Financial

Statement
Analysis
 
 
K.R. Subramanyam

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 3-2

Analyzing Financing Activities

3
CHAPTER
Leases
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Leasing – Key Points

Capital versus Operating

Buildings compared to copiers
Bank leverage ratio
 3-4

Leases

Leasing Facts
Lease – contractual agreement between a
lessor (owner) and a lessee (user or renter) that
gives the lessee the right to use an asset
owned by the lessor for the lease term.

MLP – minimum lease payments

(MLP) of the lessee to the lessor
according to the lease contract
 3-5

Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that transfer substantially all benefits
and risks of ownership—accounted for as an asset acquisition and a liability
incurrence by the lessee, and as a sale and financing transaction by the lessor
A lessee classifies and accounts for a lease as a capital lease if,
at its inception, the lease meets any of four criteria:
(i) lease transfers ownership of property to lessee by end of the lease
term
(ii) lease contains an option to purchase the property at a bargain price
(iii) lease term is 75% or more of estimated economic life of the
property
(iv) present value of rentals and other minimum lease payments at
beginning of lease term is 90% or more of the fair value of leased property
 
(2) Operating Lease Accounting For leases other than capital leases—the lessee
(lessor) accounts for the minimum lease payment as a rental expense (income)
 3-6

Leasing – Key Points

Capital leases and Operating

leases both have an interest
and a principle portion of the
payment.
 3-7

Leasing – Illustration

Leased assets have an expected life of

5 years.
Depreciation is straight line.
Annual lease payment is $2,505.
Interest rate is 8%.
 3-8

Leasing – Illustration

The total operating lease payment is

considered to be an expense.
Therefore if we consider this lease to
be an operating lease, then the annual
expense would be $2,505.
 3-9

Leasing – Illustration

If we consider the lease to be a

capital lease then we must record an
asset and a related liability associated
with the leased property.
 3-10

Leasing – Illustration

How much of the lease payment

represents interest and how much
represents principle?
How do we determine such?
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Leasing – Illustration

Step 1
We need to determine the present
value of the stream of payments.
What is the PV of $2,505 for 5 years
discounted at 8%?
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Leasing – Illustration

Step 1 continued
The PV of an annuity of 5 payment of
$1 each discounted at 8% is a factor of
3.99271.
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Leasing – Illustration

Step 1 continued
Therefore the PV of an annuity of 5
payment of $2,505 each discounted at
8% is $10,000.
($2,505 times a factor of 3.99271)
 3-14

Leasing
 3-15

Leasing – Illustration

Step 2
How much is the annual depreciation
of a $10,000 assets with an expected
life of 5 Years?
 3-16

Leasing – Illustration

Step 2
How much is the annual depreciation
of a $10,000 assets with an expected
life of 5 Years?
Answer - $2,000
 3-17

Leasing – Illustration

Step 3
What is the income statement effect
of accounting for a lease as an
operating lease compared to a capital
lease?
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Leasing
 3-19

Leasing – Illustration

Step 4
What is the balance sheet effect of
accounting for a lease as an operating
lease compared to a capital lease?
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Leases
 3-21

Leasing – Illustration

Step 5
What type of information is disclosed
in the financial statements related to
leases?
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Leasing
 3-23

Leasing – Illustration

Step 6
If a company was concerned about
having to much debt related to equity,
which of the following would reflect less
debt on the company’s books?
Operating or Capitalized leases
 3-24

Leasing – Illustration

Step 6
If a company was concerned about
having to much debt related to equity,
which of the following would reflect less
debt on the company’s books?
Answer - Operating
 3-25

Leasing – Illustration

Step 7
If we were concerned that a company
may be understanding their total debt
position by structuring leases as
operating lease instead of capital
leases what would be a “red” flag?
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Leasing – Illustration

Step 7 - Continued
If we were concerned that a company
may be understanding their total debt
position by structuring leases as
operating lease instead of capital
leases what would be a “red” flag?
Answer – Operating lease term
longer than five years
 3-27

Leasing – Illustration

Step 8
If we were concerned that a company
may be understanding their total debt
position by structuring leases as
operating lease instead of capital
leases what actions could an analyst
take?
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Leasing – Illustration

