(i.e., 70% x $120 million).

3. Disclosure of a patent infringement lawsuit is common in the pharmaceutical

industry so it is unclear if the market would react at all to such an
announcement. However, the share price would definitely fall upon
announcement that the patent infringement suit had been lost.

P10.22 Loss Contingency: Lawsuit Award

1. Since at the financial statement date the investigation was still in process,
Microsoft need only disclose the existence of the outstanding lawsuit via its
footnotes. It would not be necessary to accrue a loss at this stage, if for no
other reason than the amount of the loss is still unknown.

2. Once an adverse decision is reached, Microsoft will need to accrue an

operating loss and an accrued liability for the fine. What is unknown here is
the amount of the payment and the payment schedule, which would affect
the amount of the operating loss. If, for instance, the loss was to be paid
over a five-year period (i.e., $146.2 million per year), the loss and liability
would be established at the present value of a five-year annuity of $146.2
million discounted at a rate equal to Microsofts cost of debt.

3. Given that Microsoft had won a similar lawsuit in the past, it is unlikely that
the market would have reacted negatively to the disclosure of the EU
lawsuit. However, the market would clearly have reacted negatively to the
disclosure in 2013 that Microsoft had lost this case because it might signal
the possibility of future lawsuits in other parts of the world. Microsoft closed
down approximately 1 percent following the announcement on a day the
overall market rose slightly.

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9-10 Financial Accounting for Executives & MBAs, 3 rd Edition
P10.23 Deferred Income Taxes: Bad Debt Expense Policy.
Income statement for accounting purposes:

2011 2012
Sales $3,200,000 $5,300,000
Less: Bad debt expense (10,925) (22,500)
NIBT 3,189,075 5,277,500
Less: Income tax expense (30%) (956,723) (1,583,250)
NIAT $2,232,352 $3,694,250

Income statement for income tax purposes:

2011 2012
Sales $3,200,000 $5,300,000
Less: Bad debt expense 0 (11,500)
NIBT 3,200,000 5,288,500
Less: Income tax expense (30%) (960,000) (1,586,550)
NIAT $2,240,000 $3,701,950

Deferred tax asset $3,277 $3,300

Cumulative deferred tax asset $3,277 $6,577

P10.24 Deferred Income Taxes: Depreciation Accounting Policy.

Deferred
Income Tax
(1) (2) (3) Tax
S-L Accel Difference Effect
Year Deprec Deprec (2)-(1) 30% x (3) Asset Liability
1 $8,333 $16,667 $8,334 $2,500 $2,500
2 16,666 27,778 11,112 3,334 3,334
3 16,667 18,519 1,852 556 556
4 16,667 12,347 (4,320) (1,296) $1,296
5 16,667 8,230 (8,437) (2,531) 2,531
6 16,667 8,230 (8,437) (2,531) 2,531
7 8,333 8,229 (104) (31) 31
Totals $100,000 $100,00 $0 $0* $6,389 $6,390
0
*rounding

The difference of $1 between the deferred income tax liability of $6,390 and the
deferred income tax asset of $6,389 is due to rounding error only.

Deferred income tax assets essentially involve the prepayment of income taxes
whereas deferred income tax liabilities involve the deferment of income tax
payments. Because of the time value of money, deferred income tax liabilities
are likely to be more highly valued by the capital markets.
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Solutions Manual, Chapter 10 10-11
P10.25 Deferred Income Taxes: Natural Resource Accounting Policy.
Herberger Oil & Gas Company

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Financial:
Net income before taxes $17.00 $27.50 $34.50 $70.50 $114.50
Tax expense (30%) 5.10 8.25 10.35 21.15 34.35

Taxation:
Net income before taxes $2.60 $29.90 $36.90 $74.50 $120.10
Tax payable (30%) 0.78 8.97 11.07 22.35 36.03

Deferred income taxes

Liability $4.32 $0 $0 $0 $0
Asset 0 0.72 0.72 1.20 1.68
Cumulative $4.32 $3.60 $2.88 $1.68 $0

P10.26 (Appendix 10B) Interest Rate Swaps.

1. The financial effect of the swap was to convert GEs eight percent fixed-
rate notes into a 3.1 percent fixed-rate note plus a trailing six-month
variable London Interbank offered rate (LIBOR) as follows, all based on the
$150 million face amount:

Original note Pay 8% fixed

Swap Receive 4.9 fixed rate
Pay LIBOR (6 month trailing)
Pay 3.1 fixed rate

Net effect to GE Pay LIBOR (6 month trailing)

2. If on the date to set the interest rate, the six-month LIBOR is less than 4.9
percent, GE will pay an effective floating rate of less than eight percent and
benefits from the swap (i.e., in 2012). If, however, the six-month LIBOR rate
is greater than 4.9 percent, GE will pay an effective floating rate greater
than eight percent and loses from the swap (i.e., 2013).

