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For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-039 Leasing Decision at Magnet Beauty Products, Inc.

2

Magnet was distributing its products through alliances with high-end hotels located in Boston, New York and Miami, and airlines that used Magnet products for passengers that travelled first class.

For the 2009 fiscal year Magnet reported sales of $52.4 million experiencing a 12% increase from the previous year. Net income after taxes was $1.4 million, 10% higher than the previous year. Accounts receivable reached $30 million mainly because of the increasing importance of business coming from deals with luxury hotels and airlines. However, the company was considerably leveraged. Accounts payable and outstanding debt had reached $20 and $52 million respectively. The loans carried a 7% interest rate. Total net cash flow for 2009 was negative $1 million, and negative $2 million before financing cash flows.

Clark was happy with the way her business was progressing. Assuming that things continued to go well, she was hoping to nurture her start up for the next few years, and then sell the business to one of the large specialty retailers in her space. To achieve this objective Clark considered it important to maintain customer loyalty, focus on cost efficiencies, and as a result improve the profitability and the cash flow position of Magnet.

Accounting for leases

Existing U.S. lease accounting standards, under Financial Accounting Standard No. 13 (FAS 13), required lessees to classify their lease contracts as either capital or operating leases. Capital leases were leases that transferred to the lessee substantially all the risks and rewards incidental to ownership of the leased asset. All other leases were operating leases.1 FAS 13 provided four criteria to test whether a lease contract met the test of “substantial transfer of risks and rewards”:

1. The lease transfers ownership of the property to the lessee by the end of the lease term.

2. The lease contains a bargain lease option.

3. The lease term is equal to 75 percent or more of the estimated economic life of the leased property.

4. The present value of the minimum lease payments equals or exceeds 90 percent of the fair market value of the property.

Leases classified as capital leases were treated as similar to a purchase of the underlying asset with a loan. Consequently, the lessee recognized in its balance sheet the leased item as an asset and an obligation to pay rentals as a liability. Over the term of the lease, the lessee depreciated the leased item and apportioned lease payments between a finance charge and a reduction of the outstanding liability. The lessee recognized no similar assets or liabilities when the lease was classified as an operating lease. Instead, the lessee recognized the annual lease payments under an operating lease as rental expense.

Recently, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) decided to jointly revise their standards on lease accounting after considerable criticism that the existing accounting model for leases failed to provide useful information to users of financial statements. Critics noted that operating leases give rise to assets and liabilities that users of financial statements would like to see on the balance sheet, so they can have a more complete picture of the financial position of a firm. They also argued that the existence of different accounting models for substantially similar leases impairs comparability across companies.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

Leasing Decision at Magnet Beauty Products, Inc. 111-039

3

Finally, there was wide-spread concern that FAS 13 provided opportunities to engage in “accounting arbitrage” by structuring transactions to achieve a specific lease classification.

In mid March of 2009 FASB and IASB published a discussion paper with the preliminary views of the board members on how the accounting model for leases would change.2 The boards appeared determined to eliminate operating leases and treat all leases as capital leases regardless of the particular lease terms. As a result, a lessee would recognize an asset representing its right to use the leased item for the lease term (“right-of-use asset”), and a liability for its obligation to pay rentals for the lease term. Moreover, the board members seemed to favor an approach that would require the capitalization of leases under renewal options,a contingent rental arrangements,b and residual value guarantees.c

The discussion paper specified that the right-of-use asset should be initially measured as the present value of the lease payments discounted using the lessee’s incremental borrowing rate. The proposal suggested that the asset should be amortized over the shorter of the lease term and the economic life of the leased item. The liability to pay rentals would initially be measured as the present value of the lease payments discounted using the lessee’s incremental borrowing rate. The income statement recognition of expenses associated with leases would also be affected under the proposed accounting rules. Under the current accounting model, payments for operating leases were classified as operating expenses on a straight-line basis. Under the proposed accounting model, interest expense associated with the lease payment liability, and depreciation and amortization expense associated with the leased asset would be recorded as expenses. As the liability on the balance sheet declined over the lease term, so would the interest expense. As a result, since rentals under the operating expenses generally remained the same over the life of a lease, expenses recorded under the proposed rules would be usually higher than the currently recorded rental expenses in the initial periods of a lease. The pattern would change the other way during the later part of the lease period. In late August of 2010 FASB and IASB issued an exposure draft supporting the proposals in the discussion paper.3 The exposure draft included an exception for lease contracts of 12 or fewer months. These contracts could continue be recognized as operating leases.

