Accounting methods for leases and their impact. For financial reporting purposes, there are two

Transcription

1 SESSION 8 Accounting methods for leases and their impact on financial statements MicroStrategy discussion Role of financial analysts LEASES For financial reporting purposes, there are two types of leases: Capital leases, or operating leases For a given lease, only one of the above applies. That is, no discretion once the lease terms are set. However, companies can arrange the lease terms such that one of the two applies. Main characteristics: Capital leases: as if purchased a long-term asset using long-term debt Operating leases: simple rental 1

2 LEASES Capital lease In substance, a purchase by the lessee Lessee records: asset and liability on balance sheet interest expense, and depreciation expense. Rent payment split into CFO (interest expense) and CFF (reduction of lease obligation) On balance sheet Operating lease No transfer of ownership to the lessee Lessee records: No asset or liability on the balance sheet rent expense Information in footnotes Rent payment included in CFO (rental expense) and has no effect on CFF. Off balance sheet LEASES An example: 3-year lease; $1000 payment each year. Interest rate 10%; lease agreement signed on 12/31 of year 0. Present value of the future lease payment is: $2,487. Impact on financial statements? 2

3 LEASES Two otherwise identical firms: CAP LEASE and O-PLEASE, except that CAP LEASE uses capital leases (and straight-line depr method) and O-PLEASE uses operating leases. Which firm would have a higher EBITDA? EBIT? NI? ROE? ROIC? Firm CAP LEASE Firm O-PLEASE Sales same same by assumption COGS (excluding depr. expense) same same by assumption GM same same by assumption Rental expense higher EBITDA Higher Lower Depreciation expense higher EBIT Higher Lower under straight-line depr method Interest expense higher Income before taxes Lower in early years, higher in later years Net Income Lower in early years, higher in later years Total assets Total liabilities Debt/Asset ratio Higher Higher Higher LEASES Analysts often adjust financial statements by capitalizing firms operating leases Motivation: put firms on equal ground for comparison Main idea: What would the company s performance look like if it treated all operating leases as capital leases? 3

4 LEASES Capitalize operating leases: Main step: calculate the present value of all future operating lease payments Where to find the future payment information? What discount rate to use? Approximate with interest rate on capital leases Use TJX as an example LEASES Inferring interest rate on capital leases: assuming lease payment is made at the end of the year Future minimum lease payments, from TJX's footnote disclosure (in $1000) Capital leases Operating leases , , , , , , , , , ,383 Later years 30,397 1,625,522 Total future lease payments 49,027 3,954,279 Less amount representing interest 18,691 Net PV of capital leases 30,336 Curr portion of cap leases at end of ,348 Dr: obligations under capital leases 1348 Dr: interest expense: book value 30,336*interest rate Cr: payment for capital lease ,336*r = 3726 solve for r= 7.84% 4

5 LEASES Discounting future payments under operating leases (in $1000) Future payments under operating leases PV factor using inferred 7.84% rate from cap leases PV value , , , , , , , , , ,494 Later years 1,625,522 Assume equal payments in 5 years , , , , , , , , , ,835 total 2,785,283 LEASES Implication for assets? Liabilities? Leverage ratios? Profitability ratios? TJX's example (in $mil) Reported Operating leases Adjusted Total asset 3,940 2,785 6,726 Long term debt 707 2,785 3,492 Debt/Asset ratio 17.94% 51.92% 5

6 A QUICK RECAP ON LEASES: What information do you need to capitalize operating leases? How do you estimate the average interest rate on capital leases? True or false: Compared to operating leases, using capital leases would show: Higher depreciation expenses Lower net income More volatile ROE True or false: Company XYZ shows $100 as the current portion of capital lease obligations on its 12/31/2004 balance sheet. This means XYZ s total cash payment for capital leases will be $100 at the end of MICROSTRATEGY 6

7 MICROSTRATEGY FOLLOW-UP May 2001: PWC pays $55 million to settle class- action shareholder lawsuit over its MicroStrategy audits August 8, 2003: SEC barred PWC partner Warren Martin from auditing publicly traded companies for 2 years Former partner on MicroStrategy SEC said, Warren Martin lacked professional skepticism and didn t act with due professional care in signing off on improper accounting [at Microstrategy] FINANCIAL ANALYSTS What do they do? Buy-side analysts and sell-side analysts Sell-side work for investment banks, brokerage firms, credit rating agency, etc. Institutional investors often have their own analysts (buy-side). Most analysts reports we observe are from sell-side analysts Analyze and advise clients (investors) about firms financial situation, provide forecasts on firms future earnings, and issue stock recommendations. 7

8 FINANCIAL ANALYSTS What do sell-side analysts do? "[w]e expect an analyst to do two things -- be right, and produce transactions. If you make superb recommendations but you've done little business, you've done the firm little good.... If your performance is bad and you generate a lot of business, you've done a terrible job.... If your performance is good, and you generate a lot of business, you've done a terrific job." -- Manny Korman, director of research at Dean Witter in 1991 ("Analysts devote more time to selling as firms keep scorecard on performance, Oct. 29, 1991, WSJ)) FINANCIAL ANALYSTS Earnings forecasts: More accurate than statistical forecast model Becomes more accurate as forecast horizon shortens On average, forecasts are optimistic, i.e., their forecasts are on average higher than actual earnings. Why are analysts forecasts optimistic? 8

9 FINANCIAL ANALYSTS Stock recommendations: Disproportionably high percentage of buy/strong buy recommendations % of sells increased in recent years Do their recommendations have investment value? Can you make money following their recommendations? Yes, and no. 9

10 FINANCIAL ANALYSTS FINANCIAL ANALYSTS How do investors react to their reports? Small, but statistically significant response to new reports Some evidence of delayed response. Post-forecast drift Investors seem to recognize analyst-specific features e.g., stronger response to analysts with better track record; weaker response to analysts with potential conflicts of interest 10

11 FINANCIAL ANALYSTS Regulation Fair Disclosure (Reg. FD, 2001) Firms cannot make selective disclosures Analysts forecast accuracy lowered after Reg. FD Sarbanes-Oxley Act of 2002: Separation of investment banking branch from research branch Analysts have to disclose potential conflict of interest Global research analyst settlement: 10 investment banks settled with the SEC for $1.4 billion. Details of the settlement available at REVIEW QUESTIONS What role(s) do analysts play in financial markets? What are the main characteristics of analysts forecasts? What are the possible explanations for these characteristics? Would you pay for analysts stock recommendations? 11

12 IN PREPARATION FOR SESSION 9 Read and prepare the TSAI case on revenue recognition We will also discuss securitization of accounts receivable 12

13 Lease example 3-year lease, $1000 payment each year. Interest rate is 10%, signed on 12/31 of year 0 Present value of payment ($2,486.85) Journal entry under capital leases How related items on balance sheet evolves under capital leases At signing: at Dec. 31 of year 0 year 1 year 2 year 3 Assets: PPE - Leasehold asset Liabilities Dec. 31, year 1, first payment Cap lease obligation total Liab often presented as: Current portion Cap lease obligation (LT portion) Effects on Income statement Capital lease Operating leases Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Dec. 31, year 2, 2nd payment Revenue: COGS (exclude depr) Operating exp (incl rent) EBITDA Depr exp on leasehold ast EBIT Int exp Inc b/4 taxes Dec. 31, year 3, 3nd payment Net income (assume 30% tax rate) CFO If it's operating lease, JE each year is if avg. Total assets excl lease is then avg. total assets incl leases is Then: ROA is if avg. Total assets excl lease is then avg. total assets incl leases is Then: ROA is