Professor Paul Zarowin - NYU Stern School of Business

Professor Paul Zarowin - NYU Stern School of Business

Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes

Leases

operating vs capital lease

lease criteria

journal entries

comparison of I/S, B/S, SCF

inter-temporal effects I/S, B/S

footnote disclosure

Ahomemade@ capitalization

sale and leaseback

residual value (guaranteed vs unguaranteed), Bargain Purchase Option

Lessor: Direct Financing vs sales Type Leases

LeasesThere are two ways to account for leases, operating or capital leases. Accounting for operating leases is like cash basis (Lessee: DR expense, CR cash; Lessor: DR cash , CR revenue) with no B/S recognition of a lease asset or lease liability (called Aoff-B/S financing@). Capital lease accounting by the lessee records a lease asset and a lease liability, equal to the present value of the future lease payments. The 4 conditions that require lessee=s capital lease accounting (Type I criteria) are on page 554. Additional criteria for the lessor (Type II criteria) are on page 568. The essence of these rules is that if the lease transfers the risks and rewards of possession to the lessee, such that the lease is a de facto sale, the lease must be capitalized. In general, both the lessee and lessor handle the lease in the same way (operating or capital). One exception is when the lessee uses a different discount rate than the lessor. The one with the higher rate might fail to meet the 90% PV criteria (if none of the other 3 criteria are met) and not capitalize. The one with the lower rate might capitalize. Another exception is when the lessee=s capitalization criteria are met, but the lessor=s criteria are not; in this case only the lessee capitalizes. Note that if the lessee capitalizes but the lessor does not, the leased asset is on both firms= books, and both amortize (depreciate) it.

The example below shows the accounting for a standard 5 year capital lease, with an interest rate of 10%, with annual payments of $1000 in arrears (ordinary annuity), for both the lessee and the lessor. Note the following points:2 (1) The lessee books the lease at the discounted PV of the payments, whereas (2) The lessor books the lease at the gross (undiscounted) value of the cash payments. This gross value is divided into the PV and (unearned) interest components. (3) The lessee=s cash payment includes both interest expense and principal (return of capital).(4) The lessee=s interest expense equals the interest rate x the net BV of the lease. The net BV declines over time because each payment repays some principal. In this way, a capital lease is the same as a mortgage. This is an example of the effective interest method. (5) The lessee=s depreciation is (usually) calculated on a SL basis (annual depreciation = PV of lease payments/lease life). (6) The lessor earns the interest revenue (this is just like an installment sale) each period, using the same calculation as the lessee: interest revenue equals the interest rate x the net BV of the lease. If the lessee and lessor both use the same interest rate (which is usually the case, but is not required), then the lessee=s interest expense equals the lessor=s interest revenue each period.

Capital Lease Examplefacts: 5 year lease; $1,000 per year (in arrears); r = 10%; PV = 3.79079 x 1000 = 3791

Lessee Lessor DR CR DR CR

2Executory costs (pgs. 557-558) are not included in this example. These are treated as period costs by lessee; i.e., they are an expense when paid, and not part of the capitalized lease obligation. Residual Value (see below) is also not included in this example.

inception Leased asset 3791 Lease payments receivable 5000 Lease liability 3791 leased asset 3791 Unearned interest revenue 1209Note: entries in italics are the same each period.

period 1 Interest expense 379 (10% x 3791) Unearned interest revenue 379 Lease liability 621 (plug) Interest revenue 379 Cash 1000 depreciation exp. 758 (37915) Cash 1000 Leased asset 758 Lease payments receivable 1000





Lessor=s asset t-account, net (lease payments Lessor=s lease liability t-account receivable minus unearned interest revenue) DR CR DR CR inception 5000 1209 ---------------------------------- 3791 3791

je per 1 621 379 1000 3170 3170

je per 2 683 317 1000 2487 2487

je per 3 751 249 1000 1736 1736

je per 4 826 174 1000 910 910

je per 5 910 91 1000 0 0Note: $1 error due to rounding

Major financial reporting and analysis issues for leases are: (1) sale and leaseback, (2) guaranteed versus unguaranteed residual value, (3) bargain purchase options, (4) financial report disclosures, and (5) financial statement effects of operating vs capital leases.

