ASSIGNMENT ON

SPECIAL ITEMS INFLUENCING A FIRM’S LONG TERM

DEBT PAYING ABILITY

SUBMITTED TO SUBMITTED BY

DR. MEENA SHARMA ASTHA SAVYASACHI

JAIDEEP SINGH BHATIA

MBA-4th SEM
LEASES:

It is a contract between the owner of an asset-the lessor and another party seeking use of
asset-the lessee. Through the lease, the lessor grants the right to use the asset to the lessee.
The right to use the asset can be for a long period or a much shorter period. In exchange for
the right to use the asset , the lessee makes periodic lease payments to the lessor.

Advantages of leasing an asset:

For Lessee:

Can provide less costly financing (lower interest rates).

For Lessor:

1-Better position to take advantage of tax benefits of ownership such as depreciation and
interest.

2- Better able to value and bear risks associated with ownership such as obsolescence ,
residual value and disposition of asset.

3-Lessor may enjoy economies of scale for servicing assets.

General Advantages:

1-The total financing of the investment objects which leads to a reduced own financial effort.
Therefore, the supplementary financial resources can be used for the other investment
projects or simply for maintaining an increased liquidity;

2- Leasing proves to be a perfect alternative for obtaining equipment of a high complexity

and technicality, for which the moral depreciation has a high percent, allowing the operative
exchange of some morally depreciated equipment.
3- The rapidity of the approval of the operation process.
4-The accounting operations for the leasing contract: for the beneficiary only the registration
to the expenses of the royalties, which makes the balance sheet of the company not to modify
and also gives the possibility of contracting some credits.
5- The constant amount of the royalty enables the easy scheduling of the expenses.
6- There is not necessary any supplementary guarantee, the object of the leasing contract
being in itself a guarantee.
Disadvantages
1-The leasing is efficient only if the equipment can be operated over the whole period of the
contract; not using this equipment over the whole period of the contract, mainly due to the
lack of orders, leads to losses for the beneficiary;
2-In case the lessee could obtain a bank credit under advantageous conditions, the cost of
leasing would be higher;
3-The good that makes the object of the leasing contract doesn't belong to the lessee, and
therefore he cannot sell it during the period of the contract, and the sublease can be
accomplished only with the owner's agreement;
4-Through leasing only the usage right is given away, the ownership right being kept, but
therefore the supplier's goods can be damaged by improper usage, after the first lease being
possible that the good will not find other users.

Financing( or Capital) vs Operating Leases:

1-A finance lease is equivalent to purchase of some asset by the buyer( lessee) that is directly
financed by the seller( lessor). In this, substantially all risks and rewards are transferred to the
lessee and lessee reports a leased asset and leased obligation on its balance sheet. In this, the
lessor reports a lease receivable on its balance sheet and removes the leased asset from its
balance sheet.

2-An operating lease is an agreement allowing the use of some asset for a period of time
,essentially rental. In this case the lessee reports neither an asset nor a liability , the lessee
reports only the lease expense. In this the lessor keeps the leased asset on its balance sheet .

U.S GAAP is prescriptive in its criteria for classifying capital and operating leases:

1- Ownership of the leased asset transfers to the lessee at the end of the lease.

2- The lease contains an option for the lessee to purchase the leased asset cheaply.

3- The lease term is 75% or more of the useful life of the leased asset.

4- The present value of lease payments is 90% or more of the fair value of the leased asset.

Only one of these criteria has to be met for the lease to be considered a capital lease by the
lessee. On the lessor side, satisfying at least one of these plus revenue recognition
requirements determine a capital lease.

The key difference between a finance lease and an operating lease is whether the lessor (the
legal owner who rents out the assets) or lessee (who uses the asset) takes on the risks of
ownership of the leased assets. The classification of a lease (as an operating or finance lease)
also affects how it is reported in the accounts.

Accounting and Reporting by the Lessee:

Finance Lease:

The initial value of both the leased asset and lease payable is the lower of the present value of
future lease payments and the fair value of the leased asset. On the income statement , the
company reports interest expense on the debt and if the asset acquired is depreciable , the
company reports depreciation expense.
Operating Lease:

In this case the lessee reports neither an asset nor a liability , the lessee reports only the lease
expense. In this the lessor keeps the leased asset on its balance sheet.

Example:

XYZ Inc. Enters into a lease agreement to acquire the use of a piece of machinery for 4 years
beginning on 1 january 2010. The lease requires 4 annual payments of Rs 28679 starting on 1
jan 2010. The useful life of the machine is 4 years and its salvage value is zero. XYZ
accounts for the lease as a finance lease .The fair value of the machine is Rs 100,000. The
present value of the lease payments using the company’s discount rate of 10% is Rs 100,000.
It uses straight line depreciation.

