Description
The document presents the case analysis of Security plus case which explore the strategic use of leasing to grow a business through managing operating and sale-type leases.
SECURITY PLUS INC.
1) What is the Company’s Business Strategy? Security Plus Inc. designs, installs and services Electronic Burglar Alarms, but it only procures and assembles some components, is not involved in manufacturing. A majority of SPI’s systems are leased to commercial enterprises, the rest are either leased or sold to residential or government customers. The lease contract includes both monitoring and maintenance. SPI retains ownership of all equipment. Leases may be of 2 types: Operating Leases: ? Minimum Term: 3 yrs ? Initially constituted only 10% now moved to 50% ? Cost of equipment depreciated (straight line) over 10yrs ? Shows increased ROA Sales Type leases: ? Non Cancellable 5 yr term followed by 3 yr bargain renewal period ? Initially constituted 90% of the leases but now only 50% ? Records the present value of the future lease rentals as the sales price The shift to show more operating leases was done to show increased revenues, i.e. the amount billed to lessees and more assets, since the risk is still with SPI and hence shown on balance sheet SPI has retained sales type lease to show gain on sale on inception of the lease, hence recording financing profit over the lease period. Increased acquisitions to increase customer base: Existing customer base consisting of more long term customers, hence risk of obsolescence on customers. 2) What role does accounting play in the company’s business strategy? Advantage of Operating Leases:
? ? ?
Increased ROA Tax advantage since it retains ownership Lease payments shown as income, depreciation on assets as expense
Advantage of Sales Type Leases: ? ? Shows higher sales revenue (PV of annual payments) Records profit at inception, therefore higher profits in 1st yr
Q 3: Do you agree with the company’s use of “capital lease” accounting? Sales type capital lease As per SFAS 13, any one of the following criteria should be met for a lease to be classified as sales type capital lease : 1) The lease term is equal to or more than 75% of useful life of the asset. 2) The present value of lease payments equals or exceeds 90% of the fair value of the leased property to the lessor. 3) The lease contains a bargain purchase option. 4) The lease transfers ownership of the property of the lease to the lessee at the end of the lease term.
1) The estimated economic life of the equipment is 10 yrs. The minimum term for sales type leases is 5 yrs, followed by a bargain purchase offer period of 3yrs. Excluding the period of bargain purchase option, the company does not meet the criteria of 75%. Only after including it the company’s lease period exceeds 75%. So it does not satisfy condition 1. 2) There is no proper proof given in the case to prove that the company satisfies this criteria either. Even if the company meets the criteria in 8 years whether the company will be receiving the income in the last three years is uncertain, because the customer may or may not renew the lease. So the calculation of present value of lease payments itself is not being done correctly.
3) The leases do not contain bargain purchase option but have bargain renewal option. 4) The ownership is not transferred. Now the capital lease is further classified as direct financing or sales type lease depending on following two conditions: 1) Collectability of Minimum Lease Payments is reasonably certain. 2) There are no significant uncertainties regarding the amount of unreimbursable costs yet to be incurred by the lessor under the provisions of the lease agreement. Company’s position with respect to each criterion: 1) The company is making a provision for bad debts. 2) The company’s financing, maintenance costs are expected to increase in future which the company hopes to recover from the customers through periodic increases in lease payments. The company strictly speaking does not meet the first criteria of classifying its leases as capital lease and then as sales type lease, it is deliberately including the bargain renewal option to extend the period of the lease in order to classify it as capital lease. Moreover the company is neither the manufacturer nor the dealer in the leased equipment, it just procures them and leases them so it should classify the lease as direct financing lease. So the company books the present value of lease payments for the 8 years as the revenue for the period which violates the conservative concept. The use of sales type lease accounting allows the company to recognize income earlier than operating lease method. This allows the company to show higher Cash Flow from Operations at the inception of the lease. This aggressive recognition of income and cash flows improves financial ratios, but it reflects the firm’s operations only if the risks and benefits of leased property have been fully transferred to the
