Financial Statement Analysis K R Subramanyam Copyright

Financial Statement Analysis K. R. Subramanyam Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

3 -2 Analyzing Financing Activities 3 CHAPTER Leases

3 -3 Leasing – Key Points Capital versus Operating Buildings compared to copiers Bank leverage ratio

3 -4 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

3 -5 Leases Lease Accounting and Reporting (1) Capital Lease Accounting For leases that transfer substantially all benefits and risks of ownership—accounted 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 (2) Operating Lease Accounting For leases other than capital leases—the lessee (lessor) accounts for the minimum lease payment as a rental expense (income)

3 -6 Leasing – Key Points Capital leases and Operating leases both have an interest and a principle portion of the payment.

3 -7 Leasing – Illustration Leased assets have an expected life of 5 years. Depreciation is straight line. Annual lease payment is $2, 505. Interest rate is 8%.

3 -8 Leasing – Illustration The total operating lease payment is considered to be an expense. Therefore if we consider this lease to be an operating lease, then the annual expense would be $2, 505.

3 -9 Leasing – Illustration If we consider the lease to be a capital lease then we must record an asset and a related liability associated with the leased property.

3 -10 Leasing – Illustration How much of the lease payment represents interest and how much represents principle? How do we determine such?

3 -11 Leasing – Illustration Step 1 We need to determine the present value of the stream of payments. What is the PV of $2, 505 for 5 years discounted at 8%?

3 -12 Leasing – Illustration Step 1 continued The PV of an annuity of 5 payment of $1 each discounted at 8% is a factor of 3. 99271.

3 -13 Leasing – Illustration Step 1 continued Therefore the PV of an annuity of 5 payment of $2, 505 each discounted at 8% is $10, 000. ($2, 505 times a factor of 3. 99271)

3 -14 Leasing

3 -15 Leasing – Illustration Step 2 How much is the annual depreciation of a $10, 000 assets with an expected life of 5 Years?

3 -16 Leasing – Illustration Step 2 How much is the annual depreciation of a $10, 000 assets with an expected life of 5 Years? Answer - $2, 000

3 -17 Leasing – Illustration Step 3 What is the income statement effect of accounting for a lease as an operating lease compared to a capital lease?

3 -18 Leasing

3 -19 Leasing – Illustration Step 4 What is the balance sheet effect of accounting for a lease as an operating lease compared to a capital lease?

3 -20 Leases

3 -21 Leasing – Illustration Step 5 What type of information is disclosed in the financial statements related to leases?

3 -22 Leasing

3 -23 Leasing – Illustration Step 6 If a company was concerned about having to much debt related to equity, which of the following would reflect less debt on the company’s books? Operating or Capitalized leases

3 -24 Leasing – Illustration Step 6 If a company was concerned about having to much debt related to equity, which of the following would reflect less debt on the company’s books? Answer - Operating

3 -25 Leasing – Illustration Step 7 If we were concerned that a company may be understanding their total debt position by structuring leases as operating lease instead of capital leases what would be a “red” flag?

3 -26 Leasing – Illustration Step 7 - Continued If we were concerned that a company may be understanding their total debt position by structuring leases as operating lease instead of capital leases what would be a “red” flag? Answer – Operating lease term longer than five years

3 -27 Leasing – Illustration Step 8 If we were concerned that a company may be understanding their total debt position by structuring leases as operating lease instead of capital leases what actions could an analyst take?

3 -28 Leasing – Illustration Step 8 - Continued If we were concerned that a company may be understanding their total debt position by structuring leases as operating lease instead of capital leases what actions could an analyst take? Answer – Adjust financial statement

3 -29 Leasing – Illustration Step 9 What specific steps would be taken to convert an operating lease to a capital lease?

3 -30 Leasing – Illustration Step 9 - A Determine both the amount and the number of lease payments. The first five years are provided.

3 -31 Leasing – Illustration Step 9 – A continued Estimate the number of years remaining after the first five by dividing total remaining payments by fifth year payment amount. The total number is years is the total above plus five.

3 -32 Leasing

3 -33 Leasing – Illustration Step 9 - B Compute the PV of the various lease payments to determine that net present value of the asset. Note: This will be the amount of both the asset to be recorded and the related liability.

3 -34 Leasing – Illustration Step 9 - C To compute the net present value, we need to know what discount rate to use. Determining this rate can be challenging!

3 -35 Leasing – Implicit Interest Rate We can determine the discount rate by: Trial and error based on information related to other capital leases. Long-term debt rate. Note - May need to adjust for changes in market rates.

3 -36 Leasing – Illustration Step 9 - D The present value of the various lease payments will be our “revised” asset base and our related liability base.

3 -37 Leasing – Illustration Step 9 - E Based on our computed lease liability amount, we can compute an amortization table to determine how much of each payment will be principal and how much will be interest.

3 -38 Leases Converting Operating Leases to Capital Leases Determining the Present Value of Projected Operating Lease

3 -39 Leases Restated Financial Statements after Converting Operating Leases to Capital Leases—Best Buy 2004

3 -40 Recasting Best Buy’s Income Statement z. Operating expenses decrease by $177 million (elimination of $454 million rent expense reported in 2004 and addition of $277 million of depreciation expense). z. Interest expense increases by $193 million (to $201 million) z. Net income decreases by $10 million [$16 million pretax x (1 -. 35), the assumed marginal corporate tax rate] in 2004. Recasting Best Buy’s Balance Sheet The balance sheet impact is more substantial z. Total assets and total liabilities both increase markedly—by $3. 321 billion at the end of 2004, which is the present value of the operating lease liability. z. The increase in liabilities consists of increases in both current liabilities ($261 million) and noncurrent liabilities ($3. 06 billion).

3 -41 Leasing – Illustration What impact did the restatement of the financial statements have on “key” ratios?

3 -42 Leases

3 -43 Leases Effects of Lease Accounting Impact of Operating Lease versus Capital Lease: • Operating lease understates liabilities—improves solvency ratios such as debt to equity • Operating lease understates assets—can improve return on investment ratios • Operating lease delays expense recognition—overstates 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 payment—inflates 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

3 -44 Leases Lease Disclosure and Off-Balance-Sheet Financing Lease Disclosure Lessee must disclose: (1) future MLPs separately for capital leases and operating leases — for each of five succeeding years and the total amount thereafter, and (2) rental expense for each period on 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 lease— neither the leased asset nor its corresponding liability are recorded on the balance sheet

3 -45 Leasing – Key Points Operating leases are simpler to account far, but capitalizing leases is conceptually superior. Consider the tax advantage of the one with the highest tax bracket. Book and tax can be different.

3 -46 Leasing – Key Points Implicit interest rate in operating leases. Capital leases - assume the estimated asset value is equal to the estimated liability.