Print

Backstory

  • If you purchase an airplane on credit, you would recognize an asset (the airplane) and a liability (for the amount of money you owe on the airplane)
  • This would increase your company’s debt; you would appear to be a greater credit risk and get charged higher interest rates. Also, investors would be concerned about the ability to make the payments so your company would be less attractive
  • To keep the debt off the Balance Sheet, companies would not purchase the airplane but would instead rent (aka “lease”) the airplane
  • This way, the company recognizes Rent Expense every period, but it doesn’t capitalize the asset (and thus, the rent payments that will be owed did not appear on the Balance Sheet)
  • Companies devised complicated lease agreements to keep debt off their Balance Sheet. This gave rise to an entire industry of leasing companies that handle the arrangements.  Major airlines did not have any airplanes appearing on the Balance Sheet because they used leases to keep the debt off their Balance Sheet
  • Many people criticized this approach, saying that companies were abusing lease accounting to hide debt. The main argument of critics was this:  if you enter into a 75-year lease to rent a building, the risks and benefits of owning that building have effectively been transferred to you, even though you didn’t technically take legal title to the building

Overview

  • The FASB recently passed a new lease accounting standard to address the issue described above
  • Now, lessees must capitalize all leases that have a lease term longer than one year
  • This means the lessee (the company renting the airplane, building, etc.) will recognize the thing being leased as an asset on its Balance Sheet, and it will recognize a liability to reflect its obligation (the future lease payments) to the lessor. The obligation will be discounted to its present value
  • The impact of the new rule is substantial. Firms are being forced to add nearly $2 trillion in assets (along with the associated liabilities) to their Balance Sheets!

Here is how the new lease accounting works:

  • Lessees must classify a lease as one of two types:
    • Finance lease (from the lessor’s perspective, this is a sales-type lease1)
    • Operating Lease
  • Both approaches (a finance lease or an operating lease) result in an asset and liability being booked on the Balance Sheet. However, there are some differences in the accounting:
    • For a finance lease:
      • The total expense related to the lease is different each period
        • Amortization Expense is recorded to reduce the value of the asset
        • Interest Expense on the lease liability is recorded
      • For an operating lease:
        • The total expense related to the lease is the same each period
        • You record an account called Lease Expense each period
        • Interest Expense is not reported; interest is part of Lease Expense
        • Amortization Expense is not reported; a plug amount keeps Lease Expense the same each period; the plug amount reduces the asset’s book value
      • Here is how you determine whether a lease is a finance lease or an operating lease:
        • A lease is a finance lease if it is noncancelable and one of the following is true:
          • Ownership of the asset will be transferred to the lessee at the end of the lease
          • The lessee can purchase the asset for a bargain price at the end of the lease
          • The lease term is at least 75% of the expected economic life of the asset
          • The present value of the lease payments is at least 90% of the asset’s fair value
          • The asset is specialized and will have no value to the lessor at the end of the lease

Note:  if you’re confused about the whole lessee/lessor concept, think about it like this:  if you are renting an apartment from a landlord, then you are the lessee and the landlord is the lessor

[1] If the lessor is a financial institution, the lessor refers to it as a direct financing lease.