Monday, December 8, 2008

Accounting for capital leases vs operating leases: Balance sheet implications

I was going to write about Steak 'N Shake, but I figured a little accounting refresher was required in order to better understand its balance sheet. Companies lease a variety of things, from land and buildings to equipment, in order to maintain their operations. With leases come payment obligations. In the opinion of accountants, some of these obligations are "debt-like". They have therefore come up with a set of criteria to differentiate these "debt-like" cases from regular(operating) leases.    

In order for a lease to qualify as a capital lease, it is sufficient that any one of the following 4 conditions be met:

1. There is a transfer of ownership of the asset being leased at the end of the lease term.
2. There exists an option to purchase the asset at a "bargain price" at the end of the lease term.
3. The minimum present value of the lease payments is greater than 90% of the asset's current fair market value.
4. The lease term exceeds 75% of the asset's expected useful life.

Note that each of these conditions implies either outright ownership(1)/possibility of ownership(2) or virtual ownership((3) & (4)) of the asset in question. 

So, what happens when a lease is accounted for as a capital lease? Basically, the transaction is accounted for as though the asset was purchased with 100% debt. The assets and liabilities go up by the exact same amount. What is this amount? It is the present value of the lease payments(call this PVL). What is the discount rate that's appropriate to compute the PVL? Since the transaction is accounted for as being 100% debt financed, it makes sense to use the company's current cost of borrowing as the discount rate. Two possibilities present themselves now:

a. PVL, using the company's cost of borrowing, is less than the asset's current fair market value. In this case, the value of the asset and the liability on the balance sheet is the PVL.

b. PVL, using the company's cost of borrowing, is greater than the asset's current fair market value(FMV). In this case, the value of the asset and the liability on the balance sheet is the asset's current FMV. Also, a discount rate is calculated that makes the present value of the lease payments equal to the asset's current FMV. This discount rate is the imputed interest rate on the accounting "debt" that goes on the company's books.  

So far so good. At the inception of a capital lease, the assets and liabilities(pertaining to the lease in question) match exactly. As the lease progresses however, they diverge. The asset is depreciated (in a straight line, mostly) over the course of its useful life. As for the liability, remember that it is treated as debt and there is an imputed interest rate for that debt. The liability is reduced by the amount of "principal" repaid on that debt. Therefore, the asset is reduced by an amount, via depreciation, at a rate faster than the liability goes down. The two eventually converge to zero at the end of the lease. This is about as much as we need to understand about the change in assets and liabilities as the lease progresses.

When a lease is accounted for as an operating lease, there are no balance sheet entries at the inception of the lease. Thank god for small mercies.

In either case, there are implications for expenses, classifications of cash flows and so forth. We'll skip all of that for now. You're welcome.

Congratulations to everyone that made it to the end of this post. You will be receiving your free gift shortly.

Often wrong but seldom in doubt,
Ragu

1 comment:

  1. Interesting read. I had wondered about such issues in accounting. A follow up with some numbers would be appreciated.

    ReplyDelete