Financial Accounting Day 4 Professor Earl K. Stice Brigham Young University

Financial Accounting Day 4

Professor Earl K. SticeBrigham Young University

Lease Accounting – The Four Criteria Operating Finance/Capital Ownership transfers No at the end of the lease term Yes No Bargain purchase option Yes Lease Term Greater than or Equal to No 75% of the Life of the Leased Asset Yes Present Value of Lease Payments Greater than or Equal to No 90% of the cash price of the Leased Asset Yes

A LEASE IS ACCOUNTED FOR AS A FINANCE/CAPITAL LEASE IF IT SATISFIES ANY ONE OF THESE FOUR CRITERIA.

Page 60of packet

Operating Lease Example The following information comes from the financial statements of Company T. Total liabilities $ 80,000 Total assets 200,000 Sales 500,000 In addition, Company T has a large number of operating leases. The payments on these operating leases total $50,000 per year for the next 10 years. The assets being used under these operating lease arrangements have a useful life of 14 years. Because these leases are classified as operating leases, they are not reflected in Company T’s reported balance sheet numbers.

Page 61of packet

Operating Lease Example

1. Compute Company T’s debt ratio (total liabilities / total assets). 2. Compute Company T’s asset turnover ratio (sales / total

assets).3. Company T is able to borrow money at an interest rate of

10.557982%. Using this interest rate, what is the present value of the operating lease payments? What does this present value represent?

4. Assume that the assets being used under the operating lease arrangements have a useful life of 13 years. Does this change the classification of the leases from operating to finance/capital? Explain.

5. Compute Company T’s debt ratio assuming that the operating leases are accounted for as finance/capital leases.

6. Compute Company T’s asset turnover ratio assuming that the operating leases are accounted for as finance/capital leases.

7. Why does a company want its leases to be classified as operating leases?


1. Compute Company T’s debt ratio (total liabilities / total assets).

$80,000 / $200,000 = 40%


2. Compute Company T’s asset turnover ratio (sales / total assets).

$500,000 / $200,000 = 2.50

Operating Lease Example 3. Company T is able to borrow money at an interest rate of 10.557982%. Using this interest rate, what is the present value of the operating lease payments? What does this present value represent?

PV Excel function Excel Label Your Input Rate .10557982 Nper 10 Pmt 50000 Fv 0 Type leave this blank

PV = $300,000


4. Assume that the assets being used under the operating lease arrangements have a useful life of 13 years. Does this change the classification of the leases from operating to finance/capital? Explain.

• 10 years / 14 years = 71.4% < 75%• 10 years / 13 years = 76.9% > 75%


5. Compute Company T’s debt ratio assuming that the operating leases are accounted for as finance/capital leases.

($80,000 + $300,000) / ($200,000 + $300,000)

= 76%


6. Compute Company T’s asset turnover ratio assuming that the operating leases are accounted for as finance/capital leases.

$500,000 / ($200,000 + $300,000) = 1.00


7. Why does a company want its leases to be classified as operating leases?

By accounting for the leases as operating leases, the company, on paper,– Looks like it has lower leverage– Looks like it is using is assets more

efficiently

FedEx Leases The following summary data are from the May 31, 2000 balance sheet of FedEx. All numbers are in millions. Total current assets ..................................................... $3,285 Property, plant, and equipment (net) .......................... 7,084 Other long-term assets .................................................. 1,158 Total assets ................................................................. $11,527 Current liabilities......................................................... $2,891 Long-term debt .............................................................. 1,776 Other long-term liabilities ............................................ 2,075 Total liabilities.............................................................. $6,742 Stockholders’ equity .................................................... $4,785 ------------------------------------------------------------------------------ Total sales ................................................................... $18,257 ------------------------------------------------------------------------------

Page 62of packet

FedEx Leases A summary of future minimum lease payments under capital leases and noncancellable operating leases (principally aircraft and facilities) with an initial or remaining term in excess of one year at May 31, 2000 is as follows: .......................................................... Capital Operating ............................................................Leases Leases (In millions) 2001 ................................................. $ 15.195 $ 1,258.109 2002 .................................................... 15.174 1,087.035 2003 .................................................... 15.024 990.125 2004 .................................................... 14.894 926.290 2005 .................................................... 14.828 877.701 Thereafter ........................................ 287.673 9,263.996 ......................................................... $362.788 $ 14,403.256 ....................................................... ======= ======== At May 31, 2000, the present value of future minimum lease payments for capital lease obligations was $200.259 million.

