Leases

1. Leases RCJ Chapter 12

2. Key Issues • Lessee vs. lessor • Operating vs. capital leases • Capital lease criteria • Effective interest method • Sale and leaseback • Executory costs • I/S, B/S, and SCF effects • Footnote disclosures • Correcting financial statements • Annuities • Lessor: Direct Financing vs Sales Type Lease • Synthetic leases Paul Zarowin

3. 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 Zarowin

4. 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. Paul Zarowin

5. 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): • 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

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

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

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

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

10. Example (cont’d): T accounts = summary of JE’s Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due * Net = lease payments receivable minus unearned interest revenue.

11. Annuities Ordinary annuity (annuity in arrears): payments @ end of period  initial payment is principal + interest DR lease liability DR Interest expense CR Cash Annuity due: payments @ beginning of period  initial payment is principal (no interest) DR lease liability CR Cash Ex. P12-3, P12-4 Paul Zarowin

12. Sale-Leaseback (RCJ pg. 597-598) buyer = lessor seller=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

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

14. 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 Zarowin

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

16. Capitalization of Operating Leases (Correction JE) Use r% and payment information to capitalize operating leases DR lease assets CR lease 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): DR Lease assets DR R/E CR Lease liab Paul Zarowin

17. Example: Delta Airline 2001 report 1. Estimate future lease payment • The disclosure provides the lease payments for the first 5 years, and the aggregate of lease payments after 2006.

18. 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:

19. 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:

20. 4.Record the lease asset and obligation (assuming leased assets = lease obligation) DR Leased aircraft—capital leases $8,916   CR Obligation under capital leases $8,916 C12-1,2

21. Delta Airline Example: Effect on Debt Ratios • Before the adjustment: • Liabilities: $18,752 million • After the adjustment: • Liabilities: 18,752 + 8,916 = $27,668 million  increase 48% Ex. 12-15 P. 12-8 Paul Zarowin

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

23. I/S Effects (ex. is ordinary annuity) CapitalOperating interest + dep=n = totalRent DiffCumDiff(R/E) yr 1 379 758 1137 1000 137 137 yr 2 317 758 1075 1000 75 212 yr 3 249 758 1007 1000 7 219 yr 4 174 758 932 1000 (68) 151 yr 5 91 758 849 1000 (151) 0 total 1210 3790 5000 5000 0 0 • 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

24. 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 Zarowin

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

26. 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 front Over life of lease Paul Zarowin

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 589-590) • 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 DR Lease payments receivable - gross CR Unearned interest revenue - plug CR Sales revenue (PV) DR CGS CR Inventory

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. Can contributes only 3% of capital Capital contribution of up to 97% Independent Investor SPE Asset Company Operating lease Capital lease

29. Synthetic Leases (cont’d) • 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