Chapter 15 239 CHAPTER 15 QUESTIONS The principal advantages to a lessee in leasing rather than purchasing property are as follows: (a) Frequently, no down payment is required to attain access to property when it is leased This frees company capital to be used for purposes such as expanding production, reducing long-term debt, or providing for future pension benefits value at the end of the lease term than expected when the lease was negotiated (b) A lease avoids the risks of ownership when a company has many uncertainties as to the length of benefit from various assets If a company purchases assets, any obsolescence or reduction in usefulness of the asset would result in a loss A lease leaves these risks of ownership with the lessor rather than shifting them to the lessee (c) Leases give the lessee flexibility to get a different asset if market conditions or technological changes require it The principal advantages to a lessor in leasing property rather than selling it are as follows: (a) Lease contracts provide another alternative to those businesses needing property for customers to acquire their services This can increase the volume of sales and thus improve the operating position of the manufacturer (b) Because a lease arrangement results in an ongoing business relationship, there may be other business dealings that could develop between the lessee and lessor (c) The lease arrangement may be negotiated so that any residual value remains with the lessor Although expected residual values are usually considered in arriving at the financial terms of a lease, these estimates usually are conservative Thus, lessors may benefit from a higher residual 239 240 Chapter 15 A capital lease is accounted for as if the lease agreement transfers ownership of the asset from the lessor to the lessee Capital leases are generally long term, covering most of the economic life of the leased asset, and the lease payments are large enough that they effectively pay for the asset by the end of the lease term An operating lease, on the other hand, is accounted for as rental agreement, with no transfer of effective ownership associated with the lease (a) Title transfer The lease transfers ownership of the property to the lessee by the end of the lease term (b) Bargain purchase option The lease contains a bargain purchase option (c) Economic life The lease term is equal to 75% or more of the estimated economic life of the leased property (d) Investment recovery The present value of the minimum lease payments, excluding the portion that represents executory costs to be paid by the lessor, equals or exceeds 90% of the fair market value of the leased property Leases frequently give the lessee the option to purchase the leased asset at some future date If the price specified in the purchase option is so low that it is almost certain that the lessee will end up buying the leased asset, the option is called a bargain purchase option Because leases with bargain purchase options are likely to lead to transfer of ownership from the lessor to the lessee, they are accounted for as capital leases The two additional criteria for lessors are as follows: (a) Collectibility Collectibility of the minimum lease payments required from the lessee is reasonably predictable (b) Substantial completion No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease When a greater-than-normal credit risk is involved and the collectibility of lease payments is questionable, the lease would be accounted for as an operating lease Revenue would then be recognized as it is collected The second criterion has to with the question of whether or not the lessee has assumed substantially all the risks of ownership or if these have been retained by the lessor Thus, if the lessor had made some unusual guarantees concerning the performance of a leased asset, ownership essentially rests with the lessor, and the lease should be accounted for as an operating lease The lease term begins when leased property is transferred to the lessee and extends to the end of period for which the lessee is expected to use the property, including any periods covered by bargain renewal options If a bargain purchase option is included in the lease agreement, the term ends on the date this option is available (a) A lessee will use the lower of its incremental borrowing rate and the implicit rate in the lease agreement (if known by the lessee) If the rate used results in a capitalized value for the lease that is greater than the fair market value of the lease property at the beginning of the lease term, the fair market value should be used as the asset value Operating leases are viewed as simple rental contracts All rental payments are debited to expense when paid or incurred If rent is prepaid, the expense is recognized as the prepayment expires No asset or liability value is recognized on the balance sheet Capital leases are viewed as a purchase of an asset and the incurrence of a liability The present value of the future minimum (b) A lessor will use the interest rate implicit in the terms of the lease This is the rate that will discount the minimum lease payments plus any unguaranteed residual value to the fair market value of the leased asset For a lease to be properly accounted for as a capital lease by the lessee, at least one of the following criteria must be met: 240 Chapter 15 241 lease payments is recorded as an asset and a liability The asset is amortized as though it had been purchased by the lessee The liability is accounted for in the same manner as if a mortgage had been placed on the property Amortization expense and interest expense are recognized each year Periodic charges vary, however, because the 10 If rental payments are uneven, the debit to Rental Expense by the lessee should be made on a straight-line basis (i.e., total expense over the lease term should be allocated equally to each period) unless another systematic and rational basis better shows the time pattern in which use benefit is derived from the leased asset 11 The amount to be recorded as an asset and a liability for capital leases on the books of the lessee should be the present value of future minimum lease payments, including total rental payments and any bargain purchase option or other guarantee of the residual value made by the lessee Executory costs would be excluded from the minimum rental payments If the fair market value of the leased asset is less than the present value, the lower value is recorded 12 The asset balance is amortized over the lease term according to the lessee’s