Universal Weather and Aviation. Capital Lease Policy #

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1 Universal Weather and Aviation Capital Lease Policy # Approved on: November 3, 2010

2 Table of Contents Policy Purpose Scope Responsibility Policy Leases Lease Classification by Lessee Lease Classification by Lessor Capital Lease Accounting by Lessee Capital Lease Accounting by Lessor Accounting for Sale-Leasebacks Definitions References Exhibits Exhibit

3 Policy Title: Capital Lease Policy Policy Process Owner: Manager, Financial Reporting Approved by: Corporate Controller Approval Date: November 3, 2010 Effective Date: November 3, 2010 Revision Date: Revision No.: Policy 1.0 Purpose This policy will establish the guidelines for the accounting and the determination of what is a capital lease versus what is an operating lease. 2.0 Scope This policy applies to the Directors, officers, and employees of the Company and its majority owned subsidiaries or joint ventures. 3.0 Responsibility Universal Weather and Aviation s Corporate Manager, Financial Reporting is responsible for the development, maintenance and compliance to the guidelines set forth within this policy. Universal Weather and Aviation s local finance managers/regional Controllers are responsible for the maintenance and enforcement of the guidelines set forth within this policy and it s customization to their specific local market conditions and statutory requirements. Any variations/exceptions to this policy must first be communicated to the Corporate Controller who will validate all variations prior to submission to the Chief Financial Officer for final approval for policy changes. 4.0 Policy The determination of a capital lease versus an operating lease and the subsequent accounting is a complex issue which involves a significant degree of thought and consideration. Leasing arrangements involve transfers of various risks and rewards that allow a sharing of financial, operating, and tax characteristics of leased property. As such, Universal must exercise care when considering leasing as there are far reaching implications to such a decision. For example, Capital Leases are included in our calculation of Funded Debt within our credit agreement. This calculation determines the rate of interest we are required to pay on our borrowings under our line of credit. Therefore, an increase in funded debt will increase our interest expense over time Universal Weather and Aviation Page 1 of 15 1/11/2011

4 4.1 Leases Universal will adhere to the guidelines as set forth by Generally Accepted Accounting Principles (GAAP) in the classification of whether a lease is a capital lease or an operating lease. The FASB's guidelines for classifying and reporting leasing transactions are based on the economic characteristics of the lease agreement at the inception of the lease. A lease that transfers most all the risks and benefits incident to the ownership of the leased property should be accounted for as an asset and consequently a capital lease and as a sale or financing by the lessor. All other leases are classified as operating leases. The transfer of risks and benefits must be evaluated at the beginning of the lease to determine the lease's appropriate classification. Universal s Corporate Manager, Financial Reporting should determine which party bears the risks of changes in property values, which ends up with ownership of the leased property, what is the residual, economic value at the end of the lease term, and what guarantees (of residual value and others) are provided by the lessee. Generally, lease agreements in which substantially all the risks are retained by the lessor are classified as operating leases. This process is important, since lease classification affects several critical indicators or measures of financial performance and health of both lessee and lessor companies. Leasing arrangements which do not meet the capitalization criteria identified and discussed below shall be classified as operating leases. Operating leases are not recorded as assets and are held as an off balance sheet liability. Normally, rental on an operating lease is charged to expense over the lease term as it becomes payable. When accounting for an operating lease, the rented asset and the corresponding long-term liability are not recorded; instead, rent expense is debited periodically and cash (or a short-term accrued liability) is credited. Rent expense, lease rental payments, lease payments are all synonymous terms meaning the same thing e.g. the amount of funds one has to pay to procure to utilization of a leased asset. All leases must first be reviewed by the Legal Department and the Chief Financial Officer or Corporate Controller before a commitment is made. Additionally, all leases are subject to the Company s Delegation of Authority and Capital Expenditure policies and limitations (Policies & respectively). Headquarters accounting department should review all lease agreements for proper accounting (capital vs. operating leases). Additionally, before committing to a lease agreement, Universal s Corporate Treasurer must be notified of the determination as to whether or not the lease may be capitalized to make sure a minimal impact on our debt covenants. Universal Weather and Aviation Page 2 of 15 1/11/2011

