Rationale for Leasing: Operating vs. Capital Leases

Accounting for Leases Accounting Agenda „ „ Understand the rationale for leasing and the distinction between operating and capital leases. Understand the Income Statement and Balance Sheet differences between operating and capital leases from the lessee’s perspective. The Nature of Leases • • A lease is an agreement conveying the right to use property, plant, or equipment, usually for a stated period of time, in exchange for periodic cash payments. The owner of the property is referred to as the lessor, and the renter is the lessee. Lease _____________________________________________________ Rent Purchase „ „ „ „ What is the economic rationale for leasing rather than purchasing an asset? What is the economic rationale for capitalizing a lease? What are the accounting criteria for capitalizing a lease? How objectively can each lease criterion be applied? What judgment enters into each assessment? Economic Rationale for Leases „ Operational advantages to the lessee: ƒ Leasing ready-to-use equipment can be more attractive if the asset requires lengthy preparation and set-up. ƒ Leasing avoids having to own the asset that will be required only seasonally, temporarily or sporadically (leasing contract can be tailored). „ Lessor might be better positioned to lease the equipment again. ƒ Leasing for short periods protects against obsolescence. „ But lease payments are accordingly higher. Economic Rationale for Leases „ Financial advantages to the lessee: ƒ Lease payments can be tailored to suit the lessee’s cash flows (up to 100% financing, instead of the 80% limit by banks). ƒ Properly structured leases may be “off-balance sheet”, avoiding debt-covenant restrictions. ƒ Leasing can be tax advantageous when the lessee is unable to take the depreciation tax advantage of owning. Disadvantages to Leasing „ Disadvantages to the lessee: ƒ Leased ready-to-use equipment may be of lower quality than custom built (resulting in lower quality products and lower sales) „ High quality eq. might be unavailable for leasing ƒ Seasonal leasing may affect equipment availability and pricing. ƒ Premium must be paid for the protection against obsolescence. „ Disadvantages to financial statement users: ƒ Off-balance sheet financing can hide the true leverage of the firm. Economic substance of leases Lease ________________________________________________ Rent Purchase „ Operating lease ƒLessee rents the property. ƒLessee accrues rent expense. ƒ Capital lease ƒlessee economically owns the property. ƒLessee records the leased asset in the balance sheet (i.e. capitalizes the asset) and reflects the corresponding lease obligation. Accounting criteria for lease capitalization A lease is considered a capital lease if ANY of the following conditions apply (SFAS 13): 1. Transfer of ownership at the end of lease term 2. Existence of a bargain purchase option (BPO) ­ payment below market value after the lease term 3. Minimum present value of lease payments (including BPO, if any) at least 90% of asset's market value 4. Lease term is 75% of assets remaining useful life Accounting for operating leases-Lessee’s Books An operating lease is recorded as a rental of an asset in the financial statements. When the lease agreement is signed and lessee begins using the asset: A = L + SE No entry During the lease (as payments are made): Cash = L + Retained Earnings (PP) = (PP), as rent expense PP = Periodic lease payment Accounting for capital leases-Lessee’s Books A capital lease is recorded as an asset acquisition with a 100% debt financing in the financial statements. When the lease agreement is signed and lessee begins using the asset: Leased Property = Lease Obligation PVL PVL During the lease (as payments are made) Cash + Leased Property -Acc. Depr. = Lease Obligation + RE -PP - (PP- Int. expense) -Int. expense -Depr. -Depr. Expense PVL =Present Value of Lease = (PVA, n, r%) * PP PP = Periodic lease payment Int. expense = beginning lease liability * r%, where beginning lease liability = present value of remaining payments at r% Depr. Expense = depreciation expense Operating and Capital Leases: An Example Assume GE Capital leases an airplane to Delta Airlines. Assume the airplane has a current cost of $30,000 K, an expected life of 20 years and zero salvage value. Assume Delta has borrowing rate of 16%. Delta transactions if treated as an operating lease: When the lease agreement is signed and lessee begins using the asset: A = L + SE No entry During the lease (as payments are made): Cash = Retained Earnings Y1 -5060 -5060 Rent expense Y2 Rent expense -5060 -5060 Y3 Rent expense -5060 -5060 Y20 -5060 -5060 Rent expense Operating and Capital Leases: An Example Delta transactions if treated as an capital lease When the lease agreement is signed and lessee begins using the asset: Leased