1. Financial Reporting for Leases Revsine/Collins/Johnson: Chapter 12

2. RCJ: Chapter 12 © 2005 2 Learning objectives 1.The difference between capital leases and operating leases. 2.Lessee’s incentives to keep leases off the balance sheet. 3.The criteria used to classify leases on the lessee’s books. 4.The treatment of executory costs, residual values, and other aspects of lease contracts. 5.The effects of capital lease versus operating lease treatment on the lessee’s financial statements. 6.How analysts can adjust for ratio distortions from off-balance sheet leases when comparing firms.

3. RCJ: Chapter 12 © 2005 3 Learning objectives: Continued 7.Lessor accounting rules and how the financial reporting incentives of lessors are very different from that of lessees. 8.The difference between sales-type, direct financing, and operating lease treatment by lessors. 9.How different lease accounting treatments can affect income and net asset balances. 10.Sale/leaseback arrangements and other special leasing situations. 11.How to use lease footnote disclosures.

4. RCJ: Chapter 12 © 2005 4 Lease contracts  A lease contract conveys the right to use an asset in exchange for a fee (the lease payment).  At its inception, a lease is a mutually unperformed contract meaning that neither party has yet performed all of the duties called for in the contract.  The accounting for unperformed contracts is controversial. LesseeLessor Wants to use the asset Owns the asset Right to use Lease payment

5. RCJ: Chapter 12 © 2005 5 Evolution of lease accounting: Operating lease approach  SFAS No 13 spells out GAAP for leases. Before it was issued in 1976, virtually all leases were accounted for using the operating lease approach.  Here’s an example: Month 1 $2,000 payment Lease signed and Iris moves in Month 2 5 – year term of lease $2,000 payment

6. RCJ: Chapter 12 © 2005 6 Evolution of lease accounting: Entries for Iris Company (lessee)  At inception, when the lease contract is signed:  At the end of each month: No Entry: Executory (unperformed) contract DR Rent expense $2,000 CR Lease liability $2,000 To accrue a liability for that portion of the contract that has been performed. DR Lease liability $2,000 CR Cash $2,000 To record the payment of the stipulated rental fee at the end of the month.

7. RCJ: Chapter 12 © 2005 7 Evolution of lease accounting: Entries for Crest Company (lessor)  At inception, when the lease contract is signed:  At the end of each month: No Entry: Executory contract DR Cash $2,000 CR Rental revenue $2,000 To record the rental payment received each month. DR Depreciation expense –leased building $2,000 CR Accumulated depreciation –leased building $2,000 The building remains an asset on the books, periodic depreciation is recorded.

8. RCJ: Chapter 12 © 2005 8 Evolution of lease accounting: Why lessees like the operating lease approach  The operating approach does not reflect the cumulative economic liability for all future lease payments on the balance sheet.  Keeping the lease obligation (and asset) off of the balance sheet may: Reduce the likelihood of debt covenant violation. Improve the ability to obtain additional loans in the future. Improve financial performance ratios like ROA  However, GAAP does require footnote disclosure of this off- balance sheet lease obligation. NOPAT Average assets ROA = ROA seems higher when leased assets are not included here.

9. RCJ: Chapter 12 © 2005 9 Evolution of lease accounting: The SEC’s initiative  The SEC issued ASR No. 147 in 1973 to improve financial reporting for leases.  The SEC took a property rights approach to lease accounting: The lease conveys property rights (an asset) to the lessee. The payment stream represents the lessee’s liability.  Under this capital lease approach, the lessee makes the following entry when the lease is signed: DR Leased asset (to reflect the property right, not ownership of the asset) $XXX CR Lease obligation (to reflect the liability arising from future lease payments) $XXX

10. RCJ: Chapter 12 © 2005 10 Evolution of lease accounting: Overview of the two approaches

11. RCJ: Chapter 12 © 2005 11 Lessee accounting: SFAS No. 13 criteria for capital lease treatment If, at inception, the lease satisfies any one or more of the following criteria, it must be treated as a capital lease on the books of the lessee: The lease transfers ownership of the asset to the lessee at the end of the lease term. The lease contains a bargain purchase option. The non-cancelable lease term is 75% or more of the estimated economic life of the leased asset. The present value of the minimum lease payments equals or exceeds 90% of the current fair market value of the leased asset.