normal depreciation policy for similar owned assets The liability balance is reduced as payments are made after recognizing the accrual of interest expense on the liability balance Only if the depreciation method and the interest computation produced the same reduction would the asset and liability balances remain the same 13 The time period used for amortization of a capitalized lease depends on which criterion was used to qualify the lease as a capital lease If the lease qualified under the transfer of ownership or bargain purchase option criteria, the asset life should be used for amortizing the capitalized value If the lease qualified under the economic life or 90% of fair value criteria, the lease term should be used for amortizing the capitalized value 14 Total charges over the term of a lease are the same whether the lease is accounted for as an operating or a capital lease 241 operating lease usually provides for a constant expense each period, while the capital lease method charge varies according to the following: (a) The amortization method used to write off the cost of the leased assets, and Direct financing leases involve a lessor who primarily is engaged in financial activities, such as a bank or finance company The lessor views the lease as an investment, and the revenue generated by this type of lease is interest revenue 17 The present value of the unguaranteed residual value is deducted from both Sales and Cost of Goods Sold because the leased asset reverts to the lessor at the end of the lease term, and the residual value amount represents the portion that was not “sold.” (b) The particular lease period involved A greater charge for interest expense is recognized in the earlier periods, and there is either a greater charge for amortization in the early years or a constant amount over all years Therefore, it is more likely that the capital lease method will produce a lower net income than the operating lease method in the early years of the lease, with the reverse being true in the later years of the lease 18 Minimum lease payments include the rental payments over the lease term plus any amount to be paid for the residual value through either a bargain purchase option or a guarantee of the residual value If the lessee is making all of these payments, the minimum lease payments for the lessee and lessor will be the same However, if the guarantee of residual value is made by a third party, the guarantee will be included in the minimum lease payments of the lessor but not of the lessee This condition could result in the lease qualifying as a capital lease to the lessor under the 90% of market value criterion but failing to qualify under this criterion for the lessee 15 (a) The interest portion of the lease payments is recorded as an expense and is included in the computation of net income The principal portion of the lease payments is recorded as a financing cash outflow The amortization of the leased asset is added back to net income under the indirect method (b) The immediate cash outflow from a purchase would be reported as an investing outflow of cash The payments on the note would be handled exactly as the lease: the interest portion included in the computation of net income and the principal portion as a financing cash outflow 19 The lessor treats a lease as an investing or an operating activity If it is a direct financing lease, the lessor is using the lease as a way of investing its resources and earning a return on its investment If it is a sales-type lease, the lessor is using the lease as an alternative way of selling merchandise On the other hand, the lessee is using the lease as an alternative way of financing a purchase of an asset Principal payments made on the lease by the lessee are thus financing cash outflows 16 If a lease meets the classification criteria for a capital lease, the lessor records it as either a sales-type lease or a direct financing lease Sales-type leases involve manufacturers or dealers who use leases as a means of facilitating the marketing of their products There are two types of revenue generated by this type of lease These are as follows: (a) An immediate profit or loss, which is the difference between the cost of the property being leased and its sales price, or fair value, at the inception of the lease, and 20 Lessees are required to disclose information as to asset and liability accounts as follows: (a) The gross amount of assets recorded as capital leases and related accumulated amortization (b) Future minimum lease payments at the date of the latest balance sheet, both in the aggregate and for each of the five succeeding fiscal years These (b) The interest revenue to compensate for the deferred payment provisions 242 Chapter 15 243 payments should be separated between operating and capital leases For capital leases, executory costs should be excluded (b) Unguaranteed residual values accruing to the benefit of the lessor (c) Rental expense for each period for which an income statement is presented Additional information concerning minimum rentals, contingent rentals, and sublease rentals is required for the same periods (d) For direct financing leases only, initial direct costs (d) A general description of the lease contracts, including information about restrictions on such items as dividends, additional debt, and further leasing (e) For capital leases, the amount of imputed interest necessary to reduce the lease payments to present value 21 The following components of the net investment in sales-type and direct financing leases are required disclosures by lessors as of the date of each balance sheet presented: (a) Future minimum lease payments receivable with separate deductions for amounts representing executory costs and the accumulated allowance for uncollectible minimum lease payments receivable (c) Unearned revenue 22 The lease classification standard in IFRS 17 is that a lease should be accounted for as a capital lease if it transfers substantially all of the risk and rewards of ownership This broad standard differs significantly from the four specific lease classification criteria contained in Statement No 13 23 The international proposal suggests that the lease accounting rules be simplified as follows: All lease contracts for longer than one year are to be accounted for as capital leases Individual national standard setters (including the FASB) have circulated this proposal in their countries 24 ‡ The FASB has recommended that if the initial sale results in a profit, it should be deferred and amortized in