Leases
RCJ Chapter 12
Key Issues
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Lessee vs. lessor
Operating vs. capital leases
Capital lease criteria
Effective interest method
Sale and leaseback
Executory costs
I/S, B/S, and SCF effects
Footnote disclosures
Correcting financial statements
Annuities
Lessor: Direct Financing vs Sales Type Lease
Synthetic leases
Paul Zarowin
2
Key Terms
Lessee: borrower, user (of asset)
Lessor: lender, owner
Operating vs. capital lease
Operating lease:


usually short-term and allow the lessee to use the leased
property for only a portion of its economic life.
the economic equivalent of a rent transaction.
Capital lease:


Longer-term leases that effectively transfer all the risks and
rewards of the leased property to the lessee (sale transaction).
the economic equivalent of sales with financing arrangements the lessee buys the asset using a loan provided by lessor.
Paul Zarowin
3
Operating Lease
 Cash basis
 No B/S recognition of lease asset or lease liability
 It is a form of off-B/S financing
 Companies prefer operating leases over capital leases – see
table 12.4, page 586.
Lessee: DR expense
CR cash
Lessor: DR cash
CR revenue
Paul Zarowin
4
Lease Criteria - Lessee
If one of the following 4 conditions is met, lessee is required to
use capital lease accounting (Type I criteria - see RCJ pg. 578):
1. The lease transfers ownership of the asset to the lessee
by the end of the lease term.
2. The lease contains a bargain purchase option.
3. The noncancelable lease term is 75 percent or more of
the estimated economic life of the leased asset.
4. The present value of minimum lease payments equals or
exceeds 90 percent of the fair value of the leased asset.
(This is also referred to as the recovery of investment
criterion).
key point: is the lease really a sale?
Paul Zarowin
5
Lease Criteria - Lessor
Is this a capital lease?
(1) Is it a sale? – type I criteria; and
(2) earned and collectable? – type II criteria (see RCJ, page 590)
no
yes
Capital lease
like an installment sale with
interest – the leased asset is
removed from lessor’s B/S
Operating lease
like a ‘Rent’ deal - the leased asset
stays on the lessor’s B/S
Paul Zarowin
6
Capital Lease Example
5 year lease; $1,000 per year (in arrears); r = 10%;
PV = 3.79079 x 1000 = 3791
Lessee
Inception:
DR Leased asset
CR Lease liability
Lessor
3791
3791
period 1:
DR Int. exp(10% x 3791) 379
DR Lease liability (plug) 621
CR Cash
1000
DR Lease payments receivable
5000
CR leased asset
3791
CR Unearned interest revenue
1209
DR Unearned interest revenue 379
CR Interest revenue
379
total cash = int. exp+repayment of capital lease
DR dep. exp. (3791÷5) 758
CR Leased asset
758
DR Cash
1000
CR Lease payments receivable 1000
Note: entries in italics are the same each period
7
Example (cont’d)
Lessee
period 2:
DR Int. exp(10%x3170) 317
DR Lease liability (plug) 683
CR Cash
1000
DR dep. exp. (3791÷5) 758
CR Leased asset
758
Lessor
DR Unearned interest revenue
CR Interest revenue
317
317
DR
Cash
1000
CR Lease payments receivable 1000
period 3:
DR Int. exp(10%x2487) 249
DR Lease liability (plug) 751
CR Cash
1000
DR Unearned interest revenue
CR Interest revenue
DR dep. exp. (3791÷5) 758
CR Leased asset
758
DR
Cash
1000
CR Lease payments receivable 1000
Paul Zarowin
249
249
8
Example (cont’d)
Lessee
period 4:
DR Int. exp(10%x1736) 174
DR Lease liability (plug) 826
CR Cash
1000
DR dep. exp. (3791÷5) 758
CR Leased asset
758
period 5:
DR Int. exp(10%x910) 91
DR Lease liability (plug) 909
CR Cash
1000
DR dep. exp. (3791÷5) 758
CR Leased asset
758
Lessor
DR Unearned interest revenue
CR Interest revenue
174
174
DR
Cash
1000
CR Lease payments receivable 1000
DR Unearned interest revenue
CR Interest revenue
91
91
DR
Cash
1000
CR Lease payments receivable 1000
Paul Zarowin
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Example (cont’d):
T accounts = summary of JE’s
Lessee’s lease liability T-account
DR
Inception
je per 1
Lessor’s asset t-account, net*
DR
CR
Inception
5000
1209
je per 1
3791
379
1000
je per 2
3170
317
1000
je per 3
2487
249
1000
je per 4
1736
174
1000
je per 5
910
91
1000
CR
3791
621
3170
je per 2
683
2487
je per 3
751
1736
je per 4
826
910
je per 5
end of lease
910
0
Ex. E12-2 Ordinary Annuity, E12-4 Annuity Due
end of lease
0
10
* Net = lease payments receivable minus unearned interest revenue.
Annuities
Ordinary annuity (annuity in arrears):
payments @ end of period  initial payment is principal + interest
DR lease liability
DR Interest expense
CR
Cash
Annuity due:
payments @ beginning of period  initial payment is principal (no interest)
DR lease liability
CR
Cash
Ex. P12-3, P12-4
Paul Zarowin
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Sale-Leaseback
(RCJ pg. 597-598)
buyer = lessor
seller=lessee
Means of financing for lessee
DR Cash
DR Accum. Dep.
DR Loss
CR Asset-old (at cost)
or
CR Gain
Gain  unearned profit on sale-leaseback (liability)
Amortize liability into income:
DR unearned profit
CR Depreciation expense
Losses on sale are recognized immediately
Ex. E12-13
12
Executory Costs
(RCJ pgs. 581)
Period costs; an expense when paid, and not
part of the capitalized lease obligation.
Ex. E12-12
Paul Zarowin
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Footnote Disclosures by Lessee
 5 individual years minimum lease payments
(excluding executory costs)
 sum of lease payments for all years thereafter
 separately for capital and operating leases
 capital leases: total lease payments break
down into liability (current and non-current) +
interest
 Analogous disclosures must be made by lessors
Paul Zarowin
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Footnote Disclosures by Lessee (cont’d)

