Leases RCJ Chapter 12

Paul Zarowin2 Key Issues 1.Lessee vs. lessor 2.Operating vs. capital leases 3.Capital lease criteria 4.Effective interest method 5.Sale and leaseback 6.Executory costs 7.I/S, B/S, and SCF effects 8.Footnote disclosures 9.Correcting financial statements 10.Annuities 11.Lessor: Direct Financing vs Sales Type Lease 12.Synthetic leases

Paul Zarowin3 Key Terms Lessee: borrower, user (of asset) Lessor: lender, owner Operating vs. capital lease Operating lease:  usually short-term and allow the lessee to use the leased property for only a portion of its economic life.  the economic equivalent of a rent transaction. Capital lease:  Longer-term leases that effectively transfer all the risks and rewards of the leased property to the lessee (sale transaction).  the economic equivalent of sales with financing arrangements - the lessee buys the asset using a loan provided by lessor.

Paul Zarowin4 Operating Lease  Cash basis  No B/S recognition of lease asset or lease liability  It is a form of off-B/S financing  Companies prefer operating leases over capital leases – see table 12.4, page 586. Lessee: DR expense CR cash Lessor: DR cash CR revenue

Paul Zarowin5 Lease Criteria - Lessee If one of the following 4 conditions is met, lessee is required to use capital lease accounting (Type I criteria - see RCJ pg. 578): 1.The lease transfers ownership of the asset to the lessee by the end of the lease term. 2.The lease contains a bargain purchase option. 3.The noncancelable lease term is 75 percent or more of the estimated economic life of the leased asset. 4.The present value of minimum lease payments equals or exceeds 90 percent of the fair value of the leased asset. (This is also referred to as the recovery of investment criterion). key point: is the lease really a sale ?

Paul Zarowin6 Lease Criteria - Lessor Is this a capital lease? (1)Is it a sale? – type I criteria; and (2) earned and collectable? – type II criteria (see RCJ, page 590) Operating lease like a ‘ Rent ’ deal - the leased asset stays on the lessor ’ s B/S Capital lease like an installment sale with interest – the leased asset is removed from lessor ’ s B/S no yes

7 Capital Lease Example 5 year lease; $1,000 per year (in arrears); r = 10%; PV = x 1000 = 3791 Lessee Lessor Inception: DR Leased asset3791 DR Lease payments receivable 5000 CR Lease liability 3791 CR leased asset 3791 CR Unearned interest revenue 1209 period 1: DR Int. exp (10% x 3791) 379 DR Unearned interest revenue 379 DR Lease liability (plug) 621 CR Interest revenue 379 CR Cash 1000 total cash = int. exp+repayment of capital lease DR dep. exp. (3791÷5) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000 Note: entries in italics are the same each period

Paul Zarowin8 Example (cont ’ d) Lessee Lessor period 2: DR Int. exp(10%x3170) 317 DR Unearned interest revenue 317 DR Lease liability (plug) 683 CR Interest revenue 317 CR Cash 1000 DR dep. exp. (3791÷5) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000 period 3: DR Int. exp(10%x2487) 249 DR Unearned interest revenue 249 DR Lease liability (plug) 751 CR Interest revenue 249 CR Cash 1000 DR dep. exp. (3791÷5) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000

Paul Zarowin9 Example (cont ’ d) Lessee Lessor period 4: DR Int. exp(10%x1736) 174 DR Unearned interest revenue 174 DR Lease liability (plug) 826 CR Interest revenue 174 CR Cash 1000 DR dep. exp. (3791÷5) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000 period 5: DR Int. exp(10%x910) 91 DR Unearned interest revenue 91 DR Lease liability (plug) 909 CR Interest revenue 91 CR Cash 1000 DR dep. exp. (3791÷5) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000

10 Example (cont ’ d): T accounts = summary of JE ’ s Lessee’s lease liability T-account DRCR Inception je per je per je per je per je per 5910 end of lease0 Lessor’s asset t-account, net * DRCR Inception je per je per je per je per je per end of lease0 * Net = lease payments receivable minus unearned interest revenue. Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due

Paul Zarowin11 Annuities Ordinary annuity (annuity in arrears): end of period  initial payment is principal + interest DRlease liability DRInterest expense CRCash Annuity due: beginning of period  initial payment is principal (no interest) DRlease liability CRCash Ex. P12-3, P12-4

12 Sale-Leaseback (RCJ pg ) buyer = lessorseller=lessee Means of financing for lessee DR Cash DR Accum. Dep. DR Loss CR Asset-old (at cost) CR Gain Gain  unearned profit on sale-leaseback (liability) Amortize liability into income: DR unearned profit CR Depreciation expense Losses on sale are recognized immediately Ex. E12-13 or

Paul Zarowin13 Executory Costs (RCJ pgs. 581) Period costs; an expense when paid, and not part of the capitalized lease obligation. Ex. E12-12