Step 8 - Continued
If we were concerned that a company
may be understanding their total debt
position by structuring leases as
operating lease instead of capital
leases what actions could an analyst
take?
Answer – Adjust financial statement
 3-29

Leasing – Illustration

Step 9
What specific steps would be taken
to convert an operating lease to a
capital lease?
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Leasing – Illustration

Step 9- A
Determine both the amount and the
number of lease payments.
The first five years are provided.
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Leasing – Illustration

Step 9 – A continued
Estimate the number of years
remaining after the first five by dividing
total remaining payments by fifth year
payment amount.
The total number is years is the total
above plus five.
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Leasing
 3-33

Leasing – Illustration

Step 9 - B
Compute the PV of the various lease
payments to determine that net present
value of the asset.
Note: This will be the amount of both
the asset to be recorded and the related
liability.
 3-34

Leasing – Illustration

Step 9 - C
To compute the net present value,
we need to know what discount rate to
use.

Determining this rate can be

challenging!
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Leasing – Implicit Interest Rate

We can determine the discount rate by:

Trial and error based on information
related to other capital leases.
Long-term debt rate.
Note - May need to adjust for changes
in market rates.
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Leasing – Illustration

Step 9 - D
The present value of the various
lease payments will be our “revised”
asset base and our related liability
base.
 3-37

Leasing – Illustration

Step 9 - E
Based on our computed lease liability
amount, we can compute an
amortization table to determine how
much of each payment will be principal
and how much will be interest.
 3-38

Leases
Converting Operating Leases to Capital Leases
Determining the Present Value of Projected Operating Lease
 3-39

Leases
Restated Financial Statements after Converting
Operating Leases to Capital Leases—Best
  Buy 2004
   
 3-40

Recasting Best Buy’s Income Statement

Operating expenses decrease by $177 million
(elimination of $454 million rent expense reported in 2004
and addition of $277 million of depreciation expense).
Interest expense increases by $193 million (to $201 million)
Net income decreases by $10 million [$16 million pretax
x (1 - .35), the assumed marginal corporate tax rate] in 2004.
Recasting Best Buy’s Balance Sheet
The balance sheet impact is more substantial
Total assets and total liabilities both increase markedly—by
$3.321billion at the end of 2004, which is the present value of
the operating lease liability.
The increase in liabilities consists of increases in both current
liabilities ($261 million) and noncurrent liabilities ($3.06 billion).
 3-41

Leasing – Illustration

What impact did the restatement of the

financial statements have on “key”
ratios?
 3-42

Leases
 3-43

Leases
Effects of Lease Accounting
Impact of Operating Lease versus Capital Lease:
• Operating lease understates liabilities—improves solvency ratios
such as debt to equity
• Operating lease understates assets—can improve return on
investment ratios
• Operating lease delays expense recognition—overstates income
in early term of the lease and understates income later in lease
term
• Operating lease understates current liabilities by ignoring current
portion of lease principal payment—inflates current ratio &
other liquidity measures
• Operating lease includes interest with lease rental (an operating
expense)—understates both operating income and interest
expense, inflates interest coverage ratios,
understates operating cash flow, & overstates
financing cash flow
 3-44

Leases
Lease Disclosure and Off-Balance-Sheet
Financing
Lease Disclosure
Lessee must disclose: (1) future MLPs separately for capital leases
and operating leases — for each of five succeeding years and the
total amount thereafter, and (2) rental expense for each period on
income statement is reported
 
Off-Balance-Sheet Financing
Off-Balance-Sheet financing is when a lessee structures a lease so
it is accounted for as an operating lease when the economic
characteristics of the lease are more in line with a capital lease—
neither the leased asset nor its corresponding liability are recorded
on the balance sheet
 3-45

Leasing – Key Points

Operating leases are simpler to

account far, but capitalizing
leases is conceptually superior.

Consider the tax advantage of the

one with the highest tax bracket.

Book and tax can be different.

 3-46

Leasing – Key Points

Implicit interest rate in operating

leases.

Capital leases - assume the

estimated asset value is equal to
the estimated liability.