Qa) What are the amounts of the machinery reported as a leased asset on the balance sheet
during the years? What depreciation expenses are reported?

Qb) What are the amounts of lease liability reported on the balance sheet during the years?
What interest expenses are reported?

Qc) If it would be determined as an operating lease, what amount of expenses would be

reported on the income statements ?

Sol:

a)

Year Initial Depreciation Accumulated Carrying amt in

recognition Expense depreciation end of year.
amount
2010 100,000 25000 25000 75000
2011 100,000 25000 50000 50000
2012 100,000 25000 75000 25000
2013 100,000 25000 100,000 0
100,000

Depreciation expense=(100,000-0)/4=25000

b)Year Lease Annual lease Interest(at Reduction of Lease

liability,1 jan payment , 1 10% accrued lease liability on
jan in previous liability, 31 dec
year) 1 jan
2010 100,000 28679 0 28679 71321
2011 71321 28679 7132 21547 49774
2012 49774 28679 4977 23702 26072
2013 26072 28679 2607 26072 0
114717 14717 100,000
Ac) As an operating lease , a rent expense of Rs28679 would be reported on the income
statement each year.

Accounting and Reporting by the Lessor:

Example:

XYZ Inc. Owns a piece of machinery and plans to lease the machine on 1 january 2010. XYZ
requires 4 annual payments of Rs 28679 starting on 1 jan 2010. XYZ is confident that the
payments will be received .The useful life of the machine is 4 years and its salvage value is
zero. The fair value of the machine is Rs 100,000. The present value of the lease payments
using the company’s discount rate of 10% is Rs 100,000.

Qa) What are the amounts of the lease receivables on the balance sheet during the years?
What interest revenues are reported?

Qb) What are the interest incomes reported in the years?

Qc) If it would be determined as an operating lease, what amount of income would be

reported on the income statements?

Sol:

a,b)

Year Lease Annual lease Interest(at Reduction of Lease

receivables, payment 10% accrued lease receivables
1 jan received , 1 in previous receivables, on 31 dec
jan year) 1 jan
2010 100,000 28679 0 28679 71321
2011 71321 28679 7132 21547 49774
2012 49774 28679 4977 23702 26072
2013 26072 28679 2607 26072 0
114717 14717 100,000

c) As an operating lease , rent income of Rs. 28679 would be reported on the income
statements.
U.S GAAP distinguishes between 2 types of capital leases:

1- Direct financing lease-it results when the present value of lease payments equals the
carrying value of the leased asset. Because there is no profit on the asset itself , the lessor is
essentially providing financing to the lessee and the revenues earned by the lessor are
financing in nature.

In this, the lessor exchanges a lease receivable for the leased asset on its books. The lessor’s
receivables is derived from the interest on the lease receivable.

A direct financing lease is a type of lease that is non-leveraged. This means that the lessor is
not a dealer or manufacturer, and that the lease contains all the characteristics of a capital
lease, while including some additional requirements. With a direct financing lease, there is
the stated intent of the lessor to rent or lease the asset acquired to a third party, thus creating a
steady flow of income that helps to assure that the payments connected with the direct lease
are paid in full and on time.

The idea behind a direct financing lease is to acquire an asset that in turn can be used to
generate enough income to make the monthly payments on the lease, while also generating a
profit for the lessor. This model allows the lessor to effectively make use of funds other than
his or her own to create a revenue stream. As the lessor collects payments from his or her
customer, a portion of those payments are redirected to cover the payments stipulated in the
direct lease. Any funds above and beyond those used to make payments on the direct lease
are considered profit and may be used by the lessor in any way he or she desires.

2- Sales type lease- If the present value of lease payments exceeds the carrying amount of the
leased asset , the lease is treated as a sales type lease.

In this, a lessor reports revenue from the sale , cost of goods sold, profit on the sale and
interest revenue earned from financing the sale.

Accounting by Lessor in which one or more of the four criteria required for a Capital
Lease are met and both of the following criteria are satisfied: (1) collectibility of minimum
lease payments is predictable and (2) no important uncertainties surround the amount of
unreimbursable costs yet to be incurred. A sales type lease gives rise to a manufacturer's or
dealer's profit or loss on the assumed sale of the item in the year of lease as well as interest
income over the life of the lease. Lease payments receivable is recorded representing the
minimum lease payments (net of amounts, if any, including executory costs with any profit
thereon) plus the unguaranteed residual value accruing to the benefit of the lessor. The
difference between lease payments receivable and the discounted value of the payments is
recorded as unearned interest income. The Discount Rate used to determine the present value
of lease payments is the lessor's implicit rate
Analyst Adjustments related to Off-balance sheet financing:

A number of business activities give rise to obligations which although they are economic
liabilities of a company are not required to be reported on a company’s balance sheet .
Including such off-balance sheet obligations in a company’s liabilities can affect ratios and
conclusions based on such ratios.

