3. 3-3
Leasing – Key Points
Capital versus Operating
Buildings compared to copiers
Bank leverage ratio
4. 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
5. 3-5
Leases
(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)
Lease Accounting and Reporting
6. 3-6
Leasing – Key Points
Capital leases and Operating
leases both have an interest
and a principle portion of the
payment.
7. 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%.
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.
9. 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.
10. 3-10
Leasing – Illustration
How much of the lease payment
represents interest and how much
represents principle?
How do we determine such?
11. 3-11
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%?
12. 3-12
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.
13. 3-13
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)
16. 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
17. 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?
23. 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
24. 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
25. 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?
26. 3-26
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
27. 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?
28. 3-28
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
30. 3-30
Leasing – Illustration
Step 9- A
Determine both the amount and the
number of lease payments.
The first five years are provided.
31. 3-31
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.
33. 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.
34. 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!
35. 3-35
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.
36. 3-36
Leasing – Illustration
Step 9 - D
The present value of the various
lease payments will be our “revised”
asset base and our related liability
base.
37. 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.
40. 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).
43. 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
44. 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
45. 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.
46. 3-46
Leasing – Key Points
Implicit interest rate in operating
leases.
Capital leases - assume the
estimated asset value is equal to
the estimated liability.
