Cardinal Model Tutorial Example Leases 

What are leases all about? 

What are leases?

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What are capital and operating leases?

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How are capital and operating lease payments recognized in financial statements? 

Summary table

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Summary example

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Example: What are the tax implications for capital and operating leases?

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What are Cardinal’s leases?

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How is the interest rate on long-term debt assumption used for Cardinal’s capital leases?

You are free to customize and share this work so long as you attribute G. Peter and Carolyn R. Wilson and use it for non-commercial purposes. © 1991-2010 NavAcc LLC.

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Cardinal Model Tutorial Example Leases What are leases? 

Leases are contracts between lessees and lessors. Lessees acquire the right to use property from lessors. Cardinal leases its stores and corporate headquarters. Thus, Cardinal is a lessee in these leases.

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Cardinal Model Tutorial Example Leases What are capital and operating leases? 

For accounting purposes, leases can be classified as “capital” or “operating” leases.

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This classification decision can require considerable judgment and have significant financialstatement consequences. However, this decision does not affect pretax cash flows – lessors expect to be paid the same amount regardless of how lessees classify leases.

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At issue with this decision is whether the long-term benefits and costs associated with leases should be recognized as assets and liabilities. For Cardinal, the asset relates to the benefits that will be derived from the right to use the leased stores and corporate headquarters in the future, and the liability relates to the obligation to make future lease payments to lessors.

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Capital leases

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When a lease is classified as capital, an asset (PP&E) and liability (Long-term debt) are recognized by the lessee at the time the lease is signed.

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The capital-lease asset and liability are recognized at the present value of the lease’s future benefits and obligations when the capital lease is signed. This discounted cash flow procedure requires assumptions about the riskiness of the lease payments and the value of the leased property at the end of the lease.

Operating leases 

In the opinion of those in the accounting community that determine GAAP, there are situations where the estimates from the discounted cash flow procedure used for capital leases can not be measured reliably enough to be recognized on balance sheets. In these situations, the leases are classified as operating.

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Accounting for operating leases is very simple. The lessee recognizes expenses as payments are made to the lessor, assuming the payments are not pre-paid.

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Cardinal Model Tutorial Example Leases What are capital and operating leases? continued... 

Loosely speaking, the discounted-cash flow measurements are deemed problematic when the lease life is “too short” relative to the leased property’s economic life or the residual value at the end of the lease is “too large” relative to the value of the leased property at the start of the lease. GAAP specifies strict criteria that operationalize what is meant by “too short” or “too long” and leases that meet these criteria must be classified as operating leases. The criteria are strict in that there is no room for leeway in lease classifications once a lease contract is specified. However, it is common practice for lessors and lessees to structure lease contracts so that they can meet the criteria for operating leases.

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Moreover, it is common practice for noncancelable operating leases to extend for 15-25 years or longer. In these situations, companies have off-balance sheet financing since the economic obligations associated with these leases are not recognized on the balance sheet as liabilities. Managers generally prefer operating leases because they provide off-balance sheet financing and defer expenses (relative to capital leases) until later in the lease life.

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Cardinal Model Tutorial Example Leases How are capital and operating lease payments recognized in financial statements? Capital leases: 

In general, when a lease is classified as capital, an asset (PP&E) and liability (Long-term debt) are recognized. Subsequently, depreciation and interest expense is recognized on the income statement. The lease payments are split into two parts on the statement of cash flows: interest expense is classified as an operating cash flow and repayment of debt principal is classified as “reduction of long-term debt” in the financing section of the statement of cash flows.

Operating leases: 

In contrast, when a lease is classified as operating, nothing is recognized on the balance sheet when the lease is initiated, and subsequent payments are recognized as lease expense on the income statement. The entire lease payment is considered an operating cash flow on the statement of cash flows.

Lease payments are the same regardless of the classification of a lease. Thus, the total pre-tax cash outflows are the same. However, the financial-statement consequences vary for capital versus operating leases.

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Cardinal Model Tutorial Example Leases Statement of cash flow consequences of changing the lease payments – capital lease 

For a capital lease, lease payments are split into two parts on the statement of cash flows: 1. Interest associated with the obligation to make future lease payments is classified as an operating cash flow for capital leases. 2. Repayment of debt principal is classified as “reduction of long-term debt” in the financing section of the statement of cash flow.

