MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

Baginski & Hassell

Chapter 4

Financing Decisions (Leasing)

Topics
- The lease versus purchase decision - Off-balance-sheet financing - Lease classification & criteria: Operating lease versus Capital lease - Capital lease accounting - Terminology Lease term Minimum lease payments (MLP) Present value of MLP

Examples
Two alternatives operating and capital lease classification Operating versus capital lease classification Statement of cash flows under the two alternatives Income statements under two alternatives Balance sheets under two alternatives Sale and leaseback Pro forma adjustments to financial statements

The Lease Versus Purchase Decision

A frequent decision made by managers is whether to purchase or lease assets. Factors that might make leasing the preferred alternative include:
Possible to structure lease to provide off-balance-sheet financing. Leases classified as operating leases result in off-balance-sheet financing. Leases classified as capital leases do not result in off balance sheet financing.

 Potential tax advantages. Potential to deduct entire lease payment for tax purposes. Ability to manage risk of obsolescence. Use of short term leases shifts risk of obsolescence to lessor. In some cases, possible to secure 100% financing via leasing Banks frequently will not finance 100% of a purchase price but lessors frequently will finance 100%.

Off-Balance-Sheet Financing
A party incurs a financial obligation, but GAAP does not define nor require the obligation to be recognized in the Balance Sheet as a liability; it is an operating lease deal!

 Using off-balance-sheet financing makes financial ratios, particularly the debt to equity ratio, look better.
On balance sheet financing would increase the numerator and raise the debt to equity ratio; therefore, off balance sheet financing fails to raise the ratio

Total Debt Stockholders Equity

FAQ?
Is the apparent cosmetic improvement because of allowable alternatives in lease reporting real or an illusion?

Lease Classifications: Operating Versus Capital

Operating leases Risks and rewards of ownership remain with lessor. Capital leases Risks and rewards of ownership transferred to lessee. Lessee records transaction as if the paperwork associated with the asset was a purchase and a note payable existed.

Lease Criteria
A lease is a capital lease if it meets even one of four criteria:
Transfer of title. Bargain purchase option (BPO). Useful/physical life test. FMV test.

Any one of these leads to capitalization of the asset involved!

Capital Lease Queries

1. Does the contract transfer title from lessor to lessee at some future date? 2. Does the contract contain a BPO? 3. Does the contract concern asset use of greater than (or equal to) 75% of the remaining economic useful life of the asset? 4. Does the contract concern a present value of minimum lease payments (MLP) that are greater than (or equal to) 90% of the fair market value (FMV) of the asset?

Bias may be involved in writing leases and calculating ... The lease term > 75% of economic life 90% of FMV

The PV of MLP >

Capital Lease Accounting

An installment purchase Financed by a note payable(*) ... Leased asset is capitalized, and Depreciated.

(*) Payments are allocated between interest expense and principal, using the effective interest method.

FAQ?
What amount is capitalized in a capital lease? The present value of minimum lease payments over the lease term. Exception (rare): The leased asset and the lease obligation cannot be recorded at an amount greater than the FMV of the asset.

Terminology: Lease Term

The lease term includes the fixed, non-cancelable period and certain renewal option periods:
1. Renewal option periods where the renewal price is a bargain. 2. Renewal option periods prior to a BPO date. 3. Renewal option periods where a force forward is a lessor option.

Terminology: Lease Term

4. Renewal option periods after the date of a cancellation penalty so large that it is unlikely the lessee will pay it. 5. Renewal option periods where the lessee guarantees the lessors debt used to finance the leased asset.

Terminology: Minimum Lease Payments (not to be confused with executory costs)

Minimum lease payments (MLP) includes the following:
Periodic cash rental payments over the lease term [To keep the problems simple, we use an even, periodic cash flow payment, either an ordinary annuity or annuity due, throughout the text.] Any one-time payments at the inception/end of the contract (e.g., a downpayment, a BPO).

 Cancellation fees: Penalty fees to be paid to terminate a lease. (Included in MLP if the lessee is expected to cancel the lease at some time and pay such fees). Guaranteed residual value (GRV): The amount the lessee guarantees to the lessor (as a residual FMV) at the end of the contract period.

 Executory costs: Normal ownership costs (e.g., repairs, maintenance, insurance) on the leased assets. Lessees responsibility!
If paid directly by the lessee, these are expensed by the lessee as incurred. If paid by the lessor, then each lease payment includes a reimbursement to the lessor for the executory costs thus the [estimated and designated] amount of such is deducted from the paid amounts so that the MLP will be isolated properly for present value computations.

