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Leases

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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 ... – PowerPoint PPT presentation

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Title: 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.

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

8
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
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 _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

12
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

15
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
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 gt
    assets)
  • DR Lease assets
  • DR R/E
  • CR Lease liab

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 aircraftcapital 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
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
23
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

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
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
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
26
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
27
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

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
Company
SPE Asset
Independent Investor
Operating lease
Capital lease
29
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).
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