Leases RCJ Chapter 12 Key Issues 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Lessee vs. lessor Operating vs. capital leases Capital lease criteria Effective interest method Sale and leaseback Executory costs I/S, B/S, and SCF.
Download ReportTranscript Leases RCJ Chapter 12 Key Issues 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Lessee vs. lessor Operating vs. capital leases Capital lease criteria Effective interest method Sale and leaseback Executory costs I/S, B/S, and SCF.
Leases RCJ Chapter 12 Key Issues 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 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 2 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 3 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. Lessee: DR expense CR cash Lessor: DR cash CR revenue Paul Zarowin 4 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): 1. The lease transfers ownership of the asset to the lessee by the end of the lease term. 2. The lease contains a bargain purchase option. 3. The noncancelable lease term is 75 percent or more of the estimated economic life of the leased asset. 4. 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 5 Lease Criteria - Lessor Is this a capital lease? (1) 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 6 Capital Lease Example 5 year lease; $1,000 per year (in arrears); r = 10%; PV = 3.79079 x 1000 = 3791 Lessee Inception: DR Leased asset CR Lease liability Lessor 3791 3791 period 1: DR Int. exp(10% x 3791) 379 DR Lease liability (plug) 621 CR Cash 1000 DR Lease payments receivable 5000 CR leased asset 3791 CR Unearned interest revenue 1209 DR Unearned interest revenue 379 CR Interest revenue 379 total cash = int. exp+repayment of capital lease DR dep. exp. (3791÷5) 758 CR Leased asset 758 DR Cash 1000 CR Lease payments receivable 1000 Note: entries in italics are the same each period 7 Example (cont’d) Lessee period 2: DR Int. exp(10%x3170) 317 DR Lease liability (plug) 683 CR Cash 1000 DR dep. exp. (3791÷5) 758 CR Leased asset 758 Lessor DR Unearned interest revenue CR Interest revenue 317 317 DR Cash 1000 CR Lease payments receivable 1000 period 3: DR Int. exp(10%x2487) 249 DR Lease liability (plug) 751 CR Cash 1000 DR Unearned interest revenue CR Interest revenue DR dep. exp. (3791÷5) 758 CR Leased asset 758 DR Cash 1000 CR Lease payments receivable 1000 Paul Zarowin 249 249 8 Example (cont’d) Lessee period 4: DR Int. exp(10%x1736) 174 DR Lease liability (plug) 826 CR Cash 1000 DR dep. exp. (3791÷5) 758 CR Leased asset 758 period 5: DR Int. exp(10%x910) 91 DR Lease liability (plug) 909 CR Cash 1000 DR dep. exp. (3791÷5) 758 CR Leased asset 758 Lessor DR Unearned interest revenue CR Interest revenue 174 174 DR Cash 1000 CR Lease payments receivable 1000 DR Unearned interest revenue CR Interest revenue 91 91 DR Cash 1000 CR Lease payments receivable 1000 Paul Zarowin 9 Example (cont’d): T accounts = summary of JE’s Lessee’s lease liability T-account DR Inception je per 1 Lessor’s asset t-account, net* DR CR Inception 5000 1209 je per 1 3791 379 1000 je per 2 3170 317 1000 je per 3 2487 249 1000 je per 4 1736 174 1000 je per 5 910 91 1000 CR 3791 621 3170 je per 2 683 2487 je per 3 751 1736 je per 4 826 910 je per 5 end of lease 910 0 Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due end of lease 0 10 * Net = lease payments receivable minus unearned interest revenue. 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 11 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) or 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 12 Executory Costs (RCJ pgs. 581) Period costs; an expense when paid, and not part of the capitalized lease obligation. Ex. E12-12 Paul Zarowin 13 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 14 Footnote Disclosures by Lessee (cont’d) Capital leases DR DR Interest expense Lease liab CR Cash plug given, current liability given, next year’s payment r% = interest expense /total PV of lease liability Paul Zarowin 15 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 16 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. Year ending December 31, (in millions) Capital leases Operating Lease payments 2002 39 1271 2003 30 1238 2004 21 1197 2005 14 1177 2006 6 1144 After 2006 10 8068 Total minimum lease payments 120 14,095 Less: interest payments 21 PV of minimum capital lease payments 99 Less: Current obligations under capital leases 31 Long term capital lease obligations 68 17 To estimate the year by year lease payment after 2007 assume that the lease payments will be approximately the same as in 2006 P ayment saft er2007 8068 7.05 7 2006payment s 1044 Therefore for 7 year after 2006 the lease payments are: Year Operating lease payments 2002 1271 2003 1238 2004 1197 2005 1177 2006 1144 2007 1153 2008 1153 2009 1153 2010 1153 2011 1153 2012 1153 2013 1153 8086 1153 7 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: Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Present Operating value lease factor at payments 8% 1271 0.925926 1238 0.857339 1197 0.793832 1177 0.73503 1144 0.680583 1153 0.63017 1153 0.58349 1153 0.540269 1153 0.500249 1153 0.463193 1153 0.428883 1153 0.397114 PV of payment 1177 1061 950 865 779 726 673 623 577 534 494 458 8916 4. Record the lease asset and obligation (assuming leased assets = lease obligation) DR Leased aircraft—capital leases $8,916 CR Obligation under capital leases C12-1,2 $8,916 Delta Airline Example: Effect on Debt Ratios Before the adjustment: Liabilities: $18,752 million Debt toEquity Debt 7,781 2.06 Equity 3,769 After the adjustment: Liabilities: 18,752 + 8,916 = $27,668 million increase 48% Debt lease adj. 7,781 8,916 Debt t oEquit y 4.43 Equit y 3,769 Ex. 12-15 P. 12-8 Paul Zarowin 21 Change in D/E Ratio During Life of Lease Capitalization-based D/E at inception. Then it becomes even higher. Why? Annuity in arrears NBV Annuity due NBV L L A A Time Time Paul Zarowin 22 I/S Effects (ex. is ordinary annuity) Capital Operating interest + dep=n = total Rent Diff CumDiff(R/E) yr 1 379 758 1137 1000 137 137 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 23 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 24 Lessor: Direct Financing vs. Sales Type Leases Is this a capital lease? (1) Is it a sale? – type I criteria; and (2) earned and collectable? – type II criteria (see RCJ, page 591) no yes Capital lease Operating lease ‘Sale’ deal – the leased asset is removed from lessor’s B/S Direct financing lease ‘Rent’ deal - the leased asset stays on the lessor’s B/S Determines how the sale will be recorded on the I/S Sales type lease Paul Zarowin 25 I/S Effect Total I/S effect = profit on sale + interest revenue Why? Up front Over life of lease (PV- CGS) (CF's - PV) CF' s - CGS 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) Paul Zarowin 26 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 27 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 SPE Investor Asset Operating lease Company Capital lease 28 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 29