Lease accounting


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Lease accounting

  1. 1. Lease Presentation
  2. 2. • The lease is a contractual agreement between the lessor and the lessee. • The lease gives the lessee the right to use specific property. • The lease specifies the duration of the lease and rental payments. • The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee. Leasing: BasicsLeasing: Basics
  3. 3. • The lessee, who uses the asset and makes the lease, or rental, payments. • The lessor, who owns the asset and receives the rental payments. • Note that the lease decision is a financing decision for the lessee and an investment decision for the lessor. Parties to a Lease Transaction
  4. 4. Sale and Lease-Back • A particular type of financial lease. • Occurs when a company sells an asset it already owns to another firm and immediately leases it from them. • Two sets of cash flows occur: – The lessee receives cash today from the sale. – The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.
  5. 5. Leveraged Leases • A leveraged lease is another type of financial lease. • A three-sided arrangement between the lessee, the lessor, and lenders. – The lessor owns the asset and for a fee allows the lessee to use the asset. – The lessor borrows to partially finance the asset. – The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.
  6. 6. 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.
  7. 7. In Short • A lease is a contact between the owner of an asset (the lessor) and the party desiring to use that asset (the lessee). • Generally, leases provide for the following terms: 1. The lessor allows the lessee the unrestricted right to use the asset during the lease term 2. The lessee agrees to make periodic payments to the lessor and to maintain the asset 3. Title to the asset remains with the lessor, who usually retakes possession of the asset at the conclusion of the lease.
  8. 8. Advantages to Leasing 1. Leases often require much less equity investment than bank financing. 2. Since leases are contracts between two willing parties, their terms can be structured in any way to meet their respective needs. 3. If properly structured, neither the leased asset not the lease liability are reported on the face of the balance sheet.
  9. 9. Lease Agreement Is there transfer of ownership? Yes Is there a bargain purchase option? Yes No Is lease term equal to or greater than 75% of economic life ? Yes No Capital Lease Operating Lease Is present value of payments equal to or more than 90% FMV? Yes No Accounting by LesseeAccounting by Lessee
  10. 10. A bargain purchase option • allows the lessee to buy the leased asset • at a price significantly lower than the asset’s fair value when the option is exercisable The difference between the option price, and the fair value (when the option is exercisable) as determined at the inception of the lease must render the option reasonably assured. The Bargain Purchase OptionThe Bargain Purchase Option
  11. 11. In determining the present value of the lease payments, three important factors are considered: 1) Minimum lease payments the lessee is expected to make under the lease, 2) Executory costs (insurance, taxes, and maintenance), and 3) Discount rate (used by the lessee to determine the present value of minimum lease payments) The Recovery of Investment TestThe Recovery of Investment Test (90% Test)(90% Test)
  12. 12. Operating Lease for Lessee • Operating lease method. Under this method, neither the lease asset nor the lease liability is on the balance sheet. • Lease payments are recorded as rent expense when paid. • Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.
  13. 13. Benefits of Operating Leases 1. Leased asset is not reported on the balance sheet. 1. Lease liability is not reported on the balance sheet. 1. For the early years of the lease term, rent expense reported for an operating lease is less than the depreciation and interest expense reported for a capital lease.
  14. 14. Capital Lease for Lessee • Capital lease method. • This method requires that both the lease asset and the lease liability be reported on the balance sheet. • The leased asset is depreciated like any other long- term asset. • The lease liability is amortized like a note, where lease payments are separated into interest expense and principal repayment.
  15. 15. Capital Lease for Lessee • Capital lease method. • Therefore there is both a finance charge and a reduction of the outstanding liability. • The Finance charge should be at a periodic rate of return on the remaining balance of liability for each period.
  16. 16. Capital Leases • Capital leases – Effectively an installment purchase – Lessee assumes rights and risks of ownership – Treated as purchases • Examples of what constitutes a capital lease – PV of lease payments is the FMV of the asset – Period of the lease approximates the assets life – There is a bargain purchase price
  17. 17. Let’s summarize the two ways in which the same lease could be accounted for in the books of the Lessee: Operating lease Capital lease •No asset and liability are recorded on the lessee’s balance sheet •Lease payments are reported as expense when paid. •Both the leased asset and the lease liability are recorded on the lessee’s balance sheet •Subsequently, depreciation expense is reported relating to the asset and interest expense is recorded on the liability.