5 4.2 Lease Classification by Lessee A lease agreement must be evaluated at the beginning of the lease to classify the lease along the lines required by SFAS No. 13. SFAS No. 13 delineates the conditions under which the lessee must assume these risks and the benefits that have been transferred. Lease agreements that do not meet these conditions are classified as operating leases. Lease agreements that meet one or more of the following criteria must be classified as capital leases: o The lease transfers ownership of the property to the lessee at the end of the lease term. o The lease contains a bargain purchase option. o The lease term is equal to 75 percent or more of the estimated economic life of the leased property (this criterion is not applicable when the lease term begins within the last 25 percent of the economic life of the asset). o The present value of the minimum lease payments (MLP) (excluding executory costs) equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor. The discount rate used should be the lessee's incremental borrowing rate or the rate implicit in the lease, whichever is lower. The establishment of these criteria allow for an evaluation of whether benefits and risks are transferred by a lease agreement. o The first condition involves the transfer of ownership that would effectively transfer all of the benefits and risks of the leased property to the lessee. o Similarly, the existence of a bargain purchase option implies an identical transfer. Thus, the first two criteria satisfy the economic concepts underlying the classification of a lease as a capitalized lease. o The third criterion implies that lease terms covering at least 75 percent of the estimated economic life of the leased property transfer substantially all the risks and benefits of ownership. (This criterion cannot be used in lease classification if the inception of the lease falls within the last 25 percent of the total estimated economic life of the leased property.) This criterion presumes that a substantial portion of the benefits and risks of use occur during the initial 75 percent of the economic life. As such, this requires capitalization of the leased property. o The last criterion reflects the lessor's return on investment in the lessee's payment for the leased property. When the present value of the minimum leas payments (MLPs) equals or exceeds 90 percent of the fair value of the leased property at the inception of the lease, the lessor will have earned a fair return on investment. The lessee has effectively paid for the lease and is required to treat the leased property as it would an acquisition. The interest rate used to determine the present value, the MLP, contingent rentals, and the residual value are among the critical factors in the Universal Weather and Aviation Page 3 of 15 1/11/2011

6 application of this rule, and they should be evaluated carefully in the lease classification process. If a lease agreement meets any one of these four criteria at the inception of the lease, it must be classified as a capitalized lease (i.e., the lessee should recognize a leased asset and the obligation under capital leases). Reference the Lease Calculation Template for assistance in making this determination (See K:\finance\General Accounting\International Offices - Monthly Close\2 Entity Book Templates, Notes, etc\leases and Notes). FASB Interpretation No. 31 mandates that the classification of the lease made at the inception of the lease should not be changed in the event of a business acquisition unless the provisions of the lease agreement are changed. 4.3 Lease Classification by Lessor The economic characteristics of the lease agreement must be evaluated at the inception of the lease by the lessor to classify the lease under one of the following categories: o Operating leases o Sales-type leases o Direct-financing leases o Leveraged leases Leases that do not meet the criteria for a capital lease as reported by the lessee, nor meet either of the following two criteria would be classified as an Operating lease by the lessor. o Collectability of MLPs is reasonably predictable. o No significant uncertainties surround the amount of the non-reimbursable costs yet to be incurred by the lessor under the provisions of the lease agreement. A lease agreement that meets any one of the above noted criteria for capital leases by lessees and also meets both of the following criteria must be classified as a sales-type or a direct-financing lease by the lessor: o Collectability of MLPs is reasonably predictable. o No significant uncertainties surround the amount of the non-reimbursable costs yet to be incurred by the lessor under the provisions of the lease agreement. Distinguishing a sales-type lease from a direct financing lease relates to the existence of a manufacturer's or dealer's profit (or loss). The lessor's profit or loss is the difference between the fair value of the leased property at the inception of the lease and the manufacturers or dealer's cost or carrying amount. Directfinancing leases do not incorporate a profit or loss, but reflect an interest component earned by the lessor for the underlying financing transaction. Generally, direct-financing leases are arranged by leasing intermediaries. In a sales-type lease, the profit or loss must be recognized by the lessor at the inception of the lease. Universal Weather and Aviation Page 4 of 15 1/11/2011

