Download Operating Leases

Fourth Edition
Peter D. Easton
Mary Lea McAnally
Greg Sommers
MODULE 10
Off-Balance-Sheet
Financing
©Cambridge Business Publishers, 2015
Xiao-Jun Zhang
Learning Objective 1
Describe and illustrate the accounting
for capitalized leases.
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Off-Balance Sheet Financing
 Off-balance sheet financing means that either
assets or liabilities, or both, are not reported on
the face of the balance sheet.
 Managers generally believe that keeping such
assets and liabilities off the balance sheet
improves market perception of their operating
performance and financial condition.
 Empirical evidence suggests that analysts adjust
balance sheets to include assets and liabilities
that managers exclude.
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Leasing
 A lease is a contract between the owner of an
asset (the lessor) and the party desiring to use
that asset (the lessee).
 Generally, leases provide for the following
terms:
1. The lessor allows the lessee the unrestricted right
to use the asset during the lease term.
2. The lessee agrees to make periodic payments to
the lessor and to maintain the asset.
3. Title to the asset remains with the lessor, who
usually retakes possession of the asset at the
conclusion of the lease.
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Capital vs. Operating Leases
GAAP identifies for two different approaches in
the reporting of leases by the lessee:
 Capital lease method - both the lease asset and the
lease liability are reported on the balance sheet.
 Operating lease method - neither the lease asset nor
the lease liability is on the balance sheet.
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Capital vs. Operating Leases
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Operating Leases
Consequences for the lessee:
1. The lease asset is not reported on the balance sheet - net operating
asset turnover (NOAT) is higher.
2. The lease liability is not reported on the balance sheet - financial
leverage is improved.
3. Without analytical adjustments (see later section on capitalization of
operating leases), the portion of ROE derived from operating
activities (RNOA) appears higher, which improves the perceived
quality of the company’s ROE.
4. During the early years of the lease term, rent expense reported for an
operating lease is less than the depreciation and interest expense
reported for a capital lease. This means that net income is higher in
those early years with an operating lease. Further, if the company is
growing and continually adding operating lease assets, the level of
profits will continue to remain higher during the growth period.
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Southwest Air’s
Footnote Disclosures of Lessees
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Capitalizing Operating Leases
for Analysis Purposes
1.
2.
3.
Determine the discount rate.
Compute the present value of future
operating lease payments.
Adjust the balance sheet to include the
present value of the lease asset and lease
liability. Adjust the income statement to
include depreciation and interest in lieu of
rent expense.
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Southwest Air’s Implicit Discount Rate
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Capitalization of Southwest Air’s
Operating Leases on the Balance Sheet
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Adjustments to the Income Statement
 Remove rent expense from operating expense.
 Add depreciation expense from the lease assets
to operating expense and add interest expense
from the lease obligation as a nonoperating
expense.
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Capitalization of Southwest Air’s
Operating Leases
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Learning Objective 2
Describe and illustrate
the accounting for pensions.
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Pensions
Generally two types of plans:


Defined contribution plan – This plan requires
the company to make periodic contributions to
an employee’s account, and many plans require
an employee matching contribution.
Defined benefit plan – This plan requires the
company to make periodic payments to an
employee after retirement.
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Accounting for
Defined Contribution Plans
 From an accounting standpoint, defined
contribution plans offer no particular problems.
 The contribution is recorded as an expense in
the income statement when cash is paid or the
liability accrued.
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Two Accounting Issues Related to
Defined Benefit Plans
1. The appropriate balance sheet presentation of the
pension investments and obligation.
 The pension standard allows companies to report the
net pension liability on their balance sheet.
 Underfunded plans are reported on the balance sheet
as a long-term liability.
 Overfunded plans are reported as a long-term asset.
2. The treatment of fluctuations in pension investments
and obligations in the income statement.
 The FASB allows companies to report pension income
based on expected long-term returns on pension
investments (rather than actual investment returns), and
to defer the recognition of unrealized gains and losses
on both pension investments and pension obligations.
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Plan Assets and PBO Computations
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Balance Sheet Presentation
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PBO Components
 Service cost – the increase in the pension
obligation due to employees working another
year for the employer.
 Interest cost – the increase in the pension
obligation due to the accrual of an additional
year of interest.
 Benefits paid to employees – the company’s
obligation is reduced as benefits are paid to
employees.
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Pension Expense
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FedEx Corp’s Funded Status
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FedEx Corp’s Pension Expense
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Cash Flow Implications
One application of the pension footnote is to
assess the likelihood that the company will be
required to increase its cash contributions to the
pension plan.
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Profit Implications
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How Pensions Confound
Income Analysis
General Electric Co.
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Global Accounting
 Leases – IFRS lease standards currently allow for
operating leases, but the standards are such that it is
very difficult for a lease agreement to qualify as an
operating lease.
 Pensions – U.S. GAAP permits deferral of actuarial
gains and losses and then amortizes them to net
income over time. IFRS companies can recognize all
actuarial gains and losses in comprehensive income in
the year they occur.
 Special Purpose Entities – Under U.S. GAAP, the
primary beneficiary is required to consolidate the SPE.
IFRS focuses on the general concept of “control” to
determine if the SPE is consolidated.
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Learning Objective 3
Explain the accounting for
special purpose entities (SPEs).
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Special Purpose Entities (SPEs) –
Asset Securitization
 A sponsoring company forms a subsidiary that is
capitalized entirely with equity; this creates a
bankruptcy remote transaction, which reduces
the likelihood of bankruptcy for subsequent
investors).
 The subsidiary purchases assets from the
sponsoring company and sells them to a
securitization trust (the SPE), which purchases
the assets using borrowed funds.
 Cash flows from the acquired assets are used by
the SPE to repay its debt.
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Special Purpose Entities (SPEs)
Ford Motor Credit
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Ford’s Asset Securitization
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Rationale for SPE Financing
 Lower cost of capital – SPEs can provide lower
cost financing for a company.
 Liquidity – Securitization of assets provides a
consistent cash flow source.
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Consolidation of SPEs
 Generally, any entity that
 lacks independence from the sponsoring company
 lacks sufficient capital to conduct its operations apart from
the sponsoring company
 Must be consolidated with whatever entity bears the
greatest risk of loss and stands to reap the greatest
rewards from its activities.
 The effect of consolidation of SPEs is to report both the
assets and liabilities on the consolidated balance sheet.
 The financing is, therefore, on-balance sheet, but the
lower capital costs and liquidity of the market make this
an important financing tool for many companies.
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The End