The
accounting for operating leases is a controversial issue. Many observers argue
that firms that use operating leases are using significantly more assets and
are more highly leveraged than their balance sheets indicate. As a result,
analysts often use footnote disclosures to reconstruct and then capitalize operating
lease obligations. One way to do so is to increase a firm’s assets and
liabilities by the present value of all its future minimum rental payments.
Instructions
Go
to the SEDAR website (www.sedar.com) or the websites of the companies and
access the financial statements of Canadian National Railway Company (CNR) and
Canadian Pacific Railway Limited (CPR) for their years ended December 31, 2009.
Refer to the financial statements and notes to the financial statements and
answer the following questions.
(a)
Identify all lease arrangements that are indicated in each company’s financial
statements and notes. For each lease arrangement, give the title and balances
of the related lease accounts that are included in the financial statements.
(b)
Have CNR and CPR provided all the lease disclosures as required by the
accounting standards?
(c)
What are the terms of these leases?
(d)
What amount did each company report as its future minimum annual rental commitments
under capital leases? Under operating leases? Are there significant differences
between the two companies and the way they provide for their physical operating
capacity, or are they basically similar?
(e)
Calculate the debt-to-equity ratio for each company at December 31, 2009.
(f)
Assuming that the contract-based approach is adopted by both companies,
estimate the impact on the statement of financial position using 7% as the
lessee’s implied borrowing rate. What information is missing from the companies’
notes to make a more accurate calculation of the impact of adopting the
contract-based approach?
(g)
Recalculate the ratios in part (e), incorporating the adjustments made in (f)
above. Comment on your results.
(h)
What do you believe are the advantages of adopting the contract-based approach
when trying to compare companies? Relate your discussion to your analysis above
for CNR and CPR.
(a) Canadian National Railway (CNR) discloses the
cost, accumulated depreciation, and net book value of properties held under
capital leases in Note 5, ”Properties” totalling a net carrying value
of $1,474million. This note also
indicates that such properties consist primarily of track and roadway, rolling stock, building, information technology and other. As footnote to
this schedule, CNR also indicates that included in track and roadway is the
cost of land of which $108 million is a
right of way and has been recorded as a capital lease.CNR discloses in Note 9
an amount of “capital lease obligations and other” in its long-term debt note
of $1,054million. In Note 17, CNR
discloses the amount of future minimum lease payments for its operating leases,
capital leases and in total in its major commitments and contingencies note. The note also identifies that
the company has operating and capital leases, mainly for locomotives, freight
cars, and intermodal equipment. It also
discloses the amount of imputed interest on its capital leases ranging from
1.9% to 11.8% and the present value of the minimum lease payments at current
rate included in debt. Also in this note, CNR indicates that under some of its
capital leases, it has the option to purchase the asset at a fixed amount. We are also told that automotive equipment is
leased under operating leases with one year, non-cancellable terms and that the
estimated rental payment is $30 million.
Finally, rent expense for all operating leases was $213 million for the
2009 fiscal year.
Canadian Pacific Railway (CPR) discloses in
Note 16 the net amount of assets under capital lease and the amount of related
accumulated depreciation in its net properties note totalling $391.3
million. CPR discloses in Note 21, the
amount of obligations under capital leases of $322.7 million, the amount of
minimum payments for its capital leases, the amount of related imputed interest
and present value of these payments, and the related current portion of the
obligations in its long-term debt note. Interest rates used for the capital
lease obligations range from 5.2% to 9.38% In note 29, the amount of minimum
payments for its operating leases is included in its commitments and
contingencies note. Detailed accounts
and amounts for both companies are presented below.
|
CNR ( $ in millions)
|
|
|
|
|
|
Capital Lease Arrangements
|
|
|
Capital leases
included in properties, cost
|
$ 1,845
|
|
Accumulated
depreciation
|
371
|
|
Net book value of
assets under capital lease
|
1,474
|
|
Capital lease
obligations and other
|
1,054
|
|
|
|
|
Minimum lease
payments - capital
|
1,468
|
|
Imputed interest
on capital leases
|
417
|
|
Present value of
minimum lease payments at current rate included in debt
|
1,051
|
|
|
|
|
Operating Lease Arrangements
|
|
|
Minimum lease
payments - operating
|
$
713
|
|
|
|
|
|
|
|
CPR in millions of $'s
|
|
|
|
|
|
Capital Lease Arrangements
|
|
|
Net properties
under capital lease
|
$ 530.3
|
|
Related
accumulated depreciation
|
139.0
|
|
Net book value
|
391.3
|
|
Obligations under
capital leases
|
319.7
|
|
Obligations under
capital leases
|
CDN$ 3.0
|
|
Total minimum
lease payments (capital)
|
512.4
|
|
Imputed interest
|
189.7
|
|
Present value of
minimum lease payments - capital
|
322.7
|
|
Current portion
|
9.6
|
|
Long-term portion
|
313.1
|
|
|
|
|
Operating Lease Arrangements
|
|
|
Minimum payments
under operating leases
|
$ 940.3
|
(a)
Yes, they
appear to have provided all the lease disclosures required by the accounting
standards.
