Quick Summary: Accounting for Leases

What is a Lease?

A Lease is a contractual arrangement between the lessor, owner of an asset and the lessee for a specific period in exchange of periodic payments. The lease can be classified as Finance Lease and Operating Lease. In the U.S. finance lease is also called Capital lease.

A finance lease is essentially purchase of assets using debt as a means of financing. The lessee will recognize Assets and Liabilities both on the balance sheet by equal amounts. The depreciation expense is recognized over the life of an asset on the asset side of the balance sheet and interest expense on loan is recognized in the income statement.

An operating lease is one in which lessee pays fixed amount as lease rental, recognized as rental expense on the income statement of the lessee. The asset remains in the books of lessor. Hence, operating leases are also called ‘Off Balance Sheet Financing’.

When do we classify lease as an operating or finance lease?

For a lease to be classified as finance leases any of the following criteria should be met: - (as per US GAAP)

1) If the ownership of an asset is transferred to the lessee after the lease term

2) If the lease term exceeds 75% of an assets economic life

3) If the present value of lease payments is greater than 90% of fair value of an asset

4) If the lessee can purchase the asset at a price which is significantly lower than fair value of an asset at some future date

Else the lease is classified or treated as an operating lease.

Reporting by lessee:

Example: XYZ Ltd. leases a machine for 5 years at $10000 as lease payments which are made at the end of the year. After 5 years asset is sold at scrap value. The appropriate interest rate is 5%. Calculate impact of the lease on XYZ Balance sheet and income statement for each year. The asset depreciates on SLM basis.

The above case will be classified as a finance lease as lease term exceeds 75% of asset’s useful life (this can be inferred as after 5 years asset will be sold at scrap value).

The asset will be recognized on XYZ Ltd. balance sheet in present value terms of future lease payments.

Present Value =  10000 +   10000   + 10000    + 10000    +   10000
                       ___ _____________ ________ __________  ____________    = $42123.637                  

                              (1.06)         (1.06)^2   (1.06)^3   (1.06)^4   (1.06)^5

Further the Depreciation expense each year = $42123.637/5 = $8424.72

Impact on Balance Sheet and Profit and Loss Statement:

 (All figures are in $)

                                                                                                                                                         

As seen from the above table Interest as an expense and depreciation will be recognized every year on XYZ Ltd. income statement. The Book Value of an Asset will be reduced to the tune of Depreciation every year and Liability will reduced to the tune of Principal payments.

If the above case was treated as Operating lease then EBIT (Operating Profit) would be lower compared to Finance Lease as EBIT will not take Interest expense into consideration and hence Operating Profit will be higher for Finance Lease.

As seen from the above table EBIT would be lower for Operating Lease and Net Income would be higher for Operating Lease for early years and lower compared to finance lease during later years.

Impact on Cash Flow Statements:

As seen from the above table if a lease is classified as an Operating Lease Cash Flow from Operations will be lower compared to Cash Flow from Operations if the lease was classified as Finance Lease.

Summary:

    













Impact on Ratios:

Reporting by the Lessor:

From the lessor’s perspective, a capital lease under U.S GAAP is treated as either sales-type lease or direct financing lease. If the present value of the lease payments exceeds the carrying value of an asset, the lease is treated as sales-type lease. If the present value of lease payments equals carrying value, the lease is treated as direct financing lease.

IFRS does not distinguish between sales-type lease and direct financing lease.

Example:
XYZ Ltd. purchases an asset whose present value equals carrying value for $69302 to lease to ABC Ltd. for 4 years with an annual lease payments of $20000 at the end of each year. At the end of the lease ABC ltd. will own the asset for no additional payments. The implied rate of interest rate is 6%. Describe how XYZ Ltd. accounts for the same.

Since Present Value equals Carrying Value of an Asset it is an example of Direct Financing Lease. The Lessor (XYZ Ltd.) will receive Interest Income to the tune of 6% on Lease liability and Principal payments by ABC ltd.

As seen if the lease is classified as an Operating lease XYZ ltd. will receive periodic rentals and depreciation on Asset.

 Impact of Cash flow Statement:

Total Cash Flow is the same for an Operating Lease and Finance Lease.