Choosing the new lease contract

Clark was initially considering renewing the lease contract for her stores for five years as a three-year lease with a renewal option for two more years. Such a long-term lease would ensure that Magnet would be able to lock in its current store locations for the foreseeable future. The company

a In the boards’ view, the lease term should reflect the entity’s reasonable expectation of what the term will be. The discussion paper proposed that an entity should account for options to extend or terminate a lease by assuming the longest possible lease term that is more likely than not to occur. b In some leases, the amount of each lease payment is variable rather than fixed. This variability can arise because of features, such as contingent rentals, based on price changes, the lessee’s performance derived from the underlying asset, or the usage of the underlying asset. In the boards’ view, the measurement of the right-of-use asset and right to receive lease payments should reflect all rights received, even if the payment or receipt of those rights is contingent. c The discussion paper proposed that entities should account for residual value guarantees, in which a lessee compensates a lessor if the value of the underlying asset at the end of a lease is less than a specified amount, in the same way as it accounts for contingent rentals. In the boards’ view, a residual value guarantee is equivalent to a contingent payment at the end of the lease term.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-039 Leasing Decision at Magnet Beauty Products, Inc.

4

was beginning to establish a loyal customer base, and store location was an important aspect of cementing this advantage for years to come. The contract had specified that the renewal option would be automatically exercised subject to sales targets for the next three years for $60 million per year on average. Clark was confident that these sales targets would be achieved and therefore the effective term of the lease was most probably five years. The mall developer was offering Clark an attractive lease contract for the “three plus two years” lease. Under the proposed terms, the annual rental payment would be fixed at $10 million for the whole five-year period. Lessors were willing to offer better terms for long-term leases because long-term contracts reduced the risk of owing an unoccupied facility by the lessors. Moreover, under the proposed accounting standard, the three plus two lease would allow the developer to recognize as revenue the entire present value of the five year lease payments when the lease was signed.

To analyze the alternatives to the proposed “three plus two years” lease, Cameron had collected a market analysis of the commercial real estate market. Cameron also evaluated the option of one-year leases that could be potentially rolled over at the end of every year. Under this arrangement, Magnet would make no legal commitment to renew the lease beyond the first year. Of course, this meant that Magnet may have to move its stores some time during the next five years, should the current land-lord choose not to offer the space on a one-year basis. Further, if Magnet rented retail space year by year, Cameron’s market analysis showed that the forecasted rent would increase 5% every year for the next five years starting from $10 million in year 1 and reaching $12.2 million in year 5.

Based on the borrowing rate on the outstanding debt of Magnet, Cameron determined that the incremental borrowing rate of Magnet was 7%. He forecasted sales to increase by 12% every year for the five-year period, a growth rate that was moderately higher than the expected industry growth. Cost of goods sold and research and development expenses were expected to grow at 12% each year. Administrative and distribution expenses were expected to increase by 9% every year, a slower growth rate that reflected the forecasted cost efficiencies.

Clark received the analysis that Cameron had performed, showing how the proposed accounting rules would impact the income statement, the balance sheet, and the cash flow statement under the “three plus two years” lease (Exhibits 2 to 4) and the “five one year” leases (Exhibits 5 to 7). Under the five year lease, net income was expected to decrease from $1.5 million to $0.8 million for year 1 as a result of the accounting change. Moreover, leverage was expected to increase from 4.6 to 6.8. A shorter lease affected the income statement and the balance sheet less dramatically. Under a one-year lease, net income for year 1 would remain $1.5 million and leverage would equal 4.6. However, the lease payments would be higher in the future, reducing net cash flow before debt issues.

