Business analysis using financial statements

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Business analysis using financial statements

• Chapter 6
• Analysis-Lease and off-balance liability

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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
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Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that
transfer substantially all benefits and risks of
ownershipaccounted 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 less any related
investment tax credit retained by lessor   (2)
Operating Lease Accounting For leases other
than capital leasesthe lessee (lessor) accounts
for the minimum lease payment as a rental expense
(income)
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Operating Lease accounting

• Leases not meeting any of the four criteria
  listed above are not capitalized and no asset or
  obligation is reported in the financial
  statements since no purchase is deemed to have
  occurred. Such leases are classified as operating
  leases.
• Payments are reported as rental expense. SFAS 13
  mandates the use of the straight-line method of
  recognizing periodic rental payments unless
  another, systematic basis provides a better
  representation of the use of leased property.
• As a result, for leases with rising rental
  payments, lease expense and cash flow will not be
  identical.

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Capital lease accounting

• The lessee must recognize both an asset and a
  liability on its books as the dollar amount equal
  to the discounted present value of the minimum
  lease payments specified in the lease.
• Each lease payment includes both interest
  (measured using the effective interest method
  )and principal reduction.
• Depreciation expense in accordance with the
  lessees depreciation schedule for assets of this
  type is also recorded.

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Leases
Lease Disclosure and Off-Balance-Sheet Financing
Lease Disclosure Lessee must disclose (1) future
MLPs separately for capital leases and operating
leasesfor each of five succeeding years and the
total amount thereafter, and (2) rental expense
for each period an 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
leaseneither the leased asset nor its
corresponding liability are recorded on the
balance sheet
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Leases
Accounting for Leases An Illustration
Lease Facts   A company leases an asset on
January 1, 2000 -- it has no other assets or
liabilities Estimated economic life of leased
asset is 5 years with no salvage value --
company will depreciate the asset on a
straight-line basis over its life  Lease has a
fixed non-cancelable term of 5 years with
annual MLPs of 2,505 paid at the end of each
year Interest rate on the lease is 8 per year
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Leases
Accounting for Leases Illustration (continued)
Lease Amortization Schedule
Straight-line depreciation 2,000 per year
(10,000 - 0/5 years)

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Leases
Accounting for Leases Illustration (continued)

Income Statement Effects of Lease Methods

 
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Leases
Accounting for Leases Illustration (continued)

Balance Sheet Effects of Lease Methods

Operating Leases
Capital Leases
Date





Cash Leased asset Total   Cash Leased asset
Total   Cash Leased asset Total   Cash Leased
asset Total   Cash Leased asset
Total   Cash Leased asset Total
0 0 0   (2,505) 0 (2,505)   (5,010)
0 (5,010)   (7,515) 0 (7,515)   (10,020)
0 (10,020)   (12,525) 0 (12,525)  
Jan. 1, 2000   Dec 31, 2000   Dec 31,
2001     Dec 31, 2002   Dec 31, 2003   Dec
31, 2004
Lease liability Equity Total   Lease
liability Equity Total   Lease liability Equity
Total   Lease liability Equity Total   Lease
liability Equity Total   Lease liability Equity
Total
0 0 0  
0 (2,505) (2,505)  
0 (5,010) (5,010)  
0 (7,515) (7,515)  
0 (10,020) (10,020)  
0 (12,525) (12,525)  
 
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Leases
Effects of Lease Accounting
Impact of Operating Lease when Capital Lease is
Apt Operating lease understates
liabilitiesimproves solvency ratios such as
debt to equity Operating lease understates
assetscan improve return on investment
ratios Operating lease delays expense
recognitionoverstates 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 paymentinflates 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
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Off-Balance-Sheet Financing
Basics of Off-Balance-Sheet Financing
Off-Balance-Sheet Financing -- is the
non-recording of financing obligations   Motivatio
n To keep debt off the balance sheetpart of
ever-changing landscape, where as one standard
tries to better reflect obligations from a
certain off-balance-sheet financing transaction,
there are new and innovative means to take its
place   Transactions sometimes used as
off-balance-sheet financing Operating leases
that are indistinguishable from capital leases
Through-put agreements, where a company agrees
to run goods through a processing facility
Take-or-pay arrangements, where a company
guarantees to pay for goods whether needed or
not Certain joint ventures and limited
partnerships Product financing arrangements,
where a company sells and agrees to either
repurchase inventory or guarantee a selling
price Sell receivables with recourse and
record them as sales rather than liabilities
Sell receivables as backing for debt sold to the
public Outstanding loan commitments
GAAP
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Off-Balance-Sheet Financing
Analysis of Off-Balance-Sheet Financing
Sources of useful information Notes and MDA
and SEC Filings   Companies disclose the
following info about financial instruments with
off-balance-sheet risk of loss Face,
contract, or principal amount Terms of the
instrument and info on its credit and market
risk, cash requirements, and accounting Loss
incurred if a party to the contract fails to
perform Collateral or other security, if
any, for the amount at risk Info about
concentrations of credit risk from a counterparty
or groups of counterparties   Useful analyses
Scrutinize management communications and press
releases Analyze notes about financing
arrangements Recognize a bias to not disclose
financing obligations Review SEC filings for
details of financing arrangements
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Financial Reporting by Lessees Capital Versus
Operating Leases(Example)

