A Note on Comdiscos Lease Accounting

Accounting for Equipment Acquisition

Accounting for purchases Accounting for operating leases Accounting for capital lease
PV of Beginning Balance Inetrest Payment of Ending Balance of Lease Lease of Capital Lease Expenses @ Capital Lease Capital Lease Year Rentals Rentals Obligations 10% Obligations Obligations 1 100 90.91 379.08 37.91 62.09 316.99 2 100 82.64 316.99 31.70 68.30 248.69 3 100 75.13 248.69 24.87 75.13 173.55 4 100 68.30 173.55 17.36 82.64 90.91 5 100 62.09 90.91 9.09 90.91 0.00

Accounting in Lessor Books Operating Lease

Lease signed

Dr: Leased computer equipment $400 Cr: Inventory of computer equipment: $400 Dr: Cash $100 Cr: Rental revenue $100 Dr: Depreciation $50 Cr: Accumulated Depreciation: $50

Lease payment is received each year

Depreciation expense

Accounting in Lessor Books Capital Lease

Signing lease

Dr: Investment in financing lease: $410.15 Cr: Inventory of computer equipment: $410.15 Dr: Cash $100 Cr: Interest income: y Cr: Net investment in financing lease: 100 - y

Receiving lease payment

Year 1 2 3 4 5

Lease Rentals 100 100 100 100 150

PV of Beginning Balance Inetrest Payment of Ending Balance of Lease of Capital Lease Expenses @ Capital Lease Capital Lease Rentals Obligations 10% Obligations Obligations 90.91 410.12 41.01 58.99 351.14 82.64 351.14 35.11 64.89 286.25 75.13 286.25 28.63 71.37 214.88 68.30 214.88 21.49 78.51 136.36 93.14 136.36 13.64 136.36 0.00

Accounting for Discounted Lease Payments Operating Lease

Lease rentals assigned to bank

Dr: Cash $240.20 Cr: Discounted lease rentals $240.20

Rental payment received each year and forwarding payment to bank

Dr: Interest expense Dr: Discounted lease rental Cr: Rental revenue
Year 1 2 3 PV of Beginning Balance Inetrest Payment of Ending Balance of Lease Lease of Capital Lease Expenses @ Capital Lease Capital Lease Rentals Rentals Obligations 12% Obligations Obligations 100 89.29 240.18 28.82 71.18 169.01 100 79.72 169.01 20.28 79.72 89.29 100 71.18 89.29 10.71 89.29 0.00

Accounting for Discounted Lease Payments Capital Lease

Lease payments assigned to bank in return for cash

Dr: cash $360.50 Dr: Interest expense $18.60 Cr: Net investment in direct financing (or sales-type lease): $379.10

Leveraged-Lease Strcuture

Lessee Equipment Lease Payments

Equity investors put up to 20% of equipment value in exchange for lease payments after debt service

Owner Trustee

Lenders advance 80% of equipment value in exchange for first claim on lease payments

Equipment Owner Lessor

Lender

Symptoms of Capital Lease

Transfer of ownership at the end of lease term Purchase option to the lessee at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised; Lease term is for the major part of the economic life of the asset even if title is not transferred; At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and Leased asset is of a specialised nature such that only the lessee can use it without major modifications being made.

Symptoms of Capital Lease

If the lessee can cancel the lease, the lessors losses associated with the cancellation are borne by the lessee; Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for example in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and The lessee can continue the lease for a secondary period at a rent which is substantially lower than market rent.

