Case Project for ACCT 302 (Due 4/23/2008)

Objectives of the project: a. To perform a constructive capitalization on operating leases (i.e., as if the operating leases had been capitalized at inception of a lease contract). b. To learn how the return on assets (ROA) and debt to equity (D/E) ratios could differ when operating leases are capitalized at inception. c. To enhance the relevance and comparability of firm specific measures of risk (i.e., D/E) and performance (i.e., ROA).

Requirements:

1. Based on the constructive lease capitalization procedures developed by Imhoff, Lipe and Wright (1991) 1 on operating leases of five companies in one of the following industries: Airlines, Home furnishings, food stores, fast food, semi-fast food, clothing, and drug/food stores.2 Derive the following financial numbers and ratios:

a. unrecorded liabilities (the lease obligation assuming all operating leases are capitalized); b. unrecorded assets (the lease assets assuming all operating leases are capitalized); c. the reported ROA and D/E; and d. the revised ROA and D/E as if all operating leases were capitalized.

2. Based on your findings, draw a conclusion on the impact of lease capitalization of operating leases on net income and financial ratios.

Assumptions of the project:

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 the beginning of the year; 4. the unrecorded asset equals 70 percent of the unrecorded debt; 5. the combined effective tax rate is 40%; 6. the effect on the prior year’s equity from the lease capitalization equals zero.

1 The capitalization of operating leases is based on the method described in Imhoff, et al. (“Operating Leases: Impact of Constructive Capitalization” , March 1991, Accounting Horizons). 2 One of the databases available for company’s financial statements is Lexis/Nexis..

1 Procedures and Related Issues:

1. To estimate the unrecorded lease obligation for operating leases, the future cash flows disclosed for operating leases 3 are discounted to present using an incremental borrowing rate of 10%. The reason is that the future cash flows of operating leases represent the minimum lease payments for these leases had they been reported as capital leases. 2. The disclosure of future cash flows is only detailed for five subsequent years from the current reporting year. An aggregate cash flow amount is given for those years beyond the five subsequent year period. Thus, assuming an average remaining life of 15 years for the operating leases, the life for the aggregate amount is 10 years. To derive the annual cash flows for those years beyond the five subsequent year period, the aggregate amount should be divided by 10. These 10 annual cash flows should also be discounted to the present. 3. The sum of the present value of all future cash flows of operating leases is the unrecorded lease liability (the off-balance liability). 4. For capital lease as well as for constructive capitalization, the amount of lease assets is less than that of lease obligation 4. This is because the lease obligation is reduced by (lease payment – interest expense on unpaid lease obligation) while the lease asset is reduce by amortization of the lease asset. In general, amortization (using a straight- line method) of lease asset is greater than the amount of (lease payment - interest expense). For the purpose of this project, assume that the unrecorded lease assets equal 70 percent of the unrecorded lease liabilities. 5. The income tax savings should also be considered for the liability impact. For example, assuming an unrecorded lease liability of $10 million with a 40% effective tax rate and lease assets equal 70% of lease liabilities, the net impact of liabilities equals:

Tax savings of capital leases = $10 million * (1-70%) * 40% = $1.2 million (see note a on page 3 for detailed explanation). Net impact of liabilities = $10 million -$1.2 million = $8.8 million

3 Required by SFAS 13 for operating leases with remaining noncancelable lease terms in excess of one year. 4 Except at inception, in which the lease asset equals lease obligation, and at the termination of the lease. See Figure 1 in the paper for an illustration.

2 A Numerical Example (Based on the lease capitalization method described in Imhoff et al. (1991) and the six assumptions on page 1):

Information:

Reported financial numbers:

Net income = 4 million Total assets = 40 million Total liabilities = 25 million Total equity = 15 million

Other information and assumptions:

An effect tax rate = 40% Assuming unrecorded assets equal 70% of unrecorded liabilities. The present value of all future cash flows of operating leases (the unrecorded lease liabilities) equals $10 million dollars.5

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

Balance Sheet (partial) 12/31/x2 (in millions)

Assets: Liabilities:

Unrecorded lease Assets 7 Unrecorded Lease Liabilities 10 (unrecorded liabilities * 70%) Tax Savings a (1.2) ((10 –7) * tax rate 40%) Net Liability Effect 8.8

Stockholders’ Equity: Cumulative Effect on Retained Earnings Net of Tax Consequences (10 –7) * (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

5 You need to compute this amount based on the method described in Imhoff, etc. (1991). This method is also summarized above.

3 leases.6 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: Revised financial ratios with operating leases capitalized:

ROA = 4/40 = 10% ROA = (4-(1.8-0)) / (40+7) = 4.68%

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

6 For capital leases, the lease expense includes both interest expense and amortization expense of the lease assets while for the operating lease, the lease expense includes only the rental expense (similar to the minimum lease payment. In general, the capital lease expense is greater than that of operating lease in the first half-life of a lease contract.

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