Cameron also informed Clark that the new leasing accounting model was expected to have a widespread impact on many companies.4 Exhibits 8 and 9 show the estimated potential effects of the proposed accounting rules on reported leverage and Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) across various industries and countries.5 The highest increase in leverage and EBITDA was expected for companies in the retail and transportation industries, and in Netherlands, United Kingdom, Italy and France. Exhibit 10 shows the effect of capitalizing existing operating lease obligations reported in the footnotes of 20 of the largest U.S. retail companies, transportation companies, banks and utilities on the income statement. For most companies higher expenses would be recognized up to the 7th year of the lease and the cumulative increase in lease cost in excess of straight line rent expense varied between $98 million and $2.66 billion. As a result of the accounting change, public companies were expected to record about $1.3 trillion in leases on their balance sheets, according to estimates by the Securities and Exchange Commission. Because many

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

Leasing Decision at Magnet Beauty Products, Inc. 111-039

5

private companies also follow GAAP accounting, the number could be closer to $2 trillion, according to experts.6

As a small business owner, Clark was very concerned about managing her cash flows, to minimize the need for external financing. However, she also felt that Magnet’s reported profits could be important in determining the company’s value when she was ready to sell her business. Also, till she decided to sell the company, she wanted to make sure that she could present attractive financial statements to the banks if she needed a loan to finance Magnet’s growth.

As Clark pondered over the two leasing options for her store, she wondered how she should balance the various considerations in making her decision.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-039 Leasing Decision at Magnet Beauty Products, Inc.

6

Exhibit 1 Ingredients that are used and not used in Magnet’s products

Ingredients not used Disadvantages of Ingredients not used

Ingredients used Advantages of Ingredients used

Silicones Synthetic,non bio-degraded, which clog the pores, burden hair

Combination of dry vegetable oils

Exceptional compatibility, does not clog pores, does not burden hair moisturizing properties

Parabens Conservatives to which a large percentage of the population is overexposed to

Organic acids, food conservatives

Natural, mild, safe

Oil products (mineral oil)

Synthetics, clog skin pores Excellent quality natural oils

Exceptional compatibility, does not clog pores, moisturizing properties

Propylene-glycol Dissolution responsible for allergies

Butylene glycol High compatibility, friendly to the skin

Ethanolamines Controllers of pH responsible for allergies, rashes

Amino acid L-arginin High compatibility, moisturizing properties

Synthetic vitamin E (D- and L-tocopherol)

Only D-tocopherol has proven anti-oxidant action

Natural vitamin Ε (D-tocopherol)

Has a double anti-oxidant action

Source: Casewriters.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

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For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

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48

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1,9

43

Sou

rce:

C

asew

rite

rs.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-

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–

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Exh

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ash

flo

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tate

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in C

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Sou

rce:

C

asew

rite

rs.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-

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Sou

rce:

C

asew

rite

rs.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-

039

–

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So

urc

e:

Cas

ewri

ters

.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-

039

–

12-

Exh

ibit

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ash

flo

w s

tate

men

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For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

Leasing Decision at Magnet Beauty Products, Inc. 111-039

13

Exhibit 8 Impact of new lease accounting standard on leverage and EBITDA across industries

Increase in leverage (%) Increase in EBITDA (%)

Industry Mean Median Mean Median

Retail and Trade 64 42 55 34

Transportation and Warehousing 31 9 44 14

Telecom 20 8 16 7

Professional Services 19 12 27 20

Amusement 19 4 13 5

Accommodation 18 6 30 10

Wholesale Trade 17 8 21 11

All companies 13 4 18 7

Manufacturing 9 5 13 7

Construction 8 4 14 6

Oil, Gas and Mining 7 1 10 2

Financial services 6 2 15 5

Utilities 2 0 6 3

Source: “Proposed lease accounting: research of impact on companies”, PricewaterhouseCoopers, available at: http://www.pwc.com/be/en/publications/pdf/Proposed-lease-accounting-PwC-10.pdf, accessed August 15, 2010.

