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I. Objectives of the project

 

a. To perform a constructive capitalization on operating leases (i.e., as if the operating leases had been capitalized at the inception of a lease contract).

 

b. To learn the impact of reporting operating leases as capital leases at the inception of leases on liabilities, assets, retained earnings, net income and selected financial ratios.

 

c. To enhance the relevance and comparability of firm specific measures of risk and performance.

 

II. Procedures of Reporting Operating Leases as Capital Leases

         Imhoff, Lipe and Wright (ILW) (1991, 1997) studied the impact of lease capitalization on financial numbers and some key financial ratios.  The following financial variables were derived as if the operating leases of the firms were reported as capital leases in ILW (1991, 1997):  the unrecorded lease liabilities, the unrecorded leased assets, the impact of lease capitalization on income and retained earnings. 

          The Unrecorded Lease Liabilities (URL).  Statement of Financial Accounting Standards 13 (FASB Accounting Standards Codification 840) requires footnote disclosure of operating lease payments including five subsequent years’ lease payments and a one lump-sum payment for the remaining life of the leases.  In ILW (1991), the lease term is assumed to be 30 years and half-expired (thus, with 15 years remaining) and the lump-sum payment is assumed to be equally paid in 10 years  

                                                                                                          t+15

(15 years remaining minus the five detailed years). Thus, URLt = ∑ PV (Xi), where t is                                                                                                  i=t+1

                                                                                                                 

the test year, PV (Xi) denotes the present value of the  lease payment for year i and i = t+1 to t+15 using an appropriate discount rate.  

            The Unrecorded Leased Asset (URA).  At the inception of a lease term the unrecorded lease liability (URL) equals the unrecorded leased asset (URA), however, the URA would decline at a faster rate than the URL over the life of an individual lease.  While the URA is reduced by a straight-line depreciation expense, the URL is decreased by the lease payment minus interest expense.  Since the lease payment is predominately comprised of interest expense in the early life of a lease term, the URA is therefore, declining at a faster rate than the URL.  ILW (1991) managed this by assuming that for the half-expired 30-year lease contract, the URAt is 70% of the URLt for the test year t. For the purposes of your project, use this assumption.

           Constructive Lease Capitalization Impact on Income and Retained Earnings.  For a capital lease, the expenses charged include both depreciation and interest whereas the operating lease expense is only the lease payment (i.e., reported as the rent expense).  In the early life of a lease term (i.e., before the leased asset is about 53 % to 63 % depreciated according to IWL (1991)), depreciation plus interest expense is greater than the lease payment and therefore, the capital lease expense is greater than the operating lease expense. However, this phenomenon is reversed later in the lease term in which the operating lease expense is greater than the capital lease expense.  Therefore, the constructive lease capitalizations impact on income for a given year could be either negative (e.g. in the early life of a lease term) or positive (e.g. in the later life).  Nevertheless, the constructive lease capitalization’s impact on the retained earnings is always negative due to the cumulative nature of the retained earnings. 

         The Derivation of the Impact on Retained Earnings (∆RE).  To obtain the impact of a capital lease on retained earnings as compared to an operating lease, the excess of capital lease expenses over operating lease expenses up to the test year (year t) is calculated.  Recall that the URA is reduced by the depreciation expense while the URL is reduced by (lease payment – interest expense).  Thus, the difference of URA and URL equals [(depreciation expense) – (lease payment-interest expense)] which can be rewritten as [(depreciation expense + interest expense) – lease payment] or (capital lease expense – operating lease expense).[1]  Therefore, the cumulative excess expense of a capital lease over an operating lease is identical to the difference between URLt and URAt.  Consequently, the impact (zero or negative) on the retained earnings from the lease capitalization (hereafter, ∆RE), in the absence of tax effects, equals URAt – URLt.                      

