Financial Statement Analysis - GAP Lease Accounting Case Study-2-14

School: Edhec Business School, Paris - Course: FINANCE AC LECTURE 1 - Subject: Accounting

Gap says in its 10-k filings that as a result of applying ASC 842 for the first time, it had recognised rights of use in connection with its property assets and related lease obligations as of 1st of February 2019 (not 2020) for $5.7bn and $6.6bn, respectively. What do these two figures represent and why are they not the same? Rights of Use: this represents the existence of an operating lease that the company will use in the future. Lease Obligations: this represents the liability that the company gets as a result of entering into a lease agreement. The lease obligation is the sum of the present value of all future lease payments. In Right of Use and Lease Obligations, some additional financing such as a cash payments could be offered in order to incentivise one of the parties in the property deal. If additional financing is offered to the lessee, the Right of Use would be larger than the Lease Obligation and if financing was offered to the lessor the Right of Use would be lower than the Lease Obligation. Since the Lease Obligation is larger than the Right of Use we could expect that GAP may have incentivised the lessor through some additional financing in order to secure leases. QUESTION 1 3

QUESTION 2 Explain how the value of the Rights of Use changes over the course of a one-year period (that is explain what events will make it increase and what events will make it decrease). The Rights of Use account (RoU) is affected by the accumulated depreciation & amortization account, which in turn reduces the net value of the Rights of Use. The RoU account contains credit fixed lease payment for the period and debit interest expense for the period. The fixed lease payment reduces the RoU account and the interest expense increases the RoU account. 4

QUESTION 2 Explain how the value of the Lease Obligation changes over the course of a one-year period (that is explain what events will make it increase and what events will make it decrease). The Lease Obligation (LO) account is the opposite of the RoU, it has credit interest expense for the period and debit fixed lease payment for the period. The interest expense will increase the LO account and the fixed lease payment will decrease LO. 5

QUESTION 2 The discount rate on the future lease payments is lower than the interest on certain unsecured notes due April 2021 issued by Gap. Explain why this is the case. 6The discount rate on the lease payments can be lower than the interest rate on the notes because the lease payments are backed by the lease properties, which are being used by GAP but don't belong to them. As the notes can be unsecured notes, and they are not backed by any specific assets as such, they can carry a higher credit risk than the lease payments, which accounts for the interest rate being different to the discount rate on the lease payments. Furthermore, even if Gap doesn't use the buildings it will still have to pay the lease payments for a certain period, which adds another layer of protection for the Lessor and allows it to charge a lower interest rate.