MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

Baginski & Hassell

Chapter 4

Financing Decisions (Leasing)
‡ Topics
- The lease versus purchase decision - Off-balance-sheet financing - Lease classification & criteria: Operating lease versus Capital lease - Capital lease accounting - Terminology ‡ Lease term ‡ Minimum lease payments (MLP) ‡ Present value of MLP

Examples ± Two alternatives ± operating and capital lease classification ‡ Operating versus capital lease classification ‡ Statement of cash flows under the two alternatives ‡ Income statements under two alternatives ‡ Balance sheets under two alternatives ± Sale and leaseback ± Pro forma adjustments to financial statements .

. ‡ Leases classified as capital leases do not result in off balance sheet financing.The Lease Versus Purchase Decision ‡ A frequent decision made by managers is whether to purchase or lease assets. ‡ Factors that might make leasing the preferred alternative include: ± Possible to structure lease to provide off-balance-sheet financing. ‡ Leases classified as operating leases result in off-balance-sheet financing.

‡ Potential to deduct entire lease payment for tax purposes. ± In some cases. ± Ability to manage risk of obsolescence. ‡ Use of short term leases shifts risk of obsolescence to lessor. . possible to secure 100% financing via leasing ‡ Banks frequently will not finance 100% of a purchase price but lessors frequently will finance 100%.± Potential tax advantages.

Off-Balance-Sheet Financing A party incurs a financial obligation. but GAAP does not define nor require the obligation to be recognized in the Balance Sheet as a liability. it is an operating lease deal! .

‡ Using off-balance-sheet financing makes financial ratios. particularly the debt to equity ratio. look better. therefore. ± On balance sheet financing would increase the numerator and raise the debt to equity ratio. off balance sheet financing fails to raise the ratio Total Debt Stockholders¶ Equity .

FAQ? Is the apparent cosmetic improvement because of allowable alternatives in ³lease reporting´ real or an illusion? .

‡ Capital leases ± Risks and rewards of ownership transferred to lessee.Lease Classifications: Operating Versus Capital ‡ Operating leases ± Risks and rewards of ownership remain with lessor. . ± Lessee records transaction as if the paperwork associated with the asset was a purchase and a note payable existed.

Lease Criteria A lease is a capital lease if it meets even one of four criteria: ‡ ‡ ‡ ‡ Transfer of title. FMV test. Any one of these leads to capitalization of the asset involved! . Bargain purchase option (BPO). Useful/physical life test.

Capital Lease Queries 1. Does the contract concern a present value of minimum lease payments (MLP) that are greater than (or equal to) 90% of the fair market value (FMV) of the asset? . Does the contract transfer title from lessor to lessee at some future date? 2. Does the contract contain a BPO? 3. Does the contract concern asset use of greater than (or equal to) 75% of the remaining economic useful life of the asset? 4.

³Bias´ may be involved in writing leases and calculating .. The lease term > 75% of economic life 90% of FMV The PV of MLP > ..

(*) Payments are allocated between interest expense and principal... . using the effective interest method. Leased asset is capitalized. and « Depreciated.Capital Lease Accounting ‡ ‡ ‡ ‡ An installment purchase « Financed by a note payable(*) .

Exception (rare): The leased asset and the lease obligation cannot be recorded at an amount greater than the FMV of the asset.FAQ? What amount is capitalized in a capital lease? The present value of minimum lease payments over the lease term. .

non-cancelable period and certain renewal option periods: 1.Terminology: Lease Term The lease term includes the fixed. Renewal option periods prior to a BPO date. . 2. 3. Renewal option periods where the renewal price is a bargain. Renewal option periods where a ³force forward´ is a lessor option.

Renewal option periods where the lessee guarantees the lessor¶s debt used to finance the leased asset. 5.Terminology: Lease Term 4. Renewal option periods after the date of a ³cancellation penalty´ so large that it is unlikely the lessee will pay it. .

periodic cash flow payment. . a BPO).g.] ± Any one-time payments at the inception/end of the contract (e.Terminology: Minimum Lease Payments (not to be confused with executory costs) Minimum lease payments (MLP) includes the following: ± Periodic cash ³rental´ payments over the lease term [To keep the problems simple. throughout the text.. either an ordinary annuity or annuity due. a downpayment. we use an even.

.± Cancellation fees: Penalty fees to be paid to terminate a lease. (Included in MLP if the lessee is expected to cancel the lease at some time and pay such fees). ± Guaranteed residual value (GRV): The amount the lessee guarantees to the lessor (as a residual FMV) at the end of the contract period.

repairs. Lessee¶s responsibility! ± If paid directly by the lessee. insurance) on the leased assets.g. these are expensed by the lessee as incurred.‡ Executory costs: Normal ownership costs (e. then each lease payment includes a reimbursement to the lessor for the executory costs thus the [estimated and designated] amount of such is deducted from the paid amounts so that the MLP will be isolated properly for present value computations. .. maintenance. ± If paid by the lessor.