lessee and lessor has no performance obligation. But in case of Security Plus Inc no sale of equipment is involved and it retains the ownership to such leases, thus availing of the tax benefits and residual values related to the equipment. Q. 4 Why is the company changing its mix of leases between capital and operating leases? A lease that, in economic substance, transfers substantially all the risks and rewards inherent in the leased property to the lessee is a financing or capital lease. Under US GAAP the lease capitalization by lessors is required when the lease meets any one of the following SFAS 13 criteria at the inception of the lease: 1. The lease transfers the ownership of the property to the lessee at the end of the lease term. 2. The lease contains a bargain purchase option. 3. The lease term is equal to 75% or more of the estimated economic life of the leased property. 4. The present value of the minimum lease payments (MLP) equals or exceeds 90% of the fair value of leased property to lessor. It is also considered as capital lease if it meets both the following revenue recognition criteria: 1. Collectability of the MLP is reasonably predictable. 2. There are no significant uncertainties regarding the amount of unreimbursable costs yet to be incurred by the lessor under the provisions of the lease agreement. Under the US GAAP leases not meeting any of the four SFAS 13 criteria or both the revenue recognition criteria listed above are not capitalized and no asset or obligation is reported in the financial statement of the lessee since no purchase is deemed to have occurred. Such leases are classified as operating leases, and payments are reported as rental expenses. This is so since either the risks and benefits of leased assets have not been transferred or the earnings process is not complete. Effects of Capitalized and Operating Leases from Lessor’s point of view: Impact on Balance Sheet:
When the lease is treated as an operating lease the lessee pays only the rental income and has no obligation to buy the asset at the end of the lease term. Hence, lessors do not report any investment in leases but they continue to report the assets on the balance sheet as longterm assets, net of accumulated depreciation. The rental income received is recorded as revenue. On the other hand, when the lease is treated as a capital lease, the lessee has an obligation to buy the asset. All the risks and rewards are transferred to the lessee and in the books of the lessee an asset and liability equal to the present value of lease payments are recognized at the inception of the lease. Hence the asset moves out of the books of the lessor. The present value of future lease payments is recognized as revenue. Against it the cost of the asset for the lessor and the present value of the salvage value are treated as cost to get the net income from the lease. Over the period of the lease the interest component is recognized as income and the principal portion goes on to reduce the outstanding amortization balance standing in the books of the lessor on the assets side. Thus, from the point of view of lessee, Asset and Liability Balances increase in case of a capital lease, whereas from the point of view of the lessor, the asset is changed into an amortization note leading to no significant change in the balances.
Impact on Income Statement The operating lease method reports constant income over the lease term as straight-line depreciation is charged against the constant annual rental. This would result in increasing income over the lease term as depreciation declines. The sales type lease reports substantially higher income in the first year of the lease due to manufacturing profit t the inception of the lease. Reported income declines thereafter due to declining interest income over the remainder of the lease term. In case of a capital lease, higher revenue is recorded in the year of inception of lease, whereas in an operating lease the income recognized is evened out. Impact on Financial Ratios The operating lease method reports lower net assets each year, since income recognized is lower, and hence tend to increase return on assets relative to the capital lease method. Impact on Cash Flows
From the point of view of lessor, in case of capital lease the rental income is split between the interest component and the principal that goes on to reduce the balance of the amortization note (asset). Thus the amount that comes in is split between “Cash from Operations” and “Cash from Financing Activities”. On the other hand in case of an operating lease the entire rental income is recognized as “Cash from Operations”. Thus, due to capital lease the CFO balance is understated. Conclusion: As it is evident from the case, security plus is facing a decline in its profits due to lower business. This together with the above mentioned points makes it aptly clear that if the company shows more of operating leases it will be able to show higher Cash from Operations and also higher Profits thus reporting an increased EPS. This sounds like a good strategy especially when the stock prices are falling and shareholders are losing confidence in the wellbeing of the company. Q.5 What do you think is the potential of the company’s common stock as an equity investment as of November 15, 1993 ? As an equity investor, cash flow analysis is essential. The cash flow from operations have increased drastically from 1991 to 1993 which is majorly due to the shift from operating to sales type lease which also impacted to increase in the value of assets and hence lowering of return on assets from .055(1991) to 0.050(1993) and also asset turnover ratio from 443(1991) to 0.218(1993). The cash flow from investment has always been negative. The ratio of (CFI/CFF) 1990 & 1991 were 0.89 & 0.55; and for Sept ended 1993 was 1.14. This implies in 1991 and 1992 investments were majorly financed debts and in 1993 it was also financed by cash from operations. Hence there seems to be a deliberate attempt to shift to Capital Lease from Operating Lease as all the ratios are getting adversely affected even though the cash from operations are increasing. The main reason for the deliberate shift from operating to capital lease can also be viewed from this perspective that the company needs money for its acquisition and to grow inorganically. (workings attached in excel sheet)
doc_385024917.doc
The document presents the case analysis of Security plus case which explore the strategic use of leasing to grow a business through managing operating and sale-type leases.
