QUESTION 3) (20 pts) Refer to the Lufthansa example in your textbook (page 123-124 and 125) on asset depreciation estimates, what adjustments would be required if Lufthansa's aircraft depreciation was computed using an average life of 25 years and salvage value of 5 percent (instead of reported values of 12 years and 15 percent)? Show the adjustments only to the 2011 balance sheet. (Note: / want you to follow the same (exactly the same) methodology your book used) Deferred Taxes on Adjustments ost firms use different accounting rules for business reporting and tax reporting. As a consequence, the assets that they report in their tax statements. Consider a firm whose property, plant, and equipment have a book value of 300 in its financial statements but a tax base of 100 in its tax statements. Ignoring future investments, the firm will record a total amount of 300 in depreciation in its future financial statements, whereas it can only record an amount of 100 in tax-deductible depreciation in its future tax statements. Because the firm's tax statements are not publicy available, the analyst must estimate the firm's future tax deductions based on the book value of property, plant, and equipment as reported in the financial statements. This book value, however, overstates the firm's future tax deduc- tions by an amount of E200 (300 - 100). The IFRS Standards therefore require that the firm discloses the amount of overstatement of future tax deductions in its current financial statements. To do this, the firm recognizes a deferred tax liability on its balance sheet. Given a tax rate of 35 percent, the deterred tax liability equals 70 (300 - 100 * 0.35). This liability essentially represents the tax amount that the firm must pay in future years, in excess of the tax expense that the firm will report in its future financial statements. It also represents the tax amount that the firm would have to pay immediately were the firm to sell the asset for its current carrying amount. Al additions to reduc- tions in the deferred tax liability are accompanied by the recognition of a deferred tax expense (income) in the firm's income statement. Assets whose book values in the financial statements are below the tax bases recorded in the tax statements create a deferred tax asset. When the analyst makes adjustments to the firm's assets or liabilities to undo any distortions, the deferred tax liability for asset) is also affected. This is because the adjustments do not affect the tax statements and consequently change the difference between book values and tax bases. For example, when the analyst reduces the book value of property, plant, and equipment by 50, the deferred tax liability is reduced by an amount of 17.50 (50 ~ 0.35) to 52.50 (250 - 100) ~ 0.35) The international accounting standard for income taxes requires that deferred taxes be recognized on any difference between book values and tax bases with the exception of a few differences, such as those related to: Nondeductible assets and nontaxable liabilities. Mondeductible goodwill and nontaxable negative goodwill. Overstated depreciation for non-current assets Because non-current assets such as manufacturing equipment decrease in value over time, accounting rules require that firms systematically depreciate the book values of these assets. The reduction in the book value of the assets must be recognized as depreciation or amortization expense in the income statement Managers make estimates of asset lives, salvage values, and amortization schedules for depreciable non-current assets. If these estimates are optimistic, non-current assets and earnings will be overstated. This issue is likely to be most pertinent for firms in heavy asset businesses (e.g., airlines, utilities), whose earnings contain large depreciation components. Firms that use tax depreciation estimates of asset lives, salvage kalues, or amortization rates are likely to amortize assets more rapidly than justifiable given the assets' economic usefulness, leading to non- current asset understatements. In 2012 Lufthansa, the German national airline, reported that it depreciated skircraft over 12 years on a straight-line basis, with an estimated residual value of 15 percent of initial cost. These assumptions imply that Lufthansa's annual depreciation expense was, on average. 7.1 percent (1) - 0.15)/12) of the initial cost of te pircraft. In contrast, industry peers such as Air France-KLM and British Airways were using straight-line cicios rates ixtween ard 5 percent (of initial cost). going forward. This enables the analyst to be able to compare ratios that use assets (eg. return on assets) for the For the analyst these differences raise several questions. Do Lufthansa. Air France-KLM, and British tly different types of routes, potentially explaining the differences in their depreciation policies? Alternator more business travelers, to lower maintenance costs, or to lower fuel casts? If there do not appear to be person do they have different asset management strategies? For example, coes Lufthansa use newer planes differences that explain the differences in the two firms depreciation rates, the analyst may well decide that necessary to adjust the depreciation rates for one or both forms to ensure that their performance is compatible rates to match those of its industry peers. The following financial statement adjustments would then be require To adjust for the effect of different depreciation policies, the analyst could decrease Lufthansais depreciation 1 Increase the book value of the fleet at the beginning of the year to adjust for the relatively high deprecia tion rates