Special items influencing firm’s

long term debt paying ability

BY-ASTHA SAVYASACHI
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
 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 ?
 Solutions

Year Initial recognition Depreciation Expense Accumulated Carrying amt in end of

amount depreciation year.
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

b)Year Lease liability,1 Annual lease Interest(at 10% Reduction of lease Lease liability on
jan payment , 1 jan accrued in previous liability, 1 jan 31 dec
year)
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

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

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?
 Solutions
Year Lease receivables, Annual lease Interest(at 10% Reduction of lease Lease receivables
1 jan payment received , accrued in previous receivables, 1 on 31 dec
1 jan year) 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.
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.
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.
 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 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 PQR
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.
So,
ABC-before After PQR-Before After cap.
capitalizing cap. capitalizing
Total debt 1200 1300 2400 3001
Total equity 2000 2000 4000 4000
Debt/ 37.5% 39.4% 37.5% 42.9%
(Debt+Equit
y)