Accounting for leases

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Da_Real

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Just when I thought I was done with FSA, they throw this curve ball at me.

I'm struggling with Study Session 11: Leases and off-balance sheet debt.

I can't understand
1. LOS 44.c accounting for leasebacks
2. From lessors perspective: calculating - net invesment in lease and interest


If anyone has any words of wisdom or useful links, it'd be greatly appreciated.
I'm tempted to just skimp over this material and play the odds that it won't show up on exam
 
Caveat - FSA is not my best subject.

I think leasebacks is a pretty interesting topic, though. Suppose that a mining company owns 1M acres of property but is having a cash problem. The company can sell the property to, say, a hedge fund with a leaseback agreement that provides them the ability to mine the property for 20 years with continuing payments to the hedge fund (the lease). The problem is that GAAP doesn't give much guidance on how to account for this transaction. There are two likely candidates:
1) The cash from the sale is treated as cash from financing. This views the sale of the asset as a financing activity akin to selling stock. The mining company has given up ownership in the assets of the company in exchange for cash. It uses the cash to lease mining property which it can then use productively. This does not affect the free cash flow of the company any more than issuing new equity would affect the free cash flow (i.e., it doesn't).
2) The cash from the sale is treated as cash from investing. This views the sale as it would view the sale if there was no leaseback agreement and the land was held as a speculative investment. In this case, the free cash flow of the company increases by the amount of cash obtained in the sale because the operating lease is not treated as debt.

I think on the CFA exam, they might ask some question about adjusting FCF for the leaseback. This would just involve subtracting out the proceeds from the sale from FCF if a company accounted for it using #2.

The really big picture is that FCF isn't something that FASB cares about at all, but it is something that analysts need to care about very much. A sale/leaseback is one of many ways that a company could apparently increase FCF without changing the underlying value of the company. As an analyst, you should be able to compare FCF's from companies on an equal footing by understanding this kind of nonsense.

The other big picture is that there is no easy way to resolve this since either accounting treatment might be reasonable depending on the circumstances.
 
Is that Study Session 11??

Operating Lease -- the rental fee appears as an expense.

Capital Lease -- the leased asset appears as a fixed asset and the PV of the lease payments appear as a liability. Interest is recorded separately. For instance if you have minimum lease payments of 10,000 for 5 years on a 50,000 (10 percent interest which equals PV of 37,907.86) asset it breaks down like:

Year 1 = 3,790 interest expense and 6210 principal.

Now that you shaved 6210 off the principal the second year will appear as:

Year 2 = 3169 interest expense and 6830 principal.
Year 3 = 2486 IE and 7514 principal.
Year 4 = 1734 IE and 8276 P
Year 5 = 907 IE and 9093 P

I think I did that right (6210 + 6830 + 7514 + 8276 + 9093 = 37,923). Oh well, close enough.


Net Investment = PV of the minimum lease payments and the present value of the residual value.
 
Can someone throw some light on accoung for leases from a LESSOR's perspective. Both the sales type lease and the direct finance lease.
SOMEONE PLEASE HELP WITH THIS. THIS IS TOUGH.

I find this really tough to calculate. Just skimmed through it. The only part I remember is that in sales type lease the lessor is the manufacturer and he realises the profit early while in the direct finance the profit is the interest expense over time.
 
The picture is getting clearer.

Thank you gentlemen!
 
thanks, JoeyDVivre, for explaining the leaseback...but I still don't quite understand the motivation of the business for this kind of operations. Has anyone heard about the real-life examples of sales of assets and subsequent leasebacks? Any other ideas why it is being done? Thanks in advance!

---
later added: OK, I got the idea what is the motivation for the seller of the property (and potential lessee), but who is the buyer (and potential lessor)? And yes, why the businesses don't lease the assets from the very beginning? Why to buy some property, then sell it (surely, at discount...loss for the company) and then lease it? It is such a waste of money!!! Is it an evidence of bad management decisions in capital budgeting area? Or is it an evidence of admitting of previous mistakes by company's management and trying to correct them - by doing sales-leaseback?



Edited 1 time(s). Last edit at Thursday, September 21, 2006 at 03:07PM by CFAMontreal.
 
A business can create a special purpose vehicle as a separate entity. The SPV's only mission in life is to get money somehow (maybe just be funded by the company), buy and leaseback the property. This can be a very good business move not only for fixing up the books but also for eliminating liability.
 
selling to and leasing from SPV - makes so much sense for me now. Thanks, JoeyDVivre!
 
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