1. MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

2. Chapter 4

3. Financing Decisions (Leasing) Topics - The lease versus purchase decision - Off-balance-sheet financing - Lease classification & criteria: Operating lease versus Capital lease - Capital lease accounting - Terminology Lease term Minimum lease payments (MLP) Present value of MLP

4. Examples –Two alternatives – operating and capital lease classification Operating versus capital lease classification Statement of cash flows under the two alternatives Income statements under two alternatives Balance sheets under two alternatives –Sale and leaseback –Pro forma adjustments to financial statements

5. The Lease Versus Purchase Decision A frequent decision made by managers is whether to purchase or lease assets. Factors that might make leasing the preferred alternative include: –Possible to structure lease to provide off-balance-sheet financing. Leases classified as operating leases result in off-balance-sheet financing. Leases classified as capital leases do not result in off balance sheet financing.

6. –Potential tax advantages. Potential to deduct entire lease payment for tax purposes. –Ability to manage risk of obsolescence. Use of short term leases shifts risk of obsolescence to lessor. –In some cases, possible to secure 100% financing via leasing Banks frequently will not finance 100% of a purchase price but lessors frequently will finance 100%.

7. Off-Balance-Sheet Financing A party incurs a financial obligation, but GAAP does not define nor require the obligation to be recognized in the Balance Sheet as a liability; it is an operating lease deal!

8. Using off-balance-sheet financing makes financial ratios, particularly the debt to equity ratio, look better. –On balance sheet financing would increase the numerator and raise the debt to equity ratio; therefore, off balance sheet financing fails to raise the ratio Total Debt Stockholders’ Equity

9. FAQ? Is the apparent cosmetic improvement because of allowable alternatives in “lease reporting” real or an illusion?

10. Lease Classifications: Operating Versus Capital Operating leases –Risks and rewards of ownership remain with lessor. Capital leases –Risks and rewards of ownership transferred to lessee. –Lessee records transaction as if the paperwork associated with the asset was a purchase and a note payable existed.

11. Lease Criteria Transfer of title. Bargain purchase option (BPO). Useful/physical life test. FMV test. A lease is a capital lease if it meets even one of four criteria: Any one of these leads to capitalization of the asset involved!

12. Capital Lease Queries 1. Does the contract transfer title from lessor to lessee at some future date? 2. Does the contract contain a BPO? 3. Does the contract concern asset use of greater than (or equal to) 75% of the remaining economic useful life of the asset? 4. Does the contract concern a present value of minimum lease payments (MLP) that are greater than (or equal to) 90% of the fair market value (FMV) of the asset?

13. “Bias” may be involved in writing leases and calculating... The lease term > 75% of economic life The PV of MLP > 90% of FMV

14. Capital Lease Accounting An installment purchase … Financed by a note payable(*)... Leased asset is capitalized, and … Depreciated. (*) Payments are allocated between interest expense and principal, using the effective interest method.

15. FAQ? What amount is capitalized in a capital lease? The present value of minimum lease payments over the lease term. Exception (rare): The leased asset and the lease obligation cannot be recorded at an amount greater than the FMV of the asset.

16. Terminology: Lease Term 1. Renewal option periods where the renewal price is a bargain. 2. Renewal option periods prior to a BPO date. 3. Renewal option periods where a “force forward” is a lessor option. The lease term includes the fixed, non-cancelable period and certain renewal option periods:

17. Terminology: Lease Term 4. Renewal option periods after the date of a “cancellation penalty” so large that it is unlikely the lessee will pay it. 5. Renewal option periods where the lessee guarantees the lessor’s debt used to finance the leased asset.

18. Terminology: Minimum Lease Payments (not to be confused with executory costs) Minimum lease payments (MLP) includes the following: –Periodic cash “rental” payments over the lease term [To keep the problems simple, we use an even, periodic cash flow payment, either an ordinary annuity or annuity due, throughout the text.] –Any one-time payments at the inception/end of the contract (e.g., a downpayment, a BPO).

19. –Cancellation fees: Penalty fees to be paid to terminate a lease. (Included in MLP if the lessee is expected to cancel the lease at some time and pay such fees). –Guaranteed residual value (GRV): The amount the lessee guarantees to the lessor (as a residual FMV) at the end of the contract period.

20. Executory costs: Normal ownership costs (e.g., repairs, maintenance, insurance) on the leased assets. Lessee’s responsibility! –If paid directly by the lessee, these are expensed by the lessee as incurred. –If paid by the lessor, then each lease payment includes a reimbursement to the lessor for the executory costs thus the [estimated and designated] amount of such is deducted from the paid amounts so that the MLP will be isolated properly for present value computations.