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The interest payment is reported differently for direct- and indirect-format cash flow statements: 

On the Direct cash flow statement (DCF), Cardinal classifies the interest associated with capital leases as “interest paid.” Therefore, the lease payments directly affects “interest paid” on the DCF when the leases are classified as capital leases.

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On the Indirect cash flow statement (SCF), because Cardinal makes lease payments on the last day of the year, the interest expense and interest payment associated with capital leases are the same. Hence, the lease payments equally affects net income and cash from operations in the operating section of the SCF. As a result, no reconciliation adjustment is required.

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Cardinal Model Tutorial Example Leases Balance-sheet consequences of changing the lease payments – capital lease 

For a capital lease, lease payments have two direct balance-sheet consequences: 1. An asset is recognized when the lease is entered. It represents the benefit associated with having the right to use the leased property in the future and is measured as the present value of the lease payments. Cardinal classifies this asset as PP&E. Thus, the lease classification assumption directly affects PP&E when the leases are classified as capital leases and indirectly affects other balance-sheet items that are based on PP&E such as accumulated depreciation. 2. A liability that represents the obligation to make the future payments is also recognized when the lease is entered. It is also measured as the present value of the future lease payments. Cardinal classifies this liability as long-term debt. Thus, the lease classification assumption directly affects long-term debt and indirectly affects other balance sheet items that depend on long-term debt such as retained earnings – which is affected by interest expense on the debt balance.

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Cardinal Model Tutorial Example Leases Income-statement consequences of changing the lease payments – capital lease 

For a capital lease, the lease payments have two direct income statement consequences: 1. Depreciation expense associated with the capitalized PP&E is recognized. Cardinal classifies this depreciation as “depreciation and operating expense.” Thus, the lease classification assumption directly affects depreciation and operating expense and indirectly affects other income-statement items that depend on depreciation and operating expense such as income tax expense. 2. Interest expense associated with the lease liability is also recognized. Cardinal classifies this interest expense as “net interest expense (income).” Thus, the lease classification assumption directly affects net interest expense (income) and indirectly affects other income-statement items that depend on net interest expense (income) such as income tax expense.

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Cardinal Model Tutorial Example Leases Statement of cash flow consequences of changing the lease payments – operating lease 

The lease payments are reported differently for the direct- and indirect-format cash flow statements: 

On the Direct cash flow statement (DCF), Cardinal classifies the lease payments as “operating lease payments.” Accordingly, the lease payments and thus the lease classification assumption directly affects “operating lease payments” on the DCF when the leases are classified as operating leases.

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On the Indirect cash flow statement (SCF), because Cardinal makes lease payments on the last day of the year, the payment and expense associated with operating leases are the same (there are no accrued expenses at year end). Accordingly, the lease payments and thus the lease classification assumption equally affects net income and cash from operations in the operating section of the SCF. As a result, no reconciliation adjustment is required.

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Cardinal Model Tutorial Example Leases Balance-sheet consequences of changing the lease payments – operating lease 

Operating leases do not have a direct effect on balance sheets when the lease is initiated – there are no related assets and liabilities as there are for capital leases.

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However, the lease payments and thus the lease classification assumption affects the balance sheet indirectly. For example, retained earnings is affected by the lease payments because the payments are the same as the lease expense for an operating lease, and expenses affect retained earnings.

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Cardinal Model Tutorial Example Leases Income-statement consequences of changing the lease payments – operating lease 

For an operating lease, the lease payments and thus the lease classification assumption directly affects “depreciation and operating leases” expense on Cardinal’s income statement.

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Cardinal Model Tutorial Example Leases Summary table - Capital versus operating lease financial-statement effects 

Regardless of whether the lease is classified as an operating or capital lease, the payments are the same. All that differs is the way the transactions are classified and thus the way they are reported in financial statements.

