Agenda

1. Agenda • Leasing • FAS 13 criteria for capitalization • Lessee and lessor accounting • Capitalization of operating leases (FedEx mini-case) • Synthetic leases • VIEs • Legitimate financing technique • Consolidation under Fin-46 (Target mini-case) • Derivatives • Campbell soup mini-case

2. Operating lease Capital lease Alternative accounting treatments for leases depend on structure: • No asset and liability are recorded on the lessee’s • balance sheet • Lease payments are reported as expense when paid. • Both the leased asset and the lease liability are • recorded on the lessee’s balance sheet • Subsequently, depreciation expense is reported • relating to the asset and interest expense is recorded • on the liability.

3. How do we know whether to account for the lease as “operating” or “capital”? • Transfer of ownership test: does the lease: transfer ownership at termination? • Bargain purchase option test: does the lease contain a bargain purchase option? • Economic life test: is the lease term at least 75% of the estimated economic life of the asset? • Recovery of investment test: is the present value of the minimum lease payments > 90% of the fair value of the leased property? • GAAP outlines 4 criteria for capitalization: • If any one or more of the above tests are met, the lease must be capitalized.

4. Accounting for Capital Leases - Lessee • Record the leased asset and the lease liability at the present value of the lease payments or the fair market value of the leased asset, whichever is less. • Use lessee’s incremental borrowing rate to discount unless the implicit interest rate in the lease is known and is less • The leased asset is depreciated using the lessee’s normal depreciation method over the economic life of asset ( for criteria #1 and #2) or the lease term (criteria #3 and #4) • The lease liability is amortized just like a bond, by the effective interest method

5. FedEx mini-case

6. What is an alternate approach to selecting the discount rate?

8. FedEx mini-case concluded

9. Restatements Abound! When it comes to bookkeeping snafus, lease accounting may be the new revenue recognition. It all started in November, when KPMG LLP told fast-food chain CKE Restaurants Inc. that it had problems with the way CKE recognized rent expenses and depreciated buildings. That led CKE to restate its financials for 2002 as well as some prior years…By winter, the Big Four accounting firms had banded together to ask the Securities and Exchange Commission's chief accountant to clarify rules on lease accounting. Retail and restaurant trade groups began battling rule makers about the merits of issuing such guidance. Now, about 250 companies have announced restatements for lease-accounting issues similar to CKE's, and the number continues to rise daily. "We'd be shocked if this isn't the biggest category of restatements we've ever seen," says Jeff Szafran of Huron Consulting Group LLC, which tracks restatements. WSJ, 4/05

10. Lease payments receivable xxx Leased asset xxx Unearned income xxx Accounting for Leases - Lessors Given the payment amount, the entry the lessor makes at the inception of the lease is as follows: • The lease payments receivable is equal to the total payments to be received by the lessor during the lease term, the leased asset is credited for the price the lessor paid for it and the difference between the receivable and the asset cost is unearned income. • The unearned inc is netted from Lease/R on the B/S

11. CAT’s financing leases

12. Cost of Goods sold xxx Lease payments receivable xxx Sales (PV of lease pmts) xxx Unearned income xxx Inventory xxx Sales Type Leases - Lessor • FMV of leased asset is greater than the BV of the asset

13. Sales Type Leases • GAAP takes the position that the earning process is complete, hence the recognition of sales revenue

14. Operating leases - Lessor Record rent expense (income) when paid (received) – leased asset and receivable not capitalized Asset remains on Lessor’s balance sheet and is depreciated as usual. HP:

15. Operating Leases - Lessee • Record rent expense when paid. No recognition of rented asset or rent liability. • Depreciate leasehold improvements over UL or lease term (not including renewals). • Amortization of Leasehold Improvements - The staff believes that leasehold improvements in an operating lease should be amortized by the lessee over the shorter of their economic lives or the lease term, as defined in paragraph 5(f) of FASB Statement 13 ("SFAS 13"), Accounting for Leases, as amended. The staff believes amortizing leasehold improvements over a term that includes assumption of lease renewals is appropriate only when the renewals have been determined to be "reasonably assured," as that term is contemplated by SFAS 13. 