                Cumulative Tax Savings , Deferred Tax Benefits, Net Impact on Retained Earnings (Net ∆RE) and Net URL.   A further complication in the constructive capitalization of the leases are the differences in deferred taxes between a capital lease and an operating lease.  Since a capital lease results in higher expenses, it would enjoy a deferred tax benefit and also a reduction in cumulative income tax expenses (or cumulative tax savings) in the early years of the lease.[2]  This means that the negative impact of a capital lease on retained earnings is reduced by the cumulative tax savings.  The cumulative tax savings are calculated as the marginal tax rate of year t (TRt) times the excess of capital lease expenses over operating lease expenses up to year t (i.e., URAt-URLt ).  Therefore, the net impact on retained earnings (Net ∆RE) from lease capitalization for year t is: ∆REt – TRt x ∆REt.  Similarly, the deferred tax benefits   should also be subtracted from the URLt to obtain the Net URLt.   Thus, NetURL t = URLt  – TRt x (URAt – URLt) .

               The Impact on Income (∆IN), Tax Savings for a Given Year (TSAV),  and the Impact on Net Income (∆NetIN).  Adding the income impact of year t from lease capitalization to ∆REt-1 should result in the lease capitalization impact on retained earnings of year t (i.e., ∆REt).  Therefore, the difference of the cumulative capital lease expenses over operating leases expenses of t (i.e., ∆REt) and that of t-1 (i.e., ∆REt-1) equals the difference of the capital lease expenses and operating lease expenses of year t.  To calculate the impact on income (∆IN) from the lease capitalization for year t, one should subtract the ∆REt -1 from the ∆REt.  A negative result (i.e., ∆REt – ∆REt -1< 0) would indicate that the capital lease expenses are greater than the operating lease expenses for year t.  Therefore, the constructive lease capitalization would reduce the income of year t (referred to as a negative income impact from lease capitalization).  This phenomenon usually occurs from the inception of the lease contract until the leased asset is about 53 percent to 63 percent depreciated (IWL, 1991).  On the other hand, a positive result  (i.e., ∆REt – ∆REt -1> 0) indicates an opposite effect: that the capital lease expenses are less than the operating lease expenses for year t, and therefore, the constructive lease capitalization would increase the income for year t (i.e., referred as a positive income impact from lease capitalization).

               When the tax effect is considered, the negative (or positive) impact on income of year t from lease capitalization would be reduced by the tax savings (or additional tax cost when the impact on income is positive) of year t.  The tax savings (or additional tax cost) equals TRt times the income impact of year t (i.e., ∆REt– ∆REt -1).  Thus, with tax consideration, the net impact on income for year t (referred to as ∆NetINt) equals (1-TRt) x (∆REt– ∆REt -1).    

 

III. Assumptions and the Content of the Project Report

 

3.1 Assumptions

  • an incremental borrowing interest rate of 10%;
  • the average remaining life of the operating leases is 15 years;
  • all scheduled cash flows occur at beginning of the year;
  • the unrecorded leased asset equals 70 percent of the unrecorded lease liabilities;
  • the combined effective tax rate is 40%.

 

 3.2 Content of the Report

 

      Your group report for the project should include the following sections:

 

1.     Introduction

 

    • Describe the current accounting treatment of reporting leases as operating versus capital and the advantages of reporting leases as operating compared to capital leases. Also comment on the flexibility of the current provisions to allow the lessee to structure leases as operating leases.

·      Describe the purposes of your paper.

 

2.     Methodology

 

·      Summarize Imhoff, Lipe, and Wrights’ (1991) paper since the constructive lease capitalization method applied in your paper follows that described in ILW (1991). 

·      Describe how to derive URL, URA and the impact of lease capitalization on earnings.

 

3.     Sample and Data Collection

 

·      Select one companies from one of the following industries: airlines, package delivery, home furnishings, food stores, fast food, clothing, and drug stores. Describe the background information of your selected firms.

·      Describe the source of your data and data collection. 

  

4.     Empirical Analyses 

·      Calculate the following variables of your companies: 

 

§  The unrecorded lease liabilities of year t (URLt) as if all operating leases were capitalized and the percentage of URLt on reported total liabilities of year t. Note that  t =2016 for URL and for all subsequent variables.

§  The unrecorded leased assets of year t (URAt) as if all operating leases were capitalized and the percentage of URAt on reported total assets of year t.

