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Accounting for Leases
15.501/516 Accounting
Spring 2004
Professor S. Roychowdhury
Sloan School of Management
Massachusetts Institute of Technology
April 7, 2004
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Agenda

Understand the rationale for leasing and

the distinction between operating and
capital leases.
Understand the Income Statement and
Balance Sheet differences between
operating and capital leases from the
lessees perspective.
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The Nature of Leases
A l i i
i i ic
l
Lease
Rent Purchase
i
asset?
i li
i
i lied? j
ease s an agreement conveying the r ght to use property, plant, or
equipment, usually for a stated per od of t me, in exchange for period
cash payments.
The owner of the property is referred to as the essor, and the renter is
the lessee.
What is the economic rat onale for leasing rather than purchasing an
What is the economic rat onale for capita zing a lease?
What are the account ng criteria for capitalizing a lease?
How object vely can each lease criterion be app What udgment
enters into each assessment?
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Economic Rationale for Leases
Operational advantages to the lessee:
Leasing ready-to-use equipment can be more attractive if the
asset requires lengthy preparation and set-up.
Leasing avoids having to own the asset that will be required
only seasonally, temporarily or sporadically (leasing contract
can be tailored).
Lessor might be better positioned to lease the equipment again.
Leasing for short periods protects against obsolescence.
But lease payments are accordingly higher.
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Economic Rationale for Leases
Financial advantages to the lessee:
Lease payments can be tailored to suit the lessees cash
flows (up to 100% financing, instead of the 80% limit by
banks).
Properly structured leases may be off-balance sheet,
avoiding debt-covenant restrictions.
Leasing can be tax advantageous when the lessee is unable
to take the depreciation tax advantage of owning.
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Disadvantages to Leasing
Disadvantages to the lessee:
Leased ready-to-use equipment may be of lower quality than
custom built (resulting in lower quality products and lower
sales)
High quality eq. might be unavailable for leasing
Seasonal leasing may affect equipment availability and
pricing.
Premium must be paid for the protection against
obsolescence.
Disadvantages to financial statement users:
Off-balance sheet financing can hide the true leverage of the
firm.
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Economic substance of leases
Lease
Rent Purchase
Operating lease
Lessee rents the property.
Lessee accrues rent expense.
Capital lease
lessee economically owns the property.
Lessee records the leased asset in the balance sheet
(i.e. capitalizes the asset) and reflects the corresponding
lease obligation. 7
Accounting criteria for lease
capitalization
A lease is considered a capital lease if ANY of the
following conditions apply (SFAS 13):
1. Transfer of ownership at the end of lease term
2. Existence of a bargain purchase option (BPO) -
payment below market value after the lease term
3. Minimum present value of lease payments (including
BPO, if any) at least 90% of asset's market value
4. Lease term is 75% of assets remaining useful life
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Accounting for operating leases--
Lessees Books
An operating lease is recorded as a rental of an asset in
the financial statements.
When the lease agreement is signed and lessee begins
using the asset:
A = L + SE
No entry
During the lease (as payments are made):
Cash = L + Retained Earnings
(PP) = (PP), as rent expense
PP = Periodic lease payment
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A capital lease is recorded as an asset acquisition with a 100% debt
financing in the financial statements.
When the lease agreement is signed and lessee begins using the asset:
Leased Property = Lease Obligation
PVL PVL
During the lease (as payments are made)
Cash + Leased Property -Acc. Depr. = Lease Obligation + RE
-PP - (PP- Int. expense) -Int. expense
-Depr. -Depr. Expense
PVL =Present Value of Lease = (PVA, n, r%) * PP
PP = Periodic lease payment
Int. expense = beginning lease liability * r%, where
beginning lease liability = present value of remaining payments at r%
Depr. Expense = depreciation expense
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Operating and Capital Leases: An
airplane has a current cost of $30,000 K, an expected life of 20 years and
zero salvage value. Assume Delta has borrowing rate of 16%.
Delta transactions if treated as an operating lease:
When the lease agreement is signed and lessee begins using the asset:
A = L + SE
No entry
During the lease (as payments are made):
Cash = Retained Earnings
Y1 -5060 -5060 Rent expense
Y2 -5060 -5060 Rent expense
Y3 -5060 -5060 Rent expense
Y20 -5060 -5060 Rent expense
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Operating and Capital Leases:
When the lease agreement is signed and lessee begins using the asset:
Leased Property = Lease Obligation
30,000 30,000
During the lease (as payments are made):
Cash -Acc Depr. = Lease Obligation + Retained Earnings
Y1 -5060 -260 - 4800 Int. Exp.
-1500 - 1500 Depr. Exp.
[ Depr = (30,000-0)/20 ] [ Decrease in LO = 5060-4800 ] [ Int = 30,000*0.16 ]
Y2 -5060 -302 - 4758 Int. Exp.
-1500 -1500 Depr. Exp.