Paul Zarowin14 Footnote Disclosures by Lessee  5 individual years minimum lease payments (excluding executory costs)  sum of lease payments for all years thereafter  separately for capital and operating leases  capital leases: total lease payments break down into liability (current and non-current) + interest  Analogous disclosures must be made by lessors

Paul Zarowin15 Footnote Disclosures by Lessee (cont ’ d) Capital leases DR Interest expense DR Lease liab CRCash r% = interest expense /total PV of lease liability given, next year ’ s payment given, current liability plug

Paul Zarowin16 Capitalization of Operating Leases (Correction JE) Use r% and payment information to capitalize operating leases DRlease assets CRlease liab (Re)compute current ratio, debt/equity, ROA, etc. Notes: 1. Must adjust NI too (interest expense + depreciation vs. rent expense) but, major differences are on the B/S 2. More precise correction would be (since liab > assets): DRLease assets DRR/E CR Lease liab

17 1. Estimate future lease payment The disclosure provides the lease payments for the first 5 years, and the aggregate of lease payments after Example: Delta Airline 2001 report Year ending December 31, (in millions) Capital leases Operating Lease payments After Total minimum lease payments12014,095 Less: interest payments21 PV of minimum capital lease payments99 Less: Current obligations under capital leases31 Long term capital lease obligations68

To estimate the year by year lease payment after 2007 assume that the lease payments will be approximately the same as in 2006 Therefore for 7 year after 2006 the lease payments are: YearOperating lease payments

2. Select a discount factor: The discount rate for Delta is 8% based on the: Capital lease disclosure Long-term debt disclosure 3. Calculating the present value of lease payments:

4.Record the lease asset and obligation (assuming leased assets = lease obligation) DRLeased aircraft—capital leases$8,916 CRObligation under capital leases$8,916 C12-1,2

Paul Zarowin21 Delta Airline Example: Effect on Debt Ratios Before the adjustment: Liabilities: $18,752 million After the adjustment: Liabilities: 18, ,916 = $27,668 million  increase 48% Ex P. 12-8

Paul Zarowin22 Change in D/E Ratio During Life of Lease Capitalization-based D/E  at inception. Then it becomes even higher. Why? A L NBV Time Annuity in arrears A L Time Annuity due NBV

23 I/S Effects (ex. is ordinary annuity) Capital Operating interest + dep = n = total Rent Diff CumDiff(R/E) yr yr yr yr (68) 151 yr (151) 0 total  operating lease expense is the periodic cash (rental) payment  capital lease expense is depreciation + interest   rent =  [depreciation + interest])   Cash = principal +  interest key point: timing differs early years: rent < dep ’ n + interest later years: rent > dep ’ n +interest

Paul Zarowin24 SCF Effects Cash payment independent of the lease type Operating lease: all cash outflow is from CFO Capital lease: interest expense is from CFO; repayment of capital is CFF CFO is higher for a capital lease than for an operating lease. The difference is greatest in the later years of a lease, when most of the cash payment is repayment of capital E12-14

Paul Zarowin25 Lessor: Direct Financing vs. Sales Type Leases Operating lease ‘ Rent ’ deal - the leased asset stays on the lessor ’ s B/S Capital lease ‘ Sale ’ deal – the leased asset is removed from lessor ’ s B/S Direct financing lease Sales type lease Determines how the sale will be recorded on the I/S no yes Is this a capital lease? (1)Is it a sale? – type I criteria; and (2) earned and collectable? – type II criteria (see RCJ, page 591)

Paul Zarowin26 I/S Effect Total I/S effect = profit on sale + interest revenue Why? Relate to Xerox: switch relative portion, even if CF ’ s and CGS stay the same. Ex. E12-2, E12-6,7,8, P12-12, P12-14 (ignore RV) Up frontOver life of lease

27 Direct Financing vs. Sales Type Leases (cont’d) Direct financing lease: lessor’s only I/S effect is interest revenue (above example) Sales type lease: lessor recognizes profit on sale + interest revenue (RCJ pgs ) PV of payments (= sale price of asset) > lessor’s CGS Note: no difference for lessee; only for lessor Lessor’s only difference is at inception; periodic entries unaffected DRLease payments receivable - gross CRUnearned interest revenue - plug CRSales revenue (PV) DRCGS CRInventory

28 Synthetic Leases A synthetic lease is created when an SPE buys an asset on behalf of the company (or sometimes from the company itself) and leases this asset (back) to the company. CompanySPE Asset Independent Investor Can contributes only 3% of capital Capital contribution of up to 97% Operating lease Capital lease

Paul Zarowin29 The company records the synthetic lease as an operating lease; if it had leased the asset directly and not through a SPE it would have recorded it as a capital lease. The operating lease treatment is preferred by companies because it allows them to keep the lease obligation off-balance-sheet. There are also tax motives to use a synthetic lease (if you are interested see RCJ page 660). Synthetic Leases (cont ’ d)