FedEx Leases

Compute the following ratio values.

1.Debt ratio

(total liabilities / total assets)

2.Asset turnover

(sales / total assets)

FedEx Leases

1.Debt ratio

(total liabilities / total assets)

$6,742/$11,527 = 58.5%

2.Asset turnover

(sales / total assets)

$18,257/$11,527 = 1.58

FedEx Leases

Compute the following ratio values.

3.Debt ratio assuming that FedEx’s operating leases are accounted for as capital leases

4.Asset turnover assuming that FedEx’s operating leases are accounted for as capital leases

Hint: Assume the same proportion between present value and total cash flows for both capital and operating leases.

FedEx Leases

(200.259/362.788) x 14,403.256 =

$7,951 million in leased assets

(and lease liability)

FedEx Leases

3.Debt ratio assuming that FedEx’s operating leases are accounted for as capital leases.

($6,742 + $7,951)/($11,527 + $7,951)

= 75.4%

4.Asset turnover assuming that FedEx’s operating leases are accounted for as capital leases.

$18,257/($11,527 + $7,951)

= 0.94

FedEx Leases

Most companies have NO capital leases, so this proportion method can’t be used.

Alternate approach: Approximate the total $14.4 billion in future operating lease payments with an annuity.

FedEx Leases

Annual Payment

= About $1,000

Number of Years

= 14 or 15

Interest Rate = ????

Let’s try 8%, 10%, 12%

FedEx Leases

8% 10% 12%Years

14 $8,244 $7,367 $6,62815 $8,559 $7,606 $6,811

FASB & IASBFASB & IASB

Similarities and DifferencesSimilarities and Differences

Rules vs. PrinciplesRules vs. Principles• U.S. GAAP = detailed rules.U.S. GAAP = detailed rules.• IFRS = general principles with the details IFRS = general principles with the details

being left to the judgment of the being left to the judgment of the accountant.accountant.



Rules vs. PrinciplesRules vs. PrinciplesExample:Example:

Is a Is a leaselease to be accounted to be accounted for as a for as a rentalrental (operating)(operating) or or as a as a purchase purchase (finance/capital)(finance/capital)??



Rules vs. PrinciplesRules vs. PrinciplesIFRS Lease Accounting StandardIFRS Lease Accounting Standard

““A lease is classified as a finance lease if A lease is classified as a finance lease if it transfers substantially all the risks and it transfers substantially all the risks and rewards incidental to ownership. A lease rewards incidental to ownership. A lease is classified as an operating lease if it is classified as an operating lease if it does not transfer substantially all the risks does not transfer substantially all the risks and rewards incidental to ownership.”and rewards incidental to ownership.”



Rules vs. PrinciplesRules vs. PrinciplesU.S. GAAP Lease Accounting StandardU.S. GAAP Lease Accounting StandardThe criteria for classifying leases set forth in this paragraph and in paragraph 8 derive from the concept set forth in paragraph 60. The criteria for classifying leases set forth in this paragraph and in paragraph 8 derive from the concept set forth in paragraph 60.

If at its inception (as defined in paragraph 5(b)) a lease meets one or more of the following four criteria, the lease shall be If at its inception (as defined in paragraph 5(b)) a lease meets one or more of the following four criteria, the lease shall be classified as a capital lease by the lessee. Otherwise, it shall be classified as an operating lease. (See Appendix C for an classified as a capital lease by the lessee. Otherwise, it shall be classified as an operating lease. (See Appendix C for an illustration of the application of these criteria.)illustration of the application of these criteria.)

a. The lease transfers ownership of the property to the lessee by the end of the lease term (as defined in paragraph 5(f)).10aa. The lease transfers ownership of the property to the lessee by the end of the lease term (as defined in paragraph 5(f)).10ab. The lease contains a bargain purchase option (as defined in paragraph 5(d)).b. The lease contains a bargain purchase option (as defined in paragraph 5(d)).c. The lease term (as defined in paragraph 5(f)) is equal to 75 percent or more of the estimated economic life of the leased c. The lease term (as defined in paragraph 5(f)) is equal to 75 percent or more of the estimated economic life of the leased

property (as defined in paragraph 5(g)). However, if the beginning of the lease term falls within the last 25 percent of the property (as defined in paragraph 5(g)). However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.purposes of classifying the lease.

