Question

Analyzing and Interpreting Footnote on Operating and Capital Leases

Assume Verizon Communications, Inc., provides the following footnote relating to its leasing activities in its 10-K report. The aggregate minimum rental commitments under noncancelable leases for the periods shown at December 31, 2010, are as follows:

Years (dollars in millions)	Capital Leases	Operating Leases
2011	$ 83	$ 1,449
2012	71	1,316
2013	67	1,056
2014	63	806
2015	46	527
Thereafter	161	1,937
Total minimum rental commitments	491	$ 7,091
Less interest and executory costs	(89)
Present value of minimum lease payments	402
Less current installments	(46)
Long-term obligation at December 31, 2010	$ 356

(a) Confirm that the implicit discount rate for Verizon's capital leases is 5.01%.

N	0	1	2	3	4	5	6	7	8	9
Amount	Answer	Answer	Answer	Answer	Answer	Answer	Answer	Answer	Answer	Answer
IRR	Answer %

(b) What effect does the failure to capitalize operating leases have on Verizon's balance sheet? Over the life of its leases, what effect does this lease classification have on net income?

There is no effect on the balance sheet and income statement as a result of the classification of leases.

Total assets and total liabilities are higher than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be equal to the interest and depreciation expense that the company would record under capital leases.

Total assets and total liabilities are lower than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be equal to the interest and depreciation expense that the company would record under capital leases.

Total assets and total liabilities are lower than if the operating lease had been classified as a capital lease. Over the lease term, total rent expense under operating leases will be greater than the interest and depreciation expense that the company would record under capital leases.

1.00 points out of 1.00

(c) Compute the present value of Verizon's operating leases, assuming an 5.01% discount rate and rounding the remaining lease term to 3 decimal places. (Use a financial calculator or Excel to compute. Do not round until your final answers. Round each answer to the nearest whole number.)

($ millions)	Present Value
Year 1	Answer
Year 2	Answer
Year 3	Answer
Year 4	Answer
Year 5	Answer
After 5	Answer
Total*	Answer

* (Use subsequent rounded answers for calculation.)

Which of the following statements best describes how we might use this additional information in our analysis of the company?

To assess the company's financial condition and performance, we might add the present value of its operating leases to both operating assets and nonoperating liabilities. No adjustment is necessary for the income statement.

To assess the company's financial condition and performance, we might add the sum of the contractual payments under the operating leases to both assets and nonoperating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability.

To assess the company's financial condition and performance, we might add the present value of its operating leases to both operating assets and nonoperating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability.

Verizon's balance sheet and income statement are prepared in accordance with GAAP. No adjustments are necessary to evaluate the financial condition of the company.

1.00 points out of 1.00

Answer 1

(a) Confirmation of implicit discount rate for Verizon's capital lease is 5.01%

N	0	1	2	3	4	5	6	7	8	9
Amount	-402	83	71	67	63	46	46	46	46	23
IRR%	5.01%

(b) Total assets and liabilities would be lower than if the operating lease had been classified as a capital lease. Over the lease term, the total rent expense under operating leases would be equal to interest and depreciation expense that the company would record under capital leases.

(c) Computation of Present Value of Verizon's operating leases assuming 5.01% discount rate

($ millions)	Present Value
Year 1	1380
Year 2	1193
Year 3	912
Year 4	663
Year 5	413
After 5	1445 (assuming that payments after 2015 are made in one instalment)
Total	6005

To assess the company's financial condition and performance, we might add the sum of contractual payments under the operating leases to both assets and non-operating liabilities, and we can replace rent expense with the depreciation of the lease assets and the interest on the lease liability.