16. Synthetic Leases • Qualify as operating lease treatment under GAAP • Qualify as a capital asset for IRS • Advantages: • Off-balance sheet financing • Accelerated tax write-off (depreciation and interest vs. lease payments) • Also, lease payments are generally less

17.  Lender ($ 97%) SPE Investors ($ 3%)  Property • Lease (ROR on 3% investment + interest pmts on loan • +residual value guaranty) • Typical Options at termination: • Purchase property at original cost (lessee gets appreciation) • Sell property (lessee guarantees residual value for SPE) • Extend lease

18. Variable Interest Entities (VIEs) • Legitimate financing technique • Monitization of assets • Project Financing • Real Estate Financing (synthetic leases) • GM

19. Securitization of A/R with an SPE • SPEs (Trusts, limited partnerships, LLCs, Corporations) • Highly leveraged (3-10% equity) – asset backed securities • Limited scope of activity (generally not self-sustaining businesses) – A/R securitizations, synthetic leases • Bankruptcy protected (lower financing costs) • Previously not consolidated with transferor  • Transfers are sales • No on-balance sheet recognition of assets and liabilities

20. Current consolidation rules are based on percentage of stock owned to define “control” (e.g., > 50%). FIN46, “Consolidation of Variable Interest entities” has more subjective definition of “control” • Entity is classified as a VIE, either • total equity at risk is insufficient to finance its operations (<10% of assets) or • VIE lacks any one of the following: • Ability to make decisions • Obligation to absorb losses • Right to receive returns • Primary beneficiary • Ability to make decisions • Obligation to absorb losses • Right to receive returns • Primary beneficiary may own no voting stock Note: VIE/Primary Beneficiary status may arise subsequent to formation of the SPE: • Payments of dividends/fees are considered a return of equity and can reduce investment below 10%. • Hedging transactions, credit enhancements, guarantees, etc can mitigate 1st dollar loss and lead to consolidation.

21. Effects • Synthetic leases are likely to be affected (require consolidation) because the equity holders do not bear first dollar loss (residual value guarantees) • A/R securitizations may also be affected unless the SPE is reorganized (securities firms may have already found a way around consolidation rules). • F/S effects of consolidation: • Assets/liabilities will increase as SPEs are consolidated. Cumulative adjustment to I/S (below income from continuing operations) for FMV of equity consolidated. • Capital costs will likely increase to qualify a SPE and avoid consolidation as credit providers bear more risk. Will this impact capital availability?

22. Dell mini-case

23. Qualifying Special Purpose Entities (QSPEs) • A transfer of financial assets in which the transferor surrenders control over those assets is accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: • The transferred assets have been isolated from the transferor-put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. • Each transferee (or, if the transferee is a qualifying special-purpose entity (SPE), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor. • The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call. (SFAS 140)

24. Derivatives • Examples: • Swaps, forwards, futures used to mitigate risk • Problems: • Previously little information provided to investors about speculative risk • Orange County and others brought this to attention of regulators • FAS 133 – effective date fiscal years beginning after 6/15/00

25. Derivatives – balance sheet effects • Report derivatives on the balance sheet at fair market value together with the related asset (liability) • Since assets change, equity must change to maintain the accounting identity – the issue is whether the change in equity is reflected in income (same issue as with marketable securities).

26. Derivatives – income statement effects • Accounting for income effects of changes in value depends on character of derivative: • Speculative  report in income statement like trading securities • Hedging: • Fair value hedges (swaps) - report gains (losses) on both underlying asset and derivative in I/S (mostly offsetting so little I/S effect) • Cash flow hedges (futures/forwards) - report gains (losses) in Other Comprehensive Income (OCI) until transaction is completed, then recognize in I/S

27. Campbell Soup mini-case