3. Under U.S. GAAP, and the GAAP of most developed countries, interest rate
swaps that qualify as a hedging instrument (i.e., they are not used to
speculate but rather to reduce a firms exposure to a potential loss) are
carried on the balance sheet as a current asset (even if the swaps life is
greater than one year), recorded at cost, but to be amortized off over the life
of the swap. If the swap fails the test for hedge accounting (i.e., the swap
was undertaken for speculative purposes), it is treated as a trading security
and market-to-market accounting is used (see Chapter 8).
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 Cambridge Business Publishers, 2014
Solutions Manual, Chapter 10 10-13
P10.27 (Appendix 10B) Foreign Exchange Contracts.
1. MNE Corporation uses foreign exchange derivatives to reduce the risk of
movements in foreign exchange rates in the countries in which it does
business. The hedged items include foreign currency denominated
receivables and payables. The likely form of the foreign exchange
contracts is:
Option contract (i.e., a contract for the sale or purchase of a foreign
currency at some time in the future)
Future contract (i.e., a forward contract to purchase or sell a set
amount of a foreign currency within a set period of time)

2. The notional amount refers to the amount of the underlying contract that is
being hedged. In Year 2, for example, MNE Corporation has hedged (using
currency futures and options) $1.747 billion in sales contracts (i.e.,
receivables). MNEs exposure to currency gains or losses is far less than
$1.747 billion.

3. In Year 2, MNE reports net losses of $55 million on its foreign exchange
derivatives. These losses are measured as the difference between the cost
of the derivative (option or future) and its current fair value. Because the
derivatives are hedges against risk, and not speculative, they are entitled
to be accounted for using hedge accounting in which the losses are
deferred and reported as part of Other Comprehensive Income on the
balance sheet until the underlying receivables are collected.

P10.28 (Appendix 10B) Interest Rate Swaps.

1. Procter and Gamble uses interest rate swaps as part of its risk management
policy specifically, to manage its exposure to interest rate risk (i.e., the risk
that interest rates could rise on its variable rate debt and that interest rates
could fall on its fixed rate debt).

2. The notional amount of the debt being hedged in Year 2 is $2.149 billion;
the carrying value (i.e., cost less amortization) of its interest rate swap
contracts is $28 million; and, the fair value is $7 million. The companys
interest expense for Year 2 was $550 million this is the amount that is
effectively being hedged.

3. Yes, the risk management policy appears to have been effective since the
annual report states that the effect of the swaps on its interest expense was
immaterial. Remember that the use of hedge accounting is not to win by
speculation but to avoid further losses.

4. The unrecognized loss would be reported as part of the companys Other

Comprehensive Income on its balance sheet (i.e., as part of shareholders
equity).

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P10.29 Retirement Obligations: Funding Status.
1. Funding status using PBO as standard:

Plan assets $803 million

Less: PBO (539) million
Overfunding $264 million

The excess pension plan assets do not appear on GEs balance sheet.
Legally, GE could revert the excess funding back to the firm, but to
discourage this action, the U.S. government levies excise taxes of as much
as 50 percent on any reverted pension assets.

2. Cash paid to beneficiaries in Year 2:

Plan assets (Yr 1) $650 million ($645 + $5)

+ Earnings on plan assets (Yr 2) 200
+ Pension expense (funded in Yr 2) 10
860
Less: Plan assets (Yr 2) 803
Paid to plan beneficiaries $57 million

3. GE has no minimum pension liability because the accumulated benefit

obligation (ABO) is less than the plan assets at fair value:

Accumulated benefit obligation $480 million (478 + 2)

Plan assets at fair value 803

GE does not disclose this because GE has no minimum pension liability.

4. Under the new pension asset disclosure accounting, GE would create a new
asset account, Overfunded employee pension plan, in the amount of $264
million and a new shareholders equity account for a similar amount,
disclosed as part of Other Comprehensive Income.

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Solutions Manual, Chapter 10 10-15
P10.30 Retirement Obligations: Funding Status.
1. PBO:
Yr 1 Yr 2
Plan assets $247,783 $287,482
Less: PBO (224,904) (307,152)
Over (under) funding $22,879 $(19,670)

The companys plan is overfunded by $22,879,000 in Year 1 but

underfunded by $19,670,000 in Year 2 relative to its PBO. Since the under-
funding is not fully realized (ie. only the minimum pension liability need to be
disclosed on the balance sheet), financial statement restatement would
involve creating a liability and an unrealized loss in Other Comprehensive
Income on the balance sheet for the under-funded amount that remains
unreported on the balance sheet. That specific amount is not determinable
from the data in the problem.

2. Lowering the discount rate from eight percent (Year 1) to 7.25 percent (Year
2) will increase the PBO. Raising the expected rate of return from nine
percent (Year 1) to ten percent (Year 2) will increase the value of the plan
assets.

