Journal of Case Studies November 2015, Vol. 33, No. 2, p

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1 Journal of Case Studies November 2015, Vol. 33, No. 2, p Accounting for Leases: Operating or Capital Does It Really Matter? Karen Foust, Tulane University Christine Smith, Tulane University Beauregard Parent, Tulane University Disclaimer: This case was prepared by the authors and is intended to be used as a basis for class discussion. The views presented here are those of the authors based on their professional judgment and do not necessarily reflect the views of the Society for Case Research. The names of individuals are disguised to preserve anonymity. Copyright 2015 by the Society for Case Research and the authors. No part of this work may be reproduced or used in any form or by any means without the written permission of the Society for Case Research. Rachel Spiro was puzzled. Her intermediate accounting professor began a series of lectures on accounting for leases, however, Rachel left the classroom after the first lecture with more questions than when she entered. The most pressing in her mind was how could the Financial Accounting Standards Board (FASB) let companies get away with not reporting multiple-year, noncancellable contracts which grant them the extended right of use of a valuable asset? The professor had stated that the total expense for an operating lease would equal the total expense for a capital lease over the life of the contract, so Rachel thought, Does it truly matter how an entity classifies a lease: operating vs. capital? The professor had introduced the topic by first explaining that accounting for leases was not a one size fits all exercise: the FASB classifications varied such that under one scenario the standards required companies to add certain leased items to the balance sheet as assets with a corresponding liability (capital lease), yet in another, the payments for use of the item were considered operating expenses with no asset or liability recorded (operating lease). Wouldn t these different classifications open the door for earnings management? Rachel thought. Surely, if given a choice, wouldn t companies always choose to report more assets and fewer expenses in any given reporting period? Besides, by classifying these contracts as operating leases and recording related expense in the period, wouldn t that result in better adherence to the Matching Principle we learned so much about in the Conceptual Framework? Unfortunately, Rachel s professor had an administrative meeting immediately after class and was not available to address the many questions she raised. Rachel kept replaying in her mind one statement that the professor made: the standard was meant to prevent companies from engaging in off-balancesheet financing. What exactly did that mean? Rachel wasn t willing to wait until the next class to have these questions answered and was determined to seek out the information on her own. Her first step was to gain a better understanding of the term off-balance-sheet financing. She referred to her Spiceland s Intermediate Accounting textbook where she learned it was the practice of structuring long-term contracts such that no liability is recorded on the balance sheet. The textbook went on to say, some firms try to obscure the realities of their financial position through off-balance-sheet financing [thereby] avoiding violating terms of contracts that limit the amount of debt a company can have.[operating leases are] sometimes used as a means of off-balance-sheet financing. Page 87

2 Armed with that information, Rachel needed to see if or how these different classifications of leases manifested themselves within the story of a real company. She remembered that her accounting professor had mentioned the airline industry as one that relied heavily on leases for its flight equipment. She turned on her laptop, Googled Delta Airlines and accessed the company s latest financial statements at The consolidated balance sheets, statements of operations and cash flows and relevant financial statement footnote disclosures that Rachel reviewed appear in Tables 1-5. Rachel combed over Delta s financial statements and footnotes noting the company had leases of both types: capital and operating. Of particular interest was the Lease Obligations Footnote which detailed the total amount owed under both categories of leases. She noted as of December 31, 2013, the present value of future minimum capital lease payments was $497 million, far less than the $9.87 billion owed in operating lease payments (almost twenty times less). Rachel knew that the only way to truly understand the financial statement impact of the different lease classifications would be to convert the operating leases to capital leases. Then and only then could she interpret the impact on the story being told and answer the question: operating vs. capital does it really matter? Page 88

3 TABLE 1 Consolidated Balance Sheets (USD $) In Millions, unless otherwise specified Dec. 31, 2013 Dec. 31, 2012 Current Assets: Cash and cash equivalents $ 2,844 $ 2,416 Short-term investments Restricted cash, cash equivalents and short-term investments Accounts receivable, net of an allowance for uncollectible accounts 1,609 1,693 Fuel Inventory Expendable parts and supplies inventories, net of an allowance for obsolescence Deferred income taxes, net 1, Prepaid expenses and other 1,318 1,344 Total current assets 9,651 8,272 Property and Equipment, Net: Property and equipment, net of accumulated depreciation and amortization 21,854 20,713 Other Assets: Goodwill 9,794 9,794 Identifiable intangibles, net of accumulated amortization 4,658 4,679 Deferred income taxes, net 4,992 0 Other noncurrent assets 1,303 1,092 Total other assets 20,747 15,565 Total assets 52,252 44,550 Current Liabilities: Current maturities of long-term debt and capital leases 1,547 1,627 Air traffic liability 4,122 3,696 Accounts payable 2,300 2,293 Accrued salaries and related benefits 1,926 1,680 Frequent flyer deferred revenue 1,861 1,806 Taxes payable Fuel card obligation Other accrued liabilities 1,121 1,128 Total current liabilities 14,152 13,270 Noncurrent Liabilities: Long-term debt and capital leases 9,795 11,082 Pension, postretirement and related benefits 12,392 16,005 Frequent flyer deferred revenue 2,559 2,628 Deferred income taxes, net 0 2,047 Other noncurrent liabilities 1,711 1,649 Total noncurrent liabilities 26,457 33,411 Stockholders' Equity (Deficit): Common stock 0 0 Additional paid-in capital 13,982 14,069 Retained earnings (Accumulated deficit) 3,049 (7,389) Accumulated other comprehensive loss (5,130) (8,577) Treasury stock, at cost (258) (234) Total stockholders' equity (deficit) 11,643 (2,131) Total liabilities and stockholders' equity (deficit) 52,252 44,550 Page 89

