Off balance Sheet Financing

Leases
• The mother of all off-balance sheet liabilities is leasing. A lease that appears on the
Balance sheet is called a capital lease and a lease that does not appear on the Balance
sheet is called an operating lease. With an operating lease, the entire payment is a rental
expense and is an operating use of cash. With a capital lease, the lessee originally
records both an asset and a liability equal to the present value of the minimum lease
payments (MLP).

• With a capital lease, the annual expense includes depreciation on the leased asset and
interest on the capital lease liability. Depreciation expense can be calculated using either
straight-line or accelerated depreciation. Each payment the lessee makes on a capital
lease is divided into interest and principal (exactly as a mortgage payment), with the
payments being allocated first to interest and then to principal. That is, whatever payment
is left over after interest is a reduction in the outstanding liability. Since the lease
payments are usually constant over time, more of the capital lease payments in the earlier
years will be allocated to interest and more of the payments in the later years will be
allocated to principal. Over the life of the lease, the lease obligation is amortized to zero
and the lease asset is depreciated to zero.

• Over the life of the lease, the total expense will be the same with both an operating
and a capital lease. However, the timing of the expense recognition will differ
between operating and capital leases. In the early years of the lease, the expense will
be greater with a capital lease, because interest expense and depreciation (if an
accelerated method is used) are greater in the earlier years.

• As far as the statement of cash flows is concerned, free cash flow will always be
higher with a capital lease. The reason is that a large chunk of the capital lease
payments will be a financing use of cash - the repayment of the lease obligation. The
balance sheet implications are clear: the leverage and long-term debt situation, as
calculated directly from the Balance sheet, will look better with an operating lease.
This is the main reason why lessees prefer operating leases.

• Classification of a lease on the part of the lessee is not arbitrary. If ANY one of four
conditions are met, the lease MUST be classified as a capital lease. The conditions are:
• Bargain Purchase Option at end of lease term.
• Asset reverts to lessee at end of lease term.
• Lease term exceeds 75% of asset's useful life.
• PV of the MLP exceeds 90% of the fair market value (FMV) for the leased asset.

• If a lessee wants the lease to be accounted for as an operating lease, it must ensure that
none of these four conditions are met. The logic of these rules is that if any of these 4
conditions are met, there is strong evidence that the transaction is best described as a sale,
with an accompanying lease to finance the sale. If none of these conditions are met, then

Haim A. Mozes, 2002, all rights reserved .1

 a simple rental may be a better description of the lease transaction.

• The MLP payments are basically the minimum the lessee can pay under the
contract (including penalties for early termination), plus the guaranteed residual
value, if any. If there is a bargain purchase option, that amount is added to the
MLP. Note that executory costs (i.e., property taxes and maintainence costs
assumed) are not included in the MLP. One game with the MLP is for the lessee
to pay a third party to guarantee the residual value. In this scheme, the lessor has
the guaranteed residual it needs to make the lease work out financially, but the
lessee does not directly guarantee that value. Therefore, the lessee can keep the
residual value out of the MLP computation and fail the 90% test. Another game is
to set up a part of the lease payments on a contingency basis, such as a percentage
of revenues. Contingent lease payments do not have to be included in the MLP.
However, the firm must disclose the contingent payments actually made in the
past few years, and the formula by which contingent payments will be calculated.

• For a capital lease, the firm will report both a current liability and a non-current liability.
The current liability is the principal payment that is due in the next 12 months. This
amount is usually considerably less than the total lease payment due in the next 12
months. The difference is due to the interest component built into the lease payment due
within 12 months. The difference between the PV of the MLP and the current portion of
the lease liability is reported as a non-current liability. The non-current liability is usually
called something like "Obligations Under Capital Leases".

• The firm makes detailed footnote disclosures about its leases. For both the firm’s
operating and capital leases, it will separately disclose the MLP for each of the next five
years, plus the aggregate amounts due on the leases from year six and on. For capital
leases, the firm also discloses the PV of the MLP. By far, the most important
adjustment an analyst usually needs to make for an operating lease is to capitalize it
on the Balance sheet. This involves computing the PV of the MLP on the operating
leases and adding that amount to both assets and liabilities. Virtually any credit analyst
worth his or her salt does this type of balance sheet adjustment. The footnote data can be
easily used to capitalize the operating leases. All that is needed are estimates of:
• the firm's borrowing rate on leases.
• the payment pattern of the MLP for years six and on.

• There are two ways to estimate the appropriate interest rate:

• Impute the discount rate on the firm's capital leases, given the PV of the
capitalized lease obligation and the payment stream for the capitalized leases.

• First, compare the lease payment due next period and the current portion of the
lease obligation, to estimate the interest due on the lease obligation next year.
Then, divide this interest amount by the total lease liability at the end
(beginning) of the period or by the average lease liability for the period, to get a
good estimate of the interest rate on the lease.

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• The estimate of the payment pattern of the MLP for years six and beyond is usually not
crucial because it is so far in the future. The typical approach is to assume that the annual
payments in years 6 and beyond equals that in year 5. For example, assume that the firm
discloses that under its operating leases it will make payments of $80 million in year 5
and a total of $480 million in years 6 and beyond. One can extrapolate that the payments
in years 6 and beyond will be $80 million per year and extend from years 6 to 11.

