{"id":431437,"date":"2018-03-24T04:21:07","date_gmt":"2018-03-24T04:21:07","guid":{"rendered":"https:\/\/essaypaper.org\/procedures-of-reporting-operating-leases-as-capital-leases\/"},"modified":"2018-10-24T09:10:42","modified_gmt":"2018-10-24T09:10:42","slug":"procedures-of-reporting-operating-leases-as-capital-leases","status":"publish","type":"post","link":"https:\/\/www.benedictsol.com\/blogs\/procedures-of-reporting-operating-leases-as-capital-leases\/","title":{"rendered":"Procedures of Reporting Operating Leases as Capital Leases"},"content":{"rendered":"\n
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\u00a0<\/span><\/p>\n

I. Objectives of the project<\/span><\/strong><\/p>\n

\u00a0<\/span><\/strong><\/p>\n

a. To perform a constructive capitalization on operating leases (i.e., as if the operating leases had been capitalized at the inception of a lease contract).<\/p>\n

\u00a0<\/span><\/p>\n

b. To learn the impact of reporting operating leases as capital leases at the inception of leases on liabilities, assets, retained earnings, net income and selected financial ratios.<\/p>\n

\u00a0<\/span><\/p>\n

c. To enhance the relevance and comparability of firm specific measures of risk and performance.<\/p>\n

\u00a0<\/p>\n

II. Procedures of Reporting Operating Leases as Capital Leases <\/span><\/strong><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>Imhoff, Lipe and Wright (ILW) (1991, 1997) studied the impact of lease capitalization on financial numbers and some key financial ratios.\u00a0 <\/span>The following financial variables were derived as if the operating leases of the firms were reported as capital leases in ILW (1991, 1997):\u00a0 <\/span>the unrecorded lease liabilities, the unrecorded leased assets, the impact of lease capitalization on income and retained earnings.\u00a0 <\/span><\/strong><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>The Unrecorded Lease Liabilities (URL)<\/u><\/strong>.\u00a0 <\/span>Statement of Financial Accounting Standards 13 (FASB Accounting Standards Codification 840) requires footnote disclosure of operating lease payments including five subsequent years\u2019<\/strong> lease payments and a one lump-sum<\/strong> payment for the remaining life of the leases.\u00a0 <\/span>In ILW (1991), the lease term is assumed to be 30 years and half-expired (thus, with 15 years remaining<\/strong>) and the lump-sum payment is assumed to be equally paid in 10 years \u00a0<\/span><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0<\/span>\u00a0\u00a0<\/span>t+15<\/span><\/p>\n

(15 years remaining minus the five detailed years). Thus, URLt<\/sub> = \u2211 PV (Xi<\/sub>)<\/strong>, where t is \u00a0<\/span>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0<\/span>i=t+1<\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0<\/span><\/span><\/p>\n