Given the declining interest rate environment from Year 1 to Year 2, the
decrease in the discount rate seems appropriate. Similarly, the stock market
environment over this time period was improving, so an increase in the
expected rate of return is also consistent; however, the ten percent rate of
return is probably excessive.

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9-16 Financial Accounting for Executives & MBAs, 3 rd Edition
 CORPORATE ANALYSIS

CA10.31 The Procter and Gamble Company.

a. P&Gs commitments and contingencies are described in footnote eleven as
follows:

1. Guarantees (e.g., indemnification for representations and

warranties and retention of previously existing environmental, tax,
employee liabilities, indemnities associated with divestitures, loans
for suppliers, loans for customers)not material.
2. Purchase commitments for materials, supplies, services, and
property, plant and equipmentnot material.
3. Purchase of a Spanish business partners interest in a joint
venture resulting from the exercise of a put option. The put price is
based on a formula tied to the venture's earnings and approximates
fair value. Upon closing, subject to regulatory approvals, the
transaction will be accounted for as a purchase, recording the entire
underlying business at fair value and recognize a holding gain for the
portion of the venture currently held by P&G. The purchase price for
the partner's interest would be approximately $1 billion based on
current exchange rates, and the resulting holding gain on P&Gs
current interest in the venture would be approximately $400 to $600.
4. Operating leases for property and equipment.
5. Litigation related to various legal proceedings and claims
covering a wide range of matters such as antitrust, trade and other
governmental regulations, product liability, patent and trademark
matters, advertising, contracts, environmental issues, labor and
employments matters and income and other taxes.claims and awards
not material.

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Solutions Manual, Chapter 10 10-17
 b. Effective tax rate = 27.1 percent. Tax expense of $3.468 billion is
composed of $3.533 billion of currently due income taxes and $(0.65) billion
of deferred income taxes. According to P&Gs MD&A.

Deferred tax assets and liabilities represent future tax consequences

of events that have been recognized differently in the financial
statements than for tax purposes. Deferred tax assets generally
represent the tax effect of items that can be used as a tax deduction
or credit in future years for which we have already recorded the tax
benefit in our income statement. Deferred tax liabilities generally
represent tax expense recognized in our financial statements for
which payment has been deferred, or the tax effect of expenditures for
which a deduction has already been taken in our tax return but have
not yet been recognized in our financial statements.

A company that has a declining base of depreciable fixed assets (like P&G)
will generally see its deferred income tax liabilities decrease because the
level of depreciation expense taken for income tax purposes will be less
than that taken for financial reporting purposes, causing the income tax
expense reported on the income statement to be less than the income taxes
currently payable (i.e., deferred income taxes will decline).

c. Footnote five provides an overview of P&Gs risk management

activities. This footnote reveals that P&G uses:

1. Interest rate swaps to manage interest rate risks.

2. A combination of foreign currency forward contracts, options
and currency swaps to manage foreign currency risk.
3. Self-insurance for most insurable risks.

d. Footnote eight indicates that P&G offers the following postretirement

benefits:

Defined contribution retirement plans (principally for U.S.

employees).
Defined benefit retirement plans (principally for non-U.S.
employees).
Health care and life insurance
Employee Stock Ownership Plan to provide funding for certain
employee benefits .

At June 30, 2012, P&Gs benefit obligation (BO) totaled $19.579 billion, and
the fair value of the plan assets totaled $10.687 billion. Thus, the companys
benefit plans were unfunded relative to the BO in the amount of $8.892
billion, which is included in P&Gs Other noncurrent liabilities.

Cambridge Business Publishers, 2014

9-18 Financial Accounting for Executives & MBAs, 3 rd Edition
 Cambridge Business Publishers, 2014
Solutions Manual, Chapter 10 10-19
CA10.32 Internet-based Analysis. No solution is provided as any solution would be
unique to the company selected.

CA10.33 IFRS Financial Statements. LVMH Mote Hennessey-Louis Vuitton S.A.

LVMHs total debt at year-end 2012 stands at 24.264 billion euros (14.782
billion noncurrent plus 9.482 billion current). Thus, it appears that LVMHs off-
balance exposure of 7.5 billion euros is indeed material in the aggregate. It is
possible, however, that the companys exposure to purchase commitments,
operating leases, contingent liabilities and outstanding litigation, and collateral
and other guarantees are individually immaterial. Nonetheless, when evaluating
the companys risk exposure, these off-balance sheet liabilities should be
considered. The appropriate way to reflect this exposure is by identifying

a schedule of possible cash outflows for each category of exposure,

assigning a probability that the cash outflow will occur (ie. 100 percent
for operating leases and purchase commitments but some lesser
probability for pending litigation and financial guarantees), and
an appropriate discount rate, possibly the companys weighted average
cost of debt, to discount the cash outflows.

With this information it is possible to reasonably estimate the companys off-

balance sheet risk exposure in current euros.

Cambridge Business Publishers, 2014

9-20 Financial Accounting for Executives & MBAs, 3 rd Edition