(b)
The leases of both companies are long
term. CNR’s operating and capital leases extend at least seven years from the balance
sheet date, since the note refers to “2015 and thereafter”. CPR’s operating leases extend to 2014and the
capital leases extend to 2026 and 2031.
(c)
The
future minimum annual rental commitments under each type of lease for each
company are presented below. Even though the companies are in the same industry, there is a
difference with respect to how they provide
for capacity as evidenced by the fact that they have different proportions of operating versus capital leases measured in
terms of minimum lease payments. CNR has
a higher proportion of capital leases
than CPR, and CPR has a higher proportion of operating leases than does CNR.
In millions
of C$
|
|
CNR
|
%
|
CPR
|
%
|
|
Minimum lease
payments - operating
|
713.0
|
32.7%
|
940.3
|
64.7%
|
|
Minimum lease
payments - capital
|
1,468.0
|
67.3%
|
512.9
|
35.3%
|
(d)
The
debt-to-equity ratios for each company at December 31, 2009, are presented below.
|
|
CNR
|
CPR
|
|
Total Liabilities
|
$13,943
|
9,523.0
|
|
Total Equity
|
11,233
|
4,720.8
|
|
Debt/Equity ratio
|
1.24
|
2.0
|
(e)
Using a
7% discount rate, the capitalized value of the off-balance-sheet operating
leases is presented below for each company. (Note: the schedule below assumes
that all of the “thereafter payments” would be made in year 2016, which is
likely not correct.)
|
year
|
period
|
CNR
|
CNR PV of payments @7%
|
CPR
|
CPR PV of
payments@7%
|
|
|
|
payments
|
|
Payments
|
|
|
2010
|
1.0
|
$131
|
122.4
|
$149.4
|
139.6
|
|
2012
|
2.0
|
112
|
97.8
|
129.4
|
113.0
|
|
2013
|
3.0
|
90
|
73.5
|
118.6
|
96.8
|
|
2014
|
4.0
|
66
|
50.3
|
103.6
|
79.0
|
|
2015
|
5.0
|
42
|
29.9
|
78.7
|
56.1
|
|
Thereafter
|
6.0
|
272
|
181.2
|
360.6
|
240.3
|
|
Total payments
|
|
$713.0
|
$555.1
|
$940.3
|
$724.8
|
(f) These
operating leases would be recorded as:
Increase to intangible assets for the right of use and an increase to
contractual lease obligations. To make more accurate adjustments for the
contract-based approach, we would have needed the payments for each year after
2016. Some of these leases may mature
much later than 2016, which would change the calculation of the present
values. We have also had to make
assumptions about the effective interest rates that might not be correct. Also, the contract based approach would
include any renewal terms that were likely to be used and any contingent
rents. Finally, we were unable to make
adjustments on the statement of earnings.
In this case, the annual lease expense would be eliminated, and its
place would be amortization of the to the intangible asset on a straight-line
basis over the term of the lease and the interest charge on the lease
obligation for the year.
(g) The
debt-to-equity ratios, recalculated to include the capitalized value of the operating leases, are presented below. By including the capitalized amount of the
operating leases in the liabilities calculation, the debt-to-equity ratios of
both companies are significantly higher. For CNR, the ratio has increased from
1.24 to 1.29, which is only a 4% increase.
However, for CPR, that uses predominantly more operating lease than CNR,
the ratio has increased from 2.0 to 2.17, which represents an 8.5% increase.
|
|
CNR
|
CPR
|
|
Liabilities as
reported
|
$13,943
|
9,523.0
|
|
Capitalized value
of operating leases
|
555
|
724.8
|
|
Revised
Liabilities (including capitalized value of operating leases)
|
14,498
|
10,247.8
|
|
Total Equity
|
11,233
|
4,720.8
|
|
Debt/Equity ratio
|
1.29
|
2.17
|
(h) In the case of CNR and CPR above, the companies
use different percentages of owned versus leased assets. In order to properly compare the companies
with respect to debt ratios and asset turnover ratios, it is important to
reflect all the assets being used along with the obligations incurred to use
those assets. Consequently, the contract
based approach would ensure that the assets and related obligations are
recognized and measured appropriately on the statement of financial
position. In trying to make the
adjustments from the current notes for CNR and CPR, some assumptions were made
as to the lease terms and the interest rates which might not be correct. And as noted above, we are also missing
information to make all of the adjustments required. If the companies adopted contract based
approaches, these adjustments would no longer be required.