Capital vs. Operating

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Financial vs. Operating

Finance Lease Total lease rental > asset price Lease period = life of asset No fixed future commitment Operating Lease

Irrevocable by both parties

Purpose: financing an asset Also called capital lease Lessee bears: maintenance, insurance, taxes

Cancelable by lessee on notice

Purpose: using an asset Lessor bears: maintenance, insurance, taxes

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Financial vs. Operating

Finance Lease Operating Lease

Min lease rental = rate ~ equal Risk on asset falls on lessee to lessee marginal cost of debt Payout will include; asset cost, cost of financing, lessor overhead, rate of return Similar to mortgage loans

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Types of Financial Leases

Direct leases

Lessor purchased equipment or asset and rented it out to lessee

Sale-and-leaseback Leveraged leases

Lessor borrowed money to fund part of purchase of assets, pledging the lease contract as security for the loan

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Leveraged Lease

Parties involved..,

Lessor contributes equity (20% to 40%) Lessee Financier finance by way of term loans Airplane Satellites Ships Rails Off-shore drinking Nuclear machines Power generation plants Large chemical plants Gas pipe lines

Used for assets requiring huge capital outlay,

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Sale and Lease Back Operating Lease Type

If a sale and leaseback transaction results in an operating lease, and it is clear that the transaction is established at fair value, any profit or loss should be recognised immediately. If the sale price is below fair value, any profit or loss should be recognised immediately except that, if the loss is compensated by future lease payments at below market price, it should be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value should be deferred and amortised over the period for which the asset is expected to be used.

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Sale and Lease Back Finance Lease Type

Do not recognize any excess or deficiency of sales proceeds over the carrying amount immediately as as income or loss in the financial statements of a sellerlessee. Instead, it should be deferred and amortised over the lease term in proportion to the depreciation of the leased asset.

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Other Types of Leases

Master lease: blanket leasing Percentage lease: flat rental + additional rental over and above a revenue Wet and dry lease used in airline industry Triple net lease net of insurance, maintenance, taxes. Closed end and open end lease ownership possibilities opened to lessee Swap lease exchange assets in need of major repairs Full pay-out lease True lease fully goes with the local rules and regulations of a country Wash lease tax benefit transferred to investor Upgrade lease used in obsolescence Capital lease to transfer ownership to lessee at the end of lease term Employee lease transferring employees to Lessor and leasing it back

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Accounting for Capital Lease

At the inception of a finance lease, the lessee should recognise the lease as an asset and a liability. Such recognition should be at an amount equal to the fair value of the leased asset at the inception of the lease. However, if the fair value of the leased asset exceeds the present value of the minimum lease payments from the standpoint of the lessee, the amount recorded as an asset and a liability should be the present value of the minimum lease payments from the standpoint of the lessee. In calculating the present value of the minimum lease payments the discount rate is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessees incremental borrowing rate should be used.

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Estimating Discount Rate

Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception If the lessee knows the implicit interest rate computed by the lessor and it is less than the lessees incremental borrowing rate, then lessee must use the lessors rate.

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Recovery Test

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Capital Lease Accounting

Asset and Liability Recorded at the lower of:

Present value of the minimum lease payments (excluding executory costs) or the fair-market value of the leased asset If lease transfers ownership, depreciate asset over the economic life of the asset If lease does not transfer ownership, depreciate over the term of the lease

Depreciation Period

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Why Leasing?

Benefits to lessee..,

Leasing 100% financing Offers cash flow benefits Off balance sheet financing Avoidance of loan covenants Tax planning Creation of working capital Hedge against risk of inflation and obsolescence Fast and flexible financing To over come monopoly act Used in non-priority sector and service sector

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Why Leasing?

Benefits to lessor..,

Additional financial product Reduces risk Increases profitability Accelerates sales Higher leverage [Max. of 10:1] No gestation period Low cost of operations

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Lease vs. Buying

Lease financing

Increases companys debt capacity Used when public market is saturated Also includes interest component Investors will not recognize a financial lease liability as a form of debt?

Liabilities: PV of financial lease payments Assets: PV of financial lease payments

Possibility of increasing book income by avoiding depreciation and interest?

Lease payments includes depreciation and interest

Possibility of evading capital-expenditures To avoid capital-approval procedures

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Difference between Lessor and Lessee Creating More Value for Lease

Tax rate differences between lessor and lessee Realizing depreciation deduction by lessor and lessee Asset acquisition and maintenance cost specialization or scale of economies Realizing salvage values superiority of property knowledge Leverage abilities between lessor and lessee difference in interest deductibility

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