MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS
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Transcript of MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS
MANAGEMENT DECISIONS AND FINANCIAL
ACCOUNTING REPORTSBaginski & Hassell
Electronic presentation adaptation byDr. Barbara L. Hassell & Dr. Harold O. Wilson
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 & leaseback – Pro forma adjustments to financial statements
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.• Leases classified as capital leases do not
result in off balance sheet financing.
– Potential tax advantages.• Potential to deduct entire lease payment for
tax purposes.– Ability to manage risk of obsolescence.
• Use of short term leases shifts risk of obsolescence to lessor.
– In some cases, possible to secure 100% financing via leasing, but ...• Banks frequently will not finance 100% of a
purchase price, but lessors frequently will finance 100%.
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. – On balance sheet financing would increase the
numerator and raise the debt to equity ratio; therefore, off balance sheet financing fails to raise the ratio
Total DebtStockholders’ Equity
FAQ?
Is the apparent cosmetic improvement because of allowable alternatives in “lease reporting” real or illusion?
Lease Classifications: Operating Versus Capital
• Operating leases– Risks and rewards of ownership remain with
lessor.• Capital leases
– Risks and rewards of ownership transferred to lessee.
– Lessee records transaction as if the paperwork associated with
the asset was a purchase and a note payable existed.
Lease Criteria
• Transfer of title.
• Bargain purchase option (BPO).
• Useful/physical life test.
• FMV test.
A lease is a capital lease if it meets even one of four criteria, by definition:
Any one of these leads to capitalization of the asset involved!
Capital Lease Queries1. Does the contract transfer title from lessor
to lessee at some future date?
2. Does the contract contains 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. 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?
“Bias” may be involved in writing leases and calculating ...
The lease term > 75% of economic life
The PV of MLP > 90% of FMV
Capital Lease Accounting
• An installment purchase …• Financed by a note payable(*) ...• Leased asset is capitalized, and …• Depreciated.
(*) Payments are allocated between interest expense and principal, using the effective interest method.
FAQ?
What amount is capitalized in a capital lease?
The present value of minimum lease payments over the lease term. Exception (rare): The leased asset and the lease obligation cannot be recorded at an amount greater than the FMV of the asset.
Terminology: Lease Term
1. Renewal option periods where the renewal price is a bargain.
2. Renewal option periods prior to a BPO date.
3. Renewal option periods where a “force forward” is a lessor option.
The lease term includes the fixed, non-cancelable period and certain renewal option periods:
Terminology: Lease Term
4. Renewal option periods after the date of a “cancellation penalty” so large that it is unlikely the lessee will pay it.
5. Renewal option periods where the lessee guarantees the lessor’s debt used to finance the leased asset.
Terminology: Minimum Lease Payments (not to be confused with executory costs)
Minimum lease payments (MLP) includes the following, by definition: – Periodic cash “rental” payments over the lease
term [To keep the problems simple, we use an even, periodic cash flow payment, either an ordinary annuity or annuity due, throughout the text.]
– Any one-time payments at the inception/end of the contract (e.g., a downpayment, a BPO).
– 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.
• Executory costs: Normal ownership costs (e.g., repairs, maintenance, insurance) on the leased assets. Lessee’s responsibility!– If paid directly by the lessee, these are expensed
by the lessee, as incurred.– If paid by the lessor, 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.
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).
• Lessor: Calculate using the lessor’s implicit rate.• Note: This is the amount used in the “90% 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; rare).
Example: Lopez, the Lessee
• Material Facts: The Lopez Co. signed a 3-year, noncancellable lease for the use of manufacturing equipment now owned by Zingger, Inc., on December 31, 2000. The lease expires December 31, 2003, and has the following terms:– Annual contractual payments of $10,000 at the
end of each year, first payment due December 31, 2001.
– No down payment; no purchase option.– Asset’s December 31, 2000 FMV = $60,000
– Lopez does not guarantee any residual value at December 31, 2003.