12. RCJ: Chapter 12 © 2005 12 Lessee accounting: Capital lease treatment illustrated  SFAS No. 13 requires that the lease asset and liability initially be recorded at a dollar amount equal to the discounted present value of the minimum lease payments:

13. RCJ: Chapter 12 © 2005 13 Lessee accounting: Capital lease accounting overview  The balance sheet amount shown for the lease asset and liability are equal only at the inception and at the end of the lease:  The leased asset is amortized over time using a depreciation schedule for assets of this type.  The lease obligation is reduced in accordance with the payment schedule once interest is accrued using the effective interest method. $300,000 Inception $0 End of Lease Lease Asset PV of MLP Amortization $300,000 Inception $0 End of Lease Lease liability PV of MLP Payments and interest

14. RCJ: Chapter 12 © 2005 14 Lessee accounting: Effective interest method = $250,860.82 x 10% = $79,139.18-$19,680.77

15. RCJ: Chapter 12 © 2005 15 Lessee accounting: Annual cost of leased asset = $300,000 ÷ 5 years

16. RCJ: Chapter 12 © 2005 16 Lessee accounting: Capital lease journal entries  At inception, when the lease contract is signed: DR Leased asset –capital lease $300,000 CR Obligation under capital lease $300,000  At the end of 2005: DR Obligation under capital lease $49,139.18 DR Interest expense 30,000.00 CR Cash $79,139.18 DR Depreciation expense –capital lease $60,000.00 CR Accumulated depreciation –capital lease $60,000.00  Interest expense at the end of 2006: DR Obligation under capital lease $54,053.10 DR Interest expense 25,086.08 CR Cash $79,139.18 PV of MLP

17. RCJ: Chapter 12 © 2005 17 Lessee accounting: Capital lease summary

18. RCJ: Chapter 12 © 2005 18 Lessee accounting: Executory costs  These are the costs of using the asset—such as maintenance, taxes, and insurance.  Accordingly, they are omitted when determining minimum lease payments and the capitalized amount shown for the leased asset.  Instead, they are charged to expense when incurred: DR Obligation under capital lease $49,139.18 DR Interest expense 30,000.00 DR Miscellaneous lease expense 2,000.00 CR Cash $81,139.18 Executory costs

19. RCJ: Chapter 12 © 2005 19 Lessee accounting: Residual value guarantees  Suppose Lessee Corp. guarantees that the asset will be worth no less than $20,000 when the lease ends.  Residual value guarantees of this sort protect the lessor against two business risks: Unforeseen technological or marketplace changes that erode asset value. Possibility that the lessee does not take proper care of the asset.  With this guarantee, the new present value of minimum lease payments becomes: Without guarantee With guarantee

20. RCJ: Chapter 12 © 2005 20 Lessee accounting: Residual value guarantee details = ($312,418.40 - $20,000) ÷ 5 years = $79,139.18 -26,452.11 $264,521.06 x 10% =

21. RCJ: Chapter 12 © 2005 21 Lessee accounting: Residual value guarantee journal entries  At inception, when the lease contract is signed:  When Lessee Corp. returns the asset worth at least $20,000 to the lessor: DR Leased asset –capital lease $312,418.40 CR Obligation under capital lease $312,418.40 DR Obligation under capital lease $20,000.00 CR Leased asset –capital lease $20,000.00  When Lessee returns the asset worth only $15,000 and pays cash as required by the guarantee: DR Obligation under capital lease $20,000.00 DR Loss on residual value guarantee 5,000.00 CR Leased asset –capital lease $20,000.00 CR Cash 5,000.00

22. RCJ: Chapter 12 © 2005 22 Lessee accounting: Payments in advance  The lease contracts described thus far all involve payments that occur at the end of each period. Year 1 $XX Year 2 Term of lease $XX Inception Present values  Many lease contracts require payments to be made at the beginning of each period: Year 1 $XX Year 2 Term of lease $XX Inception Present values  If Lessee Corporation’s lease had this form, the lessor would require a smaller payment each period:

23. RCJ: Chapter 12 © 2005 23 Lessee accounting: Amortization with payments in advance The payment is smaller than before because it is made at the beginning of each period. = $228,055 x 10% $300,00 ÷ 5 years =

24. RCJ: Chapter 12 © 2005 24 Lessee accounting: Financial statement effects Lessee Company Pattern of Expense Recognition: Capital Versus Operating Rental payment Interest plus depreciation

25. RCJ: Chapter 12 © 2005 25 Lessee accounting: Use of operating and capital leases

26. RCJ: Chapter 12 © 2005 26 Lessee accounting: Footnote disclosure Off-balance sheet obligation Balance sheet liabilities

27. RCJ: Chapter 12 © 2005 27 Lessee accounting: Adjusting income

28. RCJ: Chapter 12 © 2005 28 Lessee accounting: Balance sheet and ratio effects  Capital lease accounting can effect the current ratio. Consider the Lessee Corp. lease at inception (Exhibit 12.1): Current assets Current liabilities Current assets Current liabilities Capital leaseOperating lease Increased by $49,139 Unchanged $30,000 $49,139 $79,139 Operating (amortization) Financing (interest) Operating (rent) Capital leaseOperating lease  Cash flow effects also occur:

