LeasesRCJ Chapter 12

Paul Zarowin

Key IssuesLessee vs. lessorOperating vs. capital leasesCapital lease criteriaEffective interest methodSale and leasebackExecutory costsI/S, B/S, and SCF effectsFootnote disclosuresCorrecting financial statementsAnnuitiesLessor: Direct Financing vs Sales Type LeaseSynthetic leases

Paul Zarowin

Key TermsLessee: borrower, user (of asset) Lessor: lender, ownerOperating vs. capital leaseOperating 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 Zarowin

Operating LeaseCash basisNo B/S recognition of lease asset or lease liability It is a form of off-B/S financingCompanies prefer operating leases over capital leases see table 12.4, page 586.

Lessee: DR expense CR cashLessor: DR cash CR revenue

Paul Zarowin

Lease Criteria - LesseeIf one of the following 4 conditions is met, lessee is required to use capital lease accounting (Type I criteria - see RCJ pg. 578):The lease transfers ownership of the asset to the lessee by the end of the lease term.The lease contains a bargain purchase option.The noncancelable lease term is 75 percent or more of the estimated economic life of the leased asset.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 Zarowin

Lease Criteria - LessorIs this a capital lease?Is it a sale? type I criteria; and (2) earned and collectable? type II criteria (see RCJ, page 590)Operating leaselike a Rent deal - the leased asset stays on the lessors B/SCapital leaselike an installment sale with interest the leased asset is removed from lessors B/Snoyes

Paul Zarowin

Capital Lease Example 5 year lease; $1,000 per year (in arrears); r = 10%; PV = 3.79079 x 1000 = 3791 Lessee LessorInception:DR Leased asset3791 DR Lease payments receivable 5000CR Lease liability 3791 CR leased asset 3791 CR Unearned interest revenue 1209period 1: DR Int. exp(10% x 3791) 379 DR Unearned interest revenue 379DR Lease liability (plug) 621 CR Interest revenue 379 CR Cash 1000 total cash = int. exp+repayment of capital lease DR dep. exp. (37915) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000Note: entries in italics are the same each period

Example (contd) Lessee Lessorperiod 2: DR Int. exp(10%x3170) 317 DR Unearned interest revenue 317DR Lease liability (plug) 683 CR Interest revenue 317 CR Cash 1000 DR dep. exp. (37915) 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 249DR Lease liability (plug) 751 CR Interest revenue 249 CR Cash 1000 DR dep. exp. (37915) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000

Paul Zarowin

Example (contd) Lessee Lessorperiod 4: DR Int. exp(10%x1736) 174 DR Unearned interest revenue 174DR Lease liability (plug) 826 CR Interest revenue 174 CR Cash 1000 DR dep. exp. (37915) 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 91DR Lease liability (plug) 909 CR Interest revenue 91 CR Cash 1000 DR dep. exp. (37915) 758 DR Cash 1000 CR Leased asset 758 CR Lease payments receivable 1000

Paul Zarowin

Example (contd): T accounts = summary of JEs* Net = lease payments receivable minus unearned interest revenue.Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due

Lessees lease liability T-account DRCRInception

je per 1

621 3791 je per 2683 3170 je per 3 7512487

je per 4 826 1736je per 5910910end of lease0

Lessors asset t-account, net*DRCRInception

je per 15000120937913791000je per 231703171000 je per 3 24872491000je per 4 17361741000je per 5910911000end of lease0

Annuities Ordinary annuity (annuity in arrears): payments @ end of period initial payment is principal + interestDRlease liability DRInterest expenseCRCash

Annuity due: payments @ beginning of period initial payment is principal (no interest)DRlease liabilityCRCash

Ex. P12-3, P12-4

Paul Zarowin

Sale-Leaseback (RCJ pg. 597-598)buyer = lessorseller=lesseeMeans of financing for lesseeDR CashDR Accum. Dep.DR LossCR Asset-old (at cost)CR GainGain unearned profit on sale-leaseback (liability)Amortize liability into income:DR unearned profit CR Depreciation expenseLosses on sale are recognized immediatelyEx. E12-13

or

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

Paul Zarowin

Footnote Disclosures by Lessee 5 individual years minimum lease payments (excluding executory costs)sum of lease payments for all years thereafterseparately for capital and operating leasescapital leases: total lease payments break down into liability (current and non-current) + interestAnalogous disclosures must be made by lessors

Paul Zarowin

Footnote Disclosures by Lessee (contd)Capital leasesDR Interest expenseDR Lease liabCRCash

r% = interest expense /total PV of lease liability given, next years payment given, current liability plug

Paul Zarowin

Capitalization of Operating Leases (Correction JE)Use r% and payment information to capitalize operating leasesDRlease assetsCRlease 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/S2. More precise correction would be (since liab > assets): DRLease assetsDRR/ECR Lease liab

Paul Zarowin

Example: Delta Airline 2001 report1. Estimate future lease paymentThe disclosure provides the lease payments for the first 5 years, and the aggregate of lease payments after 2006.

