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

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. 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.

Capital lease:

Paul Zarowin

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

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?

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Lease Criteria - Lessor

(1) Is it a sale? type I criteria; and (2) earned and collectable? type II criteria (see RCJ, page 590)
yes no

Is this a capital lease?

Capital lease
like an installment sale with interest the leased asset is removed from lessors B/S

Operating lease
like a Rent deal - the leased asset stays on the lessors B/S

Paul Zarowin

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 3791 3791

Lessor
DR Lease payments receivable 5000 CR leased asset 3791 CR Unearned interest revenue 1209

period 1: DR Int. exp(10% x 3791) 379 DR Lease liability (plug) 621 CR Cash 1000

DR Unearned interest revenue 379 CR Interest revenue 379

total cash = int. exp+repayment of capital lease

DR dep. exp. (37915) 758 CR Leased asset 758

DR Cash 1000 CR Lease payments receivable 1000

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Note: entries in italics are the same each period

Example (contd)
Lessee period 2: DR Int. exp(10%x3170) 317 DR Lease liability (plug) 683 CR Cash 1000 Lessor DR Unearned interest revenue CR Interest revenue 317 317

DR dep. exp. (37915) 758 CR Leased asset 758

period 3: DR Int. exp(10%x2487) 249 DR Lease liability (plug) 751 CR Cash 1000

DR Cash 1000 CR Lease payments receivable 1000

DR Unearned interest revenue CR Interest revenue

249 249

DR dep. exp. (37915) 758 CR Leased asset 758

DR Cash 1000 CR Lease payments receivable 1000

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Example (contd)
Lessee period 4: DR Int. exp(10%x1736) 174 DR Lease liability (plug) 826 CR Cash 1000 Lessor DR Unearned interest revenue CR Interest revenue 174 174

DR dep. exp. (37915) 758 CR Leased asset 758

period 5: DR Int. exp(10%x910) 91 DR Lease liability (plug) 909 CR Cash 1000

DR Cash 1000 CR Lease payments receivable 1000

DR Unearned interest revenue CR Interest revenue

91 91

DR dep. exp. (37915) 758 CR Leased asset 758

DR Cash 1000 CR Lease payments receivable 1000

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Example (contd):
DR
Inception je per 1 621 3170

T accounts = summary of JEs

Lessors asset t-account, net*

Lessees lease liability T-account CR

3791

DR
Inception je per 1 5000 3791 379 3170 317 2487 249 1736 174 910 91 0

CR
1209 1000

je per 2
je per 3 je per 4 je per 5 end of lease

683
2487 751 1736 826 910 910 0

je per 2
je per 3

1000
1000

je per 4
je per 5 end of lease

1000
1000
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Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due

* 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

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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

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Executory Costs

(RCJ pgs. 581)

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

Ex. E12-12
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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
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Footnote Disclosures by Lessee (contd)

Capital leases
DR DR Interest expense Lease liab CR Cash

plug
given, current liability given, next years payment

r% = interest expense /total PV of lease liability

Paul Zarowin

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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 > assets): DR Lease assets DR R/E CR Lease liab

Paul Zarowin

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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) 2002 2003 2004 2005 2006 After 2006 Total minimum lease payments Capital leases 39 30 21 14 6 10 120 Operating Lease payments 1271 1238 1197 1177 1144 8068 14,095

Less: interest payments

PV of minimum capital lease payments Less: Current obligations under capital leases Long term capital lease obligations

21
99 31 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 Payments after 2007 8068 7.05 7 2006 payments 1044
Year 2002 2003 2004 2005 2006 Operating lease payments 1271 1238 1197 1177 1144

Therefore for 7 year after 2006 the lease payments are:

8086 1153 7

2007
2008 2009 2010 2011

1153
1153 1153 1153 1153

2012
2013

1153
1153

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:

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

Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

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

Delta Airline Example: Effect on Debt Ratios

Before the adjustment:

Liabilities: $18,752 million

Debt to Equity

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 to Equity 4.43 Equity 3,769
Ex. 12-15

P. 12-8

Paul Zarowin

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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 A A

Time
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Time
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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 < depn + interest later years: rent > 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

(1) Is it a sale? type I criteria; and (2) earned and collectable? type II criteria (see RCJ, page 591)
yes no

Is this a capital lease?

Capital lease
Sale deal the leased asset is removed from lessors B/S

Operating lease
Rent deal - the leased asset stays on the lessors B/S

Direct financing lease

Sales type lease

Paul Zarowin

Determines how the sale will be recorded on the I/S

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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 CFs and CGS stay the same.

Ex. E12-2, E12-6,7,8, P12-12, P12-14 (ignore RV)

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Direct Financing vs. Sales Type Leases (contd)

Direct financing lease:

lessors only I/S effect is interest revenue (above example) lessor recognizes profit on sale + interest revenue (RCJ pgs 589-590) PV of payments (= sale price of asset) > lessors CGS

Sales type lease:

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.
Capital contribution of up to 97%

Can contributes only 3% of capital

Independent

SPE

Investor

Asset
Capital lease

Operating lease

Company

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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).

Paul Zarowin

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