that had been used in the past. The necessary adjustment is equal to the following amount: lion, increase Deferred Tax Liability by 151 million, and increase Shareholders' Equity by 454 million Note that these changes are designed to show Lufthansa's results as if it had always used the same depra tion assureptions as its industry peers, rather than to reflect a change in the assumptions for the current year in Lufthansa's financial statements: original minus adjusted depreciation rate X average asset age X initial asset cost. At the beginning of 2012. Lufthansa reported in the notes to its financial statements that its fleet of aircraft had originally con of Lufthansa's fleet was 7.6 years, calculated as follows 22.186 million and that accumulated depreciation was 12.238 million. This implies that the average (6 millions unless otherwise noted) Aircraft cost, 1/1/2012 22.486 Reported Depreciable cost 19,113.1 Cost x (1 -0.15) Accumulated depreciation, 1/1/2012 12.238 Reported Accumulated depreciation Depreciable cost 6403% Depreciable lite 12 years Reported Averago age of aircraft 7.684 years 12 x 0.6403 years If Lufthansa used similar life and salvage estimates as its peers and set its annual depreciation rate att percent, given the average age of its fleet, accumulated depreciation would have been 7,775 (7.684 x 0.04 * 22.486) versus the reported 12.238. Consequently, the company's Non-Current Tangible Assets well have been higher by 64.463 (12.238 - 7,775). 2 Calculate the offsetting increase in equity (retained earnings) and in the deferred tax liability. Given the 25 percent marginal tax rate, the adjustment to Non-Current Tangible Assets would have required off- setting adjustments of 1,116 (0.25 X 4.463) to the Deferred Tax Liability and 3,347 (0.75 X 4.463) to Shareholders' Equity 3 Reduce the depreciation expense (and increase the book value of the fleet) to reflect the lower deprecia tion for the current year. Assuming that 1,902 million net new aircraft purchased in 2012 were acquired throughout the year, and therefore require only half a year of depreciation, the depreciation expense for 2012 (included in Cost of Sales) would have been 1,055 million 10.045 x [22,486 + (1.902/2}]} versus the 1.660 (0.85/12) X (22,486 + (1,902/2}]} million reported by the company. Thus Cost of Sales world decline by 605 million. 4 Increase the tax expense.profit or loss and the balance sheet values of equity and the deferred tax liabilir Given the 25 percent tax rate for 2012, the Tax Expense for the year would increase by 151 million (0.23 125 Chapter 4 Accounting analysis: Accounting adjustments en romanties. By making the adjustments, the analyst substantially improves the comparability of Lufthansa's the years ended December 31, 2011 and 2012 would have to be modified as follows (references to the preceding In summary, if tufthansa were using the same depreciation method as its peers, its financial statements for described steps are reported in brackets): Adjustments Adjustments December 31, 2011 Assets Uabilities (millions) Balance sheet Non Current Tangible Assets December 31, 2012 Assets Liabilities -4.463 Detened Tax Liabity +605 +1.116 Shareholders' Equity 3,347 +1.116 -1514 -3.347 +45419 Income statement Cost of Sales -605 Tax Expense +15119 Profit or Loss +4544 In fiscal year 2013 Lufthansa decided to change its assumption about the economic useful life of its aircraft and lower its annual depreciation rate to slightly less than 5 percent, thereby underlining the practical relevance of the preceding adjustments. The change helped Lufthansa to increase operating profit and bring its accounting for aircraft more into line with the industry norm. However, following the international accounting rules, Luf- thansa adopted the new depreciation policy prospectively without adjusting past depreciation and reducing accumulated depreciation accordingly. Making Lufthansa's operating performance fully comparable with that of its peers in the years prior to and the earliest years after the change in policy would thus continue to require making some of the adjustments discussed above. Leased assets off balance sheet One of the objectives of the balance sheet is to report the assets for which a firm receives the rewards and bears the risks. These can also be assets the firm does not legally own but leases from another firm. The international standard on leases, IFRS Standards 16, therefore requires that a company leasing an asset recognizes a lease asset and a lease liability on its balance sheet, reflecting the company's right of using the asset and its obligation to make the rental payments. Prior to the adoption of IFRS Standards 16, which became effective for fiscal years starting on or after Janu- ary 1, 2019, firms had two ways in which they could record their leased assets. Under the finance lease method, the firm recorded the asset and an offsetting lease liability on its balance sheet. During the lease period, the firm then recognized depreciation on the asset as well as interest on the lease liability, comparable to what firms currently do under IFRS Standards 16. In contrast, under the operating lease method, the firm recognized the lease payment as an expense in the period in which it occurred, keeping the leased asset off its balance sheet. Assessing whether a lease arrangement should be considered an operating lease or a finance lease required judg- ment, helped by one of criteria Ilid doet on the old lease standard. The distinction depended on whether the lessee had effectively accepted most of the risks of ownership, such as obsolescence and physical deterioration. QUESTION 