proportion to the amortization of the leased asset if it is a sales-type or direct financing lease or in proportion to the rental payments if it is an operating lease If the transaction produces a loss because the fair market value of the asset is less than its undepreciated cost, an immediate loss should be recognized ‡ Relates to Expanded Material 244 Chapter 15 Note: For all PRACTICE EXERCISES involving lessor journal entries, the solutions illustrate both the gross and the net presentations of lease payments receivable For the Exercises and the Problems, only the net presentation (as shown in the textbook chapter) are illustrated PRACTICE EXERCISES PRACTICE 15–1 PRESENT VALUE OF MINIMUM PAYMENTS Business calculator keystrokes: N = years × 12 = 24 I = 12/12 = 1.0 PMT = $1,000 FV = $10,000 (guaranteed residual value at the end of 24 months) PV = $29,119 PRACTICE 15–2 COMPUTATION OF PAYMENTS Business calculator keystrokes: PV = –$50,000 (think of this as the outflow by the lessor; the value of this outflow must be equaled by the value of the inflows from the monthly payments and the guaranteed residual value) N = 48 months I = 12/12 = 1.0 FV = $8,000 (guaranteed residual value at the end of 48 months) PMT = $1,186 PRACTICE 15–3 COMPUTATION OF IMPLICIT INTEREST RATE Business calculator keystrokes: PV = –$35,000 (enter as a negative number) PMT = $1,000 FV = $10,000 N= years × 12 = 60 I = ???; the solution is 2.29% per month, or 27.48% (2.29% × 12) compounded monthly PRACTICE 15–4 INCREMENTAL BORROWING RATE AND IMPLICIT INTEREST RATE Business calculator keystrokes: N = years × 12 = 36 I = 10/12 = 0.8333 PMT = $5,000 FV = $20,000 (guaranteed residual value at the end of 36 months) PV = $169,791 Business calculator keystrokes: N = years × 12 = 36 I = 12/12 = 1.0 PMT = $5,000 FV = $20,000 (guaranteed residual value at the end of 36 months) PV = $164,516 PRACTICE 15–5 LEASE CRITERIA Chapter 15 245 Lease criteria: a Ownership does not transfer at the end of the lease term b No bargain purchase option c Lease term is less than 75% of asset life: 10 years/15 years < 75% d PV payments > 90% of fair value; PMT$35,000, I = 9%, n = 10 → $224,618 $224,618/$246,000 = 91.3% Satisfies criterion 4, so should be accounted for as a capital lease PRACTICE 15–6 JOURNAL ENTRIES FOR AN OPERATING LEASELESSEE Lease-signing date No journal entry on the lease signing date to recognize the leased asset and the lease liability for an operating lease Rent Expense Cash PRACTICE 15–7 3,000 3,000 OPERATING LEASE WITH VARYING PAYMENTSLESSEE Year Rent Expense Rent Payable Cash 30,000 20,000 10,000 Rent Expense = ($10,000 + $40,000 + $40,000)/3 years = $30,000 per year Year Year Rent Expense Rent Payable Cash 30,000 10,000 Rent Expense Rent Payable Cash 30,000 10,000 40,000 40,000 246 Chapter 15 PRACTICE 15–8 JOURNAL ENTRIES FOR A CAPITAL LEASELESSEE Business calculator keystrokes: N = 10 years I = 10 PMT = $3,000 FV = $0 (no guaranteed residual value) PV = $18,434 Leased Asset Lease Liability 18,434 18,434 Lease Liability Interest Expense ($18,434 × 0.10) Cash 1,157 1,843 Amortization Expense ($18,434/12 years) Accumulated Amortization on Leased Asset 1,536 PRACTICE 15–9 3,000 1,536 ACCOUNTING FOR A BARGAIN PURCHASE OPTIONLESSEE Business calculator keystrokes: N = years I = 11 PMT = $12,000 FV = $5,000 (bargain purchase option amount) PV = $47,318 Leased Asset Lease Liability 47,318 47,318 Lease Liability Interest Expense ($47,318 × 0.11) Cash 6,795 5,205 Amortization Expense ($47,318/8 years) Accumulated Amortization on Leased Asset 5,915 12,000 5,915 PRACTICE 15–10 PURCHASING A LEASED ASSET DURING THE LEASE TERMLESSEE Machinery Lease Liability Accumulated Amortization Leased Asset Cash 335,000 325,000 200,000 500,000 360,000 Chapter 15 247 PRACTICE 15–11 LEASES ON A STATEMENT OF CASH FLOWSLESSEE Operating activities: Net income Adjustments: none $10,000 Cash from operating activities $ 10,000 Investing activities: None $ Financing activities: None $ Net change in cash $ 10,000 Operating activities: Net income Add: Amortization $ 9,621 1,536 Cash from operating activities $11,157 Investing activities: None $ Financing activities: Repayment of lease liability $ (1,157) Net change in cash $10,000 Supplemental disclosure of significant noncash transaction: A capital lease in the amount of $18,434 was signed during the year PRACTICE 15–12 JOURNAL ENTRIES FOR AN OPERATING LEASELESSOR Purchase of equipment Leased Equipment Cash 10,000 10,000 Lease signing and receipt of first lease payment With an operating lease, no journal entry is made on the lease signing date on the lessor’s books except to record the receipt of cash Receipt of first lease payment Cash 2,600 Lease Revenue 2,600 Depreciation of leased equipment Depreciation Expense on Leased Equipment 2,000 Accumulated Depreciation on Leased Equipment 2,000 Depreciation Expense: $10,000/5 years = $2,000 PRACTICE 15–13 JOURNAL ENTRIES FOR A DIRECT FINANCING LEASELESSOR Lease signing 248 Chapter 15 Lease Payments Receivable Equipment Purchased for Lease 10,000 Lease Payments Receivable (5 × $2,600) Unearned Interest Revenue Equipment Purchased for Lease 13,000 10,000 or 3,000 10,000 Receipt of first lease payment on January Cash 2,600 Lease Payments Receivable 2,600 Recognition of interest revenue Lease Payments Receivable Interest Revenue 1,110 1,110 or, if Lease Payments Receivable are recorded at their gross amount: Unearned Interest Revenue 1,110 Interest Revenue 1,110 Interest Revenue: [($13,000 – $2,600) – $3,000] × 0.15 = $1,110 PRACTICE 15–14 DIRECT FINANCING LEASE WITH A RESIDUAL VALUE Lease signing Lease Payments Receivable Equipment Purchased for Lease or 50,000 Lease Payments Receivable [(10 × $7,800) + $1,987] 79,987 Unearned Interest Revenue 29,987 Equipment Purchased for Lease 50,000 Receipt of first lease payment on January Cash 7,800 Lease Payments Receivable 50,000 7,800 Recognition of interest revenue Lease Payments Receivable Interest Revenue 5,064 or, if Lease Payments Receivable are recorded at their gross amount: Unearned Interest Revenue 5,064 Interest Revenue Interest Revenue: [($79,987 – $7,800) – $29,987] × 0.12 = $5,064 5,064 5,064 Chapter 15 303 304 Chapter 15 $25,020 ($695 per month × 36 months) − $15,348 (expected value reduction, $46,000 − $30,652) = $9,672 in profit spread over years Loss on residual: $30,652 − $25,000 = $5,652, recognized all in the third year The financing aspect may yield only 3.7% However, if leasing is a way to move a vehicle out the door, and the spread between dealer cost and retail price is large enough (the