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The following table summarizes the pre-tax financial reporting differences of classifying leases as capital versus operating. Pre-Tax Items Affected by Lease Classification Balance Sheet Upon Signing Lease Capital Lease

Operating Lease

(DCFO)

Statement of Cash Flows (SCF)

Income Statement

Assets PP&E Liabilities Long-term debt Nothing

During Reporting Periods Thereafter Assets Capital Lease Cash Accum Depreciation Liabilities Long-term debt Owners' equity Retained earnings

Operating Lease

Direct Cash Flow

Assets Cash Owners' equity Retained earnings

Operating section: Interest paid Net cash from Operations

Operating section: Net Income Depreciation adj Net cash from Operations

Financing section: Reductions to long-term debt Net cash from Financing: Operating section: Operating lease payments

Financing section: Reductions to long-term debt Net cash from Financing: Operating section: Net Income Net cash from Operations

Depreciation expense Interest expense Net Income

Lease expense Net Income

Assumes all lease payments are at the end of the reporting period, thus: - Capital lease interest payment and expense are the same - Operating lease payment and expense are the same 12

Cardinal Model Tutorial Example Leases Summary example - Capital versus operating lease financial-statement effects The following table illustrates that the capital lease expenses (interest plus depreciation) are greater (less) than the operating lease expenses early (late) in the lease life and the totals are the same:

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Example Assumptions 15 year lease, $100 payments and 10% interest rate for capital lease liability (lease discount rate).

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Lease Expense Debt if Classified as Capital Lease Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Beginning Payment Balance $760.61 $736.67 $710.34 $681.37 $649.51 $614.46 $575.90 $533.49 $486.84 $435.53 $379.08 $316.99 $248.69 $173.55 $90.91

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100

Interest $76.06 $73.67 $71.03 $68.14 $64.95 $61.45 $57.59 $53.35 $48.68 $43.55 $37.91 $31.70 $24.87 $17.36 $9.09

Principal $23.94 $26.33 $28.97 $31.86 $35.05 $38.55 $42.41 $46.65 $51.32 $56.45 $62.09 $68.30 $75.13 $82.64 $90.91

Ending Balance $736.67 $710.34 $681.37 $649.51 $614.46 $575.90 $533.49 $486.84 $435.53 $379.08 $316.99 $248.69 $173.55 $90.91 $0.00 Totals

Depreciation $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $760.61

Capital Operating Interest Lease plus expense depre(payment) ciation $126.77 $100.00 $124.37 $100.00 $121.74 $100.00 $118.84 $100.00 $115.66 $100.00 $112.15 $100.00 $108.30 $100.00 $104.06 $100.00 $99.39 $100.00 $94.26 $100.00 $88.62 $100.00 $82.41 $100.00 $75.58 $100.00 $68.06 $100.00 $59.80 $100.00 $1,500.00 $1,500.00 13

Cardinal Model Tutorial Example Leases What are the tax implications for capital and operating leases? 

Lease classifications affect the timing of tax payments. When leases are classified as capital for tax reporting, companies deduct depreciation related to the capitalized asset and interest expense related to lease obligation.

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During the early lease years, the total expense associated with this depreciation and interest exceeds the lease expense that would be recognized if the lease were recognized as operating. By contrast, in the later lease years the total expense recognized for capital leases (depreciation plus interest) is less than the expense that would be recognized if the lease were recognized as an operating lease.

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The total expense is the same for the two classification alternatives over the life of the lease.

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Cardinal Model Tutorial Example Leases What are the tax implications for capital and operating leases? continued... 

The following table illustrates that the capital lease expenses (interest plus depreciation) are greater (less) than the operating lease expenses early (late) in the lease life and the totals are the same:

Lease Expense Debt if Classified as Capital Lease Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Beginning Payment Balance $760.61 $736.67 $710.34 $681.37 $649.51 $614.46 $575.90 $533.49 $486.84 $435.53 $379.08 $316.99 $248.69 $173.55 $90.91

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100

Interest $76.06 $73.67 $71.03 $68.14 $64.95 $61.45 $57.59 $53.35 $48.68 $43.55 $37.91 $31.70 $24.87 $17.36 $9.09

Principal $23.94 $26.33 $28.97 $31.86 $35.05 $38.55 $42.41 $46.65 $51.32 $56.45 $62.09 $68.30 $75.13 $82.64 $90.91