3) (20 pts) Refer to the Lufthansa example in your textbook (page 123-124 and 125) on asset depreciation estimates, what adjustments would be required if Lufthansa's aircraft depreciation was computed using an average life of 25 years and salvage value of 5 percent (instead of reported values of 12 years and 15 percent)? Show the adjustments only to the 2011 balance sheet. (Note: / want you to follow the same (exactly the same) methodology your book used) Deferred Taxes on Adjustments ost firms use different accounting rules for business reporting and tax reporting. As a consequence, the assets that they report in their tax statements. Consider a firm whose property, plant, and equipment have a book value of 300 in its financial statements but a tax base of 100 in its tax statements. Ignoring future investments, the firm will record a total amount of 300 in depreciation in its future financial statements, whereas it can only record an amount of 100 in tax-deductible depreciation in its future tax statements. Because the firm's tax statements are not publicy available, the analyst must estimate the firm's future tax deductions based on the book value of property, plant, and equipment as reported in the financial statements. This book value, however, overstates the firm's future tax deduc- tions by an amount of E200 (300 - 100). The IFRS Standards therefore require that the firm discloses the amount of overstatement of future tax deductions in its current financial statements. To do this, the firm recognizes a deferred tax liability on its balance sheet. Given a tax rate of 35 percent, the deterred tax liability equals 70 (300 - 100 * 0.35). This liability essentially represents the tax amount that the firm must pay in future years, in excess of the tax expense that the firm will report in its future financial statements. It also represents the tax amount that the firm would have to pay immediately were the firm to sell the asset for its current carrying amount. Al additions to reduc- tions in the deferred tax liability are accompanied by the recognition of a deferred tax expense (income) in the firm's income statement. Assets whose book values in the financial statements are below the tax bases recorded in the tax statements create a deferred tax asset. When the analyst makes adjustments to the firm's assets or liabilities to undo any distortions, the deferred tax liability for asset) is also affected. This is because the adjustments do not affect the tax statements and consequently change the difference between book values and tax bases. For example, when the analyst reduces the book value of property, plant, and equipment by 50, the deferred tax liability is reduced by an amount of 17.50 (50 ~ 0.35) to 52.50 (250 - 100) ~ 0.35) The international accounting standard for income taxes requires that deferred taxes be recognized on any difference between book values and tax bases with the exception of a few differences, such as those related to: Nondeductible assets and nontaxable liabilities. Mondeductible goodwill and nontaxable negative goodwill. Overstated depreciation for non-current assets Because non-current assets such as manufacturing equipment decrease in value over time, accounting rules require that firms systematically depreciate the book values of these assets. The reduction in the book value of the assets must be recognized as depreciation or amortization expense in the income statement Managers make estimates of asset lives, salvage values, and amortization schedules for depreciable non-current assets. If these estimates are optimistic, non-current assets and earnings will be overstated. This issue is likely to be most pertinent for firms in heavy asset businesses (e.g., airlines, utilities), whose earnings contain large depreciation components. Firms that use tax depreciation estimates of asset lives, salvage kalues, or amortization rates are likely to amortize assets more rapidly than justifiable given the assets' economic usefulness, leading to non- current asset understatements. In 2012 Lufthansa, the German national airline, reported that it depreciated skircraft over 12 years on a straight-line basis, with an estimated residual value of 15 percent of initial cost. These assumptions imply that Lufthansa's annual depreciation expense was, on average. 7.1 percent (1) - 0.15)/12) of the initial cost of te pircraft. In contrast, industry peers such as Air France-KLM and British Airways were using straight-line cicios rates ixtween ard 5 percent (of initial cost). going forward. This enables the analyst to be able to compare ratios that use assets (eg. return on assets) for the For the analyst these differences raise several questions. Do Lufthansa. Air France-KLM, and British tly different types of routes, potentially explaining the differences in their depreciation policies? Alternator more business travelers, to lower maintenance costs, or to lower fuel casts? If there do not appear to be person do they have different asset management strategies? For example, coes Lufthansa use newer planes differences that explain the differences in the two firms depreciation rates, the analyst may well decide that necessary to adjust the depreciation rates for one or both forms to ensure that their performance is compatible rates to match those of its industry peers. The following financial statement adjustments would then be require To adjust for the effect of different depreciation policies, the analyst could decrease Lufthansais depreciation 1 Increase the book value of the fleet at the beginning of the year to adjust for the relatively high deprecia tion rates