1_____________________________________________________ Accounting for Leases 15.501/516 Accounting Spring 2004 Professor S. Roychowdhury Sloan School of Management Massachusetts Institute of Technology April 7, 2004 2 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 lessee’s perspective. 3 The Nature of Leases • A l i ii i ic • lLease Rent Purchase  iasset?  i li i i lied? jease 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 periodcash 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? Page 1Economic 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. 4 Economic Rationale for Leases  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 can be tax advantageous when the lessee is unable to take the depreciation tax advantage of owning. 5 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. 6 Page 2________________________________________________ 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 8 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 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 9 Page 3Page 4 10 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 11 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 12 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--Lessee’s Books Example irlines.Assume GE Capital leases an airplane to Delta A Assume the An Example Delta transactions if treated as an capital leaseLease 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