1. Leases

2. Reasons To Lease Short period of use Cheaper finance No down payment Fixed rates May have fewer covenants Less risk of obsolescence Potential financial reporting advantage Tax advantage

3. Lease Types Finance (Capital) Lease Operating Lease

4. Finance Lease U.S.GAAP Any of the 4 criteria met o Title transferred at the end of the lease o A bargain purchase option exists o Lease period is at least 75% of the asset’s useful life o PV of all lease payments ≥ 90% of leased asset’s value IFRS o Potentially all rights and risks of ownership are transferred

5. Finance Lease Treatment Reporting by the Lessee o Treat as if the leased asset is purchased with debt o At the inception the lower of PV of all lease payments OR fair value of leased asset is recognised both as an asset and a liability o During the tenure the asset is depreciated and interest expense recognised o Interest expense equals lease liability at the beginning of the year multiplied by the lease interest rate o In C/F statement lease payment is separated into principal and interest payments o Principal portion = Total lease payment – Interest portion o U.S.GAAP: Principal (as CFF), Interest (as CFO) o IFRS: Principal (as CFF/CFO), Interest (as CFF/CFO)

6. Practice Qs Affordable leasing company leases a machine for its own use for four years with annual payments of $10,000 at the end of each year. At the end of the lease, the machine is returned to the lessor, who will sell it for scrap value. The appropriate interest rate is 6%. Calculate the impact of lease on Affordable company’s Balance Sheet and Income Statement. Affordable Leasing depreciates all assets with SLM. YearBeginning Leasehold Value Interest Expense Lease Payment Lease Liability Book Value of the Asset 0 1 2 3 4

7. Balance Sheet Year Beginning Leasehold Value Interest Expense Lease Payment Lease Liability Book Value of the Asset 0 1 2 3 4 Income Statement YearDepreciationInterest Finance Lease Expense Book Value of the Asset 0 1 2 3 4

8. Finance Lease Treatment Reporting by the Lessor o Leased asset removed from B/S and replaced with lease investment account (lease receivable) o The treatment is like the lessor has given both the asset and the loan to buy it o The principal portion of lease payment reduces the lease receivable account o In the I/S the lessor recognizes interest income over the term of the lease o In C/F statement interest is CFO, principal is CFF Sales – type Lease o When PV of lease payments > carrying value of asset on B/S o Typical when the lessor is a manufacturer or a dealer of leased asset Direct Financing Lease o When PV of lease payments = carrying value of asset

9. Practice Qs Assume Johnson Company purchases an asset for $69,302 to lease to Carver, Inc. for 4 years with an annual lease payment of $20,000 at the end of each year. At the end of the lease, Carver will own the asset for no additional payment. The implied interest rate in the lease is 6%. How should Johnson account for the lease payment from Carver? YearBeginning Lease Receivable Interest Income Lease Payment Ending Lease Receivable 0 1 2 3 4

10. Impact on Financial Statements Balance Sheet o Finance lease results in reported assets and liability o Turnover ratios that use total or fixed assets in denominator will be lower o ROA will be lower o Debt-to-asset, debt-to-equity will be higher o Principal payment due in next year is reported as current liability, hence reduces current ratio and working capital Income Statement o Operating income will be higher for companies using finance lease as compared to companies using operating lease

11. Financial Statement Impact of Lease Accounting Finance LeaseOperating Lease Assets Liabilities Net Income (early years) Net Income (later years) Total Net Income EBIT (Operating Income) CFO CFF Total Cash Flow

12. Financial Statement Impact of Lease Accounting Finance LeaseOperating Lease AssetsHigherLower LiabilitiesHigherLower Net Income (early years)LowerHigher Net Income (later years)HigherLower Total Net IncomeSame EBIT (Operating Income)HigherLower CFOHigherLower CFFLowerHigher Total Cash FlowSame

13. Ratio Impact of Lease Accounting Finance LeaseOperating Lease Current Ratio (CA / CL)LowerHigher Working Capital (CA – CL)LowerHigher Asset Turnover (Revenue / TA)LowerHigher ROA * (NI / TA)LowerHigher ROE * (NI / SE)LowerHigher Debt / AssetsHigherLower Debt / EquityHigherLower * In the early years