Leases

CFA Level I FRA
#1

Hi all,

I was attempting this leasing question from past schweser mocks. I could not understand why they have depreciated the asset over 9 years and not 11 years.

Does the asset have to be depreciated over the same number of years as the years in the lease contract?

Question:

On December 31, 2000, Asheville Corp. executed a 9-year lease with annual payments of $3,300,000 for sophisticated equipment for its precision specialty manufacturing facility. The economic life of the equipment was 11 years. Asheville has the option to purchase the equipment for its then-current fair market value at the end of the lease. The interest rate implicit in the lease is 10 percent. Asheville Corp.’s incremental borrowing rate is 10 percent. The fair market value of the equipment on December 31, 2000 was $25,000,000. Treating the above transaction as an operating lease, Asheville Corp.’s income statement for the year ended December 31, 2001 was as follows:

Sales

$82,000,000

Cost of Goods Sold

(38,000,000)

Gross Profit

44,000,000

Depreciation

(8,300,000)

Lease Expense

(3,300,000)

Sales and Administration

(18,400,000)

Operating Profit

14,000,000

Interest Expense

(2,000,000)

Income Taxes

(5,000,000)

Net Income

$7,000,000

  • After considering whether the equipment lease should be reclassified as a capital and holding income taxes constant at $5,000,000, Asheville’s net profit margin will:

A) decrease from 8.54 percent to 5.35 percent.

B) decrease from 8.54 percent to 6.22 percent.

C) remain unchanged.

D) decrease from 8.54 percent to 7.67 percent.

Explanation

Asheville’s net profit margin (net income / sales) with the lease classified as an operating lease was ($6,000,000 / $82,000,000 =) 8.54 percent. The equipment lease is a capital lease because of the fact that the lease is for (9 years / 11 years =) 82 percent, which is more than 75 percent of the assets’ economic life. The minimum interest rate between the lease’s implicit rate of 10 percent and Asheville Corp.’s incremental borrowing rate of 10 percent is used to capitalize the lease. The present value of the lease payments is (PV annuity N = 9, I/Y = 10, PMT = $900,000) $19,004,779. The $3,300,000 payment made December 31, 2001 is allocated ($19,004.779 * 0.10 =) $1,900,478 to interest and ($3,300,000 - $1.900,478 =) $1,399,522 to principal.

Depreciation expense is computed over 9 years on a straight line basis ($19,004,779 / 9 =) $2,111,642. Adjusting the income statement to remove operating lease expense and include depreciation expense results in operating profit of ($14,000,000 + $3,300,000 - $2,111,642 =) $15,188,358. Lease related interest expense of $1,900,478 is added to $2,000,000 to arrive at total interest expense of $3,900,478. The adjusted net profit margin (net income / sales) is ($15,188,358 - $3,900,478 - $5,000,000 =) $6,287,880 / $82,000,000 = 7.67 percent.

#2

The lease, which is a contractual obligation for both parties, allows the lessee to use the equipment for 9 years not 11. Since the lessee only has a guaranteed use of the equipment for 9 years, this will be the depreciable time horizon. In the event that they do purchase the equipment at the conclusion of the lease and determine it still has useful economic life remaining, they would adjust the basis by the purchase price and then adjust the time of depreciation for the basis. This would be considered a change in estimate and does not require retrospective adjustments in the accounting records.

Hope this helps.

#3

Thanks man. That makes perfect sense. :slight_smile:

Do you mean the lessor would charge money for selling the asset if it still has some economic life remaining? or something else?

The depreciation time will be extended? For example, from 9 to 11 years in the above example. or something else?

Also, just out of curiosity, what would happen if the lessee fails to make the lease payment? Would the company be considered in default just like in bonds’ case or the maximum penalty would just be just be a fine and return the asset to the lessor? This is out of curriculum.

Thanks

#4

If we depreciate and then all of a sudden realize that it has a longer useful life we have what is called a change in estimate. Same will go for purchasing an asset from a lessor, the purchase price would be capitalized and added to the basis of the asset and the additional economic life would be calculated. We must remember that depreciation is simply an estimate made by management as to the useful economic life and salvage value. Since these are estimates, if we have changes to the underlying fundamentals, (ie: change in basis or useful life) then we have a “change in estimate”. As noted before, we are not required to restate previous financials (retrospective adjustment) we simply must adjust for these changes in the current and all future period (prospective adjustment).

For example. We lese equipment on a 9 year contract that is a capital lease and with a book value of $9,000. We depreciate $1,000 per year (straight-line) over the 9 years. At the beginning of year 7 we get agree to purchase the asset from the lessor for $3,000 and estimate that the remaining useful economic life of the asset is 5 years. At that point, we would add the $3,000 purchase price to the asset basis and then depreciate the remaining basis over the useful economic life.

Below is a description of net book value (NBV) and annual depreciation (DEP) and accumulated depreciation (AD) for the end of each year.

Year 0 – NBV: $9,000 DEP: $0 AD: $0

Year 1 – NBV: $8,000 DEP: $1,000 AD: $1,000

Year 2 – NBV: $7,000 DEP: $1,000 AD: $2,000

Year 3 – NBV: $6,000 DEP: $1,000 AD: $3,000

Year 4 – NBV: $5,000 DEP: $1,000 AD: $4,000

Year 5 – NBV: $4,000 DEP: $1,000 AD: $5,000

Year 6 – NBV: $3,000 DEP: $1,000 AD: $6,000

NBV + $3,000 (purchase price) annual deprecation = ($3,000+$3,000)/5 = $1,200

Year 7 – NBV: 4,800 DEP: AD: $7,200

Year 8 – NBV: $3,600 DEP: $1,200 AD: $8,400

Year 9 – NBV: $2,400 DEP: $1,200 AD: $9,600

Year 10 – NBV: $1,200 DEP: $1,200 AD: $10,800

Year 11 – NBV: $0 DEP: $1,200 AD: $12,000

I hope this clears it up a bit.

As for a missed payment, the outcome would be determined by the terms of the contract and would vary depending on the situation. I would assume in most cases it would begin with a late payment fee and possibly and with long-term failure to pay a reposition of the asset by the lessor.

#5

Thanks man. :slight_smile: