Tutorial assignment W4E1. Adjusting for operating leases ACCT3013 Financial Statement Analysis Workshop Accounting adjustments [For enquiries please contact zihang.peng@sydney.edu.au] Airline companies typically do not own their aircrafts. Rather, they lease aircrafts from commercial lessors (e.g. General Electrics finance subsidiary). According to US GAAP, companies are required to disclose their lease information in the footnotes of their financial statements. Recall from ACCT2011 that leases can be classified into finance leases (or capital leases in American English) and operating leases (US GAAP and IFRS apply virtually the same rules to leases). Airlines may structure their lease contracts to skilfully avoid the capitalization requirement for capital leases. The footnote on leases of the 2016 annual report of Delta Air Lines, a major US airline, is provided below: ------------------------------------------2016 ANNUAL REPORT------------------------------------------------- NOTE 7 . LEASE OBLIGATIONS 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 $1.3 billion for the year ended December 31, 2016 and $1.2 billion for the years ended December 31, 2015 and 2014 . 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 our minimum rental commitments under capital leases and noncancelable operating leases (including certain aircraft flown by regional carriers) with initial or remaining terms in excess of one year for the years succeeding December 31, 2016 : ------------------------------------------2015 ANNUAL REPORT------------------------------------------------- NOTE 7 . LEASE OBLIGATIONS 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 $1.2 billion for the years ended December 31, 2015 and 2014 and $1.1 billion for the year ended December 31, 2013 . 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 our minimum rental commitments under capital leases and noncancelable operating leases (including certain aircraft flown by regional carriers) with initial or remaining terms in excess of one year for the years succeeding December 31, 2015 : Suppose you are an analyst following Delta Air Line, and you believe all its operating leases are of the nature of capital leases. Therefore, you decide to capitalize all its operating leases for your analysis. Additional information & assumptions Recapitalized operating lease asset is 80% of the existing operating lease liability if the operating leases were capitalized. The difference between the lease asset and lease liability reflects accumulated depreciation and impairments from previous years. New leases initiated in 2016 are assumed to take effect from the end of 2016. Recapitalized lease assets are depreciated over a useful life of 10 years. Lease obligations due after 5 years from the reporting date (thereafter) are evenly distributed to the next 8 years. Ignore any tax effect. Required Prepare the adjusting journal entries required to capitalize Deltas operating leases, and verbally describe the impact of the recapitalization of operating leases on the 2016 financial statement of Delta Air Line. [For hints, read the notes below.] Notes on leases Accounting standards (US GAAP and IFRS-based standards) classify leases into operating leases and capital leases. A capital lease is in fact a financing transactionin the sense that it is equivalent to borrowing funds from financiers and then purchase the asset using the borrowed funds. Many firms have incentives to avoid its lease transactions to be classified as capital leases. One key consideration for this preference is that the firm profitability appears more robust, or of higher quality, when it is generated from a relatively smaller asset base. Specifically, a prominent measure of firm profitability is ROE (return on equity), which is equal to ROA (return on assets) multiplied by financial leverage (Asset-to-equity ratio). To increase ROE, a firm can either increase ROA or increase its leverage. But leverage also adds risk to the businessif ROA turns negative then leverage magnifies losses. Therefore, an increase in ROA is considered a superior way of improving ROE. Classifying more leases as operating leases helps reduce the asset base, and hence increases ROA. Accounting, by itself, should have no effect on value, but it will almost always affect prices. Therefore, the misclassification may not change what the firm really worth, but the market perception of the differential quality based on lower asset base may induce an optimistic price impact. To protect us from paying for this accounting artefact, we need to adjust for lease misclassifications. Generally, we go through the following steps. First, we must find the implied discount rate applicable to capital leases. This can be done by solving for the internal rate of return that equates the present value of the future lease obligations to the current book value of capital leases. Note that the timing of lease obligations is not always clear. US firms typically disclose lease obligations that are due each year up to 5 years into the future, but Australian firms tend to group leases into coarser groups of those due within one year and those due from 2 to 5 years, etc. We often need to make assumptions on the lease obligations are distributed across the years. Second, we recapitalize existing operating leases at the beginning of the period. In doing so, we create an asset and lease liability. Note that, lease assets are subject to depreciation and impairments, and lease liabilities are subject to amortization. The former is typically larger than the latter, so lease assets are typically smaller than their respective lease liability. The difference is attributed to depreciation and impairments that would have been charged in previous years were the operating leases capitalized initially, and thus it is captured by opening retained earnings. Third, we apportion the lease payment of the current year, which is booked as lease expenses, into interest expenses and debt repayments. Fourth, we should recapitalize new operating leases initiated during the year. This can be gauged by comparing the present values of future operating lease obligations as the end and beginning of the year and the debt repayment adjustment in the former step. The newly initiated leases may be subject to depreciation charges depending on the timing of their inceptions. Finally, consider tax effects if required (review relevant materials in ACCT2011). Note, of course, there are genuine operating leases. In real cases, we must examine the circumstances extensively to determine the precise proper classification of leases. Also, firms who may misclassify leases are not necessarily violating accounting standards (most of them do not). Lease contracts can be structured carefully to get around the rigid requirements of the standards for capital leases.