[ Depr = (30,000-0)/20 ] [ Decrease in LO = 5060-4758 ] [ Int = (30,000-260)*0.16 ]
Y3 -5060 -350 - 4710 Int exp
-1500 -1500 Depr. Exp
[ Depr = (30,000-0)/20 ] [ Decrease in LO = 5060-4710 ] [ Int = (30,000-260-302)*0.16 ]
Accounting for capital leases--
Lessees Books
Example
irlines. Assume GE Capital leases an airplane to Delta A Assume the
An Example
Delta transactions if treated as an capital lease
Lease Obligation
Calculation Worksheet
Yr
Interest
Expense
Lease
Pmt
End of
Yr Oblig Yr
Interest
Expense
Lease
Pmt
End of
Yr Oblig
0 30,000 10 24,456
1 4,800 5,060 29,740 11 3,913 5,060 23,309
2 4,758 5,060 29,438 12 3,730 5,060 21,979
3 4,710 5,060 29,089 13 3,517 5,060 20,436
4 4,654 5,060 28,683 14 3,270 5,060 18,645
5 4,589 5,060 28,212 15 2,983 5,060 16,569
6 4,514 5,060 27,666 16 2,651 5,060 14,159
7 4,427 5,060 27,032 17 2,266 5,060 11,365
8 4,325 5,060 26,298 18 1,818 5,060 8,123
9 4,208 5,060 25,445 19 1,300 5,060 4,363
10 4,071 5,060 24,456 20 698 5,060 1
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0
1 2 3 4 5 6 7 8 9
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Capital vs. Operating Lease:
Income Statement Effects
1000
2000
3000
4000
5000
6000
7000
10 11 12 13 14 15 16 17 18 19 20
Interest expense +
depreciation expense
(capital lease)
Rent expense
(operat ng lease)
Capital vs. Operating Lease:
0
Balance Sheet Effects
5000
10000
15000
20000
25000
30000
35000
Lease Obligation
(capital lease)
Leased Asset
(capital lease)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
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----------------------------------- ----------- ----------
Financial Statement Disclosures
Assume this is Deltas only lease and they use capital lease treatment. How
would their lease footnote look at the end of year 8?
Years Ending
Y9
Y10
Y11
Y12
Y13
Y14 and after
Total minimum lease payments
Less: amounts representing interest
Capital Leases
5,060
5,060
5,060
5,060
5,060
35,420 = 5,060 x 7
60,720
34,422 = 60,720 - 26,298 (below)
Present value of future minimum
capital lease payments 26,298 = 5060 x (PVA,12yr,16%)
Less: current obligations under capital leases 852
Long-term capital lease obligations 25,446 = 26,298 - 852
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Actual lease disclosures -- Delta
LEASE OBLIGATIONS (Footnote)
Years Ending June 30, Capital Operating
(In Millions) Leases Leases
2001
2002
2003
2004
2005
After 2005
Total minimum lease payments
Less: Amounts of lease payments that
represent interest
Present value of future minimum
capital lease payments
Less: Current obligations under
capital leases
Long-term capital lease obligations
$ 57 $ 1,200
57 1,200
48 1,170
32 1,120
17 1,110
23 9,060
234 $14,860
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190
43
$147
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Financial disclosures -- Target
Future Minimum Lease Payments
(millions) Operating Leases Capital Leases
2000 $ 113 $ 22
2001 105 21
2002 96 21
2003 80 19
2004 70 18
After 2004 634 124
Total future minimum lease payments $ 1,098 $ 225
Less: interest* (302) (90)
Present value of minimum lease payments $ 796 $ 135 **
*Calculated using the interest rate at inception for each lease (the weighted
average interest rate was 8.8 percent). RARELY provided in the footnotes.
** Includes current portion of $10 million.
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Courtesy of U.S. Securities and Exchange Commission. Used with permission.
Courtesy of U.S. Securities and Exchange Commission. Used with permission.
Financial statement
disclosures-- Target
Based on information in the lease footnote, what value does Target
show for lease liability on its Balance sheet?
$135 million = PV of lease pmts on capital leases, $125 million under
Long-Term Obligations, $10 million under Current Liabilities
The footnote says Targets borrowing rate is 8.8 percent. Could this
amount be independently computed?
Capital lease oblig
t
r = interest expense
t+1
Capital lease oblig
t
r = LP
t+1
principle reduction
t+1
r = (22 10) / 135 = 12/135 = 8.89%
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Financial statement
disclosures-- Target
Why might a user wish to know the effect on Targets
balance sheet and income statement of capitalizing the
leases mentioned in this note?
To determine the effect of off-balance sheet financing
How could a user derive an estimate of the reporting
effects of capitalizing leases?
By treating all operating leases as capital leases.
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Leasing and Debt Covenants
Example
Borrower agrees that it will not create, incur, assume or
suffer to exist any Lien, encumbrance, or charge of any
kind (including any lease required to be capitalized under
GAAP) upon any of its properties and/or assets other than
Permitted Liens.
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Off Balance Sheet Financing
What is the definition of liabilities in GAAP?
Probable future sacrifices of resources
Little or no discretion to avoid the sacrifice
Transaction or event giving rise to the obligation has occurred
Classification on a continuum
Examples:
Operating leases
Contingencies, i.e., lawsuits.
Motivation for off balance sheet financing?
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