Leverage is interest bearing debt over shareholder’s equity. EBITDA is earnings before interest, taxes and depreciation.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-039 Leasing Decision at Magnet Beauty Products, Inc.

14

Exhibit 9 Impact of new lease accounting standard on leverage and EBITDA across countries

Increase in leverage (%) Increase in EBITDA (%) Country Mean Median Mean Median

Netherlands 27 12 27 12 United Kingdom 20 9 24 11 Italy 20 4 30 11 France 20 10 31 22 Sweden 17 7 21 12 Germany 16 5 18 10 United States 15 5 15 7 All companies 13 4 18 7 Switzerland 12 4 28 10 Singapore 8 3 20 7 Hong Kong 7 1 18 4 China 5 1 13 2 Japan 2 1 30 14

Source: “Proposed lease accounting: research of impact on companies”, PricewaterhouseCoopers, available at: http://www.pwc.com/be/en/publications/pdf/Proposed-lease-accounting-PwC-10.pdf, accessed August 15, 2010.

Leverage is interest bearing debt over shareholder’s equity. EBITDA is earnings before interest, taxes and depreciation.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

Leasing Decision at Magnet Beauty Products, Inc. 111-039

15

Exhibit 10 Impact of new accounting standard on timing of lease expense for 20 large US firms

Company

Cumulative increase in lease cost in excess of straight line to

turn around point Year of turn

around

1st year increase in lease cost vs straight

line

% in excess of straight line cash expense in the

1st year

Walgreen’s 2,664 10 456 23

CVS 1,500 9 330 19

Wal-Mart 838 8 194 17

Home Depot 581 9 125 16

Target 487 15 50 21

Sears 374 6 118 14

Kroger 323 6 112 14

Best Buy 275 6 127 12

Delta A/L 298 7 110 10

United A/L 303 7 149 11

Cont A/L 777 7 223 16

American A/L 498 7 146 15

US Air 624 7 285 11

FEDEX 632 7 211 12

BNSF 437 7 117 19

Bank America 913 6 305 13

JP Morgan 891 7 269 16

Citigroup 319 4 157 11

Exelon 98 9 21 16

AEP 178 7 55 18

Source: “An analysis of the impact on lessees of the new approach to lease accounting”, William Bosco, available at: http://fasri.net/wp-content/uploads/2010/03/elfa-cfo-mag-article-2.pdf, accessed August 15, 2010.

Results are in millions of $.

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.

111-039 Leasing Decision at Magnet Beauty Products, Inc.

16

Endnotes

1“Accounting for lease”, Financial Accounting Standards Board’s Statement No. 13, 1976.

2“Discussion paper: leases, preliminary views”, Financial Accounting Standards Board’s Statement No. 1680-100, 2009.

3“Proposed accounting standards update: Leases”, Financial Accounting Standards Board’s update No. 1850-100, 2010.

4“New accounting rules ruffle the leasing market”, Julie Satow, The New York Times, June 22 2010, available at: http://www.nytimes.com/2010/06/23/realestate/commercial/23fasb.html

5Source: “Proposed lease accounting: research of impact on companies”, Price Waterhouse Coopers, available at: http://www.pwc.com/be/en/publications/pdf/Proposed-lease-accounting-PwC-10.pdf., and “An analysis of the impact on lessees of the new approach to lease accounting”, William Bosco, available at: http://fasri.net/wp-content/uploads/2010/03/elfa-cfo-mag-article-2.pdf.

6“New accounting rules ruffle the leasing market”, Julie Satow, The New York Times, June 22 2010, available at: http://www.nytimes.com/2010/06/23/realestate/commercial/23fasb.html

For the exclusive use of A. Almutham, 2022.

This document is authorized for use only by Ahmed Almutham in FINC6602_Spring_2022-1 taught by FANG CHEN, University of New Haven from Feb 2022 to May 2022.