Sale and LeasebackSale-Leasebacks are discussed on pgs. 597-598. A sale and leaseback is a transaction where an asset is sold and then leased back. It is a means of financing for the lessee: a way for the lessee to get cash (by selling the asset), while still retaining use of the asset. The journal entries for the lease are shown in the examples we have discussed, and you all know the journal entries for an asset sale: DR CR

Cash Accum=d Dep=n Asset-old (at cost) Loss or GainThe only new twist for a sale and leaseback is that a gain on sale typically does not hit the I/S in the period of sale. If the lease life is a large fraction of the useful life of the asset, then the gain is CR=d to a liability account unearned profit on sale-leaseback that is amortized into income over the life of the lease; i.e., it is an unrealized gain. The amortization (DR) of the unrealized gain is usually done by a CR to (decrease in) depreciation expense during the lease term, thereby increasing net income. In this way, the gain is amortized into net income over time3.

Guaranteed Residual Value (GRV) versus Unguaranteed Residual Value (URV)Residual value (RV) is the value of the leased asset at the end of the lease term. Both parties have an expectation of what the asset will be worth (FMV) when the asset is returned to the lessor at this time. The key issue is whether this value is guaranteed or not; i.e., who bears the loss if the asset is worth less than the expected value. If the RV is guaranteed, then the lessee must make up the difference to the lessor, so the lessee bears the loss. If the RV is unguaranteed, then the lessee does not make up the difference to the lessor, so the lessor bears the loss. Thus, the issue of RV, either GRV or URV, is only relevant if the asset reverts to the lessor at the end of the lease term.

The key points of the GRV case are: (1) Both the lessee and the lessor make the inception journal entry for the value of both the periodic payments plus the GRV. As always, the lessee books at PV, whereas the lessor books at gross (undiscounted) value. (2) The lessee=s periodic payment journal entries amortize only the PV of the periodic payments; thus, after the last periodic payment, the PV of the GRV is still left unamortized. This last part gets amortized when the GRV is returned to the lessor. (3) Similarly, the lessee=s periodic depreciation is based on the total PV - the GRV. (4) The lessor=s amortization schedule is also based only on the periodic payments, not the GRV. (5) If the asset=s FMV at he end of the lease term is less than the GRV, the lessee must make up the difference in cash, and records this difference as a loss. Thus, the lessee bears the loss in the URV case, if GRV > FMV.

The key points of the URV case are: (1) The lessor=s journal entries, both the inception entry and the periodic entries, are identical to the GRV case. The lessor=s inception entry includes (the undiscounted value) of both the periodic payments and the RV. This seems to be inconsistent with accounting conservatism; i.e., the lessor includes the (full) value of the RV, even though he might get less. (2) The only accounting difference for the lessor is at the end of the lease term; if the FMV of the asset is worth less than the expected RV, the lessor records thisdifference as a loss.Thus, the lessor bears the loss in the URV case, if URV > FMV. Also note that since the lessor=s periodic entries ignore the RV, there is the additional amount to be amortized when the leased asset is returned (see the amortization schedule at the end of the illustration). (3) The lessee only books the (PV of the) periodic payments, not the RV. The lessee then does all the accounting, both the periodic depreciation and the amortization of the lease liability, based on this amount. Thus, unlike the lessor, the lease is fully amortized after the final payment. In effect, the RV is invisible to the lessee in the URV case.

3Losses on sale are generally recognized immediately in income.

