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1999 by Robert F. Halsey

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
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Overview of Leasing
Economic Substance of Leases
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)
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.
In many respects, this transaction is similar to a company
purchasing an asset and financing the purchase with the issuance
of a bond.
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Examples of companies that utilize leasing to acquire
assets:
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.
Who does the leasing?
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
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Leasing Advantages
May avoid obsolescence of assets.
CThe lessee can lease a newer version of the asset when the lease term is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.
CSince 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.
CMany leases are structured with less of a down payment than would be
required if the lessee were to own the asset outright. The lessees funds
are, thus, preserved for other business uses.

Lessors borrowing rate may be less than lessees.
CIf 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 ...
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Off-Balance Sheet Financing
CIf the lease is structured properly no asset and liability are
recorded on the lessees balance sheet and the financing is off-
balance sheet.
There are two main benefits that result:
C 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.
C Since the liability is not recorded, the debt-to-equity ratio
appears stronger and the lessee looks less risky.
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C 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):
C The transaction is, thus, on-balance sheet. Both the asset and
the liability are initially recorded at the present value of the
lease payments.
C 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
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Lets compare the two ways in which the same lease
could be accounted for:
Operating lease
g Capital lease
No asset and liability are recorded on the lessees
balance sheet
Lease payments are reported as expense when paid.
Both the leased asset and the lease liability are
recorded on the lessees balance sheet
Subsequently, depreciation expense is reported
relating to the asset and interest expense is recorded
on the liability.

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GAAP outlines 4 criteria for capitalization:
How do we know whether to account for the
lease as operating or capital?
C If any one or more of the above tests are met, the lease must be capitalized.
Recovery of investment test: is the present value of the minimum
lease payments > 90% of the fair value of the leased property?
Economic life test: is the lease term at least 75% of the estimated
economic life of the asset?
Bargain purchase option test: does the lease contain a bargain
purchase option?
Transfer of ownership test: does the lease transfer ownership
at termination?
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Transfer of Ownership Test
CGAAP 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.
CSome leases are written such that title to
the asset passes from the lessor to the
lessee automatically at the termination of
the lease.
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Bargain Purchase Option Test
4 Note that when the lease is signed the parties must
estimate the assets FMV to be realized when the lease
term is finished.
4 The FASB closed that loophole by requiring
capitalization if the purchase price is significantly
lower than the assets expected fair market value
so that exercise is reasonably assured.
4 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.
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Economic Life test
4 Note that this requires the parties to estimate
whether the lease renewal rate will assure
extension at some point in the future.
4 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.
4The lease term used is generally the fixed,
noncancellable term of the lease
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Recovery of Investment Test
C 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.
C 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.
C The lessees incremental borrowing rate should be
used as the discount rate.

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Accounting for Leases - Lessee
CRecord 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.
CUse lessees incremental borrowing rate to discount
unless the implicit interest rate in the lease is known and
is less
CThe leased asset is depreciated using the lessees normal
depreciation method over the economic life of asset ( for
criteria #1 and #2) or the lease term (criteria #3 and #4)
CThe lease liability is amortized just like a bond, by the
effective interest method
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Accounting for Leases - Lessors
CLeases 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 lessors 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)
CIf 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.

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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.

Chosen to provide a desired rate of return on the leased asset
(like a bond yield)
Payment = FMV leased asset
PV Factor
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Accounting for Leases - Lessors
Given the payment amount, the entry the lessor
makes at the inception of the lease is as follows:

C 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.
Lease payments receivable xxx
Leased asset xxx
Unearned income xxx
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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.
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Lets take a look at a complete example for
both the lessee and the lessor.
Read the lease accounting example.
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CIn 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:
C 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.
Rent expense 17,208
Cash 17,208
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Over the life of the lease, the total expense reported in
the lessees 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:
Year Interest
expense
Depreciation
expense
Total Rent
expense
1 0 15,000 15,000 17,208
2 4,279 15,000 19,279 17,208
3 2,986 15,000 17,986 17,208
4 1,567 15,000 16,567 17,208
Total 8,832 60,000 68,832 68,832
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CIn general, more expense is reported for capital leases
in the early years of the lease life due to the increased
interest expense.
CThis 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.
CAirlines 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:
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This is the property and equipment section form Deltas 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.
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Similarly, of the $5.1 billion in total long-term
liabilities on Deltas balance sheet, capitalized lease
obligations amount to only $249 million.
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CThe lease footnote
indicates that most of
Deltas 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!
CMost of Deltas liability
for the aircraft it uses is
off-balance sheet.
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If one were to compute Deltas 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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The End