29. RCJ: Chapter 12 © 2005 29 Lessor accounting: Capital and operating leases  From the lessor’s perspective, a capital lease must both: Transfer property rights in the leased asset to the lessee, and Allow reasonably accurate estimates regarding the amount and collectibility of the eventual net cash flows to the lessor.  When both conditions are not simultaneously met, the lease must be treated as an operating lease. Lease Sales-typeDirect-financingOperating CapitalOperating

30. RCJ: Chapter 12 © 2005 30 Lessor accounting: Decision tree  Asset removed from books.  Two profit streams: Manufacturer’s/dealer’s profit Financing profit over time  Asset removed from books.  Financing profit only  Asset remains on books.  Rental income over time

31. RCJ: Chapter 12 © 2005 31 Lessor accounting: Sales-type lease example Recognized at inception Recognized over time as earned

32. RCJ: Chapter 12 © 2005 32 Lessor accounting: Direct-financing lease example Recognized over time as earned

33. RCJ: Chapter 12 © 2005 33 Lessor accounting: SFAS No. 13 criteria for capital lease treatment  Ownership is transferred to lessee by end of lease term.  Lease contains a bargain purchase option.  Noncancelable lease term is 75% or more of estimated economic life.  Present value of minimum lease payments exceeds 90% of the FMV of the leased asset.  Collectability of minimum lease payments is reasonably assured.  There are no important uncertainties surrounding the amount or unreimbursable costs yet to be incurred by the lessor under the lease. Type 1 characteristics (at least one of these is met…) Type 2 characteristics (…and both of these are met) Critical event Measurability

34. RCJ: Chapter 12 © 2005 34 Lessor accounting: Expanded decision tree

35. RCJ: Chapter 12 © 2005 35 Lessor accounting: Direct-financing lease treatment illustrated Also equals the present value of MLP plus GRV

36. RCJ: Chapter 12 © 2005 36 Lessor accounting: Implied rate of return on direct-financing lease PV of MLP PV of GRV

37. RCJ: Chapter 12 © 2005 37 Lessor accounting: Amortization schedule for direct-financing lease $258,699.85 x 11% = = $79,189.18 - $22,881.94

38. RCJ: Chapter 12 © 2005 38 Lessor accounting: Journal entries for direct-financing lease  At inception, when the lease contract is signed: DR Gross investment in leased asset $415,695.90 CR Equipment $304,359.49 CR Unearned financing income –leases 111,336.41 DR Cash $79,139.18 CR Gross investment leased asset $79,139.18 DR Unearned financing income –leases $33,479.54 CR Financing income –leases $33,479.54  At the end of the first year (2005): DR Equipment $20,000.00 CR Gross investment in leased asset $20,000.00  At the end of the lease when the asset is returned:

39. RCJ: Chapter 12 © 2005 39 Lessor accounting: Journal entries for an operating lease  At inception, when the lease contract is signed: No Entry: Asset remains on lessor’s books  At the end of the first year (2005): DR Cash $79,139.18 CR Rental revenue $79,139.18 DR Depreciation expense $56,871.90 CR Accumulated depreciation $56,871.90  At the end of the lease when the asset is returned: No Entry

40. RCJ: Chapter 12 © 2005 40 Lessor accounting: Comparison of operating and direct-financing $79,139.18 - $56,871.90 =

41. RCJ: Chapter 12 © 2005 41 Lessor accounting: Journal entries for sales-type lease  At inception, when the lease contract is signed: DR Cash $79,139.18 CR Gross investment leased asset $79,139.18 DR Unearned financing income –leases $33,479.54 CR Financing income –leases $33,479.54  At the end of the first year (2005): DR Equipment $20,000.00 CR Gross investment in leased asset $20,000.00  At the end of the lease when the asset is returned: DR Gross investment in leased asset $415,695.90 DR Cost of goods sold 240,000.00 CR Sales revenue $304,359.49 CR Unearned financing income –leases 111,336.41 CR Inventory 240,000.00 Manufacturer’s profit recognized at inception

42. RCJ: Chapter 12 © 2005 42 Lessor accounting: Sales-type lease with executory costs  Suppose Lessor Company also promises to provide maintenance services on the leased asset for an additional annual fee of $2,000.  The “gross investment” calculation is now:  The following entry is made at year-end 2005 when the first payment is received: DR Cash $81,139.18 CR Gross investment in leased asset $79,139.18 CR Maintenance revenue 20,000.00 DR Unearned financing income –leases $33,479.54 CR Financing income –leases $33,479.54