that had been used in the past. The necessary adjustment is equal to the following amount: lion, increase Deferred Tax Liability by 151 million, and increase Shareholders' Equity by 454 million Note that these changes are designed to show Lufthansa's results as if it had always used the same depra tion assureptions as its industry peers, rather than to reflect a change in the assumptions for the current year in Lufthansa's financial statements: original minus adjusted depreciation rate X average asset age X initial asset cost. At the beginning of 2012. Lufthansa reported in the notes to its financial statements that its fleet of aircraft had originally con of Lufthansa's fleet was 7.6 years, calculated as follows 22.186 million and that accumulated depreciation was 12.238 million. This implies that the average (6 millions unless otherwise noted) Aircraft cost, 1/1/2012 22.486 Reported Depreciable cost 19,113.1 Cost x (1 -0.15) Accumulated depreciation, 1/1/2012 12.238 Reported Accumulated depreciation Depreciable cost 6403% Depreciable lite 12 years Reported Averago age of aircraft 7.684 years 12 x 0.6403 years If Lufthansa used similar life and salvage estimates as its peers and set its annual depreciation rate att percent, given the average age of its fleet, accumulated depreciation would have been 7,775 (7.684 x 0.04 * 22.486) versus the reported 12.238. Consequently, the company's Non-Current Tangible Assets well have been higher by 64.463 (12.238 - 7,775). 2 Calculate the offsetting increase in equity (retained earnings) and in the deferred tax liability. Given the 25 percent marginal tax rate, the adjustment to Non-Current Tangible Assets would have required off- setting adjustments of 1,116 (0.25 X 4.463) to the Deferred Tax Liability and 3,347 (0.75 X 4.463) to Shareholders' Equity 3 Reduce the depreciation expense (and increase the book value of the fleet) to reflect the lower deprecia tion for the current year. Assuming that 1,902 million net new aircraft purchased in 2012 were acquired throughout the year, and therefore require only half a year of depreciation, the depreciation expense for 2012 (included in Cost of Sales) would have been 1,055 million 10.045 x [22,486 + (1.902/2}]} versus the 1.660 (0.85/12) X (22,486 + (1,902/2}]} million reported by the company. Thus Cost of Sales world decline by 605 million. 4 Increase the tax expense.profit or loss and the balance sheet values of equity and the deferred tax liabilir Given the 25 percent tax rate for 2012, the Tax Expense for the year would increase by 151 million (0.23 125 Chapter 4 Accounting analysis: Accounting adjustments en romanties. By making the adjustments, the analyst substantially improves the comparability of Lufthansa's the years ended December 31, 2011 and 2012 would have to be modified as follows (references to the preceding In summary, if tufthansa were using the same depreciation method as its peers, its financial statements for described steps are reported in brackets): Adjustments Adjustments December 31, 2011 Assets Uabilities (millions) Balance sheet Non Current Tangible Assets December 31, 2012 Assets Liabilities -4.463 Detened Tax Liabity +605 +1.116 Shareholders' Equity 3,347 +1.116 -1514 -3.347 +45419 Income statement Cost of Sales -605 Tax Expense +15119 Profit or Loss +4544 In fiscal year 2013 Lufthansa decided to change its assumption about the economic useful life of its aircraft and lower its annual depreciation rate to slightly less than 5 percent, thereby underlining the practical relevance of the preceding adjustments. The change helped Lufthansa to increase operating profit and bring its accounting for aircraft more into line with the industry norm. However, following the international accounting rules, Luf- thansa adopted the new depreciation policy prospectively without adjusting past depreciation and reducing accumulated depreciation accordingly. Making Lufthansa's operating performance fully comparable with that of its peers in the years prior to and the earliest years after the change in policy would thus continue to require making some of the adjustments discussed above. Leased assets off balance sheet One of the objectives of the balance sheet is to report the assets for which a firm receives the rewards and bears the risks. These can also be assets the firm does not legally own but leases from another firm. The international standard on leases, IFRS Standards 16, therefore requires that a company leasing an asset recognizes a lease asset and a lease liability on its balance sheet, reflecting the company's right of using the asset and its obligation to make the rental payments. Prior to the adoption of IFRS Standards 16, which became effective for fiscal years starting on or after Janu- ary 1, 2019, firms had two ways in which they could record their leased assets. Under the finance lease method, the firm recorded the asset and an offsetting lease liability on its balance sheet. During the lease period, the firm then recognized depreciation on the asset as well as interest on the lease liability, comparable to what firms currently do under IFRS Standards 16. In contrast, under the operating lease method, the firm recognized the lease payment as an expense in the period in which it occurred, keeping the leased asset off its balance sheet. Assessing whether a lease arrangement should be considered an operating lease or a finance lease required judg- ment, helped by one of criteria Ilid doet on the old lease standard. The distinction depended on whether the lessee had effectively accepted most of the risks of ownership, such as obsolescence and physical deterioration