We will now talk about Leases, so here is a picture that
illustrates what's going on. When we talk about a lease,
there are two major players; the lessor and the
lessee. The lessor is the owner of the asset, so let's say that we have a
company that owns lots of earth moving equipment
so the lessor is the entity that actually owns the equipment
but the lessor leases the equipment to a lessee
who uses the asset and then in return for using the
asset the lessee makes payments over the lease term so if it is a
3 year lease then over a 3-year period the lessee will be making
payments to the lessor. A lease can be classified as an
operating lease or a finance lease.
In the US, sometimes the finance lease is also called
a capital lease. The accounting treatment is different depending on how the lease
is categorized and we will see this later.
First, let's talk about the advantages of leasing
and when we say advantages of leasing here we are talking about
a basic operating lease. From a lessee perspective, the lessee is
the entity that is using the asset and then making payments.
A basic idea with operating leases is that it is
off balance sheet. What does this mean? One way of getting an asset is to pay
for it, now when you pay for an asset let's say
you pay using credit then you build a liability on your
balance sheet and you also show an
asset on your balance sheet. Wen you show an asset on your balance sheet what
happens to ratios such as return on assets and so on?
Those ratios become worse because if your asset
is going up then return on asset is going to come down. If you borrow
money to buy the asset, what's happening to your debt? That's
going up so your ratios that involve debt, such as
solvency ratios, they will also look worse. So very often companies that
can try to use off-balance sheet financing.
So less costly financing lease requires no
initial payment. What this means is, with leases you are simply making your
lease payments you don't need to make a huge
upfront payment for the lease equipment. Leases typically pay less financing
cost relative to the purchase on credit. Now, you might say that instead of buying
the asset you simply borrow money in which case
you do not need to make that upfront payment, but then the advantage of
leasing is that typically the lease rate tends to be lower than interest rate, why?
Because, whatever asset you are leasing that is
collateral. If you don't make your payment, what can
the lesser do? The lesser can just take the asset back, so often with leases
you can get a lower rate relative to borrowing. Reduced risk of
obsolescence. Now, you are using this earth moving equipment and after two
years or three years, a much better piece of
equipment comes into the market if you don't own that equipment you are
not stuck with it. Because of leasing you are simply
renting it, so if that equipment is no more as
useful as maybe some other newer equipment
you are not stuck with it, so reduced risk of obsolescence
improves your leverage ratios compared to borrowing
the funds to purchase the asset. I've already talked about this since we are
doing off-balance sheet financing, your leverage ratios will be better with
operating leases, and then this is a subtle little point.
In some countries, what you can do is show a leased
asset as an asset on your tax reporting side,
but on the financial reporting side you show a
operating lease. When this happens you have a
synthetic lease. What's the advantage of doing this?
If you can show an asset on the tax side, then through depreciation you can reduce
your taxes. All these items were from the
lessee perspective. Okay now from the lesser perspective.
Lessor might have a tax advantage by keeping the asset on its
balance sheet. The other scenario might be
that it might possibly be more efficient for the lesser to
maintain the asset, so if you have a particular asset that
requires a very high level of technical skill to
maintain then it makes sense for one company to own all those assets and then
provide the maintenance, so this team of 2 or 3 highly paid
engineers working for one company maintaining all the assets that have
been leased out might be more efficient than
every lessee having to pay for an engineer at their location, so
there might be some efficiencies for the lessor, but generally the big advantage
is for the lessee. Finance Lease versus
Operating Lease. Traditionally, under IFRS if the risk and reward associated with
an asset was transferred to the lessee, the lease
would be categorized as a finance lease. In the US a finance lease is also
called a capital lease, so in this situation the accounting
would involve recognizing an asset and a liability
on the lessee's balance sheet. In the past, if the risk and reward
was not transferred to the lessee then the lease
would be recorded as an operating lease, and with an operating lease
the asset would not be transferred to the balance sheet of the lessee,
but that has changed. There is a new standard,
IFRS 16, this requires lessees to record both finance and
operating leases in an identical manner, so regardless of whether the risk and
reward is being transferred to the lessee,
the lessee has to show a lease asset on the balance sheet,
and the associated liability is also shown on the balance sheet.
This accounting treatment will be discussed shortly.
The point made here is with respect to the lessee.
For the lessor, this doesn't hold true. A lessor will classify
a lease as an operating lease or a finance lease
depending on whether the risk and reward is being transferred.
So if the risk and reward is being transferred
then the lease will be classified as a finance lease,
so in that case the leased asset will be removed
from the balance sheet of the lessor. On the other hand, if the risk and reward
is not being transferred then the lease will be classified as an
operating lease, and the asset will remain on the balance
sheet of the lessor. Under US GAAP, the accounting treatment
has not changed much. As before a lease must be classified by
a lessee as a finance lease or capital lease.
If any one of these four criteria are met;
criteria one is ownership transfer, so at the end of the lease,
the ownership of the asset is formally transferred to the lessee
or there is a bargain purchase option whereby the lessee
can buy the asset at the end of the lease at a very low price
or if the lease term is 75 or more of the useful life,
and the fourth criteria is that the present value of lease payments is 90
or more of the fair value of the leased asset.
So if any of these conditions hold then under US GAAP, a lease is classified as
a finance lease and the asset is shown on the balance
sheet of the lessee. If all these criteria
are not met, then a lease is classified as
an operating lease under US GAAP, and in this case lease payments are
essentially rental payments. In general, a lessor will prefer
finance leases and a lessee will prefer operating leases. Let us now get
into the reporting and we will first take the lessee perspective then we will
take the lessor perspective. Okay,
now operating lease from the perspective of the
lessee. Anything recorded on the balance sheet?
No, it is an operating lease. Effectively, what is happening is that the
lessee is saying that every period I will make a payment,
so that is a lease payment, it is like a rental.
Does it show up on the income statement? Yes, it shows up as
a rent expense or lease expense. What part of the income statement would
this be, operating or non operating? It would be a operating expense. What
about the cash flow statement? This would impact CFO, so it would be a
cash outflow shown in the CFO segment of the
cash flow statement. Fairly simple. Now again, staying with the lessee
perspective, how do we show a finance lease?
With the finance lease, effectively, the asset now
comes on the balance sheet of the lessee at inception, the lower of the
present value of lease payments, and the fair value of the leased asset
is recognized as an asset and a liability.
So what is the impact on equity? Zero. What you do initially is you say that
the asset is coming on to the balance sheet of the lessee
and what is the value of the asset? It is the present
value of all the payments that need to be made.
At the same time you also increase a liability, that liability is called lease
payable. If I, as a company, am leasing an asset so
the asset shows up on my balance sheet but I need to make payments.
Making payments is an obligation, so I need to show the present value of that
obligation on the liability side, and what's that obligation called? It's a
lease payable so that's what happens on the balance sheet initially,
and as I said before, equity is not impacted.
What about the income statement? The interest expense which needs to be shown
on the income statement is equal to the liability at the beginning of a period
times the interest rate and we'll go through
an example which will illustrate this. Always,
an interest expense is equal to a rate multiplied by the liability at the start
of a period. What about the CFO? When we make a lease
payment, let's say our lease payment is 100, that payment really has two components;
one component is an interest component and the other
component is a principal component. The interest component will reduce CFO
and especially in US GAAP where interest payments need to be shown in the
operating part of the cash flow statement, the interest
payment will be in CFO. What about the principal?
That will hit the financing part or the CFF part of the cash flow
statement.