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Chapter15: Leases

Lease Disclosures

Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years. Other required disclosures are specific to the type of lease and include: residual values, contingent rentals, sublease rentals, and executory costs. The lessor must disclose its net investment in the lease. This amount is the present value of the gross investment in the lease total of periodic rental payments and residual value., which is the total of the minimum lease payments (plus any unguaranteed residual value). Some representative disclosure examples are shown in Graphics 15-13 (lessor) and Graphic 15-14 (lessee).

The lessor’s net investment in the lease is the present value of the gross investment, which is the total of the minimum lease payments (plus any unguaranteed residual value).

p. 836

GRAPHIC 15-12

Lease Terms and Concepts: A Comprehensive Summary

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aBeyond any amount guaranteed by the lessee ($8 + 6 minus any amount paid by the lessee).
bAny portion of rental payments that represents maintenance, insurance, taxes, or other executory costs is not considered part of minimum lease payments. In this case, rentals are reduced as follows: $102 – 2 = $100.
cBy lessee and/or by third party.
dIn this context, a residual value and a BPO price are mutually exclusive: if a BPO exists, any residual value is expected to remain with the lessee and is not considered an additional payment.
ePresent value of annuity due of $1: n = 4, i = 12%.
fPresent value of $1: n = 4, i = 12%.

   IBM is a manufacturer that relies heavily on leasing as a means of selling its products. Its disclosure of sales-type leases is shown in Graphic 15-13.

p. 837

GRAPHIC 15-13

Lessor Disclosure of Sales-Type Leases—IBM Corporation

Real World Financials

G Financing Receivables (in part)
(dollars in millions)

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Net investment in sales-type and direct financing leases is for leases that relate principally to the company's equipment and are for terms ranging from two to seven years. Net investment in sales-type and direct financing leases includes unguaranteed residual values of $916 million and $915 million at December 31, 2008 and 2007, respectively, and is reflected net of unearned income of $1,049 million and $1,016 million and of allowance for uncollectible accounts receivable of $217 million and $127 million at those dates, respectively.

   Walmart Stores leases facilities under both operating and capital leases. Its long-term obligations under these lease agreements are disclosed in a note to its financial statements (see Graphic 15-14).

GRAPHIC 15-14

Lessee Disclosure of Leases—Walmart Stores

Real World Financials

Note 9 Commitments (in part)

The Company and certain of its subsidiaries have long-term leases for stores and equipment. Rentals (including, for certain leases, amounts applicable to taxes, insurance, maintenance, other operating expenses and contingent rentals) under all operating leases were $1.8 billion, $1.6 billion, and $1.4 billion in 2009, 2008, and 2007, respectively. Aggregate minimum annual rentals at January 31, 2009, under non-cancelable leases are as follows (in millions):

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p. 838

DECISION MAKERS' PERSPECTIVE—Financial Statement Impact

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As indicated in the Decision Makers' Perspective at the beginning of the chapter, leasing can allow a firm to conserve assets, to avoid some risks of owning assets, and to obtain favorable tax benefits. These advantages are desirable. It also was pointed out earlier that some firms try to obscure the realities of their financial position through off-balance-sheet financing or by avoiding violating terms of contracts that limit the amount of debt a company can have. Accounting guidelines are designed to limit the ability of firms to hide financial realities. Nevertheless, investors and creditors should be alert to the impact leases can have on a company's financial position and on its risk.

Leasing sometimes is used as a means of off-balance-sheet financing.

Balance Sheet and Income Statement

Capital lease transactions impact several of a firm's financial ratios. Because we record liabilities for capital leases, the debt-equity ratio (liabilities divided by shareholders' equity) is immediately impacted. Because we also record leased assets, the immediate impact on the rate of return on assets (net income divided by assets) is negative, but the lasting effect depends on how leased assets are utilized to enhance future net income. As illustrated in this chapter, the financial statement impact of a capital lease is no different from that of an installment purchase.

Lease liabilities affect the debt to equity ratio and the rate of return on assets.