7 o The accounting procedures under these two types of leases are equivalent except for the treatment of initial direct costs. These costs may be expensed as incurred in sales-type leases, whereas they must be amortized to income over the life of the lease under direct-financing leases Financing leases, which are financed principally with nonrecourse borrowings at lease inception and which meet certain criteria, are accounted for as leveraged leases. Leveraged lease contracts receivable are stated net of the related nonrecourse debt service, which includes unpaid principal and aggregate remaining interest on such debt. Unearned income represents the excess of anticipated cash flows (including estimated residual values after taking into account the related debt service) over the Company's investment in the lease. 4.4 Capital Lease Accounting by Lessee The following example depicts how a typical lease would be viewed, the determination as to whether or not it is a capital lease and the subsequent accounting for a capital lease by the lessee. Lease Provisions: The lease term is six years and is non-cancelable. The fair value of the machinery at the inception of the lease is $240,000, it has an estimated economic life of six years, and it has no residual value. There is no bargain purchase option, and the lessor retains ownership at the end of the lease. The lessor's implicit rate is 10 percent, and the lessee has been informed of this implicit rate. The lessee's incremental borrowing rate is 11 percent. The lessee depreciates similar machinery on a straight-line basis. The lease requires annual payments of $54, at the beginning of each year. This annual payment includes $4,000 for maintenance and insurance (executory costs). The lease should be accounted for as a capital lease because the lease term is equal to the estimated economic life and the present value of the MLPs exceeds 90 percent of the fair value of the machinery. (Only one condition needs to be met to classify it as a capital lease.) The annual MLPs are $50,096.12, and their present value should be computed as follows: Capitalized Asset and Liability Amount = ($54, = $50, = $240,000 The lessor's implicit rate must be used, since it is lower than the lessee's incremental borrowing rate and it is known to the lessee. Universal Weather and Aviation Page 5 of 15 1/11/2011

8 The amortization schedule reflects the application of the effective interest method and allocates each annual payment to executory costs, interest, and a reduction of the balance of the lease obligation. No interest is recorded on the first payment of January 1, 2010, since it is the inception of the lease and as such no interest has been incurred. The interest component in years 2 through 6 is computed by applying the interest rate to the unpaid obligation. The reduction in lease obligation is determined annually by the difference between the payment (net of executory costs) and the interest computed as in the previous calculation. The balance sheet should reflect the capitalized lease asset and the obligations under capital leases, showing the short- and long-term components. Each period should reflect the amount of the obligation expected to be reduced by the next payment as a short-term obligation. Journal Entries Debits Credits 1. At inception, January 1, 2010 Capitalized lease asset $240, Obligations under capital leases: Short-term $ 50, Long-term 189, First lease payment, January 1, 2010 Executory expenses 4, Obligation under capital leases 50, Cash 54, Recognition of accrued interest, December 31, 2010 Interest expense 18, Interest payable 18, Lease payment, January 1, 2011 Executory expenses 4, Interest payable 18, Obligations under capital leases 31, Cash 54, Amortization of leased asset, December 31, 2010 Depreciation expense 40, Accumulated depreciation leased asset 40, December 31, 2015 Debits Credits Accumulated depreciation leased asset $240, Capitalized leased asset 240, (5) This entry will be made each year, since the company uses the straight-line method for depreciation. The lease payment entries will follow the amortization schedule and the format depicted in (4) above. Universal Weather and Aviation Page 6 of 15 1/11/2011

