Accounting for Leases Part 13

Chapter 15 - Leases Requirement 4 In accordance with FASB ACS 840–30–40–1, the asset and obligation representing the original lease would be removed from the accounts and a loss would be recognized for the difference. The journal entry Dowell would record in connection with the sublease is: Lease payable (balance after 4 quarters; from req. 1). . 30,816,422 Loss on sublease (to balance).................................. 1,183,578 Accumulated depreciation (balance: from req. 2)..... 8,000,000 Leased warehouses (balance: PV of lease payments) 40,000,000 First, this case has no single right answer. Communication Case 15-3The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Discussion likely will include the following: a. Possible advantages of leasing include: 1. Leasing can preserve the ability to borrow under lines of credit. 2. Leasing can provide an interest rate lower than the incremental borrowing rate. 3. Leasing may avoid violating restrictive loan agreements that prohibit the issuance of additional debt securities. 4. Leasing can lessen the risk of obsolescence. 5. Leasing allows 100% financing at fixed interest rates as compared with 70% to 90% financing when assets are purchased. b. The lessee views a noncancelable lease as a capital lease if it meets at least one of the following criteria. 1. The lease transfers ownership of the property to the lessee at the end of the lease term. 2. The lease contains a bargain purchase option. 3. The lease term is equal to 75% or more of the estimated economic life of the leased property. 4. The present value of the minimum lease payments, excluding executory costs, equals or exceeds 90% of the fair value of the leased property. Chapter 15 - Leases 1. and 3. are not met. 2. and 4. are met – if the purchase option is viewed as a bargain purchase option. Is $290,000 enough less than $300,000 that exercise of the option is expected to occur? If so: 2. The right to purchase the vans at the end of the lease term for $290,000, when the estimated fair value is $300,000, is a bargain purchase option. 4. The present value of the minimum lease payments, not including the executory costs, is greater than 90% of the fair value of the vans, calculated as follows: Present value of minimum lease payments, assuming a Case 15-3 (continued) BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 In this case, it is a capital lease. Otherwise: Present value of minimum lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Fair value of vans 90% of the fair value of the vans $1,240,000 x 90% $1,116,000 In this case, it is an operating lease to the lessee. Either way, it is a capital lease to the lessor: Present value of minimum lease payments, assuming a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 Present value of minimum lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Residual value ($300,000 x 0.68301) 204,903 Chapter 15 - Leases Total $1,250,958 Since Interstate’s cost, $1,050,000, was less than its “selling price,” this is a sales-type lease to Interstate. Case 15-3 (concluded) c. VIP would record the following at December 31, 2011: Interest expense ([$1,100,000 – 300,000] x 10%).................... 80,000 Lease liability.................................................................. 220,000 Cash............................................................................ 300,000 Operating expenses......................................................... Cash............................................................................ 1,000 1,000 If a BPO is assumed, VIP would have the vans for 7 years: Depreciation expense ([$1,100,000 – 50,000] ÷ 7 yrs.) Accumulated depreciation ......................................... 150,000 150,000 If a BPO is not assumed, VIP would have the vans for 4 years: Depreciation expense ([$1,100,000 – 300,000] ÷ 4 yrs.) Accumulated depreciation ......................................... Ethics Case 15-4 200,000 200,000 Discussion should include these elements: Leasehold improvement depreciation period There may be some degree of latitude associated with uncertainty concerning the life of the leasehold improvements. However, trade publications indicate 25 years probably is out of range. The suggestion to use 25 years clearly is motivated by the desire to “window dress” performance. Ethical Dilemma: How does a doubtful justification for the estimated life of leasehold improvements compare with the perceived need to increase reported profits? Who is affected?: Person Keene Other managers Shareholders Potential shareholders Chapter 15 - Leases Employees Creditors The company’s auditors Chapter 15 - Leases IFRS Case 15-5 Requirement 1 Dell’s operating lease commitments at January 30, 2009 are: Lease Commitments — Dell leases property and equipment, manufacturing facilities, and office space under non-cancelable leases. Certain of these leases obligate Dell to pay taxes, maintenance, and repair costs. At January 30, 2009, future minimum lease payments under these non-cancelable leases are as follows: $89 million in Fiscal 2010; $77 million in Fiscal 2011; $63 million in Fiscal 2012; $42 million in Fiscal 2013; $34 million in Fiscal 2014; and $153 million thereafter. Requirement 2 There is no single way to estimate the effect of capitalizing Dell’s operating leases. The objective is to find the present value of the series of lease payments required by the operating lease obligations. Information, though, is insufficient to make exact calculations. We can use the amount of payments after 2014 to estimate the number of years those payments are due. $153/ $34 = about 4 years We can then use the midpoint of 4 years, 2 years, in the calculation: ($ in millions) Fiscal years 2010 2011 2012 2013 2014 2015 and subsequent Total minimum rentals Operating leases $ 89 77 63 42 34 153 $458 PV factor 6% .943 .890 .840 .792 .747 .667* Present value $ 84 69 53 33 25 102 $366 * This is the PV factor for i=6%, n=7, which treats payments after 2014 as occurring in 2016, 2 years after 2014, the midpoint of the 4 years after 2014. Case 15-5 (concluded) or: An alternative (more accurate, but more difficult) way to estimate the present value of the payments beyond 2014 is: to view them as a deferred annuity: Chapter 15 - Leases $38.25 ($153/4) x 3.46551** = $133 $133 x .747*** = $ 99 ** present value of an ordinary annuity of $1, i=6%, n=4 *** present value of $1, i=6%, n=5 (2010-2014) Requirement 3 If capitalized, these operating lease commitments would add $366 million to Dell’s liabilities. The impact of this on the percentage of Dell’s debt to equity would be to increase the percentage slightly from 520% to 529%: Without capitalization: With capitalization: $ 22,229 / $ 4,271 = 520% ($22,229 + $366) / $4,271 = 529% Note two indications from this analysis. First, Dell’s debt to equity ratio is quite high. Often it is less than one, but Dell’s is over 5 to 1. Second, note that capitalizing operating leases had a negligible impact on the ratio for two reasons – the ratio is high to begin with and Dell has relatively small (and declining) operating lease commitments. For many companies, airlines and grocery chains for instance, capitalizing operating leases can greatly increase, often double, the ratio. We made reasonable assumptions about the timing of payments and estimated the present value of all future payments to be made on the operating leases as we did in the “Decision-Makers’ Perspective” section at the end of the chapter. Other reasonable assumptions should yield comparable results. In any case, we have a rough estimate. Real World Case 15-6Requirement 1 Leasing can allow a firm to conserve assets, to avoid some risks of owning assets, and obtain favorable tax benefits. Also, leasing sometimes is used as a means of “off-balance-sheet financing.” When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt-equity ratio and other mechanical indicators of riskiness. Also, the purchased asset increases total assets and thus reduces calculations of the rate of return on assets. In spite of research that indicates the market is not fooled, managers continue to avoid reporting of assets and liabilities by leasing rather than buying and by constructing lease agreements in such a way that capitalizing the assets and liabilities is not required. Whether or not there is any real effect on security prices, off-balance-sheet financing can help a firm avoid exceeding contractual limits on designated financial ratios (like the debt to equity Chapter 15 - Leases ratio, for instance). In fact, in its annual report, Wal-Mart indicates that they have several restrictive covenants, one of which relates to the debt to equity ratio. Requirement 2 When capital leases are first recorded, both assets and liabilities increase by the present value of minimum lease payments. In later years, though, the amounts differ. Leased assets are reduced by depreciation. Lease liabilities are reduced by the principal portion of lease payments. Requirement 3 ($ in millions) Interest expense (difference)........................ Lease payable (current obligation: given).... Cash (lease payment: given).................... 287 316 603 Requirement 4 $ 287 ÷ 3,919 7.3% 2009 interest (from requirement 3) Beginning balance in lease liability–given: $316 + 3,603 Approximate average interest rate = 7.3% Chapter 15 - Leases Requirement 1 Real World Case 15-7 In a sale-leaseback transaction the owner of an asset sells the asset and immediately leases it back from the new owner. We view the sale and simultaneous leaseback of the asset as a single borrowing transaction. On the surface there appear to be two separate transactions, but the substance of the agreement indicates otherwise. The seller-lessee (FedEx in our case) still retains the use of the asset owned prior to the sale-leaseback, but in the process acquires (a) cash from the sale and (b) an obligation to make lease payments over the term of the lease. In substance, the seller-lessee has borrowed cash to be repaid over the lease term (along with interest). So, from this perspective of “substance over form,” we do not immediately recognize any gains that result from sale-leaseback transactions, but defer the gains to be recognized over the term of the lease. There typically is interdependency between the lease terms and the price at which the asset is sold. As a result, the earnings