Ifrs Case 15-5

Requirement 1

Dell’s operating lease commitments at January 30, 2009 are:

Lease Commitments — Dell leases property and equipment, manufacturing facilities, and office space under non-cancelable leases. Certain of these leases obligate Dell to pay taxes, maintenance, and repair costs. At January 30, 2009, future minimum lease payments under these non-cancelable leases are as follows: $89 million in Fiscal 2010; $77 million in Fiscal 2011; $63 million in Fiscal 2012; $42 million in Fiscal 2013; $34 million in Fiscal 2014; and $153 million thereafter.

 

Requirement 2

There is no single way to estimate the effect of capitalizing Dell’s operating leases. The objective is to find the present value of the series of lease payments required by the operating lease obligations. Information, though, is insufficient to make exact calculations. We can use the amount of payments after 2014 to estimate the number of years those payments are due.

$153/ $34 = about 4 years

We can then use the midpoint of 4 years, 2 years, in the calculation:

($ in millions)

Fiscal Operating PV factor Present years leases 6% value

2010 $ 89 .943 $ 84

2011 77 .890 69

2012 63 .840 53

2013 42 .792 33

2014 34 .747 25

2015 and subsequent 153 .667* 102

Total minimum rentals $458 $366

* This is the PV factor for i=6%, n=7, which treats payments after 2014 as occurring in 2016, 2 years after 2014, the midpoint of the 4 years after 2014.

Case 15-5 (concluded)

or:

An alternative (more accurate, but more difficult) way to estimate the present value of the payments beyond 2014 is: to view them as a deferred annuity:

$38.25 ($153/4) x 3.46551** = $133

$133 x .747*** = $ 99

** present value of an ordinary annuity of $1, i=6%, n=4

*** present value of $1, i=6%, n=5 (2010-2014)

Requirement 3

If capitalized, these operating lease commitments would add $366 million to Dell’s liabilities. The impact of this on the percentage of Dell’s debt to equity would be to increase the percentage slightly from 520% to 529%:

Without capitalization: $ 22,229 / $ 4,271 = 520%

With capitalization: ($22,229 + $366) / $4,271 = 529%

Note two indications from this analysis. First, Dell’s debt to equity ratio is quite high. Often it is less than one, but Dell’s is over 5 to 1. Second, note that capitalizing operating leases had a negligible impact on the ratio for two reasons – the ratio is high to begin with and Dell has relatively small (and declining) operating lease commitments. For many companies, airlines and grocery chains for instance, capitalizing operating leases can greatly increase, often double, the ratio.

We made reasonable assumptions about the timing of payments and estimated the present value of all future payments to be made on the operating leases as we did in the “Decision-Makers’ Perspective” section at the end of the chapter. Other reasonable assumptions should yield comparable results. In any case, we have a rough estimate.

Real World Case 15-6

Requirement 1

Leasing can allow a firm to conserve assets, to avoid some risks of owning assets, and obtain favorable tax benefits. Also, leasing sometimes is used as a means of “off-balance-sheet financing.” When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt-equity ratio and other mechanical indicators of riskiness. Also, the purchased asset increases total assets and thus reduces calculations of the rate of return on assets. In spite of research that indicates the market is not fooled, managers continue to avoid reporting of assets and liabilities by leasing rather than buying and by constructing lease agreements in such a way that capitalizing the assets and liabilities is not required. Whether or not there is any real effect on security prices, off-balance-sheet financing can help a firm avoid exceeding contractual limits on designated financial ratios (like the debt to equity ratio, for instance). In fact, in its annual report, Wal-Mart indicates that they have several restrictive covenants, one of which relates to the debt to equity ratio.

Requirement 2

When capital leases are first recorded, both assets and liabilities increase by the present value of minimum lease payments. In later years, though, the amounts differ. Leased assets are reduced by depreciation. Lease liabilities are reduced by the principal portion of lease payments.

Requirement 3

($ in millions)

Interest expense(difference) 287 Lease payable (current obligation: given) 316 Cash(lease payment: given) 603

Requirement 4

$ 287 2009 interest (from requirement 3)

÷ 3,919 Beginning balance in lease liability–given: $316 + 3,603

7.3%

Approximate average interest rate = 7.3%

Real World Case 15-7

Requirement 1

In a sale-leaseback transaction the owner of an asset sells the asset and immediately leases it back from the new owner. We view the sale and simultaneous leaseback of the asset as a single borrowing transaction. On the surface there appear to be two separate transactions, but the substance of the agreement indicates otherwise. The seller-lessee (FedEx in our case) still retains the use of the asset owned prior to the sale-leaseback, but in the process acquires (a) cash from the sale and (b) an obligation to make lease payments over the term of the lease. In substance, the seller-lessee has borrowed cash to be repaid over the lease term (along with interest). So, from this perspective of “substance over form,” we do not immediately recognize any gains that result from sale-leaseback transactions, but defer the gains to be recognized over the term of the lease. There typically is interdependency between the lease terms and the price at which the asset is sold. As a result, the earnings process is not complete at the time of sale but is completed over the term of the lease. So, viewing the sale and the leaseback as a single transaction is consistent with the realization principle.

Requirement 2

When amortizing the deferred gain over the lease term, if the lease meets the criteria to be viewed as a capital lease, we reduce depreciation expense each period by the amortized portion of the gain.

If the leaseback portion of a sale-leaseback transaction is classified as an operating lease, the gain still is deferred, but is recognized as a reduction of rent expense rather than depreciation. Because FedEx amortizes its deferred gains “ratably over the life of the lease as a reduction of rent expense” it apparently considers the leases to be operating leases.

Communication Case 15-8