9 Lessee Company Lease Amortization Schedule Date Annual lease payment Executory costs Interest on unpaid obligation Reduction of lease obligation Balance of lease obligation Jan. 1, 2010 $240, Jan. 1, 2010 $ 54, $ 4, $ 50, , Jan. 1, , , $18, , , Jan. 1, , , , , , Jan. 1, , , , , , Jan. 1, , , , , , Jan. 1, , , , a 45, $324, $24, $60, $240, Capital Lease Accounting by Lessor The accounting for sales-type leases is illustrated using the assumptions from the above example (lessee accounting) but with changes and additional assumptions. Assumptions: The machinery cost $150,000 to manufacture. The unguaranteed residual value is $5,000. Initial direct costs of $5,000 are incurred at inception. The normal selling price is $242, The collectability of lease payments is reasonably predictable, and no additional costs are expected. The lessor's gross investment in the lease is: MLPs (net of executory costs): $50, = $300, Unguaranteed residual value Gross investment in leased property 5, $305, The net investment should be computed as follows: Universal Weather and Aviation Page 7 of 15 1/11/2011

10 Present value of an annuity due of $50, for 6 periods at 10% (50, ) = $240, Present value of $5,000 at end of 6 years at 10% a year ($5, ) = $2, $242, Journal Entries Debits Credits 1. At inception Gross investment in leased property $305, Cost of sales (cost less present value of unguaranteed residual value) 147, Sales revenue (present value of minimum lease payments) $240, Machinery 150, Unearned interest income 62, Initial direct costs 5, Cash 5, Cash 54, Gross investment in leased asset 50, Executory cost 4, Unearned interest income 19, Interest income 19, Lessor Company Lease Amortization Schedule for Sales-Type Leases Year Beginning of year present value of net investment Annual Payments Amortization of unearned interest income a, b Reduction in net investment End-of-year present value of net investment 1 $242, $50, $19, $30, $211, , , , , , , , , , , , , , , , , , , , , , , , , d $ $62, $237, d Represents the unguaranteed residual value. Universal Weather and Aviation Page 8 of 15 1/11/2011

11 4.6 Accounting for Sale-Leasebacks At this writing, the sale-leaseback of any property or equipment is expressly prohibited by the Delegation of Authority Policy (No ). The process supporting these types of transactions have been included as Exhibit 1, but are for information purposes only should a future situation warrant the need to account for this type of transaction. 5.0 Definitions Bargain Purchase Option A bargain purchase option gives the lessee the right to purchase leased property for a specified amount, which at the inception of the lease is sufficiently lower than the expected fair value of the property at exercise date to virtually guarantee the exercise of the option. Bargain Renewal Option A bargain renewal option gives the lessee the right to renew the lease agreement at a specified rental payment, which at the inception of the lease is sufficiently lower than the expected fair rental at the exercise date to virtually guarantee the exercise of the option. Cancelability Leases should be regarded as non-cancelable when cancellations are only possible under the following conditions: Contingent Rentals o The permission of the lessor is required. o A contingency considered remote at the inception of the lease occurs. o A cancellation penalty is incurred of an amount that at inception provides reasonable assurance that the lease will be continued. SFAS No. 29, Determining Contingent Rentals, defines contingent rentals as increases or decreases in lease payments due to changes in factors determining lease payments occurring subsequent to the inception of the lease. Minimum lease payments (MLPs) are based on factors that exist and are measurable at the inception of the lease; these are the factors that should be included in the MLPs. Examples include payments based on construction cost or consumer price indices and on the prime interest rate. Subsequent changes in Universal Weather and Aviation Page 9 of 15 1/11/2011

12 these factors change lease payments. However, these changes are considered contingent rentals and are included in income determination as they are accrued. Changes in minimum lease rentals due to changes in construction or acquisition cost of leased property or changes in costs during construction or preconstruction phases are not contingent rentals but rather components of MLPs. (See fair value of leased property, as amended by SFAS 23, Inception of the Lease. ) Finally, the portion of rental payments due only to the passage of time are excluded from contingent rentals. Estimated Economic Life of Leased Property SFAS No. 13, paragraph 5(g) defines the estimated economic life of leased property as the remaining period during which the property, given normal maintenance and repairs, may be economically usable for its intended function at the inception of the lease. The economic life is not limited by the lease term and should be estimated by methods used to determine the depreciable life of similar property. Estimated Residual Value of Leased Property The estimated residual value is the estimated or expected fair value of the leased property at the end of the lease term (i.e., the expected market value at the end of the lease term) and is equivalent to the expected salvage value at the end of the depreciable life of similar property. Executory Costs The executory costs include costs of insurance, maintenance, and taxes on the leased property. Lessee payments for guarantees of residual value from unrelated third parties are also executory costs. Executory costs, whether paid by lessee or lessor, are not components of MLPs. Lessor's profit, if any, on executory costs is treated similarly. Fair Value of Leased Property The fair value of leased property is generally the selling price of the property if it were sold in an arm's-length transaction between unrelated parties. The fair value of the leased property may be known or determinable through negotiation or inquiry in the marketplace. However, it need not be equal to the normal selling price and should always be determined in the context of existing market conditions at the inception of the lease. Inception of the Lease Universal Weather and Aviation Page 10 of 15 1/11/2011

