Problem:
Electronic Arts develops. Markets, publishes, and distributes interactive software games. An abridged “less commitments” footnote from the company’s 2002 annual report reads:
“In 2001, we renewed the lease on our headquarters facility in Redwood City, California and account for this arrangement as an operating lease. We have an option to purchase the property (land and facilities) for $145.0 million or, at the end of the lease in 2006, to arrange for (1) an additional extension of the lease or (2) sale of the property to at third party. In December 2000, we entered into a second lease for a five-year term to expand our Redwood Shores, California headquarters facilities and develop adjacent property. We also accounted for this arrangement as an operating lease and have an option to purchase this property for $127.0 million.”
Operating leases are “off-balanced-sheet” obligations, meaning that GAAP does not include the debt among the liabilities shown on a company’s balance sheet. Operating lease obligations are only disclosed in the financial statement footnotes. Capital leases, on the other hand, are included among balance sheet liabilities. This liabilities increase if offset by a corresponding increase to a balance sheet assets representing the leased property or equipment.
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Electronic Arts
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Selected financial data($ in thousands)
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2002
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NOPAT
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$110,374
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Average assets
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1,539,146
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Long-term debt
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0
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ROA (NOPAT/Average assets)
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7.17%
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Required to do:
1. Suppose Electronic Arts had entered into a capital lease rather than an operating lease. Describe in qualitative terms how this change would alter the company’s balance sheet.
2. Describe in qualitative terms what impact a capital lease would have on the company’s ROA and Long-term debt to assets ratios.
3. Would the change in these ratios, if any, be favorable from management’s perspective? Why or why not?