process is not complete at the time of sale but is completed over the term of the lease. So, viewing the sale and the leaseback as a single transaction is consistent with the realization principle. Requirement 2 When amortizing the deferred gain over the lease term, if the lease meets the criteria to be viewed as a capital lease, we reduce depreciation expense each period by the amortized portion of the gain. If the leaseback portion of a sale-leaseback transaction is classified as an operating lease, the gain still is deferred, but is recognized as a reduction of rent expense rather than depreciation. Because FedEx amortizes its deferred gains “ratably over the life of the lease as a reduction of rent expense” it apparently considers the leases to be operating leases. Communication Case 15-8 Suggested Grading Concepts and Grading Scheme: Content (80%) 30 15 Sale portion of the sale-leaseback (10 each). Record cash for the sale price. Decrease equipment at its undepreciated cost. Establish a deferred gain for the excess of the sale price of the equipment over its undepreciated cost. Gain on the sale portion (5 each; maximum 15). Amortized over the lease term. As a reduction of depreciation expense. Chapter 15 - Leases Results in essentially same depreciation and interest as if the asset were not sold and leased back, but a note issued for cash instead. Because the sale and the leaseback are two components of a single transaction rather than two independent transactions. Consistent with the realization principle. 15 Leaseback portion of the sale-leaseback transaction (5 each; maximum 15). Both an asset. And a liability. At the present value of minimum lease payments. Excluding any executory costs. Asset amount cannot exceed fair value. 20 Conceptual basis (10 each). Economic effect of a long-term capital lease on the lessee is similar to that of an installment purchase. Transfers substantially all of the benefits and risks incident to the ownership of property to the lessee. 80 points Writing (20%) 5 6 Terminology and tone appropriate to the audience (CFO). Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points A solution and extensive discussion materials each case in the Deloitte & Touche Trueblood Case 15-9 accompany Trueblood Case Study Series. IFRS Case 15-10Requirement 1 The desire to obtain “off-balance-sheet financing” sometimes is a leasing stimulus. When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt-equity ratio and other quantifiable indicators of riskiness. Similarly, the purchased asset increases total assets and correspondingly lowers Chapter 15 - Leases calculations of the rate of return on assets. As a result, management often try to avoid reporting assets and liabilities by leasing rather than buying and by constructing lease agreements in such a way that capitalizing the assets and liabilities is not required. Requirement 2 Whether or not there is any real effect on security prices, sometimes off-balance-sheet financing helps a firm avoid exceeding contractual limits on designated financial ratios (like the debt to equity ratio, for instance). For these reasons, SCI would prefer an operating lease. SCI should not specify a bargain purchase option or the transfer of ownership to the lessee. SCI could structure the lease so that the lease term is less than 75% of its useful life of the leased asset and the present value of lease payments are less than 90% of the asset’s fair value. Requirement 3 It would be more difficult for SCI to obtain “off-balance-sheet financing” through an operating lease under IFRS, because IAS No. 17 stresses substance over form. IFRS does not provide a specific percentage for determining what constitutes a “major portion” of the asset’s economic life or “substantially all” of the leased asset’s fair value. IFRS also provides a fifth indicator of a lease that normally leads to a finance lease as well as three more indicators that might lead to a finance lease. Professional judgment rather than specific rules determine whether the risks and rewards of ownership have been transferred to the lessee. British Airways Case Requirement 1 In general – yes. More specifically – no. Both sets of standards attempt to identify leases under which substantially all the risks and rewards of ownership are transferred to the lessee and treat the assets as if they had been purchased outright. However, to distinguish between a capital lease and an operating lease, U.S. GAAP uses four specific classification criteria, whereas IFRS uses a variety of “indicators” of a capital (finance) lease. In this regard, IFRS is considered to be more principles-based while U.S. GAAP is more rules-based. Chapter 15 - Leases Requirement 2 At March 31, 2009, BA’s operating lease commitments for aircraft totaled £862 million. Its finance lease commitments for aircraft totaled £3,522 million. Under both U.S. GAAP and IFRS, lessees report operating and finance lease commitments for the upcoming five years. However, we see that BA, using IFRS, reports commitments in the next year, years 2-5, and five years or more. Under U.S. GAAP, lessees report commitments in each of the next five years and then in total for beyond five years.