AC303 Summer 2105 Prof. G. Thomas White

Largest group of leased equipment involves:  Information technology equipment  Transportation (trucks, aircraft, rail)  Construction  Agriculture A lease is a contractual agreement between a lessor and a lessee, that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. The Leasing Environment LO 1

The Leasing Environment LO 1 Illustration 21-2 What Do Companies Lease?

Banks Who Are the Players? Captive Leasing Companies Independents ► Wells Fargo ► Chase ► Citigroup ► PNC ► Caterpillar Financial Services Corp. ► Ford Motor Credit (Ford) ► IBM Global Financing Market Share47% 23% 26% LO 1 The Leasing Environment ► International Lease Finance Corp.

1.100% financing at fixed rates. 2.Protection against obsolescence. 3.Flexibility. 4.Less costly financing. 5.Tax advantages. 6.Off-balance-sheet financing. Advantages of Leasing LO 1 The Leasing Environment

LO 1

Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable. Conceptual Nature of a Lease Leases that do not transfer substantially all the benefits and risks of ownership are operating leases. LO 1 The Leasing Environment

For a capital lease, the FASB has identified four criteria. 1.Lease transfers ownership of the property to the lessee. 2.Lease contains a bargain-purchase option. 3.Lease term is equal to 75 percent or more of the estimated economic life of the leased property. One or more must be met for capital lease accounting. 4.The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property. Accounting by the Lessee LO 2

Capitalization Criteria Transfer of Ownership Test  If the lease transfers ownership of the asset to the lessee, it is a capital lease. Bargain-Purchase Option Test  At the inception of the lease, the difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured. Accounting by the Lessee LO 2

Economic Life Test (75% Test)  Lease term is generally considered to be the fixed, noncancelable term of the lease.  Bargain-renewal option can extend this period.  At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. Capitalization Criteria Accounting by the Lessee LO 2

Recovery of Investment Test (90% Test) Minimum Lease Payments: Minimum rental payment Guaranteed residual value Penalty for failure to renew or extend the lease Bargain-purchase option Executory Costs: Insurance Maintenance Taxes Exclude from present value of Minimum Lease Payment Calculation Capitalization Criteria Accounting by the Lessee LO 2

Discount Rate Capitalization Criteria Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception. ► If the lessee knows the implicit interest rate computed by the lessor and it is less than the lessee’s incremental borrowing rate, then lessee must use the lessor’s rate. Accounting by the Lessee LO 2

Asset and Liability Recorded at the lower of: 1.present value of the minimum lease payments (excluding executory costs) or 2.fair-market value of the leased asset. Asset and Liability Accounted for Differently Accounting by the Lessee LO 2

Depreciation Period  If lease transfers ownership, depreciate asset over the economic life of the asset.  If lease does not transfer ownership, depreciate over the term of the lease. Asset and Liability Accounted for Differently Accounting by the Lessee LO 2

Effective-Interest Method  Used to allocate each lease payment between principal and interest. Depreciation Concept  Depreciation and the discharge of the obligation are independent accounting processes. Asset and Liability Accounted for Differently Accounting by the Lessee LO 2

Operating Method (Lessee) The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting, any commitments to make future payments. Accounting by the Lessee LO 2

LO 3

1.Interest revenue. 2.Tax incentives. 3.High residual value. Benefits to the Lessor LO 4 Accounting by the Lessor

A lessor determines the amount of the rental, basing it on the rate of return—the implicit rate—needed to justify leasing the asset. If a residual value is involved (whether guaranteed or not), the company would not have to recover as much from the lease payments. Economics of Leasing LO 4 Accounting by the Lessor

A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. Classification of Leases by the Lessor Illustration LO 4 Accounting by the Lessor

In substance the financing of an asset purchase by the lessee. Lessor records:  A lease receivable instead of a leased asset.  Receivable is the present value of the minimum lease payments. Direct-Financing Method (Lessor) Accounting by the Lessor LO 5

