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Leases. RCJ Chapter 12. 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

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Leases l.jpg

Leases

RCJ Chapter 12


Key issues l.jpg
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


Key terms l.jpg
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


Operating lease l.jpg
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


Lease criteria lessee l.jpg
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


Lease criteria lessor l.jpg
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


Capital lease example l.jpg
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


Example cont d l.jpg
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


Example cont d9 l.jpg
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


Example cont d t accounts summary of je s l.jpg
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.


Annuities l.jpg
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


Sale leaseback rcj pg 597 598 l.jpg
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


Executory costs rcj pgs 581 l.jpg
Executory Costs (RCJ pgs. 581)

Period costs; an expense when paid, and not part of the capitalized lease obligation.

Ex. E12-12

Paul Zarowin


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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


Footnote disclosures by lessee cont d l.jpg
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


Capitalization of operating leases correction je l.jpg
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


Example delta airline 2001 report l.jpg
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.


Slide18 l.jpg

  • Therefore for 7 year after 2006 the lease payments are:


  • Slide19 l.jpg

    2. Select a discount factor: that the lease payments will be approximately the same as in 2006

    • 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:


    Slide20 l.jpg

    4. that the lease payments will be approximately the same as in 2006Record 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


    Delta airline example effect on debt ratios l.jpg
    Delta Airline Example: Effect on Debt Ratios that the lease payments will be approximately the same as in 2006

    • 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


    Change in d e ratio during life of lease l.jpg
    Change in that the lease payments will be approximately the same as in 2006D/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


    I s effects ex is ordinary annuity l.jpg
    I/S Effects that the lease payments will be approximately the same as in 2006(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


    Scf effects l.jpg
    SCF Effects that the lease payments will be approximately the same as in 2006

    • 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


    Lessor direct financing vs sales type leases l.jpg
    Lessor: that the lease payments will be approximately the same as in 2006Direct 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


    I s effect l.jpg
    I/S Effect that the lease payments will be approximately the same as in 2006

    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


    Direct financing vs sales type leases cont d l.jpg
    Direct Financing vs. Sales Type Leases (cont’d) that the lease payments will be approximately the same as in 2006

    • 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


    Synthetic leases l.jpg
    Synthetic Leases that the lease payments will be approximately the same as in 2006

    • 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


    Synthetic leases cont d l.jpg
    Synthetic Leases (cont that the lease payments will be approximately the same as in 2006’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


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