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. 15.514 2003 Session 15 1The 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? 15.514 2003 Session 15 2Economic 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. 15.514 2003 Session 15 3Disadvantages 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. 15.514 2003 Session 15 4Economic 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?” 15.514 2003 Session 15 5Accounting 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 15.514 2003 Session 15 6Operating 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 15.514 2003 Session 15 7Accounting 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 15.514 2003 Session 15 8Operating 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) 15.514 2003 Session 15 9Accounting 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 15.514 2003 Session 15 10Capital 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 15.514 2003 Session 15 11Capital v Operating Lease: I/S Effects 7000 6000 5000 4000 $ 3000 2000 1000 0 1 2 3 4 5 6 7 interest expense + depr. expense (capital lease) rent expense (operating lease) 8 9 10 11 12 13 14 15 16 17 18 19 20 Year 15.514 2003 Session 15 12Capital v Operating Lease: B/S Effects Pattern annual of asset and liability values over time for capital lease: 35000 30000 25000 20000 $ 15000 10000 5000 Year 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 “S.E. effect” of treatment treatment. liability book value asset book value capital lease S.E. 8,298 lower under capital lease treatment in year 8 compared to operating lease 15.514 2003 Session 15 13Financial 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