  18. 18. Accounting and Leasing Balance Sheet Truck is purchased with debt Truck RM100,000 Debt RM100,000 Land RM100,000 Equity RM100,000 Total Assets RM200,000 Total Debt & Equity RM200,000 Operating Lease Truck Debt Land RM100,000 Equity RM100,000 Total Assets RM100,000 Total Debt & Equity RM100,000 Capital Lease Assets leased RM100,000 Obligations under cap. lease RM100,000 Land RM100,000 Equity RM100,000 Total Assets RM200,000 Total Debt & Equity RM200,000
  19. 19. Accounting for Leases - Lessors •
  20. 20. Operating Lease – For Lessor • The Lessor will recognize the leased asset on its Balance Sheet. • Lessor will claim depreciation on the leased asset. • Lease income from operating leases shall be recognised in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished.
  21. 21. Rental Income on a straight line basis • 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
  22. 22. Capital Lease for Lessor • Lessors shall recognise assets held under a finance lease in their Balance Sheet as a receivable at an amount equal to the net investment in the lease (Asset) • The Payments shall be recognized as interest expense and Principal repayments. • The Principal repayments will reduce the value of the receivable on the Balance Sheet (Receivables). • The interest will be recognized as Income • The recognition of Interest Income should be based on a pattern reflecting the Lessor’s Net outstanding investment in the lease.
  23. 23. In general, more expense is reported for capital leases in the early years of the lease life due to the increased interest expense. This 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. Airlines 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:
  24. 24. 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 Federal Express leases a portion of its delivery trucks
  25. 25. Leasing Advantages • May avoid obsolescence of assets. The 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. Since 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. Many leases are structured with less of a down payment than would be required if the lessee were to own the asset outright. The lessee’s funds are, thus, preserved for other business uses. • Lessor’s borrowing rate may be less than lessee’s. If 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 ...
  26. 26. “Off-Balance Sheet Financing” If the lease is structured “properly” no asset and liability are recorded on the lessee’s balance sheet and the financing is “off-balance sheet”. There are two main benefits that result: 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. Since the liability is not recorded, the debt-to-equity ratio appears stronger and the lessee looks less risky.
  27. 27. Why is Off-Balance Sheet Financing Important? • In other words, why are firms so interested in “hiding” debt? – If analysis reveals that debt is excessive, companies may face the prospect of a reductions in bond ratings, resulting in higher cost of debt. – Likewise, excessive leverage can result in a higher cost of equity capital and a consequent reduction in stock price.
  28. 28. Motives for using Off-Balance Sheet Financing • In general, companies desire to present a balance sheet with sufficient liquidity and less indebtedness. • The reasons for this are as follows: liquidity and the level of indebtedness are viewed as two measures of solvency. • Companies that are more liquid and less highly financially leveraged are generally viewed as less likely to go bankrupt. • As a result, the risk of default on their bonds is less, resulting in a higher rating on the bonds and a lower interest rate.
  29. 29. Off-Balance Sheet Financing • Off-balance sheet financing means that either liabilities are kept off of the face of the balance sheet.
  30. 30. Capitalizing Operating Leases for Analysis Purposes 1. Determine the discount rate to compute the present value of the operating lease payments. This can be inferred from the capital lease disclosures, or one can use the company’s debt rating and recent borrowing rate for intermediate term secured obligations as disclosed in its long-term debt footnote. 1. Compute the present value of the operating lease payments. 2. Add the present value computed in step 2 to both assets and liabilities.
  31. 31. Capitalization of Midwest Air Operating Leases
  32. 32. Footnote Disclosures of Lessees
  33. 33. NPV Analysis of the Lease-vs.-Buy Decision • A lease payment is like the debt service on a secured bond issued by the lessee. • In the real world, many companies discount both the depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee.
  34. 34. Reasons for Leasing • Good Reasons – Taxes may be reduced by leasing. – The lease contract may reduce certain types of uncertainty. – Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset. • Bad Reasons – Accounting
  35. 35. Example of how a finance lease resembles a loan • A trader who wants an asset costing £1,000 could borrow £1,000 at 10% from a bank and use the money to buy the asset. • The trader will pay the bank the interest and also repay the capital. • The capital could either be repaid in one lump sum at the end of the loan period • or it could be structured like a repayment mortgage, with small capital payments and large interest payments at first • and, towards the end, large capital payments and small interest payments.
  36. 36. • The same commercial result can be achieved with a finance lease. • The finance lessor (often a subsidiary of a bank) buys the asset for £1,000 and leases it to the lessee. • The lessee is the one who uses the asset. • The lessor charges the lessee rentals which, over the term of the lease, will repay the capital with a commercial rate of 'interest'.
  37. 37. • The 'interest' charges included in a finance lease agreement may fluctuate with base rate or with other changes (such as tax rate or régime changes) and so there will often be provisions in the lease which spell out the consequences. • Usually, the aim is to leave the finance lessor making its desired turn on the finance whatever happens: the lessee picks up any increased costs and benefits from any reduced costs.