Business Week article says the difference between sales price and cost of goods sold is $10,000 per vehicle), then maybe it is better to take the low return on the leasing aspect just to be able to get some of the profit stemming from the large markup Discussion Case 15–69 Apart from human beings, there are no restrictions as to what can and cannot be leased As long as a lease agreement meets one of the four general lease classification criteria outlined in the text, the lease is capitalized, whether it is a lease of animal, vegetable, or mineral By the way, can human beings be leased? In essence, many of the temporary personnel services firms that exist today lease employees to other firms Hunterstown's expected useful life will vary depending on the use for which the horse is leased It is reasonable to expect that as a racehorse, Hunterstown's useful life is shorter than as a stud The initial terms of the lease called for a lease term of years This time period generally does not exceed 75% of a stallion's useful life as a stud However, years is longer than most thoroughbreds race Thus, in terms of the economic useful life lease criterion, the use of the animal would affect how the lease would be classified If the horse were initially leased for breeding purposes, the economic life criteria would, in all likelihood, not be met, and the lease would be treated as an operating lease (assuming none of the other lease criteria were satisfied) After the lease is renegotiated and the horse is being used for racing, the lease could be classified as a capital lease Discussion Case 15–70 ‡ This case requires students to consider the economic reality of a transaction over its legal form The FASB has addressed the issue of sale-leaseback transactions and determined that the sale-leaseback is, in effect, one complex transaction rather than two separate transactions While Mr Carson argues that the profit on the transaction should be recognized immediately, the FASB reasons that the earnings process will be completed over the life of the lease and has determined that profits should be recognized over the lease term ‡ Relates to Expanded Material Chapter 15 305 SOLUTIONS TO STOP & THINK Stop & Think (p 927): How exactly does using a higher incremental borrowing rate reduce the likelihood that a lessee will be required to account for a lease as a capital lease? The use of a higher discount rate results in a lower computed present value A lower present value reduces the probability that a lease will satisfy the 90% of market value criterion and thus reduces the likelihood that the lease will be classified as a capital lease Stop & Think (p 953): Why would a company sell an asset and then turn right around and lease that same asset back? One reason for a firm to a sale-leaseback is to remove an asset (and the associated payment obligation) from the balance sheet A carefully constructed sale-leaseback deal results in the lease being classified as an operating lease—with the leased asset and the lease liability disclosed only in the financial statement notes Another reason to a sale-leaseback is to put the property in the hands of a professional property management firm, allowing the company to concentrate on its core business For example, imagine a large engineering consulting firm with an office building located on a prime piece of land in a large city What does an engineering consulting firm know about maximizing the use of the property? Nothing But it needs the office building So, the firm sells the building and property to a property management firm and then leases them back The engineering consulting firm is now concentrating on what it does best—engineering—and the property is being managed by a firm of professionals 306 Chapter 15 SOLUTIONS TO STOP & RESEARCH Stop & Research (p 937): Wal-Mart is a lessee under both operating and capital lease arrangements Access a copy of Wal-Mart’s most recent set of financial statements and determine (1) the dollar amount of new capital leases signed during the year (see the supplemental disclosure for the statement of cash flows) and (2) what fraction of Wal-Mart’s leases are capital leases In its January 31, 2002, financial statements, Wal-Mart disclosed at the bottom of its statement of cash flows that it had made capital lease obligations with a present value of $225 million during the most recent year Wal-Mart included the following in the notes to its January 31, 2002, financial statements: The Company and certain of its subsidiaries have long-term leases for stores and equipment Rentals (including, for certain leases, amounts applicable to taxes, insurance, maintenance, other operating expenses and contingent rentals) under all operating leases were $1,043 million, $893 million, and $762 million in 2002, 2001, and 2000, respectively Aggregate minimum annual rentals at January 31, 2002, under noncancelable leases are as follows (in millions): Fiscal year Operating leases Capital leases 2003 $ 623 $ 425 2004 602 424 2005 586 423 2006 565 419 2007 547 409 5,131 3,414 $8,054 5,514 Thereafter Total minimum rentals Less estimated executory costs 63 Net minimum lease payments 5,451 Less imputed interest at rates ranging from 6.1% to 14.0% 2,258 Present value of minimum lease payments $3,193 Using the total minimum rentals to represent the relative amounts of capital and operating leases, Wal-Mart’s capital leases comprise 40.6% [$5,514/($5,514 + $8,054)] of its total leases This is a much higher proportion of capital leases than one sees with most companies Chapter 15 307 Stop & Research (p 952): Access the IASB’s Web site (http:// www.iasb.org.uk) and determine whether the IASB is currently moving forward on this “new approach” to lease accounting As of June 27, 2002, the IASB reported the following with respect to lease accounting: “The IASB has embarked on active research, often in collaboration with others, on the following topics [including lease accounting], with the intention that, when preparatory work is concluded, they should be moved to the IASB's main agenda Leasing is a global business, and differences in accounting standards can lead to considerable noncomparability This project would seek to improve the accounting for leases by developing an approach that is more consistent with the conceptual framework definitions of assets and liabilities The project would result in an amendment or replacement of IFRS 17, Leases.” 