1. Chapt. 16 Capital Lease & debt ratios 1 Chapter 16 Leases as Capital Assets;Debt Ratios Ref: page 757  763 DO: p.768 BE16-12,13,14 p.770 E16-11,12,13 p.773 P16-9A p.777 BYP16-2, 8

2. Chapt. 16 Capital Lease & debt ratios 2 Car rental is an example of an operating lease LEASE LIABILITIES OPERATING LEASE p.757 In an operating lease the intent is temporary use of the property by the lessee with continued ownership of the property by the lessor. The lease (rental) payments are recorded as an expense by the lessee (renter) and as revenue by the lessor (landlord).

3. Chapt. 16 Capital Lease & debt ratios 3 LEASE LIABILITIES CAPITAL LEASES p.758 A capital lease transfers substantially all the benefits and risks of ownership from the lessor to the lessee (“renter”). = “installment purchase plan!” In a capital lease, the present value of the cash payments for the lease are capitalized and recorded as an asset.

4. Chapt. 16 Capital Lease & debt ratios 4 LEASE LIABILITIES CAPITAL LEASES p.758 The lessee must record the lease as an asset (a capital lease) if any one of the following conditions exist: 1.the lease transfers ownership of the property to the lessee (e.g., contains a bargain purchase option). 2.The lease term is equal to 75% or more of the economic life of the leased property. 3.The present value of the lease payments equals or exceeds 90% of the fair market value of the leased property.

5. Chapt. 16 Capital Lease & debt ratios 5 ACE leases a 747 from GE Aviation on May 8 th. The lease period is for 15 years and the economic life of the airplane is 20 years. The present value of the lease is $185 million and the fair market value of the plane is 200 million. There is no transfer of ownership from GE to ACE  Why has ACE has essentially purchased the airplane  Lease term is 75% of the economic life of the asset  PV of cash payments > 90% of value Journalize the capital lease: Leased Asset (747 airplane)185 Lease Liability185

6. Chapt. 16 Capital Lease & debt ratios 6 CAPITAL LEASE ENTRIES The leased asset is reported on the balance sheet under capital assets. The portion of the lease liability expected to be paid in the next year is reported as a current liability. The remainder is classified as a long-term liability. If none of the four conditions for capitalizing a lease are met, the company does not report an asset. This procedure is referred to as off- balance sheet financing….like rent

7. Chapt. 16 Capital Lease & debt ratios 7 DEBT TO TOTAL ASSETS p.759 The debt-to-total-assets ratio indicates the percentage of total assets owed to creditors, providing one measure of leverage. It is calculated by dividing total debt by total assets.  How is the company financed?  The higher the value, the greater the risk of default Total DebtTotal Assets Debt to Total Assets  

8. Chapt. 16 Capital Lease & debt ratios 8 INTEREST COVERAGE RATIO p.760 The interest coverage ratio measures the company’s ability to meet interest payments as they come due. It is calculated by dividing income before interest expense, income tax expense and amortization expense (EBITA) by interest expense  Ability to service the debt (pay the interest)  Cash based EBITA Interest Expense Interest Coverage  