Leases
RCJ Chapter 12
Key Issues
1. Lessee vs. lessor
2. Operating vs. capital leases
3. Capital lease criteria
4. Effective interest method
5. Sale and leaseback
6. Executory costs
7. I/S, B/S, and SCF effects
8. Footnote disclosures
9. Correcting financial statements
10. Annuities
11. Lessor: Direct Financing vs Sales Type Lease
12. Synthetic leases
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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.
Capital lease:
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.
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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 Lessor: DR cash
CR cash CR revenue
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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
Is this a capital lease?
(1) Is it a sale? – type I criteria; and
(2) earned and collectable? – type II criteria (see RCJ, page 590)
yes no
Capital lease Operating lease
like an installment sale with like a ‘Rent’ deal - the leased asset
interest – the leased asset is stays on the lessor’s B/S
removed from lessor’s B/S
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Capital Lease Example
5 year lease; $1,000 per year (in arrears); r = 10%;
PV = 3.79079 x 1000 = 3791
Lessee Lessor
Inception:
DR Leased asset 3791 DR Lease payments receivable 5000
CR Lease liability 3791 CR leased asset 3791
CR Unearned interest revenue 1209
period 1:
DR Int. exp(10% x 3791) 379 DR Unearned interest revenue 379
DR Lease liability (plug) 621 CR Interest revenue 379
CR Cash 1000
total cash = int. exp+repayment of capital lease
DR dep. exp. (3791÷5) 758 DR Cash 1000
CR Leased asset 758 CR Lease payments receivable 1000
Note: entries in italics are the same each period
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Example (cont’d)
Lessee Lessor
period 2:
DR Int. exp(10%x3170) 317 DR Unearned interest revenue 317
DR Lease liability (plug) 683 CR Interest revenue 317
CR Cash 1000
DR dep. exp. (3791÷5) 758 DR Cash 1000
CR Leased asset 758 CR Lease payments receivable 1000
period 3:
DR Int. exp(10%x2487) 249 DR Unearned interest revenue 249
DR Lease liability (plug) 751 CR Interest revenue 249
CR Cash 1000
DR dep. exp. (3791÷5) 758 DR Cash 1000
CR Leased asset 758 CR Lease payments receivable 1000
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Example (cont’d)
Lessee Lessor
period 4:
DR Int. exp(10%x1736) 174 DR Unearned interest revenue 174
DR Lease liability (plug) 826 CR Interest revenue 174
CR Cash 1000
DR dep. exp. (3791÷5) 758 DR Cash 1000
CR Leased asset 758 CR Lease payments receivable 1000
period 5:
DR Int. exp(10%x910) 91 DR Unearned interest revenue 91
DR Lease liability (plug) 909 CR Interest revenue 91
CR Cash 1000
DR dep. exp. (3791÷5) 758 DR Cash 1000
CR Leased asset 758 CR Lease payments receivable 1000
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Example (cont’d): T accounts = summary of JE’s
Lessee’s lease liability T-account Lessor’s asset t-account, net*
DR CR DR CR
Inception 3791 Inception 5000 1209
3791
je per 1 621 je per 1 379 1000
3170 3170
je per 2 683 je per 2 317 1000
2487 2487
je per 3 751 je per 3 249 1000
1736 1736
je per 4 826 je per 4 174 1000
910 910
je per 5 910 je per 5 91 1000
end of lease 0 end of lease 0
Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due
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* 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 (cont’d)
Capital leases
plug
DR Interest expense
DR Lease liab given, current liability
CR Cash given, next year’s payment
r% = interest expense /total PV of lease liability
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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
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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, Capital Operating Lease
(in millions) leases payments
2002 39 1271
2003 30 1238
2004 21 1197
2005 14 1177
2006 6 1144
After 2006 10 8068
Total minimum lease payments 120 14,095
Less: interest payments 21
PV of minimum capital lease payments 99
Less: Current obligations under capital leases 31
Long term capital lease obligations 68
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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
Therefore for 7 year after 2006 the lease payments are:
Year Operating lease payments
2002 1271
2003 1238
2004 1197
8086
2005 1177 1153
2006 1144 7
2007 1153
2008 1153
2009 1153
2010 1153
2011 1153
2012 1153
2013 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 PV of
Year payments 8% payment
2002 1271 0.925926 1177
2003 1238 0.857339 1061
2004 1197 0.793832 950
2005 1177 0.73503 865
2006 1144 0.680583 779
2007 1153 0.63017 726
2008 1153 0.58349 673
2009 1153 0.540269 623
2010 1153 0.500249 577
2011 1153 0.463193 534
2012 1153 0.428883 494
2013 1153 0.397114 458
8916
4. Record the lease asset and obligation
(assuming leased assets = lease obligation)
DR Leased aircraft—capital 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 7,781
Debt to Equity 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 21
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 L
A A
Time 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 dep’n +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
Is this a capital lease?
(1) Is it a sale? – type I criteria; and
(2) earned and collectable? – type II criteria (see RCJ, page 591)
yes no
Capital lease Operating lease
‘Sale’ deal – the leased asset ‘Rent’ deal - the leased asset stays
is removed from lessor’s B/S on the lessor’s B/S
Determines how the sale
Direct Sales will be recorded on the
financing type I/S
lease lease
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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 CF’s
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 (cont’d)
Direct financing lease:
lessor’s only I/S effect is interest revenue (above example)
Sales type lease:
lessor recognizes profit on sale + interest revenue (RCJ pgs
589-590)
PV of payments (= sale price of asset) > lessor’s CGS
Note: no difference for lessee; only for lessor
Lessor’s 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.
Can contributes Capital
only 3% of contribution of
capital up to 97%
Independent SPE Operating Company
lease
Investor Asset
Capital
lease
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Synthetic Leases (cont’d)
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).
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