Lease Accounting at FedEx

Krishna an MBA (Finance) student at a premier B-school of India who aspires to be an investment banker, was doing his internship with a renowned financial services firm in Mumbai to complete-a2month mandatory internship after the first year. His project included financial analysis of FedEx's financial statement. Being a very enthusiastic student, he had almost completed his analysis on FedEx, most of its financial details, prepared a draft report on FedEx and its financial condition. Before finalizing the draft, he decided to meet his Team Lead Daniel and discuss his findings. Krishna was satisfied with the progress in his work and was expecting an early leave (a week before) from his internship as he had planned to submit the project in next 4 days. He had tentatively planned a Goa trip if he could save a week. On November 21st 2013, Krishna goes to Daniel to discuss the draft report. While reading his financial report, Daniel observes that Krishna had not considered any off balance sheet information for the analysis. Krishna had overlooked a very important item i.e., the operating lease amount, which was kept off balance sheet. Daniel asks Krishna to go through the FASB's newly proposed lease accounting changes and then redraft the required analysis as FedEx's lease amounts might bring a significant difference in the analysis once included in the on balance sheet.

Krishna was unaware about the FASB's proposal and decided to go through the proposed new policy. While reading about it on internet, he finds that FedEx has been one of many companies opposing this new lease accounting proposal by FASB.1 He realises that if he considers FedEx's operating leases as capital leases2 it might lead to dramatic changes in his financial analysis of the company. Was this the reason for FedEx's vehement opposition of FASB's new proposal3? Krishna was prepared to work overnight to find his answers and to save his week.

Federal Express: An Overview

FedEx, instituted in January 1998 with the acquisition of Calibre System Inc., is the renowned American global courier delivery service company headquartered in Memphis, Tennessee. FedEx Express is the industry's global leader, providing rapid, reliable, time-definite delivery to more than 220 countries and territories. Most of the competition has built their business on the hub-and-spoke and track-and-trace models, which FedEx introduced first. Competitors in this industry include other package delivery concerns, principally United Parcel Service, Inc. ("UPS"), DHL, passenger airlines offering express package services, regional express delivery concerns, airfreight forwarders and the US Postal Service. The principal competitors to FedEx in the international market are DHL, UPS, foreign postal authorities such as Deutsche Post and TNT N.V., freight forwarders, passenger airlines and all-cargo airlines. FedEx Ground is a leading North American provider of ground small-package delivery services, providing service to the US and Canada. It includes FedEx Smart Post, which specializes in the consolidation and delivery of high volumes of low-weight, less time-sensitive business-to-consumer packages using the US Postal Service for final delivery to any residential address or P.O. Box in the US. FedEx Freight is the market leader in providing less-than-truckload (LTL) freight services across all lengths of haul. It also includes FedEx Custom Critical, North America's largest time-specific, critical shipment carrier. FedEx Services operates combined sales, marketing, administrative and information technology functions in shared services operations that support transportation businesses and allow them to obtain synergies from the combination of these functions. Today FedEx provides us with a fully integrated system to ship packages around the world. According to the Centre for Responsive Politics, FedEx Corp is the 21st largest campaign contributor in the US. In 2005, FedEx was among the 53 entities that contributed the maximum of $250,000 to sponsor the second inauguration of President George W. Bush. FedEx was named by Fortune magazine as one of the top 100 companies to work for in 2013, citing the company's choice to downsize with voluntary buyouts rather than involuntary layoffs.

FinancialPerformanceofRecentFiscalYear

With a boost from e-commerce, FedEx posted a year with industry-leading margins. Revenue share increased for 54 consecutive quarters, an outstanding performance driven by superior service that is faster to more locations than any other ground service. At FedEx Express, acquisitions in Brazil, France, Poland, Mexico, and India are on course to deliver solid returns. Results for 2013 reflected a significant impact of certain charges, which negatively affected its earnings by $1.31 per diluted share. Despite these factors, results for 2013 benefited from the strong performance of FedEx Ground, which continued to grow market share, and on-going profit improvement at FedEx Freight. However, a decline in profitability was experienced at FedEx Express segment resulting from on-going shifts in demand from priority international services to economy international services, which could not be fully offset by, network cost and capacity reductions in 2013. The results included business realignment costs of $560 million, primarily related to their voluntary cash buyout. Furthermore, in May 2013, the company made the decision to retire from service 10 aircraft and related engines, which resulted in non-cash asset impairment charge of $100 million. In addition, actions in 2012 at FedEx Express related to fleet modernization resulted in the accelerated retirement of certain aircraft, which negatively affected the 2013 results by $69 million due to additional depreciation recorded for the shortened lives of the aircraft. Revenues increased 4% in 2013 primarily driven by increases in international domestic revenue at FedEx Express and volume growth at FedEx Ground. Total operating expenses as on May 31st 2013 was $ 41,736 (in millions) from $39,494 in the FY2012. Therefore, the 2013 operating income and operating margin decreased primarily due to the impact of business realignment costs, aircraft impairment charges and accelerated aircraft depreciation. Interest expense increased $30 million in 2013 primarily due to a reduction in capitalized interest and increased interest expense from 2013 debt issuances. The effective tax rate was 36.4% in 2013, 35.3% in 2012 and 35.9% in 2011. As of 2013, total assets on FedEx's consolidated balance sheet was $33567 million and total liabilities (exc equity) was $ 16169 million. Net interest paid being $61 million and operating income - $2551 million