SECURITY PLUS INC.
1) What is the Company’s Business Strategy? Security Plus Inc. designs, installs and services Electronic Burglar Alarms, but it only procures and assembles some components, is not involved in manufacturing. A majority of SPI’s systems are leased to commercial enterprises, the rest are either leased or sold to residential or government customers. The lease contract includes both monitoring and maintenance. SPI retains ownership of all equipment. Leases may be of 2 types: Operating Leases: ? Minimum Term: 3 yrs ? Initially constituted only 10% now moved to 50% ? Cost of equipment depreciated (straight line) over 10yrs ? Shows increased ROA Sales Type leases: ? Non Cancellable 5 yr term followed by 3 yr bargain renewal period ? Initially constituted 90% of the leases but now only 50% ? Records the present value of the future lease rentals as the sales price The shift to show more operating leases was done to show increased revenues, i.e. the amount billed to lessees and more assets, since the risk is still with SPI and hence shown on balance sheet SPI has retained sales type lease to show gain on sale on inception of the lease, hence recording financing profit over the lease period. Increased acquisitions to increase customer base: Existing customer base consisting of more long term customers, hence risk of obsolescence on customers. 2) What role does accounting play in the company’s business strategy? Advantage of Operating Leases:
? ? ?
Increased ROA Tax advantage since it retains ownership Lease payments shown as income, depreciation on assets as expense
Advantage of Sales Type Leases: ? ? Shows higher sales revenue (PV of annual payments) Records profit at inception, therefore higher profits in 1st yr
Q 3: Do you agree with the company’s use of “capital lease” accounting? Sales type capital lease As per SFAS 13, any one of the following criteria should be met for a lease to be classified as sales type capital lease : 1) The lease term is equal to or more than 75% of useful life of the asset. 2) The present value of lease payments equals or exceeds 90% of the fair value of the leased property to the lessor. 3) The lease contains a bargain purchase option. 4) The lease transfers ownership of the property of the lease to the lessee at the end of the lease term.
1) The estimated economic life of the equipment is 10 yrs. The minimum term for sales type leases is 5 yrs, followed by a bargain purchase offer period of 3yrs. Excluding the period of bargain purchase option, the company does not meet the criteria of 75%. Only after including it the company’s lease period exceeds 75%. So it does not satisfy condition 1. 2) There is no proper proof given in the case to prove that the company satisfies this criteria either. Even if the company meets the criteria in 8 years whether the company will be receiving the income in the last three years is uncertain, because the customer may or may not renew the lease. So the calculation of present value of lease payments itself is not being done correctly.
3) The leases do not contain bargain purchase option but have bargain renewal option. 4) The ownership is not transferred. Now the capital lease is further classified as direct financing or sales type lease depending on following two conditions: 1) Collectability of Minimum Lease Payments is reasonably certain. 2) There are no significant uncertainties regarding the amount of unreimbursable costs yet to be incurred by the lessor under the provisions of the lease agreement. Company’s position with respect to each criterion: 1) The company is making a provision for bad debts. 2) The company’s financing, maintenance costs are expected to increase in future which the company hopes to recover from the customers through periodic increases in lease payments. The company strictly speaking does not meet the first criteria of classifying its leases as capital lease and then as sales type lease, it is deliberately including the bargain renewal option to extend the period of the lease in order to classify it as capital lease. Moreover the company is neither the manufacturer nor the dealer in the leased equipment, it just procures them and leases them so it should classify the lease as direct financing lease. So the company books the present value of lease payments for the 8 years as the revenue for the period which violates the conservative concept. The use of sales type lease accounting allows the company to recognize income earlier than operating lease method. This allows the company to show higher Cash Flow from Operations at the inception of the lease. This aggressive recognition of income and cash flows improves financial ratios, but it reflects the firm’s operations only if the risks and benefits of leased property have been fully transferred to the
