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FIN 551 - Financial Statement Analysis 1

Off-Balance Sheet Financing:

Operating Leases & Other Topics

Session 7

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FIN 551 - Financial Statement Analysis 3

Off-Balance-Sheet

Obligation with Leases

§ Capital leases versus operating leases

§ Capital lease:

– Leases which effectively transfer all/most of the

rewards and risks to the lessee

– Economic equivalent of financed sales

§ Operating leases:

– Short-term leases which allow the lessee to use

the asset for a short period of time.

Leasing Rules

§ Rules invoked at the inception of the lease:

– Transfer of ownership

– Bargain purchase option in the lease – Lease life ≥75% of economic life

» Exception if asset is within last 25% of its life

– PV of lease payments ≥90% of 1st cost

» Discount rate: Lower of lessee’s incremental borrowing rate or lessor’s implicit interest rate

§ Violation of one rule results in treating the lease as

a capital lease.

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FIN 551 - Financial Statement Analysis 5

Circumvent the Lease Rules

§ Why bother?

Only matters to lessee because:

– Profits and incentive compensation affected!

– Improved ratios for profitability, leverage, and

turnover

– Debt kept off the balance sheet

» May circumvent bond covenants

§ Lessor: Wants to use capital lease treatment.

Accounting for Lessee:

Operating Lease vs. Capital Lease

Operating Lease Debit: Rental expense Credit: Rental payable or

cash

Capital Lease Debit: Fixed asset Credit: LT liabilities

Debit: Depreciation expense Credit: Accumulated

depreciation Debit: Interest expense Debit: LT liabilities

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FIN 551 - Financial Statement Analysis 7

Accounting Treatment: Lessee

§ Exhibit 8-12 of White, Sondhi, and Fried

– Puts numbers to the accounting treatment

– Discusses:

» Balance sheet » Income statement » Statement of cash flows.

Accounting for Lessor:

Operating Lease vs. Capital Lease

Operating Lease Debit: Rental receivable Credit: Rental revenue

Leased asset remains on books as a fixed asset. Depreciation taken annually.

Capital Lease Debit: Account receivable Credit: Sales revenue Debit: Cost of sales

Credit: Inventory/fixed asset Debit: Interest receivable Credit: Interest income

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FIN 551 - Financial Statement Analysis 9

Accounting Treatment: Lessor

§ Exhibit 8-15 of White, Sondhi, and Fried

– Puts numbers to the accounting treatment

– Discusses:

» Balance sheet » Income statement » Statement of cash flows.

Capitalize the Operating Leases

§ Capital lease ratio approach

Formula:

NPV = PV of capital leases x total op. leases

Total capital leases

§ Net present value approach

Formula:

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FIN 551 - Financial Statement Analysis 11

Example:

Capitalizing Operating Leases

§ Manpower, Inc.’s 1993 annual report shows:

Total lease obligations = $238,584

‘94 $44,364 ‘95 $34,951 ‘96 $27,630 ‘97 $20,843 ‘98 $15,299 Later $95,497

§ Note 6 of the report: Convertible debt issued at 6.25% § PV = $44,364/(1.065) + $34,951/(1.065)2 + $27,630/(1.065)3 + $20,843/(1.065)4 + $15,299/(1.065)5 + [$15,916/(1.065)6 + ... + $15,916/(1.065)11] = $178,949.

Other

Off-Balance-Sheet Financing

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FIN 551 - Financial Statement Analysis 13

In-substance Defeasance of Debt

§ Definition of Defeasance:

An instrument accompanying a bond,

containing a condition which, when performed,

defeats or undoes it.

§ In-substance defeasance means that the

bond does not contain the “condition” but

the firm can still “undo” the bond.

§ Why bother?

§ How is it done?

Why Bother?

§ Removes debt from the balance sheet

– Improves debt/equity ratio

§ Usually results in a profit

– Improves profitability ratios

– Profit is tax deferred until maturity date of debt

§ Overall: Less risky & more profitable

§ Higher profits higher compensation.

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FIN 551 - Financial Statement Analysis 15

How Does it Work...?

§ Necessary debt characteristics

– Fixed rate, fixed maturity

– Nonconvertible, non-callable

– U.S. treasury rate

>

debt’s coupon rate

§ Find present value of company’s debt issue

PV = Interest x (PVIFA r%, n yrs)

+ principal x (PVIF r%, nth yr)

§ Book value of debt

>

market value of debt.

How Does it Work...?

§ Company pays market value of debt to an

irrevocable trust

– Means: Money flows in one direction

– Trustee responsible for making payments to

debtholders

§ Accounting

» Debit: Debt at book value $70,000

» Credit: Cash (market value of debt) $55,000 » Credit: Gain on retirement of debt. $15,000

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FIN 551 - Financial Statement Analysis 17

How Does It Work?

§ Irrevocable trust buys government securities

with the cash

– Interest rate for gov’t securities > coupon rate

of company debt

– Principal + interest for gov’t securities used to

pay off company debt as obligations come

due.

Nonsub Sub

§ XYZ Corp. developing a new product with

long lead time to market

– Approaches engineers/scientists to start a new

company to develop the product

» XYZ Co. provides convertible debt financing » New company successful: XYZ Co. converts the

debt to equity — takes over the new company

• Consolidates new company with XYZ Co.

» New company unsuccessful: XYZ Co. writes off its investment

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FIN 551 - Financial Statement Analysis 19

R& D Partnerships

§ XYZ Corp. forms partnership to develop a

product

– XYZ: general partner

– Investors: limited partners

§ Partnership has no facilities/personnel —

sub-contracts the work

§ XYZ Corp. likely the contractor.

R&D Partnership...

Corporation

Purchase/lease

Limited

Trfs. rights

Partners

Cash

Limited Partnership

Cash/losses Research product

Contractor

(likely the Corporation) Royalties

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FIN 551 - Financial Statement Analysis 21

The End

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