WHAT IS A DERIVATIVE?

“Too much of a good thing can be wonderful” ~ Mae West

One can easily be overwhelmed by the apparently countless types of derivative instruments traded in the market place. Do not be misled however; derivatives are not nearly as mystifying as they may seem.  Derivatives are “Instruments” that derive their value from an underlying price, index, etc.

An asset is an item of ownership having positive monetary value. A liability is an item of ownership having negative monetary value. The term “instrument” is used to describe a “CONTRACT” that gives rise to assets and liabilities. Contract is more general term which is an agreement between two or more parties for an economic consideration enforceable by law.

A derivative contract usually has a notional face value or reference amount which is the ‘volume’ of the contract. Applying the volume to a change in the underlying price determines the amount to be exchanged at the settlement date.

Fundamentally, there are only two types of derivative contracts – a forward contract and an option contract.  Hence the derivative market is F&O (Futures & Options)

A forward is a contract to buy or sell an underlying asset at some pre-specified future date at a price agreed upon today. No money changes hands until the expiration date, at which time the buyer pays the cash and the seller delivers the underlying asset.

One would wonder then what are futures? Futures are exchange-traded Forward contracts. 

Swaps tantamount to exchange of cash flows between two parties. So is swap too a forward? Yes true!! Swaps branch from a family of forwards. They are single contract encompassing mini forward contracts or a collection of small forward contracts in a single contract.

An option is a contract to buy or sell an underlying at some pre-specified date at a price agreed today. Unlike a forward however, the buyer has the right but not an obligation to buy or sell an underlying at the option expiration. The seller’s obligation depends upon whether or not the buyer chooses to exercise the option.  

Derivatives and Your Career

The primary use of derivatives is in risk management. Businesses, by their very nature, face risks. Some of those risks are acceptable; indeed a business must assume some type of risk or there is no reason to be in business. But other types of risk are unacceptable and should be managed.

Take an example; a small handicraft manufacturing unit borrows money from a bank at floating interest rate to reflect current interest rates in the market. The handicraft manufacturer is in the business of making money off the handicraft sales. It is not particularly suited to forecast interest rate movements. Yet interest rate increases could severely hamper its ability to make a profit from its business. If it sells its products in foreign countries, it may face significant foreign exchange volatility risk. Risks have the potential to undermine the success of main line of business.

It was but a few years back that a small firm would not be expected to use derivatives to manage its interest rate or foreign exchange risk, nor would it be able to do so if it wanted. The minimum sizes of transactions then were too large. Times have changed and smaller firms are now more able to use derivatives.

If your career takes you in investment management, you will surely encounter derivatives. Those in public sectors like LIC, etc find numerous applications of derivatives. Those responsible for commodities and green concept (carbon emission) will encounter situations where derivatives are or can be used. In short, derivatives are becoming commonplace and are likely to be more so for the foreseeable future.

Derivatives lie at the very heart of every business!!

The pot of gold lies at the bottom of the pyramid!!

Our country experienced an upswing in realizing the potential needs and demands for a variety of necessities of bottom-of-the-pyramid customers post 2008-09 crises. From microfinance to micro-insurance; the latest to replicate the trend is providing ‘aam aadmi makan’ (low income home). An article titled “A Market Solution to Affordable housing” in ‘The Mint’ on 21 January 2013 speaks about a 35-year old Bangalore based senior financial analyst who discovered this utopia - for under INR 15lakhs. The 2-bedroom pad located outskirts of main city is well constructed; the major attraction being its cost- INR 11lakh!!!

I’d like to talk about the major challenges in development of affordable/ low cost housing in India and initiatives by Government and private players alike.

Demand side drivers

• Rise in Urban Population: As per 2011 Census the population of India has grown 17.64% (in absolute terms) over the past decade. As per data compiled by the Ministry of Housing and Urban Poverty Alleviation (MHUPA) the urban housing shortage for Economically Weaker sections (EWS) of the society (whose monthly per capita expenditure being INR0-INR3000) has been 21.78million for 21.81million households- a shortfall of 99.99%.