the test year, PV (Xi<\/sub>) denotes the present value<\/strong> of the \u00a0<\/span>lease payment for year i and i = t+1 to t+15 using an appropriate discount rate. \u00a0<\/span><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>The Unrecorded Leased Asset (URA)<\/u><\/strong>.\u00a0 <\/span>At the inception of a lease term the unrecorded lease liability (URL) equals the unrecorded leased asset (URA), however, the URA would decline at a faster rate than the URL over the life of an individual lease.\u00a0 <\/span>While the URA is reduced by a straight-line depreciation expense, the URL is decreased by the lease payment minus interest expense.\u00a0 <\/span>Since the lease payment is predominately comprised of interest expense in the early life of a lease term, the URA is therefore, declining at a faster rate than the URL.\u00a0 <\/span>ILW (1991) managed this by assuming that for the half-expired 30-year lease contract, the URAt<\/sub> is 70% of the URLt<\/sub> <\/strong>for the test year t. For the purposes of your project, use this assumption.<\/strong><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>Constructive Lease Capitalization Impact on Income and Retained Earnings<\/u><\/strong>.\u00a0 <\/span>For a capital lease, the expenses charged include both depreciation and interest whereas the operating lease expense is only the lease payment (i.e., reported as the rent expense).\u00a0 <\/span>In the early life<\/strong> of a lease term (i.e., before the leased asset is about 53 % to 63 % depreciated according to IWL (1991)), depreciation plus interest expense is greater than the lease payment and therefore, the capital lease expense is greater<\/strong> than the operating lease expense. However, this phenomenon is reversed later in the lease term in which the operating lease expense is greater than the capital lease expense.\u00a0 <\/span>Therefore, the constructive lease capitalizations impact on income for a given year could be either negative <\/strong>(e.g. in the early life of a lease term) or positive <\/strong>(e.g. in the later life).\u00a0 <\/span>Nevertheless, the constructive lease capitalization\u2019s impact on the retained earnings<\/strong> is always negative <\/strong>due to the cumulative nature<\/strong> of the retained earnings.\u00a0 <\/span><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>The Derivation of the Impact on Retained Earnings (\u2206RE)<\/u><\/strong>.<\/u>\u00a0 <\/span>To obtain the impact of a capital lease on retained earnings as compared to an operating lease, the excess of capital lease expenses over operating lease expenses up to the test year (year t) is calculated.\u00a0 <\/span>Recall that the URA is reduced by the depreciation expense while the URL is reduced by (lease payment \u2013 interest expense).\u00a0 <\/span>Thus, the difference of URA and URL equals [(depreciation expense) \u2013 (lease payment-interest expense)] which can be rewritten as [(depreciation expense + interest expense) \u2013 lease payment] or (capital lease expense \u2013 operating lease expense).<\/span>[1]<\/span><\/span><\/span><\/span><\/span>\u00a0 <\/span>Therefore, the cumulative excess expense of a capital lease over an operating lease is identical to the difference between URLt<\/sub> and URAt.<\/sub>\u00a0 <\/span>Consequently, the impact (zero or negative) on the retained earnings from the lease capitalization (hereafter, \u2206RE<\/strong>), in the absence of tax effects<\/strong>, equals URAt<\/sub> \u2013 URLt<\/sub><\/strong>.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>Cumulative Tax Savings , Deferred Tax Benefits, Net Impact on Retained Earnings (Net \u2206RE) and Net URL. <\/u><\/span><\/strong>\u00a0\u00a0<\/span>A further complication in the constructive capitalization of the leases are the differences in deferred taxes between a capital lease and an operating lease.\u00a0 <\/span>Since a capital lease results in higher expenses, it would enjoy a deferred tax benefit and also a reduction in cumulative income tax expenses (or cumulative tax savings) in the early years of the lease.<\/span>[2]<\/span><\/span><\/span><\/span><\/span>\u00a0 <\/span>This means that the negative impact of a capital lease on retained earnings<\/strong> is reduced by the cumulative tax savings.\u00a0 <\/span>The cumulative tax savings are calculated as the marginal tax rate of year t (TRt<\/sub><\/strong>) times the excess <\/strong>of capital lease expenses over operating lease expenses up to year t (i.e., URAt<\/sub>-URLt<\/sub><\/strong> ).\u00a0 <\/span>Therefore, the net<\/u><\/strong> impact on retained earnings (Net \u2206RE)<\/strong> from lease capitalization for year t is: \u2206REt<\/sub> \u2013 TRt<\/sub> x \u2206REt<\/sub><\/strong>.\u00a0 <\/span>Similarly, the deferred tax benefits\u00a0\u00a0 <\/span>should also be subtracted from the URLt<\/sub> to obtain the Net URLt<\/sub>.\u00a0\u00a0 <\/span>Thus, NetURL t<\/sub> = URLt<\/sub>\u00a0 <\/span>\u2013 TRt<\/sub> x (URAt<\/sub> \u2013 URLt<\/sub>) .<\/sub> <\/strong><\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>\u00a0<\/span>The Impact on Income (\u2206IN), Tax Savings for a Given Year (TSAV), \u00a0<\/span>and the Impact on Net Income (\u2206NetIN)<\/u>.\u00a0 <\/span><\/strong>Adding the income impact of year t from lease capitalization to \u2206REt-1<\/sub> should result in the lease capitalization impact on retained earnings of year t (i.e., \u2206REt<\/sub>).\u00a0 <\/span>Therefore, the difference of the cumulative capital lease expenses over operating leases expenses of t (i.e., \u2206REt<\/sub>) and that of t-1 (i.e., \u2206REt-1<\/sub>) equals the difference of the capital lease expenses and operating lease expenses of year t.\u00a0 <\/span>To calculate the impact on income (\u2206IN) from the lease capitalization for year t, one should subtract the \u2206REt -1<\/sub> from the \u2206REt<\/sub><\/strong>.\u00a0 <\/span>A negative result (i.e., \u2206REt<\/sub> \u2013 \u2206REt -1<\/sub>< 0) would indicate that the capital lease expenses are greater than the operating lease expenses for year t.\u00a0 <\/span>Therefore, the constructive lease capitalization would reduce<\/strong> the income of year t (referred to as a negative <\/strong>income impact from lease capitalization).\u00a0 <\/span>This phenomenon usually occurs from the inception of the lease contract until the leased asset is about 53 percent to 63 percent depreciated (IWL, 1991).\u00a0 <\/span>On the other hand, a positive result\u00a0 <\/span>(i.e., \u2206REt<\/sub> \u2013 \u2206REt -1<\/sub>> 0) indicates an opposite effect: that the capital lease expenses are less than the operating lease expenses for year t, and therefore, the constructive lease capitalization would increase<\/strong> the income for year t (i.e., referred as a positive <\/strong>income impact from lease capitalization). <\/span><\/p>\n

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 <\/span>When the tax effect is considered, the negative (or positive) impact on income of year t from lease capitalization would be reduced by the tax savings (or additional tax cost when the impact on income is positive) of year t.\u00a0 <\/span>The tax savings (or additional tax cost) equals TRt<\/sub> times the income impact of year t (i.e., \u2206REt<\/sub>\u2013 \u2206REt -1<\/sub>).\u00a0 <\/span>Thus, with tax consideration, the net impact on income for year t (referred to as \u2206NetINt<\/sub><\/strong>) equals (1-TRt<\/sub>) x (\u2206REt<\/sub>\u2013 \u2206REt -1<\/sub><\/strong>).\u00a0\u00a0\u00a0\u00a0 <\/span><\/span><\/p>\n

\u00a0<\/span><\/strong><\/p>\n

III. Assumptions and the Content of the Project Report <\/span><\/strong><\/p>\n

\u00a0<\/span><\/strong><\/p>\n

3.1 Assumptions<\/span><\/p>\n