Capital leases
DR
DR
Interest expense
Lease liab
CR
Cash
plug
given, current liability
given, next year’s payment
r% = interest expense /total PV of lease liability
Paul Zarowin
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Capitalization of Operating Leases
(Correction JE)
Use r% and payment information to capitalize operating leases
DR lease assets
CR
lease liab
(Re)compute current ratio, debt/equity, ROA, etc.
Notes:
1. Must adjust NI too (interest expense + depreciation vs. rent
expense) but, major differences are on the B/S
2. More precise correction would be (since liab > assets):
DR Lease assets
DR R/E
CR Lease liab
Paul Zarowin
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Example: Delta Airline 2001 report
1. Estimate future lease payment
 The disclosure provides the lease payments for the first 5 years,
and the aggregate of lease payments after 2006.
Year ending December 31,
(in millions)
Capital
leases
Operating Lease
payments
2002
39
1271
2003
30
1238
2004
21
1197
2005
14
1177
2006
6
1144
After 2006
10
8068
Total minimum lease payments
120
14,095
Less: interest payments
21
PV of minimum capital lease payments
99
Less: Current obligations under capital leases
31
Long term capital lease obligations
68
17


To estimate the year by year lease payment after 2007 assume
that the lease payments will be approximately the same as in
2006
Payments after 2007 8068

 7.05  7
2006 payments
1044
Therefore for 7 year after 2006 the lease payments are:
Year
Operating lease payments
2002
1271
2003
1238
2004
1197
2005
1177
2006
1144
2007
1153
2008
1153
2009
1153
2010
1153
2011
1153
2012
1153
2013
1153
8086
 1153
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2. Select a discount factor:

The discount rate for Delta is 8% based on the:
 Capital lease disclosure

Long-term debt disclosure
3. Calculating the present value of lease payments:
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Present
Operating
value
lease
factor at
payments
8%
1271
0.925926
1238
0.857339
1197
0.793832
1177
0.73503
1144
0.680583
1153
0.63017
1153
0.58349
1153
0.540269
1153
0.500249
1153
0.463193
1153
0.428883
1153
0.397114
PV of
payment
1177
1061
950
865
779
726
673
623
577
534
494
458
8916
4. Record the lease asset and obligation
(assuming leased assets = lease obligation)
DR Leased aircraft—capital leases $8,916
CR
Obligation under capital leases
C12-1,2
$8,916
Delta Airline Example: Effect on Debt Ratios