Eg: Discuss the change in debt/(debt+equity)ratio:

Adjustment to debt for operating lease payments:

Q)An analyst is evaluating the capital structure of 2 cos –ABC and PQR, as of the beginning
of 2006. ABC makes less use of operating leases than PQR.

ABC AABC ABCA PQR

TOT. DEBT 1200 2400
TOT. EQUITY 2000 4000
AVG. INT.RATE 10% 8%
Lease pay. 2006 10 90
2007 18 105
2008 22 115
2009 25 128
2010 and after 75 384

Initially , the debt/(debt+equity) ratios for ABC and PQR are same for both:37.5%

ABC PQRABC AB PQR QR

2006 9.09 83.33
2007 14.88 90.02
2008 16.53 91.29
2009 17.08 94.08
2010 15.52 87.11
2011 14.11 80.66
2012 12.83 74.69
TOTAL PV 100.04 601.18

Now, these capitalised debt obligations are added to the total debt of the cos.

ABC-before After cap PQR-Before After cap

capitalizing fter cap. capitalizing er cap.
apitalizing PQR-Before
capitalizing
Total debt 1200 1300 2400 3001
Total equity 2000 2000 4000 4000
Debt/(Debt+Equity) 37.5% 39.4% 37.5% 42.9%
Income Statement Consideration when determining Long-term Debt-paying Ability

Times Interest Earned

1-It indicates a firm’s long-term debt-paying ability from the income statement view
2-It this ratio is adequate, the firm can easily pay its interest obligations.
3-If this ratio has good record, it can be able to refinance principal amount.
4-The companies maintain the good record of this ratio, can finance relatively high
proportion of debt in relation to shareholders’ equity.
5-They can obtain funds at favorable rates.
6-The company issues debt obligations to obtain funds at an interest less than the earnings
from these funds. This is called trade on the equity or leverage.
7-If the interest rate is high, the risk is that company cannot earn profits more than cost of
funds.

Time Interest Earned =

Recurring Earnings, excluding interest expense, tax expense, equity earnings, and minority Earnings
Interest Expense including capitalized interest

The following nonrecurring items should be excluded:

1. Discontinued operations
2. Extraordinary items
3. Cumulative effect of a change in accounting principle

The following should also be excluded:

1. Interest Expense
This added back to net income because the time interest earned will be understated.

2. Income Tax Expense

If this item is deducted from net income, this is also be added back.

3. Equity earnings(losses) of nonconsolidated subsidiaries

These items should be excluded.

4. Minority Income (Loss)

All of the interest expense of the firm consolidated is included in the consolidated
income statement. Therefore, all of the income of the firm consolidated should be considered
in the coverage.

The interest capitalized should be included with the total interest expense in the denominator
of the times interest earned ratio because it is part of the interest payment.
An example of capitalized interest would be interest during the current year on a bond issued
to build a factory.
 Capitalized interests are normally disclosed in a footnote and sometime on the face of
income statement.
 Computing interest earned for three to five years provides insight on the stability of
the interest coverage.
  Interest coverage on long-term debt is sometimes computed separately from the
normal times interest earned.
 In the long run, a firm must have the funds to meet all of its expenses but in the short
run, a firm can often meet its interest obligations even when the times interest is less
than 1.00.
Some of the expenses do not require funds in the short run.

 Depreciation expense
 Amortization expense
 Depletion expense
 To get the better indication of a firm’s ability to cover interest payments in the short
run, the non-cash expenses can be added back to the numerator of the times interest
ratio.
 This ratio will be less conservative and it gives a cash basis times interest earned
useful for evaluating the firm in the short-run.

Fixed Charge Coverage

The fixed charge coverage ratio is an extension of the times interest earned ratio. It is
computed as follows:

Time Interest Earned =

Recurring Earnings, excluding interest exp ., T exp., equity earnings, and minority Earnings + Interest Portion of rentals
Interest Expense including capitalized interest + Interest Portion of rentals

 A difference of opinion occurs in practice as to what should be included in the fixed

charges.
 The lessee treats a capital as an acquisition and includes the leased asset in fixed assets
and related obligation in liabilities.
 In case of operating lease, part of the Minimum lease payment (MLP) is considered to be
interest expense.
 In case of capital lease, the interest expense on the income statement includes interest
related to capital lease.
 Operating leases are not on the balance sheet, they are reflected on the income statement
in the rental expense.
 An operating lease is a type of long-term financing and the part of the lease payment is
really interest.
 One-third of the operating leases’ rental charges are included in the fixed charges because
this is an approximation of the proportion of lease payment that is interest.