21. Terminology: Present Value of Minimum Lease Payments (PVMLP) Lessee: Calculate using the lower of the lessee’s incremental borrowing rate or lessor’s implicit rate (if known to the lessee). Lessor: Calculate using the lessor’s implicit rate. Note: This is the amount used in the “90% test!” PVMLP: The amount used by the lessee to record the leased asset and lease obligation if the lease is capitalized (unless the amount is greater than the fair market value of the asset which is rare).

22. Example: Lopez, the Lessee Material Facts: The Lopez Co. signed a 3-year, noncancellable lease for the use of manufacturing equipment now owned by Zingger, Inc., on December 31, 2004. The lease expires December 31, 2007, and has the following terms: –Annual contractual payments of $10,000 at the end of each year, first payment due December 31, 2005. –No down payment; no purchase option. –Asset’s December 31, 2004 FMV = $60,000

23. –Lopez does not guarantee any residual value at December 31, 2007. –Lopez can borrow at 10% per year for a 3-year loan; Lopez does not know Zingger’s implicit rate. –Two alternatives for estimated useful life of the asset: (1) 5 years, (2) 4 years What to do?

24. Example: Operating Versus Capital Classification The lease does not meet three of “the four criteria under either alternative: –No transfer of title –No BPO –Fails 90% test: n=3; i=10%; R=$10,000 ordinary annuity PVMLP = $24,870 FMV = $60,000 41%

25. Regarding the fourth criterion, the 75% test: –Alternative 1 fails the test: 3  5 < 75%; treat as operating lease –Alternative 2 meets the test: 3  4  75%; treat as capital lease. The leased asset and lease obligation are recorded at $24,870.

26. Example: Amortization Table for Alternative 2

27. Lopez Capital Lease Amortization Schedule Date 12/31 Cash Payment Int. Exp. @ 10% Principal Reduction Book Value 0424,870 0510,0002,4877,51317,357 0610,0001,7368,2649,093 0710,000*9079,0930 Total30,0005,13024,870 *Rounded

28. Statement of Cash Flows Under Two Alternatives Lopez Co. Statement of Cash Flows (cash outflows in parentheses) 200520062007 Alternative 1: Operating Operating Activities Lease payment (10,000)

29. Lopez Co. Statement of Cash Flows (cash outflows in parentheses) 200520062007 Alternative 2: Capital Operating Activities: Interest payment( 2,487)( 1,736)( 907) Financing Activities: Lease payment( 7,513)( 8,264)( 9,903) Net Cash Flow(10,000)

30. Separate Schedule of “Significant Investing and Financing Activities Not Involving Cash” Attached to Statement of Cash Flows Alternative 2: Capital2004 Acquisition of equipment by capital lease24,870

31. Income Statements Under Two Alternatives Lopez Co. Income Statement 200520062007 Alternative 1: Operating Operating Expenses Lease payment10,000

32. Lopez Co. Income Statements 200520062007 Alternative 2: Capital Operating Expenses: Depreciation expense*8,290 Other Rev (Exp), Gains (Losses): Interest expense( 2,487)( 1,736)( 907) Total Lease-Related Exp. **10,77710,0269,197 *$24,870  3 = $8,290 **total = $30,000 over the three years

33. Example: Balance Sheets Under Two Alternatives Lopez Co. Balance Sheet (12/31) 200520062007 Alternative 1: Operating Current Assets Cash(10,000)(20,000)(30,000) Owners’ Equity Retained earnings(10,000)(20,000)(30,000)

34. Lopez Co. Balance Sheet (12/31) 2004200520062007 Alt. 2: Capital Assets Current Assets Cash0(10,000)(20,000)(30,000) Property, plant, equipment, net Manufacturing equipment24,87016,5808,2900

35. Lopez Co. Balance Sheet (12/31) 2004 20052006 Liabilities Current Liab. Lease obligation 7,5138,2649,0930 Long-term Liab. Lease obligation 17,3579,09300 Owners’ Equity Retained Earnings 0(10,777)(20,803)(30,000)

36. Sales and Leasebacks A company may sell an asset to a buyer and then immediately sign a lease to lease the asset from the buyer. –The two transactions result in a buyer-lessor and a seller-lessee. –If the seller-lessee has a profit on the sale, the profit is deferred and recognized over the life of the lease. –The seller-lessee accounts for the lease as an operating lease or a capital lease in the normal manner.

37. Pro Forma Financial Statement Adjustments Operating lease footnote disclosures may be adequate to allow informal pro forma adjustments to a company’s financial statement data to “capitalize” the leases. Analysts must decide on some interest rate data, and make some assumptions about cash flow patterns, etc. What if ?

38. End of Chapter 4