13 The inception of the lease is the date of the lease agreement or the date of the commitment if it is earlier. A commitment is a written agreement specifying all the principal terms of the lease agreement, and it should be signed by all the interested parties. The classification of the lease is determined at the lease's inception, as defined above. Implicit Interest Rate The interest rate implicit in the lease agreement is the discount rate at which the present value of the MLPs and the unguaranteed residual value accruing to the lessor is equal to the fair value of the leased property to the lessor at the inception of the lease. The implicit interest rate is essentially the lessor's rate of return (ROR) on the lease and is the rate charged by the lessor to a given lessee. Incremental Borrowing Rate The incremental borrowing rate at the inception of the lease is the rate at which the lessee would be able to borrow funds required to purchase the property to be leased. The terms should be substantially similar for all the alternatives. The lessee may obtain information on the borrowing rate externally from financial intermediaries or develop it internally by computing the expected borrowing rate for similar term transactions. Initial Direct Costs SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated With Originating or Acquiring Loans and Initial Direct Costs of Leases, defines initial direct costs to include only the incremental costs incurred in negotiating transactions and costs incurred by the lessor for completed leases. SFAS No. 91 excludes advertising, promotional, administrative, and other indirect costs of leasing activities from the computation of initial direct costs. Lease Incentives Lease Term Examples of lease incentives are a lessor's direct payments to a lessee and a lessor's assumption of a lessee's costs or losses from an existing lease. The lease term includes the fixed non-cancelable term and periods covered by the following provisions where applicable: o Bargain renewal options Universal Weather and Aviation Page 11 of 15 1/11/2011

14 o Ordinary renewals during which the lessee's guarantee of the lessor's debt is directly or indirectly related to the leased property o Renewals assured by the existence of significant termination penalties (at the inception of the lease) o Ordinary renewals during periods preceding the date at which bargain renewal options are exercisable o Renewals at the option of the lessor SFAS No. 13 specifies that the lease term cannot extend beyond the date a bargain purchase option is exercisable. SFAS No. 98 amends the SFAS No. 13 definition of the lease term to include all renewal periods during which there will be a loan outstanding from the lessee to the lessor. Minimum Lease Payments MLPs constitute one of the most significant determinants of required accounting for leases. For the lessee, MLPs include the following: o The minimum rental payments specified over the lease term o Guarantees of residual value of leased property at the end of the lease term regardless of whether the guarantee constitutes a purchase of the leased property, since the guarantee make certain s that the lessee bears the risk of the changes in value of the leased property (If the lessee is required to purchase the leased property at the termination of the lease, the purchase price is regarded as the lessee guarantee. Finally, the lessee may be required to make up any deficiency in the residual value below a stated amount. In that case, the stated amount constitutes the guarantee that should be included in the MLPs.) o Payments required upon failure to renew or to extend leases at the expiration of the lease term regardless of whether the payments constitute a purchase of the leased property o Payments required under bargain purchase options MLPs exclude contingent rentals, lessee guarantees of lessor debt, and executory costs. This definition of MLPs should be used in computing present values and the implicit interest rate defined previously. The lessor's definition of MLPs includes all of the above factors plus any guarantees of minimum rental payments or residual values beyond the lease term by an unrelated third party, provided that the third party is financially capable of discharging the obligations under the guarantee. Universal Weather and Aviation Page 12 of 15 1/11/2011