Balance sheet consideration when determining Long-term Debt-Paying Ability

The firm’s ability to carry debt, as indicated by the balance sheet, can be viewed by
considering the debt ratio and the debt/equity ratio. These ratios are now reviewed.
Debt Ratio

The debt ratio indicates the firm’s long-term debt-paying ability. It is computed as follows:

Total Liabilities
Debt Ratio = Total Assets

Total Liabilities includes

1. Short-term liabilities,
2. Reserves,
3. Deferred tax liabilities,
4. Minority shareholders’ interests,
5. Redeemable preferred stock,
6. Any other noncurrent liabilities.
It does not include stockholders’ equity.

Short-term Liabilities

 Some firms exclude short-term liabilities because they are not long-term sources of funds.
 Other firms include short-term liabilities because these liabilities become part of the total
sources of outside funds in the long run.
 Example is accounts payable are relatively short term but accounts payable in total
becomes a rather permanent part of the entire sources of funds.
 This book takes a conservative position that includes the short-term liabilities in the debt
ratio.

Reserves

1-The reserve accounts classified under liabilities (some short-term and some long-term).
2-These are created by charging an expense to the income statement and an equal increase in
the reserve account on the balance sheet.
3-These reserve accounts do not represent definite commitments to pay out funds in the
future but they are estimates of funds that will be paid out.
4-This book takes a conservative position that includes the reserves in liabilities in the debt
ratio.

Deferred Taxes (Interperiod Tax Allocation)

1-In the US, a firm may recognize certain income and expense items in one period for the
financial statements and in another period for the tax return.
2-This can result in financial statement income in any one period that is substantially
different from tax return income.
3-In the United States, taxes payable based on the tax return can be substantially different
from income expense based on financial statement income.
4-The difference between tax expense and taxes payable is recorded as deferred income
taxes.
5-The concept that results in deferred income taxes is called Interperiod tax allocation.
6-In addition to temporary differences, the tax liabilities can be influenced by an operating
loss carryback and /or operating loss carryforward.
7-A company can elect to forgo a carryback.
8-A corporate reports deferred taxes in two classifications:
 A net current account
 A net non-current amount
9-The excess of tax depreciation over financial reporting depreciation would be reported as a
noncurrent liability.
10-Some individuals disagree with the concept of deferred taxes (Interperiod tax allocation).
They consider the deferred tax to as soft account due to uncertainty in payment and receipt.
So, should be excluded from the liabilities at the time of analysis.

Minority Shareholders’ Interest

Some firms excludes and some includes but this book takes the conservative position of
including minority shareholders’ interest in the primary computation of debt ratios

Redeemable Preferred Stock

It should be included in liabilities.

Debt/Equity Ratio

Total Liabilities
Debt/Equity Ratio = Shareholders' Equity
Debt to Tangible Net worth Ratio

Total Liabilities
Debt to Tangible Net Worth = Shareholders' Equity - Intangible Assets

Other Long-Term Debt-Paying Ability Ratios

Current Liabilities
Current Debt/net worth ratio = Shareholders' Equity
The higher the proportion of funds provided by current liabilities, greater the risk.
Total Capitalization Ratio

Long-Term Debt
Total Capitalization Ratio = Total Capitalization

Total capitalization consists of long-term debt, preferred stock, common stockholders’ equity.

The lower the ratio, the lower the risk.

Fixed Asset/Equity Ratio

This ratio indicates the extent to which shareholders have provided funds in relation to fixed
assets. Some firms subtract intangibles from the shareholders’ equity to obtain tangible net
worth. This result is more conservative ratio. The higher the fixed assets in relation to equity,
the greater the risk.

Special Items that Influence a Firm’s Long-Term Debt-Paying Ability

1. Long-Term Assets versus Long-Term Debt

2. Long-Term Leasing
3. Pension Plans
i. Defined Contribution Plan
ii. Defined Benefit Plan
4. Postretirement Benefits other than Pensions
5. Joint Ventures
6. Contingencies
7. Financial Instruments with Off-Balance sheet Risk and Financial Instruments with
Concentrations of Credit Risk
8. Disclosures about Fair Value of Financial Instruments