# Accounting For Leases

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.

## Closing Thoughts

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.

## 20 thoughts on “Accounting For Leases”

Thanks, Jana!

BTW, where are you based out of?

• Jana Vembunarayanan says:

Thanks. I live in California, US.

Regards,
Jana

2. Michael says:

Hey Jana,

Very nice post.

Regarding the 8x, it derives from capitalizing operating leases by the specified rate of return and maturity of the operating lease.

For example, the 8x multiple can derive from capitalizing infinite op. lease payments by required rate of return of 12.5%. To understand it clearly, think about John Doe who rents a tractor for \$500 a month. If you acknowledge that the standard rate of return for tractors just like John’s in the same area where he works regularly is 12.5%, than you can calculate the value of John’s leased tractor by capitalizing his monthly rent \$500 * 12 months / required rate of return 12.5%. Therefore, we’d get that John’s leased tractor is worth \$48,000, or 8x John’s annualized operating lease payments.

Another way to understand the 8x multiple is the more standard way I guess, and that is that this multiple derives from an op. lease contract with a maturity of 15 yrs and a required rate of return (cost of debt) of 6%.

In my opinion, whenever we deal with operating lease payments for an asset which is obviously needed as long as the business exist (like a WMT’s store or forklift), we should look at it as if the business would’ve bought this asset in its entirety if it wasn’t leasing it. That means that we shouldn’t look at the op. lease contract as if it’s limited in time, even if it’s 15 years which sounds a lot. I think that a conservative investor should treat these kind of op. lease contracts as if they are infinite, thus capitalizing the yearly op. lease payment by the proper required rate of return. This method would surly give the conservative investor a bigger amount of capitalized debt, but that would be a much more appropriate representation of the indispensable op. lease payments.
So just as an example, capitalizing \$1m of annual op. lease payment by a required rate of return of 6% for an infinite amount of time would value the leased asset for \$16.67m. Hence making it a 16.7x multiple, instead of the 8x multiple used regularly by commercial analysts – more than double. That’s not nothing.

This is where the 8x multiple comes from. So for me it means that WMT asserts that the required rate of return on the assets it leases (on an operating leases) is 12.5%. (Keep in mind that as this multiple gets higher, WMT’s operating lease capitalized *debt* gets lower, and vice versa).
I didn’t read WMT’s financial reports, but I would think that much of its operating leased assets are real estate assets, like stores, logistics center and offices (sometimes there is a subdivision to different operating lease payments in the notes – how much for land, buildings and plants; how much for machinary; etc.).
Hence I would think that an 8x multiple is quite high for real estate, as it reflects a required rate of return of 12.5%, and therefore it artificially reduces WMT’s capitalized debt.
Usually, when I capitalize real estate operating leases I do it more conservatively and never use a higher rate of return than 8%, which is a 12.5x multiple (almost always I use 6-7%, which is 16.7x-14.3x multiple). Of course it depends on the actual market’s RoR, which one should check before calculating the capitalized value.

You can check out another discussion on this topic which I had some year and a half ago –

Kind regards,

Michael

• Jana Vembunarayanan says:

Thanks a ton Michael.

Regards,
Jana

• Michael says:

Sure thing =]

Keep up the excellent work!

Michael

3. Michael says:

Another thing,

WMT’s calculation of the adjusted operating income for the purpose of ROI seems flawed to me, as they don’t take into consideration D&A costs, or at least some amount of normalized maintenance capex costs, which are obviously ongoing operational costs.

Any way, if they would have taken into consideration the depreciation amount, they would also need to take into account the amount of depreciation concealed in the op. lease payment.

Michael

• Jana Vembunarayanan says:

Michael,

I think they added D & A costs back is because they have added the accumulated depreciation to the denominator.

Regards,
Jana

• Michael says:

No. The denominator represents the amount of invested capital – the value of the PP&E + working capital + needed cash (which you can say is in the working capital, but never mind) – i.e. net value of all the capital the business apply in order to operate.

The nominator is the operating income, which needs to take into account all the ongoing operatingl costs of the business, which is to say ‘all costs except financial costs’ (usually the interest payments on the gross debt) – i.e. net sales less all operating costs and less income tax payments.

So, unless maintenance costs for the stores, logistics centers, forklifts etc. aren’t operational costs, they should be taken into account in the operating income.

Michael

4. Michael says:

I said that operating income = “net sales less all operating costs and less income tax payments.”

I meant Of course that this is the profit figure which should be applied to the ROIC ratio – i.e. NOPAT (Net Operating Profit After Tax), which is obviously different than ‘Operating income’. So sorry if I confused anyone.

Any way, in my opinion an investor should look at the business normalized profitability after taking into account all the ongoing operating costs, which includes maintenance costs, and also tax (what can you do.. you don’t want to start something withe the IRS).