Before the adjustment:

Liabilities: $18,752 million
Debt to Equity 

Debt
7,781

 2.06
Equity 3,769
After the adjustment:

Liabilities: 18,752 + 8,916 = $27,668 million  increase 48%
Debt  lease adj. 7,781  8,916
Debt to Equity 

 4.43
Equity
3,769
Ex. 12-15
P. 12-8
Paul Zarowin
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Change in D/E Ratio During Life of Lease


Capitalization-based D/E  at inception.
Then it becomes even higher. Why?
Annuity in arrears
NBV
Annuity due
NBV
L
L
A
A
Time
Time
Paul Zarowin
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I/S Effects
(ex. is ordinary annuity)
Capital
Operating
interest + dep=n = total
Rent
Diff
CumDiff(R/E)
yr 1
379
758
1137
1000
137
137
yr 2
317
758
1075
1000
75
212
yr 3
249
758
1007
1000
7
219
yr 4
174
758
932
1000
(68)
151
yr 5
91
758
849
1000 (151)
0
total 1210
3790
5000
5000
0
0
 operating lease expense is the periodic cash (rental) payment
 capital lease expense is depreciation + interest
  rent =  [depreciation + interest])
 
Cash =
principal +  interest
key point: timing differs
early years: rent < dep’n + interest
later years: rent > dep’n +interest
23
SCF Effects

Cash payment independent of the lease type

Operating lease: all cash outflow is from CFO


Capital lease: interest expense is from CFO;
repayment of capital is CFF
CFO is higher for a capital lease than for an operating
lease. The difference is greatest in the later years of a
lease, when most of the cash payment is repayment of
capital
E12-14
Paul Zarowin
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Lessor:
Direct Financing vs. Sales Type Leases
Is this a capital lease?
(1) Is it a sale? – type I criteria; and
(2) earned and collectable? – type II criteria (see RCJ, page 591)
no
yes
Capital lease
Operating lease
‘Sale’ deal – the leased asset
is removed from lessor’s B/S
Direct
financing
lease
‘Rent’ deal - the leased asset stays
on the lessor’s B/S
Determines how the sale
will be recorded on the
I/S
Sales
type
lease
Paul Zarowin
25
I/S Effect
Total I/S effect = profit on sale + interest revenue

Why?
Up front
Over life of lease
(PV - CGS)  (CF' s - PV)  CF' s - CGS

Relate to Xerox: switch relative portion, even if CF’s
and CGS stay the same.
Ex. E12-2, E12-6,7,8, P12-12, P12-14 (ignore RV)
Paul Zarowin
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Direct Financing vs. Sales Type Leases (cont’d)

Direct financing lease:


lessor’s only I/S effect is interest revenue (above example)
Sales type lease:


lessor recognizes profit on sale + interest revenue (RCJ pgs
589-590)
PV of payments (= sale price of asset) > lessor’s CGS
Note: no difference for lessee; only for lessor
Lessor’s only difference is at inception; periodic entries unaffected
DR Lease payments receivable - gross
CR
Unearned interest revenue - plug
CR
Sales revenue (PV)
DR CGS
CR
Inventory
27
Synthetic Leases

A synthetic lease is created when an SPE buys an asset
on behalf of the company (or sometimes from the
company itself) and leases this asset (back) to the
company.
Can contributes
only 3% of
capital
Capital
contribution of
up to 97%
Independent
SPE
Investor
Asset
Operating
lease
Company
Capital
lease
28
Synthetic Leases (cont’d)



The company records the synthetic lease as an
operating lease; if it had leased the asset directly and
not through a SPE it would have recorded it as a
capital lease.
The operating lease treatment is preferred by
companies because it allows them to keep the lease
obligation off-balance-sheet.
There are also tax motives to use a synthetic lease (if
you are interested see RCJ page 660).
Paul Zarowin
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