The following table illustrates the main points of GRV vs URV, for both lessee and lessor. Lessee Lessor inception je includes GRV inception je includes GRVGRV periodic amortization excludes GRV periodic amortization excludes GRV loss on asset return if FMV<GRV no loss on asset return

URV inception je excludes URV inception and periodic je=s same as GRV case periodic (and inception) je=s same as no RV loss on asset return if FMV<URV

Bargain Purchase Options (BPO)A BPO is a lease provision that allows the lessee to purchase the asset at the end of the lease at a price much lower than the asset=s expected FMV at that time. Since the price is so low, exercise of the option is virtually assured. Lessee accounting for a BPO is virtually identical to lessee accounting for a GRV. The lessee includes the present value of the BPO in the inception journal entry for the present value of the lease payments, just like the case of the GRV. The lessee=s amortization schedule is also identical to GRV accounting. The only difference between the lessee=s accounting for a GRV vs. for a BPO is the period of depreciation. There is no effect on the lessor=s accounting.

Lease Disclosures by Lessee - A homemade @ capitalization of operating leases Lessees must disclose (in their financial statement footnotes) contractual lease payments for each of the next 5 years after the B/S date, and the sum of contractual lease payments for all years thereafter, separately for capital and operating leases. [Analogous disclosures must be made by lessors (pg. 575).] Using the 5 individual years, one can determine (albeit imperfectly) how many years of payments are contained in the aggregate total after year 5. Thus, one can estimate the average lease term of a firm=s leases, even though it is not disclosed. For the capital leases, the total contractual lease payments is also broken down between principal (lease liability on the B/S) and interest. By definition, this breakdown does not exist for operating leases. However, using the information for the capital leases, one can estimate the capitalized liability value of the operating leases. For firms (like some airlines) whose operating lease payments overwhelm their capital lease payments, operating leases are a material off-balance sheet liability. One should therefore compute the capitalized value of the operating leases, and recognize (in a pro-forma sense) the lease asset and liability.

The simplest approach is to DR lease asset and CR lease liability for the same amount. More complicated approaches recognize that the asset and liability balances are equal only at the beginning and the end of the lease, but diverge in the interim (because the asset is amortized on an SL basis, while the liability is amortized on an effective interest basis). When they diverge,

the difference is a DR or CR to O/E. That is, the divergence implies a difference in the amount of expense previously recognized under operating vs capital leases (see paragraph on I/S effects, below). The cumulative difference in expense causes a difference in O/E.

If the lease is an ordinary annuity, the NBV of the lease liability must be greater than the NBV of the lease asset (except at inception and at the end of the lease term). If the lease is an annuity due, then the first payment (at the inception of the lease) is completely a reduction in the liability; thus, the NBV of the lease liability falls below the NBV of the lease asset. How long it stays below depends on the lease term and the effective r%.

Having calculated the capitalized value of the operating lease liability (see above), multiply this value by the ratio [capital lease asset/capital lease liability] of the on B/S leases, to calculate the value of the operating lease assets. The difference between the calculated lease asset and lease liability values is a plug to O/E. RCJ discuss this in the Appendix to Ch. 12. You can then (re)compute ratios such as debt/equity ratio and ROA. Note that the recomputation might involve adjusting not only the B/S amounts of assets and liabilities, but also net income, since the total of interest expense + depreciation might not be equal to rent expense. As RCJ point out, however, for mature firms, the expense difference will probably be small. Thus, the major differences are on the B/S.

Capital vs. Operating Leases - Financial Statement Effects on LesseeAs RCJ point out, the most significant financial statement differences between capital and operating leases are on the B/S (capital leases are recognized on the B/S; operating leases are not). Although most of the lease liability is non-current, the portion due within one year is current, thereby affecting ratios dealing with current liabilities, such as the current ratio. Note that as a lease matures, the portion of each payment that is repayment of the lease liability grows (and the portion that is interest expense shrinks). Thus, the current liability amount grows.

There are also differences between capital vs operating leases in their effects on the I/S and SCF.I/S: the expense of an operating lease is the periodic cash (rental) payment. The expenses for a capital lease are depreciation + interest. Over the full life of any individual lease, total expense is the same regardless of type (rent = [depreciation + interest]). To see this, note that the sum of the cash payments (rent) is principal + interest, and depreciation = principal. What differs is the timing of expense recognition. Annual depreciation + interest is greater than annual rent in the early years of the lease, and this reverses in the later years of the lease. Thus, if a firm continually enters into new leases year after year (before old leases expire - i.e., the firm does not just replace old leases as they expire) it can be in a perpetual situation where annual operating lease expense is less than annual capital lease expense. This is another reason why lessees prefer operating leases, in addition to not recognizing the B/S liability.4

4As you will learn in the module on Income Taxes (Chapter 13), this means that using one lease method for books and the other for taxes results in a deferred tax asset or liability.

