4.4 Financing Leases
Omitting the asset from the balance sheet does not make the firm’s total recorded assets any greater. Had the asset been recorded, this might have increased the company’s borrowing capacity. By comparison, the omission keeps down the company’s debt ratio. In other words, choosing to lease an asset has financial leverage implications.
The lease payments would still be reflected as expenses on the Income Statement and as Cash Outflow on the Cash Flow Statement. Outside analysts may thereby become aware of the lease and its financial implications, but there would be no explicit recognition of the lease apart from that.
In 1976, FASB 13[1] was passed in order to recognize that certain leases were both legally and economically speaking equivalent to long-term debt financing. In order for a lease to qualify as a “financing” or “capital” lease and, thereby, be recognized on the lessee’s balance sheet, the lease must provide the lessee with at least one of the following benefits.
- Transfers ownership by end of term
- Includes a bargain purchase option
- The term is ≥75% of the asset’s useful life
- PV of the lease payments ≥ 90% Fair Market Value of asset.
Take note that the lease payments constitute an annuity; hence, the present value of the lease payments are calculated as it was in the case of a mortgage. The payments would then consist of both principal and interest portions.
If a lease meets just one of the four foregoing criteria, it shall be treated, for accounting purposes, as a “Financing Lease.” The underlying asset must then be “capitalized” by the lessee on the balance sheet, similar in manner to a debt-financed asset. If the lease does not meet any of the foregoing pre-requisites, it is deemed an “Operating Lease,” and will not be reflected on the balance sheet at all. Operating leases are usually short-term.
TP[1]PT “FASB” stands for the Financial Accounting Standards Board,” the rule-making authority for the accounting profession when this rule was promulgated.
| In a financing lease, the lessee accounts for the asset as if it were acquired. That is, the asset is capitalized (rather than expensed) and amortized. “Capitalized” means that the asset will be carried on the Balance Sheet as a “Leased Asset.” “Amortized” means that the asset’s value will be reduced over time, in a manner similar to depreciation. |
Capitalize
Amortize |
The recorded asset value is equal to the present value of the committed lease payments. This is usually, but not always, approximately equal to the market value of the asset. The lessor records a “sale” of the asset at the inception of the lease.
A corresponding liability, “Lease Obligation,” is created on the lessee’s balance sheet. The amount equals that of the recorded asset. The discount rate used is that of the prevailing borrowing rate. Thus, the initial carrying value of both the asset and the liability are the same. Let us see, by way of example, how all this works.
- “FASB” stands for the Financial Accounting Standards Board,” the rule-making authority for the accounting profession when this rule was promulgated. ↵