d. The present value at the beginning of the lease term of the minimum lease payments (as defined in paragraph 5(j)), excluding d. The present value at the beginning of the lease term of the minimum lease payments (as defined in paragraph 5(j)), excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property (as lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property (as defined in paragraph 5(c)) to the lessor at the inception of the lease over any related investment tax credit retained by the defined in paragraph 5(c)) to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him. However, if the beginning of the lease term falls within the last 25 percent of lessor and expected to be realized by him. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. A lessor shall compute the present value of the minimum lease payments using the purposes of classifying the lease. A lessor shall compute the present value of the minimum lease payments using the interest rate implicit in the lease (as defined in paragraph 5(k)). A lessee shall compute the present value of the minimum interest rate implicit in the lease (as defined in paragraph 5(k)). A lessee shall compute the present value of the minimum lease payments using his incremental borrowing rate (as defined in paragraphlease payments using his incremental borrowing rate (as defined in paragraph

5(1)), unless (i) it is practicable for him to learn the implicit rate computed by the lessor and (ii) the implicit rate computed by the 5(1)), unless (i) it is practicable for him to learn the implicit rate computed by the lessor and (ii) the implicit rate computed by the lessor is less than the lessee’s incremental borrowing rate. If both of those conditions are met, the lessee shall use the lessor is less than the lessee’s incremental borrowing rate. If both of those conditions are met, the lessee shall use the implicit rate.implicit rate.

Bonds

Introduction

Maturity, or face, value. The amount to be paid to the bondholder at the end of the bond contract.

Maturity date. The date when the bond contract ends. Stated rate, or coupon rate. The annual interest (on the

maturity value) to be paid to the bondholder between the issuance date and the maturity date.

Maturity Value Interest Interest Interest Interest Interest Interest |----------|-----------|----------|----------|----------|--- … ----------------------------| Issuance 1 2 3 4 5 Maturity Date

Page 63of packet

BondsMatching Bond Labels and Descriptions

Some Terms Used to Describe Bonds a. debenture b. subordinated c. secured d. zero-coupon e. junk f. convertible g. Yankee h. panda

Match the labels with the following descriptions: 1. A bond that has specific company assets pledged as collateral 2. A bond that can be exchanged for shares of common stock 3. A bond that has a lower priority claim on the company’s assets in

case of bankruptcy 4. A bond denominated in U.S. dollars that is issued by a non-U.S.

company 5. A bond issued by a company with a relatively low bond rating

(below investment grade) 6. A bond that has no underlying assets pledged as collateral 7. A bond that has no periodic interest payments, only the payment

of the face value of the bond at the maturity date 8. A bond denominated in Chinese currency (renminbi) that is

issued by a non-Chinese company


1.A bond that has specific company assets pledged as collateralc. secured

2.A bond that can be exchanged for shares of common stockf. convertible

3.A bond that has a lower priority claim on the company’s assets in case of bankruptcyb. subordinated

4.A bond denominated in U.S. dollars that is issued by a non-U.S. companyg. Yankee


5. A bond issued by a company with a relatively low bond rating (below investment grade)e. junk

6. A bond that has no underlying assets pledged as collaterala. debenture

7. A bond that has no periodic interest payments, only the payment of the face value of the bond at the maturity dated. zero-coupon

8. A bond denominated in Chinese currency (renminbi) that is issued by a non-Chinese companyh. panda

BondsWhich of the two bonds will have lower market interest rate?