lessee and lessor has no performance obligation. But in case of Security Plus Inc no sale of equipment is involved and it retains the ownership to such leases, thus availing of the tax benefits and residual values related to the equipment. Q. 4 Why is the company changing its mix of leases between capital and operating leases? A lease that, in economic substance, transfers substantially all the risks and rewards inherent in the leased property to the lessee is a financing or capital lease. Under US GAAP the lease capitalization by lessors is required when the lease meets any one of the following SFAS 13 criteria at the inception of the lease: 1. The lease transfers the ownership of the property to the lessee at the end of the lease term. 2. The lease contains a bargain purchase option. 3. The lease term is equal to 75% or more of the estimated economic life of the leased property. 4. The present value of the minimum lease payments (MLP) equals or exceeds 90% of the fair value of leased property to lessor. It is also considered as capital lease if it meets both the following revenue recognition criteria: 1. Collectability of the MLP is reasonably predictable. 2. There are no significant uncertainties regarding the amount of unreimbursable costs yet to be incurred by the lessor under the provisions of the lease agreement. Under the US GAAP leases not meeting any of the four SFAS 13 criteria or both the revenue recognition criteria listed above are not capitalized and no asset or obligation is reported in the financial statement of the lessee since no purchase is deemed to have occurred. Such leases are classified as operating leases, and payments are reported as rental expenses. This is so since either the risks and benefits of leased assets have not been transferred or the earnings process is not complete. Effects of Capitalized and Operating Leases from Lessor’s point of view: Impact on Balance Sheet:
When the lease is treated as an operating lease the lessee pays only the rental income and has no obligation to buy the asset at the end of the lease term. Hence, lessors do not report any investment in leases but they continue to report the assets on the balance sheet as longterm assets, net of accumulated depreciation. The rental income received is recorded as revenue. On the other hand, when the lease is treated as a capital lease, the lessee has an obligation to buy the asset. All the risks and rewards are transferred to the lessee and in the books of the lessee an asset and liability equal to the present value of lease payments are recognized at the inception of the lease. Hence the asset moves out of the books of the lessor. The present value of future lease payments is recognized as revenue. Against it the cost of the asset for the lessor and the present value of the salvage value are treated as cost to get the net income from the lease. Over the period of the lease the interest component is recognized as income and the principal portion goes on to reduce the outstanding amortization balance standing in the books of the lessor on the assets side. Thus, from the point of view of lessee, Asset and Liability Balances increase in case of a capital lease, whereas from the point of view of the lessor, the asset is changed into an amortization note leading to no significant change in the balances.
Impact on Income Statement The operating lease method reports constant income over the lease term as straight-line depreciation is charged against the constant annual rental. This would result in increasing income over the lease term as depreciation declines. The sales type lease reports substantially higher income in the first year of the lease due to manufacturing profit t the inception of the lease. Reported income declines thereafter due to declining interest income over the remainder of the lease term. In case of a capital lease, higher revenue is recorded in the year of inception of lease, whereas in an operating lease the income recognized is evened out. Impact on Financial Ratios The operating lease method reports lower net assets each year, since income recognized is lower, and hence tend to increase return on assets relative to the capital lease method. Impact on Cash Flows
From the point of view of lessor, in case of capital lease the rental income is split between the interest component and the principal that goes on to reduce the balance of the amortization note (asset). Thus the amount that comes in is split between “Cash from Operations” and “Cash from Financing Activities”. On the other hand in case of an operating lease the entire rental income is recognized as “Cash from Operations”. Thus, due to capital lease the CFO balance is understated. Conclusion: As it is evident from the case, security plus is facing a decline in its profits due to lower business. This together with the above mentioned points makes it aptly clear that if the company shows more of operating leases it will be able to show higher Cash from Operations and also higher Profits thus reporting an increased EPS. This sounds like a good strategy especially when the stock prices are falling and shareholders are losing confidence in the wellbeing of the company. Q.5 What do you think is the potential of the company’s common stock as an equity investment as of November 15, 1993 ? As an equity investor, cash flow analysis is essential. The cash flow from operations have increased drastically from 1991 to 1993 which is majorly due to the shift from operating to sales type lease which also impacted to increase in the value of assets and hence lowering of return on assets from .055(1991) to 0.050(1993) and also asset turnover ratio from 443(1991) to 0.218(1993). The cash flow from investment has always been negative. The ratio of (CFI/CFF) 1990 & 1991 were 0.89 & 0.55; and for Sept ended 1993 was 1.14. This implies in 1991 and 1992 investments were majorly financed debts and in 1993 it was also financed by cash from operations. Hence there seems to be a deliberate attempt to shift to Capital Lease from Operating Lease as all the ratios are getting adversely affected even though the cash from operations are increasing. The main reason for the deliberate shift from operating to capital lease can also be viewed from this perspective that the company needs money for its acquisition and to grow inorganically. (workings attached in excel sheet)
doc_385024917.doc