Even operating leases, though, can significantly affect risk. Operating leases represent long-term commitments that can become a problem if business declines and cash inflows drop off. For example, long-term lease commitments became a big problem for Business-land in the early 1990s. The company's revenues declined but it was saddled with lease commitments for numerous facilities the company no longer occupied. Additionally, the stock's market price declined from $11.88 to $.88 in one year. More recently, in 2009 the economic crisis caught many companies with a deadly combination of declining cash inflows and cash outflow commitments for lease agreements. Nearly four billion dollars in off-balance sheet obligations related to operating lease commitments was a major contributor to Circuit City's demise after a 60-year history as a leader in the electronics industry.

Do operating leases create long-term commitments equivalent to liabilities?

Operating lease commitments create problems during an economic downturn.

Whether leases are capitalized or treated as operating leases affects the income statement as well as the balance sheet. However, the impact on the income statement generally is not significant. Over the life of a lease, total expenses are equal regardless of the accounting treatment of a lease. If the lease is capitalized, total expenses comprise interest and depreciation. The total of these equals the total amount of rental payments, which would constitute rent expense if not capitalized. There is, however, a timing difference between lease capitalization and operating lease treatment, but the timing difference usually isn't great.

The net income difference between treating a lease as a capital lease versus an operating lease generally is not significant.

The more significant difference between capital leases and operating leases is the impact on the balance sheet. As mentioned above, a capital lease adds to both the asset and liability side of the balance sheet; operating leases do not affect the balance sheet at all. How can external financial statement users adjust their analysis to incorporate the balance sheet differences between capital and operating leases? A frequently offered suggestion is to capitalize all noncancelable lease commitments, including those related to operating leases. Some financial analysts, in fact, do this on their own to get a better feel for a company's actual debt position.

The difference in impact on the balance sheet between capital leases and operating leases is significant.

   To illustrate, refer to Graphic 15-14 on the previous page, which reveals the operating lease commitments disclosed by Walmart Stores. If these arrangements were considered capital leases, these payments would be capitalized (reported at the present value of all future payments). By making some reasonable assumptions, we can estimate the present value of all future payments to be made on existing operating leases. For example, the interest rates used by Walmart to discount rental payments on capital leases range from 3.0% to 13.6%. If we use the approximate average rate of 10%, and make certain other assumptions, we can determine the debt equivalent of the operating lease commitments as shown in Graphic 15-15.

p. 839

GRAPHIC 15-15

Estimating the Debt Equivalent of Operating Lease Commitments; Walmart Stores

Real World Financials

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*This is the PV factor for i = 10%, n = 10, which treats payments after 2014 as occurring in 2019, an assumptiondue to not knowing precise dates of specific payments after 2014.

   If capitalized, these operating lease commitments would add $6,880 million to Walmart's liabilities and approximately $6,880 to the company's assets.30 Let's look at the impact this would have on the company's debt to equity ratio and its return on assets ratio using selected financial statement information taken from Walmart's annual report for the fiscal year ending January 31, 2009, shown next:

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   The debt to equity and return on assets ratios are calculated in Graphic 15-16 without considering the capitalization of operating leases and then again after adding $6,880 million to both total assets and total liabilities. In the calculation of return on assets, we use only the year-end total assets rather than the average total assets for the year. Also, we assume no impact on income.

GRAPHIC 15-16

Ratios with and without Capitalization of Operating Leases; Walmart Stores

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   The debt to equity ratio rises from 1.50 to 1.61, and the return on assets ratio declines from 8.2% to 7.9%.

Statement of Cash Flow Impact

OPERATING LEASES.    Remember, lease payments for operating leases represent rent—expense to the lessee, revenue for the lessor. These amounts are included in net income, so both the lessee and lessor report cash payments for operating leases in a statement of cash flows as cash flows from operating activities.

Operating leases are not reported in a statement of cash flows at the lease's inception.

p. 840

CAPITAL LEASES AND DIRECT FINANCING LEASES.    You've learned in this chapter that capital leases are agreements that we identify as being formulated outwardly as leases, but which are in reality installment purchases, so we account for them as such. Each rental payment (except the first if paid at inception) includes both an amount that represents interest and an amount that represents a reduction of principal. In a statement of cash flows, then, the lessee reports the interest portion as a cash outflow from operating activities and the principal portion as a cash outflow from financing activities. On the other side of the transaction, the lessor in a direct financing lease reports the interest portion as a cash inflow from operating activities and the principal portion as a cash inflow from investing activities. Both the lessee and lessor report the lease at its inception as a noncash investing/financing activity.

