Accounting for Leases

1
Accounting for Leases

• Items to be covered

• Introduction to leasing

• Accounting by lessees (the party who uses the
  asset
• and has an obligation to make lease payments)

• Accounting by lessors (the party who owns the
  asset and
• receives lease payments)

• Effects of leasing on financial ratios

2
Overview of Leasing

• Economic Substance of Leases

• The lessor grants the lessee the right to use
  the asset in exchange for a series of lease
  payments. The lessee expects that it will earn a
  return on the use of the asset that is greater
  than the cost of the lease.

• A Lease represents a contractual agreement
  between the party owning the asset who wants to
  earn a return on its investment (the Lessor)
  and the party desiring to use the asset (the
  Lessee)

• In many respects, this transaction is similar to
  a company purchasing an asset and financing the
  purchase with the issuance of a bond.

3
Examples of companies that utilize leasing to
acquire assets

• Delta Air Lines leases many of its airplanes

• The GAP leases most of its retail locations

• Federal Express leases a portion of its
  delivery trucks

Who does the leasing?

• Companies like General Electric Capital
  Services, a subsidiary of General Electric
  Company, which leases a broad range of equipment,
  Ryder System, Inc., the truck leasing company,
  real estate investment companies, and a large
  number of other companies.

4
Leasing Advantages

• May avoid obsolescence of assets.
• The lessee can lease a newer version of the
  asset when the lease term is completed and the
  lessee bears the risk of loss on sale of the asset

• Flexibility of contracting.
• Since a lease is a contractual agreement, it can
  contain any terms that meet the needs of both
  parties.

• Low or no down-payment preserves capital.
• Many leases are structured with less of a down
  payment than would be required if the lessee were
  to own the asset outright. The lessees funds
  are, thus, preserved for other business uses.

• Lessors borrowing rate may be less than
  lessees.
• If the lessee is small or a new business, its
  borrowing rate may be higher than the larger,
  more established, leasing company which can pass
  on the savings to the lessee.

• And probably most important ...

5
Off-Balance Sheet Financing

• If the lease is structured properly no asset
  and liability are recorded on the lessees
  balance sheet and the financing is off-balance
  sheet.

There are two main benefits that result

• Since the asset is not recorded, financial
  ratios like total asset turnover appear stronger
  and the lessee looks like it is managing its
  assets more effectively.

• Since the liability is not recorded, the
  debt-to-equity ratio appears stronger and the
  lessee looks less risky.

6
? However, if the lease arrangement is
essentially a disguised purchase of the asset.
such that substantially all risks and benefits of
ownership are transferred, under GAAP the leased
asset must be capitalized and obligation recorded
(just like a purchase)
? The transaction is, thus, on-balance sheet.
Both the asset and the liability are initially
recorded at the present value of the lease
payments.
7
Lets compare the two ways in which the same
lease could be accounted for
?

• No asset and liability are recorded on the
  lessees
• balance sheet

• Lease payments are reported as expense when paid.

• Both the leased asset and the lease liability are
• recorded on the lessees balance sheet

• Subsequently, depreciation expense is reported
• relating to the asset and interest expense is
  recorded
• on the liability.

8
How do we know whether to account for the lease
as operating or capital?

• GAAP outlines 4 criteria for capitalization

• Transfer of ownership test does the lease
  transfer ownership
• at termination?

• Bargain purchase option test does the lease
  contain a bargain
• purchase option?

• Economic life test is the lease term at least
  75 of the estimated
• economic life of the asset?

• Recovery of investment test is the present value
  of the minimum
• lease payments gt 90 of the fair value of the
  leased property?

• If any one or more of the above tests are met,
  the lease must be capitalized.

9
Transfer of Ownership Test

• Some leases are written such that title to the
  asset passes from the lessor to the lessee
  automatically at the termination of the lease.

• GAAP views this type of lease as essentially a
  purchase and required accounting for it as such,
  that is, by capitalizing the asset and lease
  liability.

10
Bargain Purchase Option Test

• In order to avoid the transfer of ownership
  test,
• leases were written with a provision that the
  lessee
• could acquire the leased asset for 1 or some
  other
• nominal amount at the maturity of the lease.

• The FASB closed that loophole by requiring
• capitalization if the purchase price is
  significantly
• lower than the assets expected fair market
  value
• so that exercise is reasonably assured.

• Note that when the lease is signed the parties
  must
• estimate the assets FMV to be realized when
  the lease
• term is finished.

11
Economic Life test

• The lease term used is generally the fixed,
• noncancellable term of the lease

• Many leases are written with options to
• extend the lease term when the lease is
• finished. If this option is at a low enough
  rate
• that reasonably assures extension of the
  lease
• at maturity, then the term should include the
• renewal period as well.

• Note that this requires the parties to estimate
• whether the lease renewal rate will assure
• extension at some point in the future.

12
Recovery of Investment Test

• This test is computed by comparing the present
  value of the minimum lease payments (including
  rental payments, a guaranteed residual value,
  renewal penalties, and any bargain purchase
  options) with the fair market value of the leased
  asset at the inception of the lease.
• Any executory costs (e.g., insurance, taxes,
  maintenance, etc.) that are included in the lease
  payment are not considered in determining the
  minimum lease payment. These are expensed as
  period costs when paid.
• The lessees incremental borrowing rate should
  be used as the discount rate.

13
Accounting for Leases - Lessee

• Record the leased asset and the lease liability
  at the present value of the lease payments or the
  fair market value of the leased asset, whichever
  is less.
• Use lessees incremental borrowing rate to
  discount unless the implicit interest rate in the
  lease is known and is less
• The leased asset is depreciated using the
  lessees normal depreciation method over the
  economic life of asset ( for criteria 1 and 2)
  or the lease term (criteria 3 and 4)
• The lease liability is amortized just like a
  bond, by the effective interest method

14
Accounting for Leases - Lessors

• Leases are classified as operating or capital
  just as they are for lessees. We use the same 4
  criteria for capitalization, with two exceptions
  
• Collectibility of the payments form the lessee is
  reasonably predictable
• The lessors performance under the lease is
  substantially complete (e.g., there are no
  uncertainties relating to future costs to be
  incurred by the lessor under the terms of the
  lease)
• If any of the 4 criteria relating to lessees are
  met AND both of the criteria relating to lessors
  are met, then the lessor must capitalize the
  lease on its books.

15
Accounting for Leases - Lessors

• How are lease payments determined?
• The lessor computes a payment that will yield a
  desired rate of return on fair value of
  its leased asset. Once we know the desired rate
  of return and the term of the lease, we use the
  present value of an annuity table to compute the
  payment amount, similar to the way we computed
  the present value of a bond.

Payment FMV leased asset PV
Factor
Chosen to provide a desired rate of return on the
leased asset (like a bond yield)
16
Accounting for Leases - Lessors

• Given the payment amount, the entry the
  lessor makes at the inception of the lease is as
  follows

? The lease payments receivable is equal to the
total payments to be received by the lessor
during the lease term, the leased asset is
credited for the price the lessor paid for it and
the difference between the receivable and the
asset cost is unearned income.
17
Accounting for Leases - Lessors

• Subsequently, the lessor records the collection
  of the lease payments as a reduction of the
  receivable and recognizes interest earned on the
  lease.

• Earned interest is computed using the
  effective
• interest method, just like we used to compute
  
• interest expense for bonds.

18
Lets take a look at a complete example for both
the lessee and the lessor.
Read the lease accounting example.
19
?In our previous example, had the lease qualified
for treatment as an operating lease, the lessee
would have made the following journal entries on
each of the 4 lease payment dates
? The lessee would, therefore, report rent
expense instead of interest and depreciation
expense we recorded for the capital lease. In
addition, the lessee would not have reported the
leased asset and the lease liability on its
balance sheet.
20
Over the life of the lease, the total expense
reported in the lessees income statement would
be the same under the two accounting methods. The
amount of lease related expense reported in each
accounting period, however, will be different
21

• In general, more expense is reported for capital
  leases in the early years of the lease life due
  to the increased interest expense.

• This fact, coupled with the desire to keep
  liabilities off of the balance sheet, provides an
  incentive for companies to structure leases with
  terms that will not require lease capitalization.

• Airlines are major users of leases for most of
  their airplanes. And, the majority of these
  leases are structured as operating leases. For
  example, look at Delta Air Lines

22
This is the property and equipment section form
Deltas 1998 Annual report
Notice that Delta reports 7.2 billion in net
book value for owned assets and 299 million in
net book value for leased aircraft.
23
(No Transcript)
24

• The lease footnote indicates that most of Deltas
  leases are accounted for as operating. Total
  lease payments classified as capital amount to
  400 million while total operating lease payments
  amount to 15.1 billion!

• Most of Deltas liability for the aircraft it
  uses is off-balance sheet.

25
If one were to compute Deltas debt-to-equity
ratio, for example, utilizing reported
liabilities would underestimate the degree of
financial leverage. There is a technique to
adjust for the operating lease treatment, however.
Read about this adjustment for operating lease
treatment in the handout.
26
The End