MANAGEMENT DECISIONS AND FINANCIAL

ACCOUNTING REPORTSBaginski & Hassell

Electronic presentation adaptation byDr. Barbara L. Hassell & Dr. Harold O. Wilson

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 & 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, but ...• 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 DebtStockholders’ Equity

FAQ?

Is the apparent cosmetic improvement because of allowable alternatives in “lease reporting” real or 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

• Transfer of title.

• Bargain purchase option (BPO).

• Useful/physical life test.

• FMV test.

A lease is a capital lease if it meets even one of four criteria, by definition:

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

Capital Lease Queries1. Does the contract transfer title from lessor

to lessee at some future date?

2. Does the contract contains 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

The PV of MLP > 90% of FMV

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

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.

The lease term includes the fixed, non-cancelable period and certain renewal option periods:

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 lessor’s 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, by definition: – 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. Lessee’s 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 lessee’s incremental borrowing rate or lessor’s implicit rate (if known to the lessee).

• Lessor: Calculate using the lessor’s 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; 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, 2000. The lease expires December 31, 2003, and has the following terms:– Annual contractual payments of $10,000 at the

end of each year, first payment due December 31, 2001.

– No down payment; no purchase option.– Asset’s December 31, 2000 FMV = $60,000

– Lopez does not guarantee any residual value at December 31, 2003.

– Lopez can borrow at 10% per year for a 3-year loan; Lopez does not an implicit borrowing rate for Zingger, Inc.

– Two alternatives for estimated useful life of the asset: (1) 5 years, (2) 4 years

What to do?

Example: Operating Versus Capital Classification

• Under both alternatives, the lease does not meet three of “the four criteria:”– No transfer of title– No BPO– Fails 90% test: PV of minimum lease payment

of $24,870 $60,000 FMV = 41%!• Present value = $24,870: n = 3, i = 10%,

payment (ordinary annuity) = $10,000.

• Regarding the fourth criterion, the 75% test:

– Alternative 1: Fails the test, 3 5 < 75%, treated as operating lease!

– Alternative 2: Meets the test, 3 4 75%, treated as capital lease! The, leased asset and lease obligation recorded at $24,870.

Example: Amortization Table for Alternative 2

Lopez Capital Lease Amortization Schedule

Date

12/31

Cash

Payment

Int. Exp.

@ 10%

Principal

Reduction

Book

Value

00 24,870

01 10,000 2,487 7,513 17,357

02 10,000 1,736 8,264 9,093

03 10,000 *907 9,093 0

Total 30,000 5,130 24,870

*Rounded

Statement of Cash Flows Under Two Alternatives

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

2001 2002 2003

Alternative 1: Operating

Operating Activities

Lease payment (10,000) (10,000) (10,000)

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

2001 2002 2003

Alternative 2: Capital

Operating Activities:

Interest payment ( 2,487) ( 1,736) ( 907)

Financing Activities:

Lease payment ( 7,513) ( 8,264) ( 9,903)

Net Cash Flow (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 2000

Acquisition of equipment by capital lease 24,870

Income StatementsUnder Two Alternatives

Lopez Co. Income Statement

2001 2002 2003

Alternative 1: Operating

Operating Expenses

Lease payment 10,000 10,000 10,000

Lopez Co. Income Statements

2001 2002 2003

Alternative 2: Capital

Operating Expenses:

Depreciation expense* 8,290 8,290 8,290

Financial Revenues, (Exps.),

Gains and (Losses)

Interest expense ( 2,487) ( 1,736) ( 907)

Total Lease-Related Exp. ** 10,777 10,026 9,197

*$24,870 3 = $8,290

**total = $30,000 over the three years

Example: Balance Sheets Under Two Alternatives

Lopez Co. Balance Sheet (12/31)

2001 2002 2003

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)

2000 2001 2002 2003

Alt. 2: Capital

Assets

Current Assets

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

Property, plant, equipment, net

Manufacturing equipment 24,870 16,580 8,290 0

Lopez Co. Balance Sheet (12/31)

2000 2001 2002 2003

Liabilities

Current Liab.

Lease obligation 7,513 8,264 9,093 0

Long-term Liab.

Lease obligation 17,357 9,093 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

• Operating lease footnote disclosures may be adequate to allow informal pro forma adjustments to a company’s financial statements’ data to “capitalize” the leases.

• Analysts must decide on some interest rate data, and make some assumptions about cash flow patterns, etc.

What if?

End of Chapter 4