Michael

• Jana Vembunarayanan says:

Michael,

Thanks a lot. That was super useful. I look at pretax operating profit when comparing multiple investment opportunities. This lets me compare apples to apples. But I agree with you that tax are real costs that can’t be avoided.

Regards,
Jana

5. Michael says:

Jana,

Sure.

Of course you’re right, there is some truth to that pretax op. profit makes more of an apples to apples kind of comparisons. But as I thought on that issue I came to the conclusion that it’s still less valuable.
Think about it – let’s say we’re looking *just* at the highest ROIC ratio between 2 potential investments – 2 businesses in the same industry, one is located in the US and the other one in Switzerland.
Ok, so now let’s say that the US business’ pretax ROIC ratio turns out to be 20%, and the Swiss business’ pretax ROIC ratio turns out to be 17%. Obviously, 20% is higher than 17% by 3%, and 3% in ROIC isn’t nothing. So here we could have concluded that the US business is a better investment than the swiss business regarding only pretax ROIC.

But hey, we know that the operating profits underpinning these pretax ROIC figures wouldn’t get in their entirety to the businesses’ balance sheets. They aren’t wholly attributable to the businesses. The two businesses wouldn’t be able to apply the whole sums of the op. profits into some new invested capital or return it to shareholders. Some shares of these figures are attributable to the relevant government where the specific business is operated; just as some share of the ‘net sales’ isn’t attributable to the shareholders but to the employees. Tax payments are not discretionary, just as operating costs aren’t discretionary – these kinds of costs will always be a part of the business operations (we can’t help it – the government wants to be a partner in everything..). Therefore, these op. profits don’t give a true picture for the future operations of the businesses. (This is of course as opposed to financial costs which aren’t necessarily an integral part of the business’ operation, but depends on the business’ financial structure.)

Ok, so let’s get back to our example with the two businesses. We’ll take into account the none-discretionary tax payments. The corporate tax rate in the US is 35%, and in Switzerland is 18%. Taking these rates into effect: the US business’ ROIC turns out to be 13%, and the Swiss business’ ROIC turns out to be just below 14%. (!) So we get the opposite – now the Swiss business is a better investment than the US business.

Ok, so which comparison is better? Which comparison makes a truer statement about the attractiveness of investment in these two businesses? I think the answer is clear – the truer statement must be the one which takes into account the truer (or the more real if you’d like..) figures these businesses produce. I would say the 2nd comparison. And all other things being equal, I would invest in the Swiss business.

What would you do? =]

Michael

• Jana Vembunarayanan says:

Michael,

All else being equal I will go with Swiss company. If both the companies operate in the same country and if one of them is using a lot of tax credits (temporary in nature) to reduce its taxes then the comparison would not be fair. I would compare the pretax operating profits and understand which is better and who has a better strategy. Once that is done then I will move down to taxes.

Regards,
Jana

• Michael says:

Jana,

You are right of course. It’s just that when I calculate the ROIC I aim at the normalized NOPAT in order to get the normal ROIC for the business. So I don’t use the reported figures (unless they are credible), whether they be the D&A, operating leases, tax payments etc., but the normalized figures. So in the case of the income tax payment, I’m just deducting the appropriate standard corporate tax rate. Regarding any amount of tax assets the company has on its balance sheet, I just add it in the ‘intrinsic value’ calculation, after I discount the normalized NOPAT by my required rate of return (in the same phase when I deduct\add net debt\cash.

And if I capitalize the operating leases, which is very important as you’ve shown, I make sure to add the operating lease payments to the normalized NOPAT and deduct the capitalized depreciation sum from it (and add the capitalized leased asset to the invested capital for the ROIC ratio).

Anyway, that’s how I do it.

Michael

• Jana Vembunarayanan says:

Michael,

Makes sense. Thanks for taking time to share your knowledge with all of us. I really appreciate.

Regards,
Jana

6. Pedro says:

Jana,

Do you agree with Walmart’s calculation of return on investment? I’m not sure I do. Trying to think like a business owner/operator, I believe it makes more sense to treat the rent as an expense instead of capitalizing it, because it is so much closer to the actual cash flow of the business.

Thanks for the great work,

Pedro

• Jana Vembunarayanan says:

Pedro,

I agree with you and treating rent as an expense is cleaner and also easier to understand. But if you want to compare Walmart which uses a lot of operating lease with another company which uses a lot capital lease then we need to convert Walmart’s operating lease to capital lease. If that’s not the case then you are ok with not capitalizing the rent.

Regards,
Jana

7. Pedro says:

Jana,

I agree that we need to adjust to be able to compare. But, instead of adjusting the company that uses operating leases, wouldn’t it make more sense to adjust the company with the capital lease so that we are closer the cash flow reality for both firms?

Thanks,

Pedro

• Jana Vembunarayanan says:

Pedro,

That should be fine too. But make sure you pull the actual cash paid out to the lessor for capital leases. Also make sure you get the actual liability the company has for all its operating leases.

Regards,
Jana