Leases

Objectives

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 lessee’s perspective.

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 The Nature of Leases
A lease is an agreement conveying the right to use property, plant, or equipment
usually for a stated period of time.

The owner of the property is referred to as the lessor, and the renter is the lessee.

Lease
______________________________________________________
Rent Purchase

What is the economic rationale for leasing rather than purchasing an asset?
What is the economic rationale for capitalizing a lease?
What is the accounting criteria for capitalizing a lease?
How objectively can each lease criterion be applied? What judgement enters into
each assessment?
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 Economic Rationale for Leases
Operational advantages to the lessee:
Leasing ready-to-use equipment may 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 for short periods provides protection against obsolescence.

Financial advantages to the lessee:

Lease payments can be tailored to suit the lessee's 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 provides tax advantages from accelerated depreciation and
interest expense.

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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.
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 hides 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 essentially owns the property. Lessee records the
leased asset in the balance sheet (i.e. capitalized) together with the
corresponding lease obligation.

Where do we draw the line between renting and “essential ownership?”

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 Accounting criteria for lease capitalization
A lease is considered a capital lease if ANY of the following
conditions apply (SFAS 13):

1. Essential transfer of ownership at the end of lease term

• No payment for leased asset, or
• Bargain purchase option (BPO) - payment below market value after
the lease term

2. Minimum present value of lease payments (including BPO, if any)

at least 90% of asset's market value

3. Lease term is 75% of assets remaining useful life

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 Operating and Capital Leases: An Example

GE Capital leases an airplane to Delta Airlines.

Assume 1) The airplane has a current cost of $30,000,000

2) The expected life equals the lease term of 20 years
3) The salvage value at the end of 20 years is $0
4) Delta’s borrowing rate is 16%

What payment would GE Capital require from Delta at the end of each year?
Lease Payment = $30,000,000 / (Annuity Factor, 20 periods, 16%)

= $30,000,000 / 5.9288 1-(1+r)-n

r
= $5,060,000 per year

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 Accounting for operating leases--Lessee’s Books
An operating lease is recorded as a rental of an asset in the financial statements.

When the lease aggreement is signed and lessee begins using the asset:
A = L + E
No entry

During the lease (as payments are made):

Cash Retained Earnings
(PP) (PP) (rent exp)

PP = periodic lease payment

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 Operating Leases: An Example
Delta transactions

If treated as an operating lease

When the lease aggreement is signed and lessee begins using the asset:
A = L + E
No entry

During the lease (as payments are made):

Cash Retained Earnings
Y1 (5060) (5060) (rent exp)
Y2 (5060) (5060) (rent exp)
Y3 (5060) (5060) (rent exp)

Y20 (5060) (5060) (rent exp)

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 Accounting for capital leases--Lessee’s Books
A capital lease is recorded as an acquisition an asset with a 100% debt financing in the
financial statements.

When the lease aggreement is signed and lessee begins using the asset:
Leased Property Lease Obligation
PVL PVL

During the lease (as payments are made)

Cash -Acc. Depr. Lease Obligation Retained Earnings
(PP) (PP - Int) (Int) (int. exp.)
Depr (Depr) (dep. exp.)

PVL = present value of periodic lease payments = (PV of ordinary annuity, n payments, r %) * PP
PP = periodic lease payment
Int = beginning lease liability * r%,
beginning lease liability = present value of remaining payments at r%
Depr = depreciation expense

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 Capital Leases: An Example
Delta transactions:
If treated as an capital lease
When the lease aggreement is signed and lessee begins using the asset:
Leased Property(A) Lease Obligation(L)
30,000 30,000
During the lease (as payments are made):
Cash(A) Leased Property(A) -Acc Depr.(A) Lease Obligation(L) Retained Earnings(SE)
Y1

EBY1
Y2

EBY2
Y3

EBY3

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 Capital v Operating Lease: I/S Effects

interest expense + depr. expense

7000
(capital lease)
6000

5000

4000
rent expense
$ (operating lease)
3000

2000

1000

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Year
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 Capital v Operating Lease: B/S Effects

Pattern annual of asset and liability values over time for capital lease:
35000
liability book value S.E. 8,298 lower under
30000 capital lease treatment
in year 8 compared to
25000 operating lease
treatment.
20000
$ “S.E. effect” of
15000 capital lease
treatment
10000 asset book value

5000

Year
0
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 Delta’s only lease and they use capital lease treatment. How would
their lease footnote look at the end of year 8?
Years Ending Capital Leases
Y9 5,060
Y10 5,060
Y11 5,060
Y12 5,060
Y13 5,060
Y14 and after 35,420 (5,060 x 7)
Total minimum lease payments 60,720
Less: amounts representing interest 34,422 (60,720 - 26,298 (below))
Present value of future minimum
capital lease payments 26,298 (5060 x (PVA,12,16%)
Less: current obligations under capital leases 852
Long-term capital lease obligations 25,446 (26,298 - 852)

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 Financial statement 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).
** Includes current portion of $10 million.

This information is rarely

given in the footnote.
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 Financial statement disclosures-- Target
Based on information in the lease footnote, what value does Target show for lease
liability on its Balance sheet?

The footnote says Target’s borrowing rate is 8.8 percent. Could this amount be
independently computed?

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 Financial statement disclosures-- Target
Why might a user wish to know the effect on Target’s balance sheet and income
statement of capitalizing the leases mentioned in this note?
How could a user derive an estimate of the reporting effects of capitalizing
leases?
What financial statement ratios are affected by the lease classification?

Assume that the difference between the future minimum payments after 2004
will be $70M per year for 9 years. In addition, assume that Target’s borrowing
rate is 9.0% and that payments occur at the end of each year.
Year Future payment 9% PV(A) factor Beg.2000 value
2000 $ 113 0.91743 $ 103.67
2001 105 0.84168 88.38
2002 96 0.77218 74.13
2003 80 0.70843 56.67
2004 70 0.64993 45.50
2005-2013 70/year 0.64993x5.99525 272.75
641.10
Note that this amount is smaller than the 796 computed by
Target. The 796 assumes that all payments after 2004 occur in
2005 and that all payments are made in the middle of the year.
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 Analysis of Target Disclosures
How are financial statements of Target affected if the operating leases were
instead classified as capital leases?
If the additional liability is resulting from the capitalization of operating leases is
$641, what is the book value of the associated operating leased asset? Something
less than $641.

What financial ratios are affected?

Target’s total liabilities and total equity at 2000 were $11,461 and $5,967.
Debt-to-equity ratio = 11,461/5,967 . 1.92
Debt-to-equity ratio after
capitalization of operating leases = (11,461 + 641)/(5,967 + 449 - 641)
. 2.10

Assuming the BV asset = 70% of BV liab.

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 Leasing and Debt Covenants

TCBY

[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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