 Records each rental receipt as rental revenue.  Depreciates leased asset in the normal manner. Operating Method (Lessor) Accounting by the Lessor LO 5

a.Operating leases. b.Direct-financing leases. c.Sales-type leases. Classification of Leases by the Lessor LO 4 Accounting by the Lessor

LO 8

 General description of the nature of leasing arrangements.  The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years.  The amount of lease revenues and expenses reported in the income statement each period.  Description and amounts of leased assets by major balance sheet classification and related liabilities.  Amounts receivable and unearned revenues under lease agreements. Disclosing Lease Data Special Lease Accounting Problems LO 9

To avoid leased asset capitalization, companies design, write, and interpret lease agreements to prevent satisfying any of the four capitalized lease criteria. The real challenge lies in disqualifying the lease as a capital lease to the lessee, while having the same lease qualify as a capital (sales or financing) lease to the lessor. Unlike lessees, lessors try to avoid having lease arrangements classified as operating leases. Unresolved Lease Accounting Problems LO 9

Allocating costs of long-lived assets:  Fixed assets = Depreciation expense  Intangibles = Amortization expense  Natural resources = Depletion expense Depreciatio n is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. LO 1 Explain the concept of depreciation.

LO 2 Identify the factors involved in the depreciation process. Factors Involved in the Depreciation Process Three basic questions: (1)What depreciable base is to be used? (2)What is the asset’s useful life? (3)What method of cost apportionment is best?

Some companies try to imply that depreciation is not a cost. For example, in their press releases they will often make a bigger deal over earnings before interest, taxes, depreciation, and amortization (often referred to as EBITDA) than net income under GAAP. They like it because it “dresses up” their earnings numbers. Some on Wall Street buy this hype because they don’t like the allocations that are required to determine net income. Some banks, without batting an eyelash, even let companies base their loan covenants on EBITDA. For example, look at Premier Parks, which operates the Six Flags chain of amusement parks. Premier touts its EBITDA performance. But that number masks a big part of how the company operates—and how it spends its money. Premier argues that analysts should ignore depreciation for big-ticket items like roller coasters because the rides have a long life. Critics, however, say that the amusement industry has to spend as much as 50 percent of its EBITDA just to keep its rides and attractions current. Those expenses are not optional—let the rides get a little rusty, and ticket WHAT’S YOUR PRINCIPLE sales start to tail off. That means analysts really should view depreciation associated with the costs of maintaining the rides (or buying new ones) as an everyday expense. It also means investors in those companies should have strong stomachs. What’s the risk of trusting a fad accounting measure? Just look at one year’s bankruptcy numbers. Of the 147 companies tracked by Moody’s that defaulted on their debt, most borrowed money based on EBITDA performance. The bankers in those deals probably wish they had looked at a few other factors. On the other hand, nonfinancial companies in the S&P 500 generated a substantial EBITA margin of 20.9 percent in Some analysts are concerned that such a high number suggests that companies are reluctant to incur costs and want to stockpile cash. The lesson? Investors will do well to avoid focus on any single accounting measure. Source: Adapted from Herb Greenberg, “Alphabet Dupe: Why EBITDA Falls Short,” Fortune (July 10, 2000), p. 240; and V. Monga, “Operating Efficiency Runs High at U.S. Firms,” Wall Street Journal (February 28, 2012), p. B7.

Events leading to an impairment: a.Significant decrease in the fair value of an asset. b.Significant change in the manner in which an asset is used. c.Adverse change in legal factors or in the business climate that affects the value of an asset. d.An accumulation of costs in excess of the amount originally expected to acquire or construct an asset. e.A projection or forecast that demonstrates continuing losses associated with an asset. LO 5 When the carrying amount of an asset is not recoverable, a company records a write-off referred to as an impairment.

1.Review events for possible impairment. 2.If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred. 3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows. Measuring Impairments LO 5 Explain the accounting issues related to asset impairment.

LO 5 Loss reported as part of income from continuing operations, in the “Other expenses and losses” section.