– Lopez can borrow at 10% per year for a 3-year loan; Lopez does not an implicit borrowing rate for Zingger, Inc.
– Two alternatives for estimated useful life of the asset: (1) 5 years, (2) 4 years
What to do?
Example: Operating Versus Capital Classification
• Under both alternatives, the lease does not meet three of “the four criteria:”– No transfer of title– No BPO– Fails 90% test: PV of minimum lease payment
of $24,870 $60,000 FMV = 41%!• Present value = $24,870: n = 3, i = 10%,
payment (ordinary annuity) = $10,000.
• Regarding the fourth criterion, the 75% test:
– Alternative 1: Fails the test, 3 5 < 75%, treated as operating lease!
– Alternative 2: Meets the test, 3 4 75%, treated as capital lease! The, leased asset and lease obligation recorded at $24,870.
Lopez Capital Lease Amortization Schedule
Date
12/31
Cash
Payment
Int. Exp.
@ 10%
Principal
Reduction
Book
Value
00 24,870
01 10,000 2,487 7,513 17,357
02 10,000 1,736 8,264 9,093
03 10,000 *907 9,093 0
Total 30,000 5,130 24,870
*Rounded
Statement of Cash Flows Under Two Alternatives
Lopez Co. Statement of Cash Flows (cash outflows in parentheses)
2001 2002 2003
Alternative 1: Operating
Operating Activities
Lease payment (10,000) (10,000) (10,000)
Lopez Co. Statement of Cash Flows (cash outflows in parentheses)
2001 2002 2003
Alternative 2: Capital
Operating Activities:
Interest payment ( 2,487) ( 1,736) ( 907)
Financing Activities:
Lease payment ( 7,513) ( 8,264) ( 9,903)
Net Cash Flow (10,000) (10,000) (10,000)
Separate Schedule of “Significant Investing and Financing Activities Not
Involving Cash” Attached to Statement of Cash Flows
Alternative 2: Capital 2000
Acquisition of equipment by capital lease 24,870
Income StatementsUnder Two Alternatives
Lopez Co. Income Statement
2001 2002 2003
Alternative 1: Operating
Operating Expenses
Lease payment 10,000 10,000 10,000
Lopez Co. Income Statements
2001 2002 2003
Alternative 2: Capital
Operating Expenses:
Depreciation expense* 8,290 8,290 8,290
Financial Revenues, (Exps.),
Gains and (Losses)
Interest expense ( 2,487) ( 1,736) ( 907)
Total Lease-Related Exp. ** 10,777 10,026 9,197
*$24,870 3 = $8,290
**total = $30,000 over the three years
Example: Balance Sheets Under Two Alternatives
Lopez Co. Balance Sheet (12/31)
2001 2002 2003
Alternative 1: Operating
Current Assets
Cash (10,000) (20,000) (30,000)
Owners’ Equity
Retained earnings (10,000) (20,000) (30,000)
Lopez Co. Balance Sheet (12/31)
2000 2001 2002 2003
Alt. 2: Capital
Assets
Current Assets
Cash 0 (10,000) (20,000) (30,000)
Property, plant, equipment, net
Manufacturing equipment 24,870 16,580 8,290 0
Lopez Co. Balance Sheet (12/31)
2000 2001 2002 2003
Liabilities
Current Liab.
Lease obligation 7,513 8,264 9,093 0
Long-term Liab.
Lease obligation 17,357 9,093 0 0
Owners’ Equity
Retained Earnings 0 (10,777) (20,803) (30,000)
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 two transactions result in a buyer-lessor
and a seller-lessee.– If the seller-lessee has a profit on the sale, the
profit is deferred and recognized over the life of the lease
– The seller-lessee accounts for the lease as an operating lease or a capital lease in the normal manner
Pro Forma Financial Statement Adjustments
• Operating lease footnote disclosures may be adequate to allow informal pro forma adjustments to a company’s financial statements’ data to “capitalize” the leases.
• Analysts must decide on some interest rate data, and make some assumptions about cash flow patterns, etc.
What if?