4 TABLE 2 Consolidated Statements of Operations (USD $) 12 Months Ended December 31 In Millions, except Per Share data, unless otherwise specified Passenger Revenue: Passenger Revenue, Mainline $ 26,534 $ 25,173 $ 23,843 Passenger Revenue, Regional 6,408 6,581 6,414 Total Passenger Revenue 32,942 31,754 30,257 Cargo Revenue ,027 Other Revenue 3,894 3,926 3,831 Total Operating Revenue 37,773 36,670 35,115 Operating Expenses: Aircraft fuel and related taxes 9,397 10,150 9,730 Salaries and related costs 7,720 7,266 6,894 Regional carrier expense 5,669 5,647 5,470 Aircraft maintenance, materials and outside repairs 1,852 1,955 1,765 Contracted services 1,665 1,566 1,642 Depreciation and amortization 1,658 1,565 1,523 Passenger commissions and other selling expenses 1,603 1,590 1,682 Landing fees and other rents 1,410 1,336 1,281 Passenger service Profit sharing Aircraft rent Restructuring and other items Other operating expense 1,520 1,592 1,628 Total operating expense 34,373 34,495 33,140 Operating Income 3,400 2,175 1,975 Other Expense: Interest expense, net (698) (812) (901) Amortization of debt discount, net (154) (193) (193) Loss on extinguishment of debt 0 (118) (68) Miscellaneous, net (21) (27) (44) Total other expense, net (873) (1,150) (1,206) Income Before Income Taxes 2,527 1, Income Tax Benefit (Provision) 8,013 (16) 85 Net Income $ 10,540 $ 1,009 $ 854 Basic earnings per share $ $ 1.20 $ 1.02 Diluted earnings per share Cash dividends declared per common share $ $ 1.19 $ 1.01 $ 0.12 $ 0.00 $ 0.00 Page 90

5 TABLE 3 Consolidated Statements of Cash Flows (USD $) 12 Months Ended In Millions, unless otherwise specified Cash Flows From Operating Activities: Net Income $ 10,540 $ 1,009 $ 854 Depreciation and amortization 1,658 1,565 1,523 Amortization of Debt Discount, net Fuel hedge derivative contracts (114) (209) 135 Deferred Income Taxes (7,991) 17 (2) Pension, postretirement and postemployment expense less than payments (624) (208) (308) Restructuring and Other Items SkyMiles used pursuant to advance purchase under American Express Agreements (333) (333) (49) Changes in certain assets and liabilities: Receivables 90 (116) (76) Restricted Cash and Cash Equivalents 231 (51) 153 Fuel Inventory (87) (451) (8) Prepaid Expenses and Other Current Assets 28 (134) (8) Air Traffic Liability Frequent Flyer Deferred Revenue (121) (115) 82 Accounts Payable and Accrued Liabilities Other Assets and Liabilities (36) (66) (373) Other Operating Activities, net Net Cash Provided by Operating Activities 4,504 2,476 2,834 Cash Flows From Investing Activities: Flight Equipment, including advance payments (2,117) (1,196) (907) Ground Property and Equipment, including technology (451) (772) (347) Purchase of Virgin Atlantic shares (360) 0 0 Purchase of Short-term Investments (959) (958) (1,078) Redemption of short-term investments 1,117 1, Other Investing Activities, net 14 (55) (10) Net Cash Used in Investing Activities (2,756) (1,962) (1,498) Cash Flows From Financing Activities: Payments on Long-term Debt and Capital Lease Obligations (1,461) (2,864) (4,172) Cash Dividends (102) 0 0 Proceeds from Long-term Obligations 268 1,965 2,395 Repurchase of Common Stock (250) 0 0 Fuel Card Obligation Other Financing Activities, net 78 7 (112) Net Cash Used in Financing Activities (1,320) (755) (1,571) Net Increase (Decrease) in Cash and Cash Equivalents 428 (241) (235) Cash and Cash Equivalents at beginning of period 2,416 2,657 2,892 Cash and Cash Equivalents at end of period 2,844 2,416 2,657 Supplemental Disclosure of Cash Paid for Interest $ 698 $ 834 $ 925 Other Noncash Investing and Financing Items: Flight Equipment under Capital Leases $ 67 $ 28 $ 117 Built-to-suit Leased Facilities American Express advance purchase of restricted SkyMiles Page 91