Pair A1. A 7 ½ % debenture with a 2010 maturity date2. A 7 ½ % secured bond with a 2010 maturity date

Pair B1. A 7 ½ % debenture with a 2010 maturity date2. A 7 ½ % subordinated debenture with a 2010 maturity date

Pair C1. A 7 ½ % debenture with a 2010 maturity date2. A 7 ½ % debenture with a 2050 maturity date

Pair D1. A 7 ½ % debenture denominated in rupiah with a 2010 maturity date (issued by

an Indonesian company)2. A 7 ½ % debenture denominated in U.S. dollars with a 2010 maturity date

(issued by an Indonesian company)

Page 64of packet


Pair A1. A 7 ½ % debenture with a 2010 maturity date2. A 7 ½ % secured bond with a 2010 maturity date#2

Pair B1. A 7 ½ % debenture with a 2010 maturity date2. A 7 ½ % subordinated debenture with a 2010 maturity date#1


Pair C1. A 7 ½ % debenture with a 2010 maturity date2. A 7 ½ % debenture with a 2050 maturity date

#1

Pair D1. A 7 ½ % debenture denominated in rupiah with a 2010

maturity date (issued by an Indonesian company)2. A 7 ½ % debenture denominated in U.S. dollars with a

2010 maturity date (issued by an Indonesian company)

#2

Investment Securities

Trading

Harry Company paid $100 to purchase a portfolio of debt and equity securities. Harry Company intends to actively manage this portfolio in order to make money on day-to-day price fluctuations.– Dividends and interest received on the securities

in the portfolio totaled $8 during the year.– Securities in the portfolio that were purchased for

$20 were sold for $13.– As of the end of the year, the portfolio is valued at

$120.

Page 65of packet


Trading

At what amount will these securities be reported in the balance sheet at the end of the year?

$120How much investment-related income will be reported in the income statement for the year?

Dividend and interest revenue $8Realized loss ($13 - $20) (7)Unrealized gain

($120 - $80 remaining cost) 40Total investment-related income $41


Trading

Assets Liabilities Equity -- Paid-in Capital -- Retained Earnings


Available for Sale

Yosef Company paid $100 to purchase a portfolio of debt and equity securities. Yosef Company intends to hold these securities for the foreseeable future, although they could be sold at any time if the need arises.– Dividends and interest received on the securities

in the portfolio totaled $8 during the year.– Securities in the portfolio that were purchased for

$20 were sold for $13.– As of the end of the year, the portfolio is valued at

$120.


Available for SaleAt what amount will these securities be reported in the balance sheet at the end of the year?

$120How much investment-related income will be reported in the income statement for the year?

Dividend and interest revenue $8Realized loss ($13 - $20) (7)Total investment-related income $ 1

The $40 unrealized increase is reported as an increase in Accumulated Other Comprehensive Income (AOCI).


Available for Sale

Assets Liabilities Equity -- Paid-in Capital -- Retained Earnings

ChinaOil

Industry

Page 66of packet

China Oil Industry Small Group Assignment

• Break into groups.

• Review the text material on pages 66 through 68.

• Starting on page 81, prepare answers to the each of the questions identified with the word “Prepare.”

Pages 66 through 89of packet

China Oil Industry Is China an Importer or Exporter of Oil?

• During the 1970s and 1980s, China was a net oil exporter.

• China became a net oil importer in 1993.• China currently imports 32% of its oil.• By 2030, Chinese oil imports will equal imports by

the U.S. today.– Source: “China,” The 2008 World Factbook, U.S. Central Intelligence Agency, https://www.cia.gov/library/publications/the-world-factbook/print/ch.html

• Proved oil reserves– China: 16 billion barrels– Russia: 60 billion barrels– United States: 21 billion barrels– Persian Gulf: 748 billion barrels

Page 81of packet

China Oil Industry The Big Three Oil Companies

Sinopec• 71% state ownership• Initial focus was on “downstream” operations• Particularly strong in southeast China

PetroChina• 86% state ownership• Initial focus was on “upstream” operations• Particularly strong in north and northeast China

CNOOC• 65% state ownership• Historically focused on offshore oil and gas exploration and

extraction.

Page 81of packet

China Oil Industry Debt Ratio

Sinopec PetroChina CNOOC ExxonMobilDebt ratio (total liabilities / total assets) 0.546 0.281 0.253 0.497

Page 82of packet

Sinopec PetroChina CNOOC ExxonMobilDebt-to-equity ratio 0.601 0.105 0.082 0.079 (interest-bearing debt / common equity)

China Oil Industry Average Interest Rate

For 2007 (billions of RMB or U.S. dollars) 2007 2006 2007 2006 2007 2006 2007 2006Current liabilites -- interest bearing 60.5 63.5 31.5 36.6 0.0 17.8 2.4 1.7Long-term liabilities -- interest bearing 120.3 100.6 39.7 35.1 11.0 20.3 7.2 6.6

2007 interest expense 7.314 2.393 0.103 0.110

Sinopec PetroChina CNOOC ExxonMobil

Average interest rate 4.24% 3.35% 0.42% 1.23%


Page 83of packet

China Oil Industry Average Interest Rate???