• Rich Demographic Dividend
• The International Labour Organization has predicted that by 2020 India will have 116 million workers in the age bracket of 20-24 years as compared to China’s 94 million.
• The average age of an Indian citizen is expected to be 29 years in 2020 as against USA-40 years, Europe-47 years and Japan-46 years-what matters in the long run is age and not the size of population.
• Age Dependency ratio: the ratio of dependents-people younger than 15 or older than 64 to working age for India has been continuously decreasing.
  
• Land parcel shortages: The lack of land parcels within the city (metros) limits has pushed developers to seek land outside the cities (outskirts of cities) where land parcels are cheaper & thus making construction of low income housing viable. Mumbai and NCR have low income housing projects located 65-75 km away from the city centre whereas, Ahmedabad and Kolkata, provide better proximity, with projects located at a distance of 15-20 km from the city area. Bangalore, Pune and Chennai also have projects at a distance of 25-30 km from the main city.

Supply side drivers:

• Government intiatives
• Keeping in view the need for affordable housing, the Union Budget 2013 proposes to introduce a new section 80EE in the Income tax Act 1961 relating to deduction in interest up to INR 1lakh on loan taken by an individual from financial institution, provided, the loan amount should not exceed INR 25lakhs, the price of property should not exceed INR 40lakhs, the assessee should not own any residential property on date of sanction of loans and the loan should be sanctioned during FY2013-14. This section proposes to benefit the first home buyers by providing a deduction of interest from total income.
• The existing provisions allow External Commercial Borrowings (ECBs) for low cost housing has been allowed to ensure lower cost of borrowing for this segment.
• National Urban Housing and Habitat Policy (NUHHP), 2007 has identified ‘Affordable Homes for All’ as a key focus area to address the growth of slums, land shortage, housing shortfall and congested transit which in turn impacts property prices and basic amenities like water, power and open spaces in metros. The policy seeks to forge public-private partnerships to attain affordable housing objectives.
• Jawaharlal Nehru National Urban Renewal Mission (JNNURM) which was launched in December 2005 encouraged urban reforms in India. For the housing sector the main aim was to construct 1.5million homes for urban poor during 2005-2012 in 65 cities.
• Interest Subsidy scheme for Urban Poor (ISHUP) which was introduced by Central Government as 1% interest subvention scheme.  As per the scheme if an HFC (Housing Finance Company) disburses a loan to urban poor then 1% interest subsidy by the government will be credited in the HFC’s account which in turn will have to be passed on to the respective customer.
• Housing Finance Companies (HFCs): The emergence of various HFCs in the segment have ensured availability of formal financing options thus dissuading urban poor from going to private money lenders or loan sharks and pay interest up to 3-4% per month.

Opportunities-What’s in the store for builders and investors alike?

• On comparing the low income housing with a luxury housing one does observe that IRRs are significantly higher due to-ability to turnaround and project execution is relatively faster than luxury segment.
• With the estimated market size of INR 10,000billion there is an inherent demand as far as low income housing segment is concerned as the 90% of India’s total population (approximately 1billion) earns less than INR 24000 p.m.
• From a builders perspective the project will be bigger because one has smaller units and hence the number of units will be bigger thus lowering construction costs as a result IRR would be better.

Challenges in the segment: Some of the challenges are common across as a real estate industry and some of them being very specific to this segment, are listed as -

• Government rules are weighted towards the rich. It’s easier to build farmhouse on a two-acre plot than to construct 100 affordable homes on the same plot because of approvals. There are approx 56 departments from whom approvals are required. Construction delays due to lack of approvals results in higher costs, lower margins or self-defeating price escalation.
• Currently, FDI norms are such that smaller projects are not viable for FDI.
• The Government has to build additional infrastructure for people to commute as such houses will not be in the city centre but will be located outside the city limits.

Despite the challenges and low income housing being at its primitive stage there is an air of optimism about the sector’s growth emphasizing the segment to be one of a kind where units are funded by private sector companies and built by private sector companies. Emergence of nuclear families, rise in urban population, rich demographic dividends (aspiring youth of India) has given rise to several townships and the ‘aam aadmi’s makan’ segment is expected to grow significantly in future.