For a comparison, return to the $1,000 per year, 5 year, r=10% example, at the beginning of this module: annual lessee expenses under capital vs operating leases are (the cumulative difference at the right is the excess of the lease liability over the lease asset at the end of each year): Capital Operating interest + dep = n = total Rent Diff CumDiffyr 1 379 758 1137 1000 137 137yr 2 317 758 1075 1000 75 212yr 3 249 758 1007 1000 7 219yr 4 174 758 932 1000 (68) 151yr 5 91 758 849 1000 (151) 0 total 1210 3790 5000 5000 0 0SCF: the periodic cash payment is independent of the lease type (the lessor doesn=t care what the lessee calls the lease), but for an operating lease all cash outflow is from CFO. For a capital lease, the interest expense is part of CFO, but the repayment of capital is a cash outflow from financing. Thus, while total cash flow is unaffected, CFO is higher for a capital lease than for an operating lease. The difference is greatest in the later years of a lease, when most of the cash payment is repayment of capital.

Lessor AccountingAlthough we have focussed on the lessee, we have already discussed many issues, and seen examples, for lessor accounting. Some additional important issues are: (1) capital vs operating lease criteria, and (2) direct financing vs sales type leases.

Capital vs operating lease criteria for lessorIn addition to one of the four capitalization criteria for the lessee, lessors must satisfy two additional criteria for capitalization. These amount to standard criteria for revenue recognition. Note that a lessor capital lease is really an installment sale with interest. Examine the lessor=s capital lease entries; the account Aunearned revenue@ is analogous to installment=s deferred GP. Since lessor=s (Type II) capital lease criteria assume that the revenue recognition criteria are met, capital lease accounting accelerates lessor=s revenue recognition, which lessors prefer. This is analogous to acceleration of expense recognition by the lessee under capital lease accounting (which the lessee dislikes).

Direct Financing versus Sales type leasesThere are two types of capital leases for the lessor. The basic kind of capital lease that you are familiar with (shown in the above example and in RCJ=s illustration on pgs. 592-596) is a direct financing lease. In this lease, the lessor=s only revenue is interest revenue. Since a lease is an alternative to a sale, this means that there is no profit on the sale.

The other type of capital lease for the lessor is a sales type lease. The conditions that distinguish a direct financing lease from a sales type lease are discussed in RCJ on pages 589-591; the difference is that in a sales type lease, the present value of the payments, which equals the sale price of the asset, is greater than the lessor=s CGS of the leased asset (i.e., includes a profit

margin). For example, when IBM leases a computer rather than sells it, they include a profit in the calculation of the lease payments. Note that for the lessee, the entries for a sales type lease are exactly the same as for a direct financing lease. There is only a difference for the lessor. The only difference for the lessor at the initial booking of the lease. You can think of the lessor=s initial journal entry as 2 entries. Entry 1 is almost exactly the same as the lessor entry at the inception of a direct financing lease: DR CR Lease payments receivable - gross Unearned interest revenue - plug Sales revenue (PV)The only difference is the CR to sales revenue, rather than to the leased asset itself. The lessor=s second journal entry is the standard DR to CGS and CR to Inventory that you know.

Capital vs. Operating Leases - Financial Statement Effects on LessorThe financial statement effects of operating vs capital leases on the lessor are analogous to the effects on the lessee, just in reverse. While total income over the lease=s life is identical, capital lease accounting accelerates revenue recognition. ROA will also be higher in the early years under capital lease accounting, and this effect reverses in the later years. However, if the lessor constantly enters into new leases, the higher income effect under capitalization can perpetuate.

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Professor Paul Zarowin - NYU Stern School of Business