• Financial reporting by lessees will be
  illustrated using a noncancellable lease
  beginning December 31, 19X0, with annual MLPs of
  10,000 made at the end of each year for four
  years. Ten percent is assumed to be the
  appropriate discount rate.
• Operating lease. if the lease does not meet any
  criteria requiring capitalization
• (1) No entry is made at the inception of the
  lease.
• (2) Over the life of the lease, only the
  annual rental expense of 10,000 will charged to
  income and CFO.

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Financial Reporting by Lessees Capital Versus
Operating Leases(Example)

• Capital Lease. If the lease meets any one of the
  four criteria of a capital lease, then
• (1) At the inception of the lease, an asset
  (leasehold asset) and liability (leasehold
  liability) equal to the present value of the
  lease payments, 31,700, is recognized.
• (2) Over the life of the lease
• The annual rental expense of 10,000 will be
  allocated between interest and principal payments
  on the 31,700 leasehold liability according to
  the following amortization schedule

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Financial Reporting by Lessees Capital Versus
Operating Leases(Example)

• Allocation of
• Payment
  of 10,000
• Year Opening Liability Interest Principal
  Closing Liability
• X0
  31,700
• X1 31,700 3170
  6830 24,870
• X2 24,870 2487
  7513 17,357
• X3 17,357 1735
  8265 9,092
• X4 9,092 909
  9092 0
• 10 of the opening liabihty.
• Equals the opening liability less the periodic
  amortization of the lease obligation. Also equals
  the present value of the remaining MLPs.

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Balance Sheet Effect of Lease Capitalization

• 
  19X0 19Xl 19X2 19X3
  19X4
• Assets
• Leased assets
  31,700 31,700 31,700 31,700 31,700
• Accumulated depreciation 0
  7,925 15,850 23,775 31,700
• Leased assets, net
  31,700 23,775 15,850 7,925
  0
• Liabilities
• Current portion of lease obligation 6,830
  7,513 8,265 9,092 0
• Long-term debt lease obligation 24,870
  17,357 9,092 0 0
• 
  31,700 24,870 17,357 9,092
  0

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Income Effects of Lease Classification

• Operating Lease
  Capital Lease
• Operating Operating
  Nonoperating
• Total Expense Expense
  Expense
• Year Rent Depreciation
  Interest Total Expense
• Xl 10,000 7,925
  3,170 11,095
• X2 10,000 7,925
  2,487 10,412
• X3 10,000 7,925
  1,735 9,660
• X4 10,000 7,925
  909 8,834
• 40,000 31,700
  8,300 40,000

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Cash Flow Effect of Lease Classification

• Operating Lease Capital Lease
• Year Operations Operations
  Financing
• X0
• Xl 10,000 3,170
  6,830
• X2 10,000 2,487
  7,513
• X3 10,000 1,735
  8,265
• X4 10,000 909
  9,091

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Study questions and problem

• Question 1. An airline operator signs an
  agreement to lease an aircraft for twenty years.
  Annual lease obligations, payable at the
  beginning of the year, are 4.7 million. What
  are the financial statement effects of this
  transaction if the lease is recorded as (a) a
  capital lease or (b) an operating lease? As a
  corporate manager, what forecasts do you have to
  make to decide which alternative to use? Which
  method would you prefer to use to report the
  lease? Why? As a financial analyst, what
  questions would you raise with the firms CFO?

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Study questions and problem

• Question 2. United Airlines sells a round-trip
  ticket for a flight from Boston to London for
  750. The customer also receives 5,000 award
  miles, equivalent to 20 percent of the miles
  required for a free domestic flight. United
  expects 20 percent of its customers to redeem
  awards for future air travel, and the average
  forgone revenues from these flights to be 400
  per passenger.Finally, United estimates that the
  incremental costs associated with redemption of
  frequent flyer awards amount to 100 per
  passenger. What are the financial statement
  effects of this transaction if (a) the
  incremental cost approach is used, and (b)
  revenue is recognized using the deferred revenue
  approach? What forecasts, if any, do you have to
  make to complete the recording of this
  transaction? What factors would determine which
  of these two approaches is appropriate? As a
  financial analyst, what questions would you raise
  with the firms CFO?
•  

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Study questions and problem

• Question3. The CFO of a large bank argues It
  is ridiculous to recognize any fair- value gains
  or losses on our debt instruments that we intend
  holding to maturity. Since we intend holding
  these securities, we are insulated from the whims
  of the market. Do you agree? Explain why or why
  not. Given your answer, what are the implications
  for financial analysts following the company?