308 Chapter 15 SOLUTION TO NET WORK EXERCISE Net Work Exercise (p 921): According to the “Leasing Library” at http:// www.leasesource.com, at the end of your lease, you may one of five things: • Return the vehicle to its rightful owner (the lessor) closed-end lease; • Trade your leased vehicle in on a new one In the unlikely event that there is "equity" in the vehicle (in other words, the vehicle is worth more than what you would have to pay the leasing company to buy it), you can economically acquire your leased vehicle and trade it in on a new one Typically, this will not be the case because leases are designed to yield zero equity at lease end Depending on the state, the economics of doing this may be jeopardized by an aggressive sales tax scheme; • Purchase the vehicle outright from the lessor, usually for an amount equal to the residual value stated in your lease agreement plus any purchase option and administrative fees; • Extend the lease for some limited period, usually at the same monthly rate; or • Re-lease the vehicle under a new agreement (basically, a used car lease) This is called a "walkaway" on a Depreciation, on average, represents the largest component of your lease payment The second largest component is called the lease charge or rent charge This is the cost of money, which is akin to interest on a loan balance Chapter 15 309 SOLUTIONS TO BOXED ITEMS Impact of Operating Leases (pp 936–937) As the given examples illustrate, the capitalization of leased assets can significantly affect the information contained in a firm's financial statements If investors and creditors are unable to use the information contained in the financial statement notes to assess a firm's actual risk, they may make suboptimal resource allocation decisions The real answer to this question goes back to the fundamental “recognition versus disclosure” question Do investors and creditors get the same information from note disclosure about operating leases as they would get if those leases were recognized in the balance sheet? With firms being able to avoid disclosing an obligation that requires the "probable future sacrifice of economic benefit," it would appear that the FASB has not had a great deal of success However, companies provide increased note disclosure relating to their lease commitments as a result of the FASB's efforts with this standard One option would be for the FASB to become like the IRS and provide detailed rules for applying every standard This would require increased effort (and costs) on the part of companies in interpreting and applying the standards If the FASB had the power to enforce compliance, it could get a company's attention by levying fines for noncompliance Finally, the FASB can continue its present course of doing its best to provide guidelines for applying standards and trusting that companies will abide by the intent of those standards One solution to the lease problem that has been proposed by some is to require the capitalization of all leases that extend beyond a specific time period (perhaps as short as one year) This would have the effect of requiring financial statement disclosure for all assets for which the company has acquired a property right and incurred an obligation Synthetic Leases (pp 946–947) If the building increases in value to $200,000 by the end of the 5-year lease term, then LesseeUser will exercise its option to buy the building for $100,000 Thus, Lessee-User benefits if the value of the building increases during the lease term If the value of the building decreases to $10,000 by the end of the 5-year lease term, then both Private Investor and Lessee-User lose The balance on the loan at the end of years will still be $97,000 because the lease payments of $10,000 each year were used to pay only interest of $9,700 ($97,000 × 0.10) each year, with the remaining $300 going to Private Investor At the end of the lease term, the only asset that Lessor-SPE has to repay the $97,000 loan balance is the building If the building is worth only $10,000, Lessor-SPE is bankrupt and Private Investor loses his or her $3,000 investment However, because Lessee-User guaranteed the loan, Lessee-User also loses because the company must repay the remaining $87,000 ($97,000 loan balance − $10,000 proceeds from the sale of the building) from its own pocket Private Investor will never earn more than a 10% return Private Investor receives $300 each year, which is a 10% return on investment If the building increases in value, then Lessee-User will exercise its option to buy the building for $100,000 This $100,000 will be used to repay the $97,000 loan balance, and Private Investor will be left with his or her original $3,000 If the building decreases in value, Private Investor loses the $3,000 So, even though Private Investor legally “owns” the building, there is no chance that Private Investor will benefit from this ownership Economically, Lessee-User owns the building Lessee-User benefits the most if the building goes up in value and loses the most if the building decreases in value Thus, Lessee-User has economic ownership of the building and is on the hook for the $97,000 loan that financed the acquisition of the building However, the synthetic lease accounting treatment allows Lessee-User to keep both the asset and the liability off its balance sheet This is deceptive accounting 310 Chapter 15 If Private Investor is related to Lessee-User in any way, then the accounting for the synthetic lease transaction is even more deceptive The only saving grace of the original arrangement is that a truly independent Private Investor would not agree to lease terms giving all of the ownership benefits to Lessee-User without getting something of value in exchange If Private Investor is affiliated with Lessee-User, even this market reasonableness test is invalid For this reason, the disclosure of related-party transactions is extremely important A Growing Trend Toward Sale-Leasebacks (pp 954–955) By selling its PP&E, a company is able to focus its efforts on managing its business rather than dealing with property management issues In addition, the cash generated from the sale can be used to expand available business opportunities If the company uses the proceeds from the sale inefficiently, then the company will find itself out of a long-term asset with little or nothing to show for it Also, the company is typically obligating itself to significant future payments associated with the leased asset Even if these obligations are not reflected on the balance sheet, the cash outflows show up on the statement of cash flows Chapter 15 311 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 15–1 (The