. ‡ Lessor: Calculate using the lessor¶s implicit rate.Terminology: Present Value of Minimum Lease Payments (PVMLP) ‡ Lessee: Calculate using the lower of the lessee¶s incremental borrowing rate or lessor¶s implicit rate (if known to the lessee). ‡ Note: This is the amount used in the ³90% test!´ PVMLP: The amount used by the lessee to record the leased asset and lease obligation if the lease is capitalized (unless the amount is greater than the fair market value of the asset which is rare).

and has the following terms: ± Annual contractual payments of $10. Inc. noncancellable lease for the use of manufacturing equipment now owned by Zingger. signed a 3-year.000 at the end of each year. 2007.. the Lessee ‡ Material Facts: The Lopez Co. ± Asset¶s December 31.000 . no purchase option. 2004. first payment due December 31.Example: Lopez. 2005. The lease expires December 31. 2004 FMV = $60. ± No down payment. on December 31.

± Lopez does not guarantee any residual value at December 31. Lopez does not know Zingger¶s implicit rate. ± Two alternatives for estimated useful life of the asset: (1) 5 years. 2007. (2) 4 years What to do? . ± Lopez can borrow at 10% per year for a 3-year loan.

870 ‡ FMV = $60. i=10%.000 ordinary annuity ‡ PVMLP = $24.000 ‡ 41% .Example: Operating Versus Capital Classification ‡ The lease does not meet three of ³the four criteria under either alternative: ± No transfer of title ± No BPO ± Fails 90% test: ‡ n=3. R=$10.

the 75% test: ± Alternative 1 fails the test: 3 z 5 < 75%. treat as capital lease. The leased asset and lease obligation are recorded at $24.‡ Regarding the fourth criterion. treat as operating lease ± Alternative 2 meets the test: 3 z 4 u 75%.870. .

Example: Amortization Table for Alternative 2 .

870 Book Value 24.Lopez Capital Lease Amortization Schedule Date Cash Int.870 17.000 *Rounded .093 24. Exp.487 1.736 *907 5.357 9.093 0 Total 30.000 2. 12/31 Payment @ 10% 04 05 06 07 10.513 8.000 10.130 Principal Reduction 7.264 9.000 10.

000) (10. Statement of Cash Flows (cash outflows in parentheses) 2005 Alternative 1: Operating Operating Activities Lease payment 2006 2007 (10.000) (10.Statement of Cash Flows Under Two Alternatives Lopez Co.000) .

000) (10.000) (10.Lopez Co.903) (10.736) ( 907) ( 7. Statement of Cash Flows (cash outflows in parentheses) 2005 Alternative 2: Capital Operating Activities: Interest payment Financing Activities: Lease payment Net Cash Flow 2006 2007 ( 2.264) ( 9.000) .487) ( 1.513) ( 8.

870 .Separate Schedule of ³Significant Investing and Financing Activities Not Involving Cash´ Attached to Statement of Cash Flows Alternative 2: Capital Acquisition of equipment by capital lease 2004 24.

000 10.000 .Income Statements Under Two Alternatives Lopez Co.000 2006 2007 10. Income Statement 2005 Alternative 1: Operating Operating Expenses Lease payment 10.

487) ( 1. Income Statements 2005 2006 2007 Alternative 2: Capital Operating Expenses: Depreciation expense* 8.290 Other Rev (Exp).197 *$24.026 9. Gains (Losses): Interest expense ( 2.290 **total = $30.290 8. ** 10.870 z 3 = $8.000 over the three years .736) ( 907) Total Lease-Related Exp.290 8.777 10.Lopez Co.

000) (20.000) (20.000) (30.Example: Balance Sheets Under Two Alternatives Lopez Co.000) (30.000) Owners¶ Equity Retained earnings (10. Balance Sheet (12/31) 2005 2006 2007 Alternative 1: Operating Current Assets Cash (10.000) .

2: Capital Assets Current Assets Cash 2005 2006 2007 0 (10. Balance Sheet (12/31) 2004 Alt.580 8.870 16.000) (20.Lopez Co. plant. net Manufacturing equipment 24.000) (30.290 0 . equipment.000) Property.

000) .803) (30. Lease obligation 17.357 7.093 0 0 0 Owners¶ Equity Retained Earnings 0 (10.Lopez Co.264 9.093 9. Lease obligation Long-term Liab.777) (20.513 8. Balance Sheet (12/31) 2004 2004 2005 2006 Liabilities Current Liab.

Sales and Leasebacks ‡ A company may sell an asset to a buyer and then immediately sign a lease to lease the asset from the buyer. ± The seller-lessee accounts for the lease as an operating lease or a capital lease in the normal manner. ± The two transactions result in a buyer-lessor and a seller-lessee. . the profit is deferred and recognized over the life of the lease. ± If the seller-lessee has a profit on the sale.

. ‡ Analysts must decide on some interest rate data. and make some assumptions about cash flow patterns. etc.Pro Forma Financial Statement Adjustments What if ? ‡ Operating lease footnote disclosures may be adequate to allow informal pro forma adjustments to a company¶s financial statement data to ³capitalize´ the leases.

End of Chapter 4 .

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