The interest portion of a capital lease payment is a cash flow from operating activities and the principal portion is a cash flow from financing activities.

SALES-TYPE LEASES.    A sales-type lease differs from a direct-financing lease for the lessor in that we assume the lessor is actually selling its product. Consistent with reporting sales of products under installment sales agreements rather than lease agreements, the lessor reports cash receipts from a sales-type lease as cash inflows from operating activities.

Cash receipts from a sales-type lease are cash flows from operating activities.

CONCEPT REVIEW EXERCISE

VARIOUS LEASE ACCOUNTING ISSUES

(This is an extension of the previous Concept Review Exercise.)
   United Cellular Systems leased a satellite transmission device from Satellite Technology Corporation on January 1, 2012. Satellite Technology paid $500,000 for the transmission device. Its retail value is $653,681.

Terms of the Lease Agreement and Related Information:


Lease term

3 years (6 semiannual periods)

Semiannual rental payments

$123,000 at the beginning of each period

Economic life of asset

4 years

Implicit interest rate (Also lessee's incremental borrowing rate)

12%

Unguaranteed residual value

$40,000

Regulatory fees paid by lessor

$3,000/twice each year (included in rentals)

Lessor's initial direct costs

$4,500

Contingent rental payments

Additional $4,000 if revenues exceed a specified base

Required:

1.

 

Prepare an amortization schedule that describes the pattern of interest expense over the lease term for United Cellular Systems.

2.

 

Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Satellite Technology.

3.

 

Prepare the appropriate entries for both United Cellular Systems and Satellite Technology on January 1 and June 30, 2012.

4.

 

Prepare the appropriate entries for both United Cellular Systems and Satellite Technology on December 31, 2014 (the end of the lease term), assuming the device is returned to the lessor and its actual residual value is $14,000 on that date.


SOLUTION

1.

 

Prepare an amortization schedule that describes the pattern of interest expense over the lease term for United Cellular Systems.

   Calculation of the Present Value of Minimum Lease Payments:

   Present value of periodic rental payments excluding executory costs of $3,000:

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*Present value of an annuity due of $1: n = 6, i = 6%.
Note: The unguaranteed residual value is excluded from minimum lease payments for both the lessee and lessor.

p. 841

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*Adjusted for rounding of other numbers in the schedule.

2.

 

Prepare an amortization schedule that describes the pattern of interest revenue over the lease term for Satellite Technology.

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*Present value of an annuity due of $1: n = 6, i = 6%.
Present value of $1: n = 6, i = 6%.
Note: The unguaranteed residual value is excluded from minimum lease payments, but is part of the lessor’s gross and net investment in the lease.

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*Adjusted for rounding of other numbers in the schedule.

3.

 

Prepare the appropriate entries for both United Cellular Systems and Satellite Technology on January 1 and June 30, 2012.

January 1, 2012
United Cellular Systems (Lessee)
Leased equipment (calculated above)........................................
625,483
 Lease payable (calculated above)........................................
625,483
Lease payable (payment less executory costs)........................................
120,000
Regulatory fees expense (executory costs)........................................
3,000
 Cash (lease payment)........................................
123,000

p. 842

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aThis is the unguaranteed residual value.
bAlso, $653,681 – ($40,000a × .70496).

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4.

 

Prepare the appropriate entries for both United Cellular Systems and Satellite Technology on December 31, 2014 (the end of the lease term), assuming the device is returned to the lessor and its actual residual value is $14,000 on that date.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/842_3.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>




30If these operating leases were capitalized, both assets and liabilities would increase by the same amount at inception of the lease. However, in later years, the leased asset account balance and the lease liability account will, generally, not be equal. The leased asset account is reduced by depreciation and the lease liability account is reduced (amortized) to zero using the effective interest method.

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