LEASES

LEASES

The Company leases certain machinery and equipment under operating leases with terms exceeding one year. Rent expense for the years ended December 31 19L, 19K, and 19J was $$$, $$$, and $$$.

The future minimum lease payments under capital and operating leases at December 31, 19L, were

Capital

Operating

Year M

$$$

Year N

$$$

Year O

$$$

Year P

$$$

Year Q

$$$

Later years

$$$

Total minimum lease payments

$$$

Less amount representing interest

$$$

Present value of net minimum lease payments

$$$

WHAT THIS MEANS

Some operating assets are result of capitalizing leases and recording the concurrent debt

Capitalized lease assets are depreciated similar to other operating assets

Debt payments include interest expense and repayment of principal

Interest expense affects income statement and CFO - principal payment affects CFF

Depreciation and interest expenses are tax deductible - principal payments are not

Other assets used under operating leases are not reported as assets or liabilities

All lease payments include an implicit interest cost

Operating lease payments are recorded as rent or lease expense and affect CFO

Rent expense is tax deductible

Companies using operating leases are not directly comparable to those owning the assets or using capital leases

Financial information reported for noncancelable leases over contract period

Financial statement amounts can be adjusted to reflect similar accounting results

ACCOUNTING FOR LEASES

Advantages of Leasing -

Lessee has alternative financing source

® $

Certain lease obligations not recorded on B/S

® ratios

May avoid risk and cost of idle equipment

® flexible

My reduce technological obsolescence

® risk

Lessee may share tax benefits of lessor

® lower cost

Types of Leases -

Capital lease (SFAS # 13 substance over form), if

Transfer of title at end of period, OR

Contains a bargain purchase option, OR

Term is > 75% of estimated economic life, OR

PV of lease payments is > 90% of property fair value

Operating Lease - if not a capital lease

Operating Leases -

Do NOT record asset or liability

Record expense as benefits received

Disclosures -

Future rent payments for each of next five years

Total minimum future noncancelable subrentals

Rental expense, any contingent or sublease rentals

EXAMPLE

Three payments $36,556 beginning 1/1/A

1/1/A

RENT EXPENSE

36,556

CASH

36,556

Capital Leases -

Record both asset and liability at PV of payments

Record depreciation and interest expense

EXAMPLE

Three payments $36,556 beginning 1/1/A

[PV,10%,3p,due] (1.73554 + 1.0) x $36,556= $100,000

Lessee retains ownership at end of term

No salvage value

1/1/A

LEASED PROPERTY

100,000

LEASE LIABILITY

100,000

LEASE LIABILITY

36,556

CASH

36,556

12/31/A

INTEREST EXPENSE

6,344

LEASE LIABILITY

6,344

DEPREC EXPENSE

33,333

ACC DEPREC

33,333

ANALYSIS OF LEASES

Lease Liabilities (Lessee) -

Capitalize operating leases to aid comparison with companies that purchase assets

OPERATING

CAPITALIZED

Balance Sheet:

No asset / liability

Lease asset

Lease liability

Asset and debt analyses affected:

Current/Quick less by capitalizing operating lease

ROA: 10 - 34% less by capitalizing operating lease

Debt/Equity: 47 - 191% more by capitalizing

Income Statement:

Rent expense

Interest expense

Depreciation expense

Related tax expense

Income account analyses affected:

Total expenses about equal over useful life of asset

Rent Exp > Deprec + Int Exp in early years

Tax considerations

Statement of Cash Flows:

CFO

Rental expense

Interest expense =

(Rent payment - principle)

Tax expense

Tax expense =

(Interest and depreciation)

CFF

Lease liability repayment =

(Rent payment - interest)

Notes:

Noncancelable lease obligations disclosed

Consider "soft" factors that require judgment:

Implicit / incremental rates

Fair values

Useful economic lives

Creative terms

Substance v. form

ANALYSIS OF LEASES

Calculate "adjusted" assets and debt for analytic purposes when operating leases reported in note to financial statement by converting operating lease portfolio to a capital lease -

Determine existing capital lease average implicit interest rate (may need to compute number or years in capital lease) or use interest rate of debt with about same maturity.

Compute number of years remaining under operating leases.

Discount future year operating lease payments using interest rate and remaining number of years estimated above to determine present value of liability and asset. Add new liability and asset to balance sheet at end of current year.

Compute straight-line depreciation expense and using calculated asset value and number of years remaining with operating lease terms and zero salvage value. Adjust expenses of following year.

Caveats

Do not confuse operating leases as a lessor with operating leases as a lessee

Lease information may be disclosed in "Commitments" note rather than "Leases".

Often operating lease information is in sentence and not in tabular form.

EXAMPLE:

Note from 20A Financial Statement -

OPERATING

CAPITAL

20B

$ 1,500

$ 2,000

20C

1,100

1,900

20D

1,000

1,700

20E

600

1,500

20F

500

1,400

Thereafter

5,300

11,200

Total payments

$10,000

$19,700

Less interest

7,744

Present value

11,956

Current portion

1,044

Long-term portion

$10,912

CALCULATIONS:

Estimate length of both leases -

Implicit interest rate of capital lease -

Operate

$5,300

Thereafter =

10.6 yrs

Payment due in 20B

$ 2,000

$ 500

20F

Current portion

1,044

Interest

$ 956

Years 20B

- 20F =

5.0

Total years =

15.6 yrs

Interest rate = 8.0%

956

Interest

11,956

Present value

Capital

$11,200

Thereafter =

8.0 yrs

OR determine implicit rate from annuity -

$ 1,400

20F

$11,956 = PV of ANN (%,13p) X $1,515 * and

Years 20B

- 20F =

5.0

7.8917 = PV of ANN (%,13p) then

Total years =

13.0 yrs

% = 8.0% from PV annuity table for 13p

* $1,515 =

$19,700

total payment

13 yrs

length of lease

OR use long-term debt rate of note with about same length as operating lease

ANALYSIS OF LEASES

Present value of operating lease -

Adjustments to 20A and 20B financial statements -

20B

$1,500 X .9259 =

$1,389

Add'l deprec (6,249 / 16) =

$ 390

20C

1,100 X .8573 =

943

Add'l interest (6,249 X 8%) =

500

20D

1,000 X .7938 =

794

Less rent exp (20B payment)

(1,500)

20E

600 X .7350 =

441

Add’l taxable income

610

20F

500 X .6806 =

340

Add'l tax exp (610 x 40%)

$ 244

Thereafter **

$ 482 X 7.139 X .6806 =

$2,342

Total

$6,249

20B Year Income State

Add'l income

$ 366

11 = Approx. length of annuity after 20F

$482 = $5,300 / 11 yrs

20A Year End Balance Sheet

8% = Capital lease implicit interest rate

Add'l asset

$6,249

7.139 = PV Annuity 11p/8%

Add’l liability - current

$1,389

Add'l liability - long-term

4,860

$6,249

20B Year Cash Flow

Add’l CFO -

(add'l taxes)

($ 244)

(add’l interest)

(500)

(less rent)

1,500

$ 756

Less CFF -

(repay liability 1,500 - 500 )

($1,000)

Less Cash -

(add’l tax)

($ 244)

Repeat the computations and adjustments for each of the following years.

EXERCISE

Assume Company L finances $7,348 of equipment through the operating lease described above. Assume Company P borrows the necessary funds and purchases the $7,348 of equipment. Further, assume both companies have other assets of $1,000, no other liabilities, owners equity of $500, and earn $5,000 before rent interest, depreciation and taxes. Compute the debt/equity ratio, return on assets, and cash flow from operations for both companies.

CASE

Examine the accompanying 1993 - 1998 financial statements of Oppley’s, Inc. and Capitol Eyes Company. Describe the solvency and profitability of each during this period. Support your comments by providing appropriate interest coverage, debt - equity, return on assets, asset turnover, and other appropriate analytic calculations. Which company appears to have less risk and greater profitability? Why?

Capitalize the operating leases reported in the accompanying 1993 - 1998 financial statements of Oppley’s, Inc. using the capitalized lease interest rate. Compare the adjusted Oppley’s balance sheet and income statement amounts to the Capitol Eyes 1993 - 1998 financial statements.

YOUR QUESTIONS AND NOTES

OFF BALANCE SHEET LIABILITIES

Off-Balance Sheet Financing:

Obtain financial capital without incurring GAAP debt, and benefit from investment without reporting GAAP asset

Report, only when required, information in footnote

Rationale -

GAAP does not reflect "true" equity value - F/S follows historical cost - increases in market value unrecognized

Avoid reporting high debt levels and related risk

Reduce possibility of technical default under onerous debt covenant restrictions

Keep asset base off balance sheet - can then time the gains/losses to advantage

Improve financial ratios:

Debt/Equity ratio

Return on Assets

Times interest

Strategies -

Create hybrid financial securities that blur distinction between debt/equity characteristics:

Create preferred stock (P/S) with mandatory redemption or probable call option (SEC treats as debt SFAS #47 - only requires disclosure)

Create debt security where issuer can force conversion of debt to equity

Create debt security where it may be advantageous for holder to convert debt to equity

Use long-term "executory contracts":

Take or pay contract or Throughput agreement

Agree to "buy" specific amount / price of materials - pay for total amount whether material used or not

Operating leases

Liabilities subject to imprecise estimation and/or probability:

Retirement benefits (SFAS #87 & #106)

OFF BALANCE SHEET LIABILITIES

Strategies -

Net investment asset and liability:

Cost method

Equity method

Acquire less than 50% ownership in a joint venture:

With the other owners guarantee its debt service

Report investment at cost or share of net equity

Footnote debt service obligation

Sell asset but guarantee repurchase or resale price to create profit for buyer:

Sale of receivable with recourse (SFAS #77 & #105)

Product financing arrangement (SFAS #49)

ANALYSIS OF OFF BALANCE SHEET LIABILITIES

Importance of footnote information

Potential understatement of assets, liabilities, and related expenses

Resultant impact on financial ratios

10K and SFAS may differ

Adjust financial statement for unrecorded obligations:

From footnote information -

Determine annual amounts

Estimate number of years

Estimate interest rate

Calculate present value of debt using operating lease technique

YOUR QUESTIONS AND NOTES

DERIVATIVES

Value of financial instrument derived from underlying asset (e.g. stock, bond, commodity) or from basic financial indicator (e.g. interest rate, Dow-Jones, etc.)

Examples -

futures

options

forwards

swaps

Purposes -

hedge existing financial risk (e.g. foreign currency / interest rate change)

trading or speculation (i.e. to realize a gain on the financial instrument)

Risks -

counterparty unable to perform under contract

financial instrument sold before maturity at loss

SFAS #134 requires reporting derivatives in financial statements at fair value

Accounting for nontrading purposes -

Gains and losses -

interest swaps recognized currently in interest expense

foreign currency forward exchanges recognized currently in Other

specific foreign currency commitment recognized as product cost

Costs of entering into contract - Amortized over life of contract

Disclosure -

objectives of holding / issuing instrument

recognition, measurement, and reporting policies

hedges -

description of transactions

classes of derivatives

deferred gains / losses

credit and market risk

cash requirements

fair value of financial instruments

YOUR QUESTIONS AND NOTES