§  The debt-to-equity ratio of year t (D/Et) as reported in the financial statement and the adjusted D/Et as if all operating leases were capitalized.

§  The return on assets (ROAt) as reported in the financial statements of year t and the adjusted ROAt as if all operating leases were capitalized for year t. For the purpose of this project, assume that the lease capitalization impact on the retained earnings of year t –1 (t is the test year) is 20% higher than that of year t.

 

5.     Conclusion 

Based on your findings, provide your conclusion for the study (e.g. discuss the impact of lease capitalization on various financial variables/ratios and the possible motivations of firms to report leases as operating leases).     

 

Bonus Question

 

Discuss why the FASB issued ASU2016-2 and describe how leased assets and lease liabilities are reported on the balance sheet and the income statements based on ASU2016-2. Your description should include the reporting of the leased assets and lease liabilities on the balance sheet and the lease expenses on the income statement.

                                                                                                                                   

 

 

 

 

 

An Example of Operating Lease Capitalization:

 

Information:

Reported financial numbers:

Net income  = 4 million

Total assets  = 40 million

Total liabilities = 25 million

Total equity    = 15 million

 

Assumptions for the example:

1.  an incremental borrowing interest rate of 10%;

2.  the average remaining life of the operating leases is 15 years;

3.  all scheduled cash flows occur at beginning of the year;

4.  the unrecorded leased asset equals 70 percent of the unrecorded lease liabilities;

5.  the combined effective tax rate is 40%.

 

Other information:

The present value of all future cash flows of the operating leases (the unrecorded lease liabilities) equals $10 million dollars.[3]

 

 

The following partial balance sheet presents the impact of constructive capitalization of operating leases on assets, liabilities and equity:

 

 

                                        Balance Sheet (partial)

                                                 12/31/2015

                                              (in millions)

 

Assets:                                                                      Liabilities:

 

Unrecorded lease Assets              7                             Unrecorded Lease Liabilities        10

(unrecorded liabilities * 70%)                                    Tax Savings a                              (1.2)

                                                                                   ((7-10) x tax rate 40%)   

                                                                                   Net Liability Effect                       8.8

 

                                                                                    Stockholders’ Equity:

Cumulative Effect on Retained       Earnings Net of Tax Consequences

                                                                                   (7-10) x (1-40%)                       (1.8)

                                                      7                                                                                 7.0

 

a.Tax savings are income tax savings for the capital leases resulting from a greater amount of lease expense associated with the capital leases than with the operating leases.  The difference in expense charges between the two lease methods equals the difference between the unrecorded lease assets and the unrecorded lease liabilities.  This is because the difference between the unrecorded assets and unrecorded liabilities =  amortization expense – (lease payment – interest expense)

   =  amortization expense + interest expense – lease payment (the rental expense).

   The sum of amortization expense and interest expense is the expense charged under capital leases while the rental expense is the expense charged under operating leases. Thus, the difference between unrecorded assets and unrecorded liabilities is also the difference in expense charges between the two lease methods.

 

 

Reported financial ratios:                                  Adjusted financial ratios with operating leases capitalized:

 

 

ROA =   4/40 = 10%                                            ROA = (4-0.36)/ (40+7) = 7.72% 

 

D/E   =  25/15 =  1.67                                           D/E  = (25+8.8)/(15-1.8) = 2.56

 

Note: Assuming the lease capitalization impact on equity is -$2.4 for 2014 (i.e., 20% higher than that of 2015). The lease capitalization impact on the net income of 2015 = (-3- (-2.4)) x (1-40%) = -0.36 

                   

 


[1] This mathematic proof is not provided in either IWL (1991) or IWL (1997).

[2] Due to no impact on the income tax payable from adopting a different accounting method for financial reporting purposes, the reduction in the cumulative income tax expenses (or tax savings) would only reduce the deferred income tax liabilities (or incur deferred income tax benefits).

[3] You need to compute this amount for the project based on the method described in Imhoff, etc. (1991). This method is also described in page one of this outline.