Walt Disney Company) With the leasing and subleasing, the Disneyland Paris theme park assets will be used by Euro Disney According to the note, as of September 30, 2001, the $801 million receivable by Disney SNC from Euro Disney under the sublease agreement is approximately equal to the amounts that Disney SNC is obligated to pay the owner of the theme park assets Accordingly, from Disney SNC’s standpoint, the net cash flow from this lease-sublease deal will be approximately $0 It does not appear that the lease between the asset owner and Disney SNC includes a bargain purchase option Evidence for this is seen in the fact that, at the end of the 12-year lease term, Disney SNC can sell the theme park assets but must use the proceeds to repay 75% of the owner’s outstanding debt related to the assets The amount of the outstanding debt at that time is estimated to be $1.1 billion Euro Disney didn’t just lease the theme park assets directly from the owner because Euro Disney was viewed as a bad credit risk Euro Disney’s losses for the period 1993–1995 totaled over $1.4 billion (excluding the cumulative effect of an accounting change) By including Disney SNC in the middle of the lease deal, the lessor of the theme park assets is more certain of being able to collect the full amount of the lease payments Deciphering 15–2 (Safeway) Yes, Safeway has some leases that include bargain renewal options In the first paragraph of its note, we read: “Most leases have renewal options, some with reduced rental rates during the option periods.” However, the existence of a bargain renewal option does not mean that a lease should be accounted for as a capital lease Bargain renewal options only impact the specification of the length of the lease term Recorded historical cost $520.4 million ÷ 2001 amortization expense $ 38 million per year = Average useful life 13.4 years This answer is only an approximation of the exact solution because some capital leases expired during the year, and new capital leases were signed, causing amortization expense for the year to be computed on a base different from the beginning balance of the leased asset historical cost Safeway’s additional lease payments above the minimum amounts are only a small fraction of total operating lease payments Computations for the years 1999–2001 show that contingent rentals are less than 10% as large as the minimum rental amounts: (in millions) Contingent rentals ÷ Minimum rentals = % of contingent rentals relative to minimum rentals 2001 $ 16.5 $369 2000 $ 16.7 $323 1999 $ 18.6 $280 4.5% 5.2% 6.6% a Technique 1: Same ratio between present value and total gross amount of future minimum lease payments that holds for the capital leases also holds for the operating leases ($520.4 million/$1,024.0 million) × $4,847.5 million = $2,463.5 million b Technique 2: Minimum operating lease payment stream can be approximated by a $360 million per year annuity for 13 years with a 10% discount rate Present value = $360 million × (PVAF13 | 10%) = $360 million × (7.1034) = $2,557.2 million 312 Chapter 15 or with a Business Calculator: First toggle so that the payments are assumed to occur at the end (END) of the period PMT=$360; N=13; I=10% → PV = $2,557.2 Taken together, these two estimates suggest that the present value of Safeway’s future minimum payments under operating leases is about $2,500 million, much greater than the $520 million present value of the capital lease obligation Deciphering 15–3 (International Lease Finance Corporation of California) The amount of minimum future lease payments to be received as of the end of 2001 was $205.011 million This represented an increase of $40.240 million ($205.011 – $164.771) over 2000 In addition, lease payments of around $11 million were probably received in 2001, judging from the amount expected to be received in 2002 Thus, the total amount of new lease business generated in 2001 looks to be about $51 million Estimated residual values of leased flight equipment Total lease payments to be received Ratio 2001 $49,045 $205,011 23.9% 2000 $34,214 $164,771 20.8% It appears that International Lease Finance assumed a relatively higher residual value for its leased flight equipment at the end of 2001 compared to the end of 2000 The stream of future minimum lease payments can be approximated with an annuity of $15 million per year for between 13 and 14 years An additional amount of $49 million will be received at the end of each lease term in the form of the residual value Because this residual value amount will be received bit by bit each year as individual lease terms end, it is assumed to be an annuity of $3.75 million per year for 13 or 14 years The present value of this stream of payments is $142.013 million Two estimates of the interest rate are generated as follows: Assume 13 years: PMT = ($15 + $3.75); N = 13; PV = $142.013 → I = 8.78% Assume 14 years: PMT = ($15 + $3.75); N = 14; PV = $142.013 → I = 9.49% The interest rate appears to be somewhere around 9% Deciphering 15–4 (FedEx) Two methods can be used to estimate the present value of the operating lease payments a ($200.259/$362.788) × $14,403.256 = $7,951 million in leased assets (and lease liability) b Payments of $1,000 million per year for 14 years5 years detailed plus another in the “Thereafter” amount With various discount rate assumptions, the estimate is as follows: Percent 8% 10 12 Present Value $8,244 7,367 6,628 Chapter 15 313 The $7,951 million estimate is used in the ratio calculations Debt ratio $6,742/$11,527 = 58.5% Debt ratio assuming that FedEx’s operating leases are accounted for as capital leases ($6,742 + $7,951)/($11,527 + $7,951) = 75.4% Asset turnover $18,257/$11,527 = 1.58 Asset turnover assuming that FedEx’s operating leases are accounted for as capital leases $18,257/($11,527 + $7,951) = 0.94 Deciphering 15–5 (McDonald’s Corporation) The additional rentals (based on sales above a specified amount) paid by McDonald’s franchisees are significant in amount compared to the minimum rentals As shown by the following figures, the percentage rentals are as much as 1.5 times the value of the minimum rentals (In millions of dollars) Percent rent and service fees ÷ Minimum rents = Ratio of percentage rents to minimum rentals 2001 $2,290.2 $1,477.9 2000 $2,247.0 $1,465.3 1999 $2,208.8 $1,473.8 1.55 1.53 1.50 As shown below, total revenues from franchised restaurants are always at least twice as much as the minimum rents (In millions of dollars) 2001 2000 1999 Total revenues from franchised and affiliate restaurants $3,829.3 $3,776.0 $3,746.8 ÷ Minimum rents $1,477.9 $1,465.3 $1,473.8 = Ratio of total franchise revenue to minimum rentals 2.59 2.58 2.54 Using the ratio for 2001 (2.59), the forecast of 2002 total franchise revenue is $4,289.6 million, computed as follows: 2002 minimum amount $1,656.2 million × 2.59 = $4,289.6 million 314 Chapter 15 The future minimum rent payments due to McDonald’s in association with leased restaurant sites exceed the future minimum payments required for those restaurant operating leases as follows: (In millions of dollars) 2002 2003 2004 2005 2006 Thereafter Total Minimum Receipts $ 707.5 701.4 689.3 666.7 647.2 5,771.9 $ 9,184.0 Minimum Payments $ 772.3 756.8 731.1 681.1 653.5 5,901.6 $ 9,496.4 Deficiency $ 64.8 55.4 41.8 14.4 6.3 129.7 $ 312.4 In order for McDonald’s to lose money on these leased sites, several things would have to happen First, sales in the restaurants would have to decline substantially to eliminate the additional percentage rentals discussed in (2) Remember, the minimum receipts shown in the table represent less than half of the amount McDonald’s can reasonably be expected to collect Second, sales would have to be bad enough that the franchisees would abandon their franchise and lease agreements Third, the McDonald’s reputation would have to deteriorate to the point that no new franchisees would want to take over the abandoned restaurant sites As you can see, it is very unlikely that McDonald’s will ever lose money on these lease arrangements Sample CPA Exam Questions The correct answer is b In a sale-leaseback transaction when the seller-lessee retains the right to substantially all of the remaining use of the property, SFAS No 28 requires the gain, which results from a sale to be deferred and amortized in proportion to the amortization of the leased asset The correct answer is a The minimum lease payments include the periodic amount required to be paid, excluding executory costs, along with any guaranteed residual value The present value of the minimum lease payments is calculated to determine the cost of the asset and the lease obligation Writing Assignment: All leases are sales-type leases! To: President, Clear Water Bay Company From: Accountant Subject: Proper Accounting for Leases Our current accounting practice regarding leases is in conformity with U.S GAAP In most cases, GAAP require that leases accounted for as operating leases by the lessee must also be accounted for as operating leases by the lessor Discussed below are two exceptions that allow the lessor to account for the lease as a sales-type capital lease and the lessee to account for the same lease as an operating lease • Use of different discount rates An important test to determine whether a lease must be treated as a capital lease is the 90% of fair value test The present value of the future minimum lease payments is computed and compared to the fair value of the leased asset on the lease signing date If the present value of the payments exceeds 90% of the fair value, then the lease is a capital lease A difference between lessor and lessee can arise because the lessee is not required to use the same discount rate as the lessor If the lessee cannot find out the discount rate used by the lessor in computing the lease payments, then the lessee uses its own incremental borrowing rate as the discount rate The lessee’s incremental borrowing rate is usually higher than the rate implicit in the lease A higher discount rate leads to a lower computed present value So if the lessee does not know the discount rate implicit in the lease, it is likely that the present value computed by the lessee will be lower than the present value computed by the lessor Thus, the Chapter 15 • 315 lessor can meet the 90% test and account for the lease as a capital lease, and at the same time the lessee can fail to meet the 90% test and thus account for the lease as an operating lease Third-party guarantee of residual value The present value calculation described above is done using the minimum lease payments From the lessor’s standpoint, any guaranteed residual value is considered part of the minimum lease payments and raises the computed present value However, if the lessee can purchase an insurance policy that pays the guaranteed residual value whenever necessary, the guaranteed residual value is not considered part of the minimum payments of the lessee This will result in the computed present value of minimum lease payments being lower for the lessee than for the lessor Again, the lessor can meet the 90% test at the same time the lessee fails the test In order for us to classify our leases as sales-type, capital leases at the same time our customers classify the leases as operating leases, we must the following: • Stop revealing our implicit lease discount rate and encourage our customers to use a higher value for their calculations • Ask our customers to arrange insurance policies to cover guaranteed residual values included in their lease agreements This, of course, will increase the cost of the leases to our customers and may lower the price they are willing to pay us Please let me know if you need further information on the accounting for leases Research Project: Should you buy or lease that car? In the December 17, 1999, issue of The Wall Street Journal, on page A9, an advertisement for Land Rover SUV’s was run The leasing option was described as follows: Down Monthly Payment Payment (includes first monthly payment) $3,744 $749 The lease term is 36 months However, since the down payment counts as the first payment and the rest of the monthly payments are made in advance, there are only 35 monthly payments, each occurring at the end of the month The cash price of the car was $53,210 If an interest rate of 12% compounded monthly (1% per month) is assumed, the present value of these lease payments is computed as follows: Present value = $2,995 + $749 + $749 (PVAF35 | 1%) Present value = $2,995 + $749 + $749 (29.4086) = $2,995 + $749 + $22,027 = $25,771 or with a Business Calculator: First toggle so that the payments are assumed to occur at the beginning (BEG) of the period PMT = $749; N = 36; I = 1% → PV = $22,776 $2,995 + $22,776 = $25,771 To calculate what the resale value of the car would have to be at the end of the lease term to make it financially smart to buy the car at the cash price rather than lease it, compare the present value of the cash outflows from leasing to the present value of cash outflows from buying Think of the problem this way: What cash inflow from selling the car at the end of 36 months would make the present value of leasing equal to the present value of buying? 