• One can also adjust the Income and Cash Flow statements that are reported under the
operating lease approach. After capitalizing the operating lease obligation and asset, one
can determine both the interest expense on the lease obligation and the depreciation on
the asset. The sum of these two components is then compared to the actual lease
payment. If the sum of the two components is greater than the lease payment, subtract the
after-tax difference from operating income, and vice versa. However, the results of this
procedure may not be too material, especially in the middle years of the lease.

• Similarly, after capitalizing the operating lease one can add back the (after-tax)
difference between the rental payment and the interest component of that payment to
operating cash flows. It is important to understand that capital leases will always
result in higher free cash flow than operating leases. The tradeoff is that when
capitalizing operating leases, the firm's debt/equity ratio declines, as does the interest
coverage ratios.

• In summary, with an operating lease, the lease will have the same effect on earnings and
operating cash flows each year, leading to more stable and predictable earnings. With a
capital lease, earnings and operating cash flows will be more volatile, as interest and
depreciation expense vary over the life of the lease.

• The tax treatment of the lease will often differ from the accounting treatment, usually
resulting in deferred tax liabilities. This is especially prevalent in safe-harbor leasing,
where one party owns the asset for financial accounting purposes and another party owns
the asset for tax purposes.

• Lease Accounting for the Lessor

• The lessor has the same four rules for capitalizing leases except that the lessor also
includes the unguaranteed residual value in the MLP. There are two types of capital
leases for the lessor: direct-financing leases and sales-type leases. In direct-financing
leases the PV of the MLP equals the lessor's cost of the leased asset, and the lessor’s
entire profit is the interest. In sales-type leases, the PV of the MLP exceeds the lessor's
cost of the leased asset. In these cases, lessors recognize a gross profit on the sale in the
year of the lease, and interest revenue over the life of the lease.

• The accounting for the lessor is a bit cumbersome. The lessor of a capital lease will
usually report the "net investment in capital leases." This is the gross (undiscounted)
receipts expected under the lease (including the residual value), less unearned interest

Haim A. Mozes, 2002, all rights reserved .3

 revenue. The unearned interest revenue is the difference between the PV of the MLP and
the gross receivable. As payments are received, both the net investment and unearned
interest revenue will decline. The accounting differs slightly depending on whether or not
the residual value is guaranteed. However, this difference is no big deal because it does
not affect the amount of gross profit recognized (it just affects sales revenue and CGS).

• A common type of lease, but with very complex accounting issues, is a leveraged-lease.
In a leveraged lease the lessor obtains long term financing from a third party. The net
investment in this case is calculated net of the third party debt. The principal
characteristic of a leveraged lease is that the net investment turns negative for a while.
This occurs because on a net basis, the lessor has extracted more than the original
investment after the first few years (through payments from the lessee and tax deductions
from accelerated depreciation). However, the net investment eventually increases back to
zero, after the lessor incurs additional tax obligations when depreciation deductions
diminish and after debt payments are made to the third party. The key
accounting/computational question with leveraged leases is how to determine the proper
discount rate on the leveraged lease.

• Crucial role of residual value

• In many leases, the estimated residual value is a crucial component of the return on the
lease. When the investment tax credit was eliminated by Congress and the lessor's tax
deductions from depreciation fell in value due to decreases in marginal corporate tax
rates, the economics of leasing soured. In order to maintain their lease rates, lessors had
to assume (hope for) a greater residual value, possibly leading to over optimistic
assumptions of residual value and overstated amounts in lessors' books for the "net
investment". According to GAAP, lessors must review their residual value estimates at
least annually. Empirical evidence indicates that lessors' estimates of residual value, as a
percentage of the asset's current MV, has increased since the Tax Reform Act of 1986.
These points are important to keep in mind when analyzing lessor firms.

• Sales-Leasebacks
• Say that XYZ Co. has an asset on its books with a BV of $50 million and a MV of $60
million. Then, XYZ sells the asset to GE Credit for $60 million and immediately leases
it back from GE Credit. Further assume that the PV of the MLP is exactly $60 million.
In GE's books, this is an ordinary lease transaction. The interesting question arises with
respect to XYZ's books. The basic question is whether XYZ can recognize any gain on
the sale-leaseback transaction. An economic analysis would suggest that a sale-
leaseback is really a loan collateralized by the asset. XYZ has the same asset as
before, with the same rights of use. All that changes is that it has $60 million more in
cash and a new obligation of $60 million. Accordingly, the general accounting answer is
that the gain can only be recognized over the life of the lease term.

• What might motivate XYZ Co. to engage in the sale-leaseback transaction? The most

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 rational explanation is a change in the tax status of XYZ. If XYZ's taxable income is
lower than previously expected, it can't efficiently use the tax shields generated by
ownership of the asset. Hence, it makes sense to sell those tax shields to GE credit and
share the tax savings with GE.

Haim A. Mozes, 2002, all rights reserved .5