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 25 2 2 25 2 1 1 1 1 25

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. 25 2 25 2 2 1 2 2 1 25

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.

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 lessee’s funds are, thus, preserved for other business uses. Lessor’s borrowing rate may be less than lessee’s. 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 ... 25 2 2 25 2 2 2 1 1 25

“Off-Balance Sheet Financing” If the lease is structured “properly” no asset and liability are recorded on the lessee’s 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. 25 2 25 2 2 1 2 2 1 25

 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”):  This is called a “capital lease” (versus an “operating lease”) and the lessee must make the following journal entry at the inception of the lease: Leased Asset xxx Lease Obligation xxx  The transaction is, thus, on-balance sheet. Both the asset and the liability are initially recorded at the present value of the lease payments.

Let’s compare the two ways in which the same lease could be accounted for:  Operating lease  Capital lease  No asset and liability are recorded on the lessee’s balance sheet Lease payments are reported as expense when paid. Both the leased asset and the lease liability are recorded on the lessee’s balance sheet Subsequently, depreciation expense is reported relating to the asset and interest expense is recorded on the liability.

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 > 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. 25 2 2 25 2 2 2 1 1 25

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.

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 asset’s expected fair market value so that exercise is reasonably assured. Note that when the lease is signed the parties must estimate the asset’s FMV to be realized when the lease term is finished.

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. 2 25 2 25 2 1 2 2 1 25

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 lessee’s incremental borrowing rate should be used as the discount rate. 2 25 2 2 25 1 2 2 1 25

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 lessee’s 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 lessee’s 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 2 25 2 2 25 1 2 2 1 25

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 lessor’s 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. 2 25 2 2 25 1 2 2 1 25

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) 2 25 2 25 2 1 2 2 1 25

Accounting for Leases - Lessors Given the payment amount, the entry the lessor makes at the inception of the lease is as follows: Lease payments receivable xxx Leased asset xxx Unearned income xxx  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.

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.

Let’s take a look at a complete example for both the lessee and the lessor. Read the lease accounting example.

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: Rent expense 17,208 Cash 17,208  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.

Over the life of the lease, the total expense reported in the lessee’s 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:

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:

This is the property and equipment section form Delta’s 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.

Similarly, of the $5.1 billion in total long-term liabilities on Delta’s balance sheet, capitalized lease obligations amount to only $249 million.

The lease footnote indicates that most of Delta’s 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 Delta’s liability for the aircraft it uses is off-balance sheet.

If one were to compute Delta’s 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.

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