In the previous post we learnt how to do accounting for long-term debt. In this post I will be writing about accounting for leases. A lease is a rental agreement by which one party (the lessor) transfers to another party (the lessee) the right to use an asset for a stated period of time in return for a stated series of payments. Take a look at the details given below for Company A and B. All else being equal can you tell which company has a better business? By taking a quick look one can easily conclude that A is better than B as it has higher accounting profits and return on assets (ROA). But that conclusion is incorrect. The difference in accounting profits and ROA is because of how both the companies account for their leases. In this post I will show that economic profits for both the companies are the same.
1. Company A uses Operating Lease
Company A and B manufactures and sells color marker pens. One day both A and B came to know about a high end machine which can manufacture more markers in less time and also with better quality. They decided to give it a try by leasing the machine for three years. On 01-Jan-2014, Company A signs a 3 year lease and imports the high end machine. The lease requires a payment of $200,000 at the end of each year.
At this point we need to ask few questions (1) what is the current market value of the machine (2) what is the present value of lease payments. The current market value of the machine is $500,000. The manager’s of company A computes the present value of the lease payments as $441,916.99 at 17% interest rate. You can get the present value by using the excel function -PV(0.17, 3, $200,000, 0). How did they arrive at 17% rate? It’s an educated guess by them.
There are two types of leases; operating and capitalizing. Firms must use capital lease accounting if it meets one of the following criteria (1) Ownership of the asset is transferred to the lessee at the end of lease (2) A bargain purchase option exists so that the lessee can buy the asset at end of lease for less than market value (3) Lease period covers more than 75% of asset’s life (4) Present value of contractual future lease payments is at least 90% of the current market value of the asset.
Let us assume that for A none of the first three criteria got satisfied. Also the present value of the lease payments is 88.38% ($441,916.99 / $500,000) of the current market value. So the fourth criteria did not get satisfied and the lease is classified as an operating lease. This means that A will not show its contractual obligation in its balance sheet. Hence an operating lease is called as an off balance sheet item. At the end of every year A shows this lease payment in its income statement. For simplicity I have assumed that A has same total assets, sales, and profits for all three years.
2. Company B uses Capital Lease
On 01-Jan-2014, Company B signs a 3 year lease and imports the high end machine. The lease requires a payment of $200,000 at the end of each year. The manager’s of company B computes the present value of the lease payments as $456,645.02 at 15% interest rate. You can get the present value by using the excel function -PV(0.15, 3, $200,000, 0). How did they arrive at 15% rate? It’s an educated guess by them.
Let us assume that for B none of the first three criteria got satisfied. But its present value of the lease payments is 91.33% ($456,645.02 / $500,000) of the current market value. So the fourth criteria got satisfied and the lease is classified as a capital lease. This means that B has to show the lease liability on its balance sheet. A 2% difference in the discount rate assumptions leads to different lease treatment. On 01-Jan-2014, B puts a journal entry as given below. In the world of accounting Dr. stands for a debit entry and Cr. stands for a credit entry. In order to get this idea into your head think that B is taking a loan for $456,645.02 to purchase the machine. Even though in reality it’s not taking a loan.
01-Jan-2014 Dr. Lease Asset $456,645.02 Cr. Lease Liability $456,645.02
On 31-Jan-2014, B needs to make several entries to its balance sheet and income statement to account for capital leases. In the income statement it shows an interest expense of $68,496.75. Why is that? Remember it recorded a liability of $456,645.02 and at 15% (discount rate it’s manager assumed) the interest expense comes to $68,496.75. It records a depreciation expense of $152,215.01. Why is that? Remember it recorded an asset of $456,645.02 and it should depreciate it over the lease term of 3 years. But B pays $200,000 as a lease payment to the lessor. This amount is much greater than the interest payment of $68,496.75. The difference of $131,503.25 is treated as payment towards the principal and the lease liability is reduced accordingly.
31-Dec-2014 Dr. Interest Expense $68,496.75 Dr. Lease Liability $131,503.25 Cr. Cash $200,000 31-Dec-2014 Dr. Depreciation Expense $152,215.01 Cr. Accumulated Depreciation $152,215.01
It will do similar entries for the year 2015 and 2016. Take a look at the income statement for B given below. For simplicity I have assumed that B has same fixed and working capital assets, sales, and operating expenses. From this you can clearly see that interest expense goes down in later years as the lease liability gets reduced. Also you can see that ROA of B increases and by the end of 2016 it converges with the ROA of company A. This clearly proves that even though the accounting profits of A and B are different its economic profits are the same.
Given below is the table which clearly shows how the lease asset and liability goes down over the lease period. Spend some time to make sure that you really understand how the math works. This is very important.
3. Looking at leases for Walmart
You can download Walmart’s 2014 annual report from here. Take a look at the balance sheet of Walmart given below. The balance sheet shows capital leases amounting to $3,097 million. Also you will not find any operating leases as they are kept out of balance sheet. Most of them are long term leases for store rentals and equipments.
But according to US GAAP the company has to show all its operating leases in the footnotes. According to the footnotes Walmart has $17,170 million in operating leases and some of it run beyond 2019. But these are obligations way out in the future. What we need is to know the present value of all the operating leases. How do we do that? There are couple of ways to do it; simple and complicated. I am going to discuss only about the simple way.
In order to capitalize the operating leases you need to take the total rental expense Walmart paid in 2014. The company paid $2.8 billion as rental expense in 2014. Multiplying that by 8 we get $22.4 billion and we add this to the balance sheet as a capital lease. Why multiply by 8? I don’t know the rational behind choosing this number. But it seems to be the standard used across the board. In the 10-K report of Walmart, I found the following: In addition, we include a factor of eight for rent expense that estimates the hypothetical capitalization of our operating leases. In fact Walmart took the pain of doing the calculations for us to convert the operating lease into a capital lease. Spend some to go through the calculations. It is really fascinating and I enjoyed going through this.
I learned these concepts by reading the book shown below. Also I took the Financial Accounting course from coursera. I would highly recommend this course for anyone who wants to know how the financial statements are put together.