Leasing in FedEx

In accordance with accounting principles generally accepted in the US, future contractual payments under the operating leases totalling $15 billion on an undiscounted basis) are not recorded in their balance sheet. Credit rating agencies routinely use information concerning minimum lease payments required for our operating leases to calculate the debt capacity.

FedEx utilizes operating leases to finance certain of their aircraft, facilities and equipment. The company leased 10% of their total aircraft fleet under operating leases as of May 31st 2013 and 10% of their total aircraft fleet under capital and operating leases as of May 31st 2012

Under the proposed new lease accounting rules (next section), the majority of these leases would be required to be recognized on the balance sheet as a liability with an offsetting right-to-use asset. Earlier, the company financed a significant portion of their aircraft needs (and certain other equipment needs) using operating leases (a type of "off-balance sheet financing") because these operating leases provided economic benefits favourable to ownership with respect to market values, liquidity or after-tax cash flows.

Leasing and Current Changes

Leasing is an important activity for many organizations. It is a means of gaining access to assets, obtaining financing, and reducing an organization's exposure to the risks of asset ownership. Many organizations lease assets such as real estate, airplanes, trucks, ships, and construction and manufacturing equipment. The earlier accounting models for leases required lessees and lessors to classify their leases as either capital leases or operating leases and to account for those leases differently. Now, these models are being criticized because they do not always provide a faithful representation of leasing transaction. As a result, there has been a widespread request from users of financial statements and other stakeholders to change the accounting guidance so that lessees would be required to recognize assets and liabilities arising from leases. The proposed changes are so to eliminate the distinction between capital and operating leases and essentially require lessees to treat all leases as capital leases. It requires a lessee to record an asset representing its right to use the leased item for the lease term and a liability for its obligation to make rent payments. The obligation to make rent payments would be recorded at the present value of the lease payments, discounted at the lessee's incremental borrowing rate. The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) on May 16th 2013 published a revised Exposure Draft proposing changes in accounting for leases owing to the fact that it would improve the quality and comparability of financial reporting. The board further explained that it would provide: Greater transparency about leverage

The assets an organization uses in its operations, and

The risks to which the firm is exposed from entering into leasing transactions

According to the earlier standards, a lessee recognizes lease assets and liabilities on the balance sheet for capital leases. Whereas, a lessee does not recognizes it on the balance sheet for operating leases. Presently, the Boards have developed an approach to lease accounting that would require a lessee to recognize assets and liabilities in the balance sheet for both operating and financial or capital leases. A lessee would now recognize assets and liabilities for leases of more than 12 months. In recent days, many big companies and other critics such as McDonald's Corp., Gap Inc. FedEx Corp., and many others have sent letters objecting to the proposal. They substantiate their objections by saying that the new rules would force banks to recognize many leases on their balance sheets that are not there as of now and change how some companies account for the costs of leases in their earnings. Critics further say that off-balance-sheet financing makes companies look less indebted than they really are. The proposals would require companies to add to their balance sheets all but the shortest leases, as liabilities affiliated to debt. "The proposed changes hurt more than they help," said Mr. Trainer, who is the Chief Executive of New Constructs, a Brentwood, Tenn., Investor-Research firm.4 Krishna, initially unaware of the new proposed exposure draft on accounting for leases, began to look through the off balance sheet lease records. To understand its impact, he started with analyzing operating lease. He analyzed the financial reports again and started noting down the impact of the changes on the income statement, the balance sheet and the cash flow statement.

Requirement:

Read the case and provide summary of the major issues and a point form sketch of your analysis.