4.80% 5.77% 3.86% 5.21%4.24% 3.35% 0.42% 1.23%

China Oil Industry Dividend Return on Equity


Dividend return on equity 3.40% 4.54% 9.52% 6.47%

Page 84of packet

China Oil Industry Dividend Yield

Page 84of packet

Sinopec PetroChina CNOOC ExxonMobilDividend return on equity 3.40% 4.54% 9.52% 6.47%

Price-to-book (PB) ratio 3.60 3.99 4.66 4.14

DIVIDEND YIELD 0.94% 1.14% 2.04% 1.56%(Dividends / Market Equity)

China Oil Industry Return on Equity


Return on equity 19.61% 22.08% 25.82% 34.47%

Page 85of packet

China Oil Industry Return on MARKET Equity

Sinopec PetroChina CNOOC ExxonMobilReturn on equity 19.61% 22.08% 25.82% 34.47%


Return on MARKET Equity 5.44% 5.53% 5.54% 8.33%(Net Income / Market Equity)

Page 85of packet

China Oil Industry After-Tax Return on Assets

(billions of RMB or U.S. dollars) 2007 2006 2007 2006 2007 2006 2007 2006Total assets 718.572 602.720 994.092 615.144 179.793 155.268 242.082 219.015

2007 average income tax rate 31.1% 25.6% 27.8% 42.4%

2007 net income 54.947 134.574 31.258 40.610Add back after-tax interest expense 5.039 1.780 0.074 0.063NOPAT 59.986 136.354 31.332 40.673

Return on assets 9.08% 16.95% 18.70% 17.64%


Page 86of packet

China Oil Industry Computing NOPAT

China Oil Industry After-Tax Return on Assets

Comment on how these return on asset values can be used to evaluate whether a company can afford to incur addition debt financing.

Page 81of packet

China Oil Industry Before-Tax Return on Assets

Before-tax return on assetsNOPAT 59.986 136.354 31.332 40.673

(1 minus the tax rate) 68.9% 74.4% 72.2% 57.6%

Net operating profit before tax 87.063 183.272 43.397 70.613 ((NOPAT ÷ (1 minus the tax rate))

÷ Total assets = Before-tax return on assets 13.18% 22.78% 25.90% 30.63%

Average interest rate

Including capitalized interest 4.80% 5.77% 3.86% 5.21%


China Oil Industry Price-to-Book Ratio



Page 87of packet

China Oil Industry Price-Earnings Ratio

For 2007 (billions of RMB or U.S. dollars) Sinopec PetroChina CNOOC ExxonMobilRMB RMB RMB US$

Implied market capitalization 1,084.6 2,706.2 625.9 504.2

2007 net income 54.947 134.574 31.258 40.610

Price-to-earnings (PE) ratio 19.74 20.11 20.02 12.42

Page 88of packet

China Oil Industry Free Cash Flow

For 2007 (billions of RMB or U.S. dollars) 2007 2006 2007 2006 2007 2006 2007 2006Operating cash flow 124.3 98.9 210.8 205.4 42.7 39.2 52.0 49.3Less: Cash paid for capital expenditures (110.6) (77.4) (180.7) (139.2) (26.9) (44.2) (15.4) (15.5)Less: Cash paid for interest and dividends (20.8) (19.8) (74.8) (75.3) (11.5) (9.8) (7.6) (7.6)

Note: For both CNOOC and ExxonMobil, "cash paid for interest and dividends" is includes just cash paid for dividends.

For these two companies, operating cash flow already includes a subtraction for cash paid for interest.

Free cash flow (7.2) 1.7 (44.7) (9.0) 4.2 (14.8) 29.0 26.2


Page 88of packet

China Oil Industry Financing of Expansion

Financing Options

• Internal financing through internally-generated surplus cash flows

• External borrowing

• External equity financing through the sale of some state-owned shares to private investors

Page 89of packet

The EndThe EndThe EndThe End

Conclusion

Documents

Financial Accounting Day 4 Professor Earl K. Stice Brigham Young University