316 Chapter 15 Present value of leasing $25,771 $25,771 Resale = $53,210 – Resale (PVF36|1% ) = $53,210 – Resale (0.6989) = ($53,210 – $25,771) ÷ 0.6989 = $39,260 Resale value must make up the remainder of the present value: $53,210 – $25,771 = $27,439 Toggle so that the payments are assumed to occur at the end (END) of the period PV = $27,439; N = 36; I = 1% → FV = $39,259 It makes more sense to buy the car if you think you can sell it for $39,260 or more after using it for three years In this case, that seems quite unlikely, so the lease makes economic sense An important assumption here is the discount rate For practice, you might redo the calculations above assuming a discount rate of 18% compounded monthly (1.5% per month) and see how that impacts the required resale value of the car The Debate: When classifying leases, just use common sense! Stricter Guidelines • The simple fact is that firms will whatever they can to keep their lease obligations off the balance sheet So, given any kind of choice, firms will go to great lengths in order to be able to classify as many leases as possible as operating leases • The only way to combat this preference is to rigidly define capital leases so that they include all leases that embody a transfer of economic ownership of an asset FASB Statement No 13 was an attempt to accomplish this objective • FASB Statement No 13 is not the end The statement has been amended and interpreted over a dozen times Further amendment is needed to fill the loopholes discovered by firms In addition, the criteria should be tightened In fact, the presumption should be that all leases are capital leases, and the only leases that can qualify for operating lease treatment are a small group that satisfy a rigid set of criteria • Only this approach can get lease obligations onto the balance sheet where they belong Accounting Judgment • Accountants and auditors can identify a capital lease when they see one With most leases, it is easy to discern that a long-term noncancelable lease effectively transfers ownership of the asset to the lessee • Current rules only provide a screen behind which firms can hide their leases Leases that everyone can identify as capital leases are carefully structured around the Statement No 13 criteria to fit, just barely, under the operating lease classification • If the rules are modified, firms will modify their lease agreements This can turn into an eternal round of rules, firm adaptation, and then more rules No matter what the rules, firms will figure out how to restructure their leases so that they can be classified as operating leases • The only answer is to put the classification entirely in the hands of the accountants and auditors If leases are classified by professional accounting judgment, then the accountants and auditors will feel all financial statement users are looking over their shoulders The accountants and auditors will know that if a firm fails and the financial statements come under suspicion, the professional judgment on lease classification will be carefully scrutinized With this classification technique, there will be no numerical criteria to hide behind Chapter 15 317 Ethical Dilemma: Using operating leases to fool the bank The first thing that should be realized is that the bank should take care of itself Leases are a very common business transaction, and the bank has no excuse for failing to anticipate that an operating lease could be used to circumvent the interest coverage ratio constraint In fact, the bank could have written the loan covenant in such a way as to prevent this very thing—instead of an interest coverage ratio, the bank could have defined the constraint in terms of a fixed charge coverage ratio [(Operating income + Lease expense)/(Interest expense + Lease expense)] So, don’t feel too sorry for the bank—it had its chance to prevent RAM from using operating leases to bypass the loan covenant On the other hand, the use of this accounting trick to get around the loan covenant could potentially harm RAM’s relationship with the bank Even though the bank could have written the covenant in such a way as to protect itself, that doesn’t mean that it won’t be upset when it finds out about the operating leases Rightly or wrongly, the bank will feel that RAM has acted in an underhanded way to circumvent the intent of the loan covenant If analysis shows that the operating leases make economic sense, go ahead and them This seems like an excellent way to avoid the costly loan renegotiation that would result from a violation of the Commercial Security Bank loan covenant At the same time, in order to preserve your relationship with the bank, you should give it advance notice of what you plan to As part of this notice, you should include the most current forecasts of your operating cash flow for the next few years, hopefully demonstrating that you will have the cash to repay the Commercial Security loan on time, even with the additional lease payment obligations Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search In Note 10 (Lease Obligations) to its 2001 financial statements, Delta reported that rental expense for operating leases totaled $1.3 billion in 2001 Delta has many more operating leases than capital leases In Note 10, Delta reports that it has 42 aircraft leased under capital lease arrangements and 313 aircraft leased under operating lease arrangements In addition, total minimum payments under capital leases are $120 million compared to $14,095 million for operating leases As of December 31, 2001, the net book value of flight and ground equipment purchased was $15,754 million Recall that the $14,095 million in future payments under operating leases is an undiscounted number Therefore, it looks like the amount of flight and ground equipment purchased substantially exceeds the amount of flight and ground equipment leased ... calculator keystrokes: PV = –$50,000 (think of this as the outflow by the lessor; the value of this outflow must be equaled by the value of the inflows from the monthly payments and the guaranteed... associated with the lease (a) Title transfer The lease transfers ownership of the property to the lessee by the end of the lease term (b) Bargain purchase option The lease contains a bargain purchase option... of the minimum lease payments, excluding the portion that represents executory costs to be paid by the lessor, equals or exceeds 90% of the fair market value of the leased property Leases frequently