15 Related Parties Lease SFAS No. 13 defines related parties in leasing transactions to include parent companies and their subsidiaries, joint ventures and partnerships, and investor companies and their investees. These relationships constitute related parties if the parent or investor exercises significant influence over the operating and financial policies of the investee. Significant influence may be implied through guarantees of indebtedness, extensions of credit, ownership of debt or equity securities, and common ownership or common boards of directors or officers. This definition is significant, since guarantees by third parties related to the lessee are considered lessee guarantees. A lease is an agreement conveying the right to use specific property, plant or equipment (land and/or depreciable assets) for a stated, fixed period of time. All new lease agreements must be reviewed by the Legal Department. Lease Renewal A lease renewal is a lease agreement which has been extended past its initial period or revised for whatever reason and mutually agreed to by both parties. It still requires the appropriate level of approval, but does not require Legal review unless terms and conditions have been modified or if the original lease had not been reviewed. 6.0 References Delegation of Authority No Capital Expenditures No Exhibits Exhibit 1 Accounting for Sale-Leasebacks Universal Weather and Aviation Page 13 of 15 1/11/2011

16 Exhibit 1 Accounting for Sale-Leasebacks Sale-leaseback transactions are the sales of property by the owner and a lease of the property back to the seller. SFAS No. 28 identifies three categories of leasebacks based on the percentage of present value to the fair value of the asset sold. SFAS No. 28 prescribes the accounting on the basis of the substance of the use of the asset after the sale. If the use of the asset continues after the sale, the saleleaseback is essentially a financing transaction and no profit or loss on the transaction should be recognized. Thus, the extent of the continuing use after sales is the critical factor in determining the accounting for the transaction. The extent of use is based on the present value of reasonable rentals as a proportion of the fair value of the asset sold and leased back. ( Reasonable rentals are defined with reference to the current property.) Minor Leasebacks o The accounting for sale-leasebacks is determined by the relationship between the present value of reasonable rentals and the fair value of the asset sold. If the present value is less than 10 percent of the fair value of the asset, the leaseback is considered minor. This criterion relates to the 90 percent of fair value recovery test in the classification of leases, and the leaseback is considered substantially equivalent to a sale of the property. The sale and leaseback should be treated as two separate transactions and any gain (loss) on the transaction must be recognized in full in the current accounting period. These procedures cannot be used if the lease rentals are not reasonable, and the gain (loss) should not be recognized in the current accounting period. Essentially, a proportionate amount of the gain (loss) must be deferred and amortized over the lease term in proportion to amortization of the leased property if the leaseback can be classified as a capital lease. If it is classified as an operating lease, the deferral is amortized in proportion to the rental payments. More than Minor but Less Than Substantially All o When the present value of rentals exceeds 10 percent but is less than 90 percent of the fair value of the asset sold, the sale-leaseback is accounted for as a single transaction. Universal Weather and Aviation Page 14 of 15 1/11/2011

17 o When the sale results in a profit and the leaseback meets the criteria for a capital lease, all or part of the gain must be deferred and amortized in proportion to the amortization of the leased property. The amount of the gain to be deferred is given by the carrying value of the property (the fair value of the property or the present value of the MLPs, whichever is lower). The excess gain must be recognized in the current accounting period. For operating leases, the gain to be deferred is the present value of the MLPs, and it should be amortized in proportion to the rental payments under the operating lease. Excess gains are recognized currently. o When the sale-leaseback results in a loss, a portion of the loss (fair value less the un-depreciated cost) must be recognized currently. The excess loss (selling price less fair value) is deferred. This excess loss is amortized in proportion to the amortization of leased property for capital leases and in proportion to rental payments for operating leases. Substantially All Leasebacks o A leaseback falls into this category when the present value of the MLPs is equal to or exceeds 90 percent of the fair value of the property sold. The entire gain (loss) must be deferred and amortized to income as described in the previous section. Universal Weather and Aviation Page 15 of 15 1/11/2011

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