Year ending December 31,(in millions)Capital leasesOperating Lease payments2002391271200330123820042111972005141177200661144After 2006108068Total minimum lease payments12014,095Less: interest payments21PV of minimum capital lease payments99Less: Current obligations under capital leases31Long 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 payments200212712003123820041197200511772006114420071153200811532009115320101153201111532012115320131153

Paul Zarowin

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

Paul Zarowin

Sheet1

YearOperating lease paymentsPresent value factor at 8%PV of payment

200212710.92592592591177

200312380.85733882031061

200411970.793832241950

200511770.7350298528865

200611440.680583197779

200711530.6301696269726

200811530.5834903953673

200911530.5402688845623

201011530.5002489671577

201111530.4631934881534

201211530.4288828593494

201311530.3971137586458

8916

Sheet2

YearOperating leases payments

20021271

20031238

20041197

20051177

20061144

After 200780687.0524475524

1152.5714285714

Sheet3

1390.925925925936.11111111111.08

2300.857338820325.7201646091

3210.79383224116.6704770614

4140.735029852810.2904179392

560.6805831974.0834991822

660.63016962693.7810177613

740.58349039532.333961581

98.9906492453

4.Record the lease asset and obligation (assuming leased assets = lease obligation)DRLeased aircraftcapital leases$8,916 CRObligation under capital leases$8,916

C12-1,2

Paul Zarowin

Delta Airline Example: Effect on Debt RatiosBefore the adjustment:Liabilities: $18,752 million

After the adjustment:Liabilities: 18,752 + 8,916 = $27,668 million increase 48%Ex. 12-15P. 12-8

Paul Zarowin

Change in D/E Ratio During Life of LeaseCapitalization-based D/E at inception. Then it becomes even higher. Why? ALNBVTimeAnnuity in arrearsALTimeAnnuity dueNBV

Paul Zarowin

I/S Effects (ex. is ordinary annuity) Capital Operating interest + dep=n = total Rent Diff CumDiff(R/E)yr 1 379 758 1137 1000 137 137yr 2 317 758 1075 1000 75212yr 3 249 758 1007 1000 7 219yr 4 174 758 932 1000 (68) 151yr 5 91 758 849 1000 (151) 0 total 1210 3790 5000 5000 0 0operating lease expense is the periodic cash (rental) paymentcapital lease expense is depreciation + interest rent = [depreciation + interest]) Cash = principal + interestkey point: timing differsearly years: rent < depn + interestlater years: rent > depn +interest

SCF Effects Cash payment independent of the lease type Operating lease: all cash outflow is from CFOCapital 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 Zarowin

Lessor: Direct Financing vs. Sales Type LeasesOperating leaseRent deal - the leased asset stays on the lessors B/SCapital leaseSale deal the leased asset is removed from lessors B/SDirect financing leaseSales type leaseDetermines how the sale will be recorded on the I/SnoyesIs this a capital lease?Is it a sale? type I criteria; and (2) earned and collectable? type II criteria (see RCJ, page 591)

Paul Zarowin

I/S EffectTotal I/S effect = profit on sale + interest revenueWhy?

Relate to Xerox: switch relative portion, even if CFs and CGS stay the same.

Ex. E12-2, E12-6,7,8, P12-12, P12-14 (ignore RV)Up frontOver life of lease

Paul Zarowin

Direct Financing vs. Sales Type Leases (contd)Direct financing lease: lessors only I/S effect is interest revenue (above example)Sales type lease: lessor recognizes profit on sale + interest revenue (RCJ pgs 589-590)PV of payments (= sale price of asset) > lessors CGS Note: no difference for lessee; only for lessorLessors only difference is at inception; periodic entries unaffectedDRLease payments receivable - grossCRUnearned interest revenue - plugCRSales revenue (PV)DRCGS CRInventory

Synthetic LeasesA 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.

Company

SPE AssetIndependentInvestorCan contributes only 3% of capitalCapital contribution of up to 97%Operating leaseCapital lease

Synthetic Leases (contd)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).

Paul Zarowin