Ending Balance $736.67 $710.34 $681.37 $649.51 $614.46 $575.90 $533.49 $486.84 $435.53 $379.08 $316.99 $248.69 $173.55 $90.91 $0.00 Totals

Depreciation $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $50.71 $760.61

Capital Operating Interest Lease plus expense depre(payment) ciation $126.77 $100.00 $124.37 $100.00 $121.74 $100.00 $118.84 $100.00 $115.66 $100.00 $112.15 $100.00 $108.30 $100.00 $104.06 $100.00 $99.39 $100.00 $94.26 $100.00 $88.62 $100.00 $82.41 $100.00 $75.58 $100.00 $68.06 $100.00 $59.80 $100.00 $1,500.00 $1,500.00

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Cardinal Model Tutorial Example Leases What are the tax implications for capital and operating leases? continued... 

As a result of the expense timing differences for the lease classifications, companies can accelerate deductions and thus defer tax payments by classifying leases as capital for tax reporting.

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Generally leases are classified the same way for tax and financial reporting because the classification criteria are similar for financial and tax reporting. Cardinal follows this convention. Thus, Cardinal accelerates tax deductions under the initial assumptions (when leases are capital). However, Cardinal does not pay taxes during the early years because it has pretax losses. Example Pretax and after-tax implications of lease classifications

Assumptions 

15 year lease,

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$100 payments due at the end of each year and

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10% interest rate for lease liability (lease discount rate).

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Analysis

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If the lease is classified as a capital lease: 

A $760.61 asset and liability is recognized at the start of the first lease year. This is the present value of the 15 payments of $100.

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The annual depreciation is $50.71 = $760.61/15.

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The interest expense decreases each year as the lease liability decreases: 

Year-1 interest expense is $76.06 = 10% x $760.61.

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The debt decreases by $23.94 at the end of year 1,

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$23.94 = $100 payment - $76.06 interest.

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Thus, the debt at the start of year 2 is $736.67.

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Year-2 interest expense is $73.67 = 10% x $736.67. 16

Cardinal Model Tutorial Example Leases What are Cardinal’s leases? 

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Like most retailers, Cardinal plans to enter long-term leases for its stores and administrative buildings. 

In year 0, Cardinal will enter 30-year leases for the administrative building and the store that it plans to open in year 1 in market 1.

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In year 1, it will enter a 30-year lease for the store that it plans to enter in year 2 in market 2, and so on …

In the model, the cost of a leased store, and thus the lease payment, depends on two factors: 1. The size of the market where the leased store will be located, with the idea that bigger markets require bigger stores that are more costly. 2. The location of the store within the market, with the idea that prime locations that help generate more sales are more costly. Specifically, the lease cost is the market size multiplied by a “location charge” per dollar of market size. The same location charge is assumed for the seven markets that Cardinal plans to enter in years 1-7.

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The model assumes that Cardinal makes a single lease payment each year for the stores. Lease payments start the year after leases are signed. For example, the payments for the leases entered at the end of year-0 start at the end of year 1. Accordingly, there are no lease payments in year 0.

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Cardinal Model Tutorial Example Leases How is the interest rate on long-term debt assumption used for Cardinal’s capital leases? 

The interest rate on long-term debt is used to determine the present value of Cardinal’s future obligations for capital lease payments and the imputed interest expense associated with these capital leases.

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More specifically, the interest rate on long-term debt is used as the discount rate when calculating the present value of Cardinal’s future lease payments. This implies that the riskiness of the lease payments are comparable to those of Cardinal’s loan payments.

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Once the present value of the capital lease payments is determined, this value is recognized as an asset (PP&E) and liability (long-term debt) at the time the capital lease is signed.

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Under the initial assumptions, Cardinal’s leases are classified as capital. Thus, the model applies the interest rate on long-term debt to calculate the present value of its future lease obligations for Cardinal’s stores and headquarters and the imputed interest expense on these capital leases.

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Hence, changing the interest rate on long-term debt assumption changes the present value calculations for capital leases, which changes the amount recognized as PP&E and long-term debt. Consequently, this changes the imputed interest and depreciation expenses.

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