Thursday, December 11, 2008

Accounting for capital leases: An example

For the reader that wanted an illustration of the balance sheet changes during the life of a capital lease, here goes:

Assume a company leases(capital lease) a tractor for a period of 5 years, beginning today. The fair market value of the tractor today is $15000. The annual lease payments amount to $4000. The company's long-term cost of borrowing is 10%. Also assume that the asset will be fully depreciated on a straight line over the lease period i.e. annual depreciation will be ($15000/5 = $3000).

The present value of the lease payments based on the company's long-term borrowing rate of 10% = $15,164.35

Since this is greater than the current FMV of $15000, the asset and liabilities side of the balance sheet will go up by the current FMV (it is not reasonable to capitalize an asset at a value greater than its current FMV).

Assets (A): +$15,000

Liabilities(L): +$15,000 (this is considered long-term debt)

The next step is to compute an interest rate for this "debt" as the company's long-term rate of borrowing didn't fit(too low). This is the rate for which the present value of the lease payments equals the asset's current FMV. It turns out that this rate is 10.42%(the TI BA II Plus calculator is of some use after all).

How do the balance sheet entries change as we progress through the lease? Remember the annual depreciation on the asset is $3000. So, the carrying value of the asset on the books is reduced by $3000 annually over 5 years until it reaches zero.

The liability goes down by the amount of "principal" repaid on this debt. If you run an amortizing calculator on a loan amount of $15000 at an interest rate of 10.42% over 5 years, you will get an amortization schedule that looks like this:

Year Principal payment Interest payment Principal balance
1      2436.51               1563                    12563.49
2      2690.39               1309.12               9873.1
3      2970.73               1028.78               6902.37
4      3280.28               719.23                 3622.09
5      3622.09               377.42                 0

So, here's how the carrying values of the asset and liability for this lease look at year-end as the lease progresses:

Remember that at lease inception they are both carried on the books at $15000.

Year Asset's book value Liability's book value
1      $12000                  $12563.49
2      $9000                    $9873.1
3      $6000                    $6902.37
4      $3000                    $3622.09
5      $0                          $0

Hope this was helpful. Feel free to ask if any of this is unclear.

Often wrong but seldom in doubt,
Ragu

4 comments:

  1. This is a great example. Thanks for putting the effort and writing it up.

    ReplyDelete
  2. Ragu,

    Does this bring down the owner's equity by the same amount to balance the assets/liabilities ? Sorry, I am a newbie :)

    thanks,
    Qleap

    ReplyDelete
  3. Qleap,

    Owner's equity is unchanged at the time of the inception of the lease(the book value of the asset and the corresponding liability match). As the lease progresses, and as you note, owner's equity will be understated as the book value of the liability exceeds the book value of the asset.

    Everyone progresses from being a newbie at some point. So, there's no need to be apologetic.

    --Ragu

    ReplyDelete