43. RCJ: Chapter 12 © 2005 43 Additional leasing aspects: Sale and leaseback  First Company gets a $1 million cash infusion and can treat the entire annual rental ($120,000) as a deductible expense for tax purposes.  The same SFAS No. 13 criteria are used to determine if the lease qualifies for capital or operating lease treatment. Second Company First Company “Sale” transaction transfers title to asset “Lease back” allows use to be retained

44. RCJ: Chapter 12 © 2005 44 Additional leasing aspects: Sale and leaseback (continued)  However, First Company’s “gain” cannot be recognized immediately.  If it qualifies as a capital lease, First Company would make the following entries at inception: $200,000 deferred gain Amortized using the some rate and life used for leased asset Capital lease $200,000 deferred gain Amortized in proportion to rental payments Operating lease DR Cash (or receivable) $1,000,000 CR Plant and equipment $800,000 CR Deferred gain 200,000 DR Leased asset –capital leases $1,000,000 CR Obligation under capital leases $1,000,000

45. RCJ: Chapter 12 © 2005 45 Additional leasing aspects: Leveraged lease  Lessor borrows money from a third-party. This non-recourse loan provides the “leverage.”  Lessor then buys an asset and leases it.  A leveraged lease does not affect the lessee’s accounting.  The lessor must use the “direct- financing” approach and special details apply (SFAS No. 13). LessorBank Lessee Non-recourse financing Standard lease contract 1 2

46. RCJ: Chapter 12 © 2005 46 Additional leasing aspects: Tax accounting  U.S. income tax laws also distinguish between operating leases and capital leases.  However, the tax criteria are not the same as SFAS No. 13.  Firms often favor one treatment for tax purposes and another treatment for financial reporting purposes: OperatingCapital Operating Financial reportingIncome tax Lessee Lessor Accelerates expense recognition Delays revenue recognition

47. RCJ: Chapter 12 © 2005 47 Additional leasing aspects: Lessors’ disclosures

48. RCJ: Chapter 12 © 2005 48 Additional leasing aspects: Lessors’ disclosures (concluded) Expected cash flow

49. RCJ: Chapter 12 © 2005 49 Summary  The treatment of leases in SFAS No. 13 represents a compromise between the “unperformed contracts” and “property-rights” approaches.  SFAS No. 13 adopts a middle-of-the-road approach and specifies precise intermediate circumstances under which leases are capitalized.  Several of the lease capitalization criteria are arbitrary, which allows lease contracts to be structured in ways that avoid required capitalization.  Because the proportion of operating lease payments to capital lease payments can vary greatly between firms in the same industry, analysts must often constructively capitalize operating leases to make valid comparisons.

50. RCJ: Chapter 12 © 2005 50 Summary concluded  The FASB has issued 10 statements on leases subsequent to SFAS No. 13 and numerous interpretations of the original statement in an effort to close the loopholes for keeping leases off the balance sheet.  New loopholes are likely to be discovered and invented.  When lessors use the capital lease approach, income recognition is accelerated and financial statement ratios are improved. It is not surprising that capital leases appear frequently on lessor’s financial statements.

51. RCJ: Chapter 12 © 2005 51 Appendix: Constructive capitalization  Some companies structure lease contracts to evade capital lease criteria, thereby keeping most of their leases off the balance sheet.  Other companies have a large proportion of capital leases.  The most straightforward method for making balance sheet data comparable is to treat all leases as if they were capital leases. This is called constructive capitalization. $ Firm 1 $$ Firm 2 $ Operating leases Capital leases

52. RCJ: Chapter 12 © 2005 52 Appendix: Operating lease footnote  To estimate the balance sheet liability that would have been recorded under the capital lease approach, we need to calculate the present value of the MLP.

53. RCJ: Chapter 12 © 2005 53  Two alternatives for determining the discount rate can be used: The weighted-average discount rate implicit in capital leases. The weighted-average discount rate on long-term debt.  Here’s how to find the discount rate implicit in capital leases:  A similar approach is used to find the discount rate on long-term debt Appendix: Determining the discount rate

54. RCJ: Chapter 12 © 2005 54 Appendix: Estimating payments beyond five years Panel at bottom Page 664

55. RCJ: Chapter 12 © 2005 55 Appendix: Lease asset & liability (payments at year-end)

56. RCJ: Chapter 12 © 2005 56 Appendix: Lease asset & liability (payments at start of year)

57. RCJ: Chapter 12 © 2005 57 Appendix: Albertson’s capitalized leased asset  A footnote reveals that:  Applying this same proportion to the company’s operating leases yields: $257 million $321 million Net capital lease assets Net capital lease obligations $257 $321 ≈80% $1,536 million $1,920 million Capitalized operating lease asset Capitalized operating lease obligation 80%

58. RCJ: Chapter 12 © 2005 58 Appendix: Financial statement impact

59. RCJ: Chapter 12 © 2005 59 Appendix: Financial ratio impact