Property = Lease Obligation 30,000 30,000 During the lease (as payments are made): Cash -Acc Depr. = Lease Obligation + Retained Earnings Y1 -5060 -260 - 4800 Int. Exp. -1500 - 1500 Depr. Exp. [ Depr = (30,000-0)/20 ] Y2 -5060 [ Decrease in LO = 5060-4800 ] -302 -1500 [ Depr = (30,000-0)/20 ] Y3 -5060 [ Decrease in LO = 5060-4758 ] -350 -1500 [ Depr = (30,000-0)/20 ] [ Decrease in LO = 5060-4710 ] [ Int = 30,000*0.16 ] - 4758 Int. Exp. -1500 Depr. Exp. [ Int = (30,000-260)*0.16 ] - 4710 Int exp -1500 Depr. Exp [ Int = (30,000-260-302)*0.16 ] Lease Obligation Calculation Worksheet Interest Expense Yr 0 1 2 3 4 5 6 7 8 9 10 Lease End of Pmt Yr Oblig 30,000 5,060 29,740 5,060 29,438 5,060 29,089 5,060 28,683 5,060 28,212 5,060 27,666 5,060 27,032 5,060 26,298 5,060 25,445 5,060 24,456 4,800 4,758 4,710 4,654 4,589 4,514 4,427 4,325 4,208 4,071 Yr 10 11 12 13 14 15 16 17 18 19 20 Interest Expense 3,913 3,730 3,517 3,270 2,983 2,651 2,266 1,818 1,300 698 Lease End of Pmt Yr Oblig 24,456 5,060 23,309 5,060 21,979 5,060 20,436 5,060 18,645 5,060 16,569 5,060 14,159 5,060 11,365 5,060 8,123 5,060 4,363 5,060 1 Capital vs. Operating Lease: Income Statement Effects Interest expense + depreciation expense (capital lease) 7000 6000 5000 4000 3000 Rent expense (operating lease) 2000 1000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Capital vs. Operating Lease: Balance Sheet Effects Lease Obligation (capital lease) 35000 30000 25000 20000 15000 10000 Leased Asset (capital lease) 5000 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Financial Statement Disclosures Assume this is Delta’s only lease and they use capital lease treatment. How would their lease footnote look at the end of year 8? Years Ending Y9 Y10 Y11 Y12 Y13 Y14 and after Total minimum lease payments Less: amounts representing interest Present value of future minimum capital lease payments Less: current obligations under capital leases Long-term capital lease obligations Capital Leases 5,060 5,060 5,060 5,060 5,060 35,420 = 5,060 x 7 60,720 34,422 = 60,720 - 26,298 (below) 26,298 = 5060 x (PVA,12yr,16%) 852 25,446 = 26,298 - 852 Actual lease disclosures -- Delta LEASE OBLIGATIONS (Footnote) Years Ending June 30, (In Millions) ----------------------------------2001 2002 2003 2004 2005 After 2005 Total minimum lease payments Less: Amounts of lease payments that represent interest Present value of future minimum capital lease payments Less: Current obligations under capital leases Long-term capital lease obligations Capital Operating Leases Leases -------------------$ 57 $ 1,200 57 1,200 48 1,170 32 1,120 17 1,110 23 9,060 234 $14,860 44 190 43 $147 Courtesy of U.S. Securities and Exchange Commission. Used with permission. Financial disclosures -- Target Future Minimum Lease Payments (millions) Operating Leases 2000 $ 113 2001 105 2002 96 2003 80 2004 70 After 2004 634 Total future minimum lease payments $ 1,098 Less: interest* (302) Present value of minimum lease payments $ 796 Capital Leases $ 22 21 21 19 18 124 $ 225 (90) $ 135 ** *Calculated using the interest rate at inception for each lease (the weighted average interest rate was 8.8 percent). RARELY provided in the footnotes. ** Includes current portion of $10 million. Courtesy of U.S. Securities and Exchange Commission. Used with permission. Financial statement disclosures-- Target Based on information in the lease footnote, what value does Target show for lease liability on its Balance sheet? ƒ$135 million = PV of lease pmts on capital leases, $125 million under Long-Term Obligations, $10 million under Current Liabilities The footnote says Target’s borrowing rate is 8.8 percent. Could this amount be independently computed? Capital lease obligt × r = interest expenset+1 Capital lease obligt × r = LPt+1 – principle reductiont+1 r = (22 – 10) / 135 = 12/135 = 8.89% Financial statement disclosures-- Target „ Why might a user wish to know the effect on Target’s balance sheet and income statement of capitalizing the leases mentioned in this note? ƒTo determine the effect of off-balance sheet financing „ How could a user derive an estimate of the reporting effects of capitalizing leases? ƒBy treating all operating leases as capital leases. Leasing and Debt Covenants Example Borrower agrees that it will not create, incur, assume or suffer to exist any Lien, encumbrance, or charge of any kind (including any lease required to be capitalized under GAAP) upon any of its properties and/or assets other than Permitted Liens. Off Balance Sheet Financing „What is the definition of liabilities in GAAP? „ Probable future sacrifices of resources „ Little or no discretion to avoid the sacrifice „Transaction or event giving rise to the obligation has occurred „Classification on a continuum „Examples: „Operating leases „Contingencies, i.e., lawsuits…. „Motivation for off balance sheet financing?