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

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.

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.

Lessee DR expense CR cash Lessor DR cash CR revenue
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?

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
Operating lease like a Rent deal - the leased
asset stays on the lessors B/S
Capital lease like an installment sale with
interest the leased asset is removed from
lessors B/S
7
Capital Lease Example

• 5 year lease 1,000 per year (in arrears) r
  10
• PV 3.79079 x 1000 3791
• Lessee
  Lessor
• Inception
• DR Leased asset 3791 DR Lease payments
  receivable 5000
• CR Lease liability 3791 CR
  leased asset 3791
  
  
  CR Unearned interest
  revenue 1209
• period 1
• DR Int. exp(10 x 3791) 379 DR Unearned
  interest revenue 379
• DR Lease liability (plug) 621 CR
  Interest revenue 379
• CR Cash 1000
• total cash int. exprepayment of
  capital lease
• DR dep. exp. (37915) 758 DR Cash
  1000
• CR Leased asset 758 CR
  Lease payments receivable 1000
• Note entries in italics are the same each period

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Example (contd)

• Lessee
  Lessor
• period 2
• DR Int. exp(10x3170) 317 DR Unearned
  interest revenue 317
• DR 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(10x2487) 249 DR Unearned
  interest revenue 249
• DR 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

9
Example (contd)

• Lessee
  Lessor
• period 4
• DR Int. exp(10x1736) 174 DR Unearned
  interest revenue 174
• DR 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(10x910) 91 DR Unearned
  interest revenue 91
• DR 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

10
Example (contd) T accounts summary of JEs
Lessees lease liability T-account Lessees lease liability T-account Lessees lease liability T-account
DR CR
Inception je per 1 621 3791
je per 2 683 3170
je per 3 751 2487
je per 4 826 1736
je per 5 910 910
end of lease 0
Lessors asset t-account, net Lessors asset t-account, net Lessors asset t-account, net
DR CR
Inception je per 1 5000 1209
Inception 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
end of lease 0
Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due
Net lease payments receivable minus unearned
interest revenue.
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Annuities

• Ordinary annuity (annuity in arrears)
• payments _at_ end of period ? initial payment is
  principal interest
• DR lease liability
• DR Interest expense
• CR Cash
• Annuity due
• payments _at_ beginning of period ? initial payment
  is principal (no interest)
• DR lease liability
• CR Cash
• Ex. P12-3, P12-4

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Sale-Leaseback (RCJ pg. 597-598)

• buyer lessor sellerlessee
• 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
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

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Footnote Disclosures by Lessee (contd)

• Capital leases
• DR Interest expense
• DR Lease liab
• CR Cash
• r interest expense /total PV of lease
  liability

plug
given, current liability
given, next years payment
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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 gt
  assets)
• DR Lease assets
• DR R/E
• CR Lease liab

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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
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• 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

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
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• 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

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• 4. Record the lease asset and obligation
• (assuming leased assets lease obligation)
• DR Leased aircraftcapital leases 8,916  
• CR Obligation under capital leases 8,916

C12-1,2
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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
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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
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I/S Effects (ex. is ordinary annuity)

• Capital
  Operating
• interest depn 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 lt depn interest
•  later years rent gt depn interest

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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
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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
Operating lease Rent deal - the leased asset
stays on the lessors B/S
Capital lease Sale deal the leased asset is
removed from lessors B/S
Determines how the sale will be recorded on the
I/S
Direct financing lease
Sales type lease
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I/S Effect

• Total I/S effect profit on sale interest
  revenue
• Why?
• 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 front
Over life of lease
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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) gt
  lessors CGS
• Note no difference for lessee only for lessor
• Lessors 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

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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
Company
SPE Asset
Independent Investor
Operating lease
Capital lease
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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).