6 TABLE 4 LEASE OBLIGATIONS FOOTNOTE DECEMBER 31, 2013 We lease aircraft, airport terminals, maintenance facilities, ticket offices and other property and equipment from third parties. Rental expense for operating leases, which is recorded on a straight-line basis over the life of the lease term, totaled approximately $1.1 billion for each of the years ended December 31, 2013, 2012 and Amounts due under capital leases are recorded as liabilities, while assets acquired under capital leases are recorded as property and equipment. Amortization of assets recorded under capital leases is included in depreciation and amortization expense. Our airport terminal leases include contingent rents, which vary based upon: facility usage, enplanements, aircraft weight and other factors. Many of our aircraft, facility and equipment leases include rental escalation clauses and/or renewal options. Our leases do not include residual value guarantees and we are not the primary beneficiary in or have other forms of variable interest with the lessor of the leased assets. As a result, we have not consolidated any of the entities that lease to us. The following tables summarize, as of December 31, 2013, our minimum rental commitments under capital leases and noncancelable operating leases (including certain aircraft flown by Contract Carriers) with initial or remaining terms in excess of one year: Capital Leases Years Ending December 31, (in millions) 2014 $ Thereafter 74 Total minimum lease payments 694 Less: amount of lease payments representing interest (197) Present value of future minimum capital lease payments 497 Less: current obligations under capital leases (98) Long-term capital lease obligations $ 399 Total Operating Leases Years Ending December 31, (in millions) Delta Lease Payments (1) Contract Carrier Aircraft Lease Payments (2) Total 2014 $ 1,079 $ 350 $ 1, , , , , Thereafter 5, ,666 Total minimum lease payments $ 9,869 $ 1,625 $ 11,494 (1) (2) Includes payments accounted for as construction obligations. See Note 5. Represents the minimum lease obligations under our Contract Carrier agreements with Chautauqua Airlines, Inc. ( Chautauqua ), Compass Airlines, Inc., ExpressJet Airlines, Inc., GoJet Airlines, LLC, Shuttle America Corporation ( Shuttle America ) and SkyWest Airlines, Inc. Page 92

7 TABLE 5 LEASE OBLIGATIONS FOOTNOTE DECEMBER 31, 2012 We lease aircraft, airport terminals, maintenance facilities, ticket offices and other property and equipment from third parties. Rental expense for operating leases, which is recorded on a straight-line basis over the life of the lease term, totaled approximately $1.1 billion for each of the years ended December 31, 2012, 2011 and Amounts due under capital leases are recorded as liabilities, while assets acquired under capital leases are recorded as property and equipment. Amortization of assets recorded under capital leases is included in depreciation and amortization expense. Our airport terminal leases include contingent rents, which vary based upon: facility usage, enplanements, aircraft weight and other factors. Many of our aircraft, facility and equipment leases include rental escalation clauses and/or renewal options. Our leases do not include residual value guarantees and we are not the primary beneficiary in or have other forms of variable interest with the lessor of the leased assets. As a result, we have not consolidated any of the entities that lease to us. The following tables summarize, as of December 31, 2012, our minimum rental commitments under capital leases and noncancelable operating leases (including certain aircraft flown by Contract Carriers) with initial or remaining terms in excess of one year: Capital Leases Years Ending December 31, (in millions) Total 2013 $ Thereafter 113 Total minimum lease payments 914 Less: amount of lease payments representing interest (313 ) Present value of future minimum capital lease payments 601 Plus: unamortized premium Less: current obligations under capital leases 2 (120) Long-term capital lease obligations $ Operating Leases Years Ending December 31, (in millions) Delta Lease Payments (1) Contract Carrier Aircraft Lease Payments (2) 2013 $ 1,005 $ 502 $ 1, , , , ,000 Thereafter 6,414 1,001 7,415 Total minimum lease payments $ 10,590 $ 3,256 $ 13,846 (1) Includes payments accounted for as construction obligations. See Note 5. (2) Represents the minimum lease obligations under our Contract Carrier agreements with ExpressJet Airlines, Inc., Chautauqua Airlines, Inc. ( Chautauqua ), Pinnacle, Shuttle America Corporation ( Shuttle America ) and SkyWest Airlines, Inc. Total Page 93

8 At December 31, 2012, we operated 109 aircraft under capital leases and 68 aircraft under operating leases. Our Contract Carriers operated 568 aircraft for us accounted for as operating leases. References Delta Air Lines, Inc Annual Report. Spiceland, J. D., Sepe, J. F., & Nelson, M. W. Intermediate Accounting, 7th ed., New York, NY: McGraw-Hill Irwin, Page 94