Terminology: Present Value of Minimum Lease Payments (PVMLP)

Lessee: Calculate using the lower of the lessees incremental borrowing rate or lessors implicit rate (if known to the lessee). Lessor: Calculate using the lessors implicit rate. Note: This is the amount used in the 90% test! PVMLP: The amount used by the lessee to record the leased asset and lease obligation if the lease is capitalized (unless the amount is greater than the fair market value of the asset which is rare).

Example: Lopez, the Lessee

Material Facts: The Lopez Co. signed a 3-year,
noncancellable lease for the use of manufacturing equipment now owned by Zingger, Inc., on December 31, 2004. The lease expires December 31, 2007, and has the following terms: Annual contractual payments of $10,000 at the end of each year, first payment due December 31, 2005. No down payment; no purchase option. Assets December 31, 2004 FMV = $60,000

 Lopez does not guarantee any residual value at December 31, 2007. Lopez can borrow at 10% per year for a 3-year loan; Lopez does not know Zinggers implicit rate. Two alternatives for estimated useful life of the asset: (1) 5 years, (2) 4 years What to do?

Example: Operating Versus Capital Classification

The lease does not meet three of the four criteria under either alternative:
No transfer of title No BPO Fails 90% test: n=3; i=10%; R=$10,000 ordinary annuity PVMLP = $24,870 FMV = $60,000 41%

 Regarding the fourth criterion, the 75% test:

Alternative 1 fails the test: 3 z 5 < 75%; treat as operating lease Alternative 2 meets the test: 3 z 4 u 75%; treat as capital lease. The leased asset and lease obligation are recorded at $24,870.

Example: Amortization Table for Alternative 2

Lopez Capital Lease Amortization Schedule

Date Cash Int. Exp. 12/31 Payment @ 10% 04 05 06 07 10,000 10,000 10,000 2,487 1,736 *907 5,130 Principal Reduction 7,513 8,264 9,093 24,870 Book Value 24,870 17,357 9,093 0

Total 30,000 *Rounded

Statement of Cash Flows Under Two Alternatives

Lopez Co. Statement of Cash Flows (cash outflows in parentheses)

2005 Alternative 1: Operating

Operating Activities Lease payment

2006

2007

(10,000) (10,000) (10,000)

Lopez Co. Statement of Cash Flows (cash outflows in parentheses)

2005 Alternative 2: Capital Operating Activities: Interest payment Financing Activities: Lease payment Net Cash Flow

2006

2007

( 2,487) ( 1,736)

( 907)

( 7,513) ( 8,264) ( 9,903) (10,000) (10,000) (10,000)

Separate Schedule of Significant Investing and Financing Activities Not Involving Cash Attached to Statement of Cash Flows
Alternative 2: Capital Acquisition of equipment by capital lease 2004 24,870

Income Statements Under Two Alternatives

Lopez Co. Income Statement

2005 Alternative 1: Operating Operating Expenses Lease payment 10,000

2006

2007

10,000

10,000

Lopez Co. Income Statements 2005 2006 2007 Alternative 2: Capital Operating Expenses: Depreciation expense* 8,290 8,290 8,290 Other Rev (Exp), Gains (Losses): Interest expense ( 2,487) ( 1,736) ( 907) Total Lease-Related Exp. ** 10,777 10,026 9,197 *$24,870 z 3 = $8,290 **total = $30,000 over the three years

Example: Balance Sheets Under Two Alternatives

Lopez Co. Balance Sheet (12/31)

2005

2006

2007

Alternative 1: Operating Current Assets Cash (10,000) (20,000) (30,000) Owners Equity Retained earnings (10,000) (20,000) (30,000)

Lopez Co. Balance Sheet (12/31) 2004 Alt. 2: Capital Assets Current Assets Cash 2005 2006 2007

0 (10,000) (20,000) (30,000)

Property, plant, equipment, net Manufacturing equipment 24,870

16,580

8,290

Lopez Co. Balance Sheet (12/31) 2004 2004 2005 2006 Liabilities
Current Liab. Lease obligation Long-term Liab. Lease obligation 17,357

7,513

8,264 9,093

9,093 0

0 0

Owners Equity
Retained Earnings

0 (10,777) (20,803) (30,000)

Sales and Leasebacks

A company may sell an asset to a buyer and then immediately sign a lease to lease the asset from the buyer.
The two transactions result in a buyer-lessor and a seller-lessee. If the seller-lessee has a profit on the sale, the profit is deferred and recognized over the life of the lease. The seller-lessee accounts for the lease as an operating lease or a capital lease in the normal manner.

Pro Forma Financial Statement Adjustments

What if ?

Operating lease footnote disclosures may be adequate to allow informal pro forma adjustments to a companys financial statement data to capitalize the leases. Analysts must decide on some interest rate data, and make some assumptions about cash flow patterns, etc.

End of Chapter 4