Corporate Financial Reporting 2 Financial Reporting of Leases ·1

Corporate Financial Reporting 2 Financial Reporting of Leases ·1

SIMPLE LEASE EXAMPLE Equipment costs 30,000 new, LESSEE leases the equipment for 3 years, payments at the END of the year. Lessee expects a residual value of 20,000 at the end of the 3 years and wants to earn 10%/year. The equipment has a 7 year life. To T1 T2 T3 30,000 20,000 HOW MUCH ARE THE ANNUAL LEASE PAYMENTS? ·2

SIMPLE LEASE EXAMPLE HOW MUCH ARE THE ANNUAL LEASE PAYMENTS? To T1 T2 T3 ·3

SIMPLE LEASE EXAMPLE If you were the CEO of a publicly traded company leasing this equipment, would you like to record this equipment as your asset and liability? ·4

SIMPLE LEASE EXAMPLE Suppose you “believed” the equipment was not your asset so you did not record the asset or liability – in financial reporting terminology you would be saying the lease was an “operating lease.” ·5

SIMPLE LEASE EXAMPLE if it is an Operating Lease To T1 6,021 T2 6,021 T3 6,021 How should you record the lease payments? ·6

SIMPLE LEASE EXAMPLE if it is a capital Lease Now, suppose you believed the equipment was your asset – in reporting terminology you would be saying the lease were a “capital (or finance) lease.” ·7

SIMPLE LEASE EXAMPLE if it is a capital Lease To 30,000 T1 T2 T3 20,000 At To: (Assume for now, the residual value was not guaranteed by the lessee.) How should you record signing of the lease? ·8

SIMPLE LEASE EXAMPLE if it is a capital Lease Lessee is making 3 payments of 6,021- a total of 18,063; the liability is recorded at 14,974. The difference of 3,089 represents what? ·9

SIMPLE LEASE EXAMPLE if it is a capital Lease To 30,000 T1 T2 T3 20,000 At T1 - T3 : How should you record the lease payments? And what else should you do at the end of each year? · 10

COMPARISON OF INCOME STATEMENTS WHICH HAS MORE EXPENSE OVER THE 3 YEAR LIFE OF THE LEASE? · 11

LEASES – REPORTING SUMMARY Balance sheet: capital lease increases liabilities (and the “worst ones” at that) and increases non-current assets. Income statement: capital lease reduces income more in the early years of the lease. Cash flow statement: capital lease payments divided between operating activity and financing activity – operating leases are operating activities. · 12

LEASES – WHICH IS IT? (OR WHAT TO DO TO AVOID capital LEASES) Can the lessee cancel the lease? no yes Does title transfer at the lease end? yes no Is there a bargain purchase option? yes no Is the lease for ¾ of the asset’s useful life? yes no Is the PVMLP 90% assets fair value? yes no and BOO ! CAPITAL LEASE HURRAY ! OPERATING LEASE · 13

LEASES Additional Considerations Residual value unguaranteed or guaranteed Executory costs Lessee’s interest rate incremental borrowing rate unless · 14

LEASES Additional Considerations Lessor Accounting Lessor’s Initial Direct Costs (IDC) incremental costs & internal costs (internal indirect costs – which are not IDC-so expense immediately) · 15

LEASES Additional Considerations Real Estate Sale and Leaseback · 16

SALE AND LEASEBACK FAIRLY COMMON TRANSACTION (OR PAIR OF TRANSACTIONS) · 17

SALE AND LEASEBACK Seller / lessee Buyer / lessor “sells” the asset leases the asset back · 18

SALE AND LEASEBACK Seller / lessee’s accountant looks at it as two (related) transactions. Transaction 1 – the sale – like the sale of PPE in ACCT 3220, but with a difference: gains/losses may or may not be recorded immediately. Transaction 2 – the leaseback – either operating or capital. · 19

LEASES – WHAT YOU SHOULD DO WHEN READING FINANCIAL STATEMENTS: IAS and American standards differ in detail, but both do give you a method to “undo” management “maneuvers” to avoid capital leases. · 20

LEASES – WHAT YOU SHOULD DO WHEN READING FINANCIAL STATEMENTS: Using Sony Corporation as an example. http://www.sony.net/SonyInfo/IR/financial/ar/2006/index.html · 21

LEASES – WHAT YOU SHOULD DO WHEN READING FINANCIAL STATEMENTS: Sony Corporation Balance Sheet (in million) {original} Current assets 3,218 PP&E 11,868 Other assets 75,579 Total assets 90,665 Current liabilities 27,352 Long-term liabilities 35,613 Owners’ equity 27,700 Total L. & O.E. 90,665 · 22

LEASES – WHAT YOU SHOULD DO WHEN READING FINANCIAL STATEMENTS: · 23

LEASES – WHAT YOU SHOULD DO WHEN READING FINANCIAL STATEMENTS: in million Year ending March 31: CAPITAL OPERATING LEASES LEASE 2007 157 406 2008 82 297 2009 46 227 2010 26 139 2011 18 98 Later years 40 504 Total 369 1,671 less interest (42) Present value 327 less current portion (145) Long-term portion 182 · 24

LEASES – WHAT YOU SHOULD DO WHEN READING FINANCIAL STATEMENTS: Sony Corporation Balance Sheet (in million) {revised} Current assets 3,218 PP&E ? liabilities ? Other assets 75,579 Total assets Current liabilities Long-term Owners’ equity Total L. & O.E. ? 27,700 · 25

THE LEASE: LESSOR ACCOUNTING LESSEE: LESSOR: Operating lease Operating lease Sales type lease Capital lease or Direct financing lease · 26

THE LEASE: LESSOR ACCOUNTING In general, if it is a capital lease for the lessee, then the lessor considers the asset to be sold, but not always. To be considered “sold” the lessor has two additional criteria that must be met. · 27

LEASES QUESTIONS? · 28