Hello! I'm Professor Brian Bushee. Welcome back. In this video we're going to talk about lease contracts. And the reason that lease contracts fit in with this week is because it's a form of long-term financing for assets. And sometimes, the lease contracts look just like the accounting for loans that we've seen earlier in the week, but sometimes they don't show up at all. Let's find out why. So lease is basically a rental agreement, one party, the lessor, is transferring to another party, the lessee, the right to use an asset for a stated period of time in return for a contractual stated series of payments. So in other words, a lessor might lease an airplane or a building or equipment or vehicles, to the lessee. Now there's two types of leases or leases can be of, of basically two types of durations. Short-term leases allow use of an asset that would be inefficient to purchase. So if I'm going to go to Los Angeles for a week, I'm not going to buy a car when I get there and sell it at the end of the week. That would cost me a lot of money. I'm just going to rent a car for a week under a contract that can be cancelled at any time. Long-term leases, which is what we're going to look at in this video, are very similar to a financing arrangement to purchase a long-lived asset. So if I was going to Los Angeles for five years, then instead of buying a car I might lease a car for five years under a non-cancellable contract. >> Why would a company lease a car for five years instead of just buying it? >> I always lease my Mercedes for one year. I want to make sure that I am always driving a new car. Would one year be short-term or long-term? >> So a company might lease a car for five years, instead of buy it, because it's more economical to do so. So at first it could be that they get a better deal on the lease payments, so the present value of the lease payments is less than you'd actually have to pay in cash if you bought the car right now. Could be you get better financing through the lease field. Because essentially what you're paying through the lease payments is financing on it and maybe the leasing company can give you a better interest rate than a bank would be if you borrowed money from a bank to buy a car. In terms of the one year, is that short term or not, we're actually going to look at criteria later which will help determine how we should treat a lease contract in the financial statements. So to account for these long term leases we're going to have two different methods, capital lease method or operating lease method. The accounting rules are going to require that certain long-term leases be treated as if the company bought the asset with debt financing. Those are going to be the capital lease method leases. Under that method, we're going to record a lease asset and a lease liability. So there's going to be an asset and liability, just like we bought an asset by taking a loan from a bank. And because we have an asset, there's going to be depreciation expense, and because we have the liability, there's going to be interest expense on the income statement. But, other long term leases can still be treated as rentals this is going to be the operating lease method these are what are called off balance sheet activities because we're going to be doing these leases but there's going to be no asset or liability on the balance sheet. There'll be no evidence on the balance sheet that you're doing these leases the only place you'll see any evidence on the financial statements is that you're going to record rent expense on the Income Statement because we're treating these like rentals. >> Oh, good. I was afraid that there would only be one method this time. But seriously, why would a lease ever be treated like you bought the asset? You did not buy the asset! >> So, I guess this is the part of the course where we start accounting for things that did not really happen? Is this the fairy tale writing part of the accounting language? >> Actually rumor has it that some guy named Tom Riddle came up with these accounting standards. But, but anyway it does seem weird that we're leasing an asset or renting an asset, but we're going to treat it as if we bought it in some cases. But what we're trying to do is get to the economic substance of the transaction. If we are going to lease the asset for almost all of its life or pay almost all of its current value, then it's as if we bought the asset even though contractually we haven't. So we just viewed it as providing users of financial statements better information to treat some of these leases as if we bought the asset. And, I'll show you four criteria that we're going to use to determine whether to capitalize the lease or not, which I think will make this clear. To determine whether the company should use capital lease operating lease accounting method, there are going to be four criteria. And firms have to use capital lease accounting if any one of these four apply. The first is that ownership is transferred at the end of the lease. So at the end of the lease term you're given the asset for free. If that happens then you have to use capital lease accounting treatment. The second would be that a bargain purchase option exists, which is the right to buy the asset at the lease end for less than its market value. So if you could buy it for a dollar, then you'd have to use capital lease accounting treatment. Third is the, whether the lease period covers more than 75% of the asset's life. So if it was a asset that had a four-year life. When you lease it for more than three years, you would have to use capital lease accounting treatment. And the last criteria is the present value of the contractual lease payments is at least 90% of the current market value of the asset. So what that means is if you use the time value of money stuff we learned earlier in the week, you figure out the value of those future lease payments in today's dollars. If that's 90% or more of what you could buy it for today, then it's almost like you're paying as much as buying it and it would trip, tri, trip this criteria, and you'd have to use capital leave treatment. So again, any one of these being tripped would cause capital lease treatment. If they're all no, then you can use operating lease. And then tax rules have the same distinction, but the rules are different. I think there are something like five criteria. But as it turns out, the tax rules are essentially irrelevant for the choice. Capital versus operating lease accounting for financial reporting. So whatever you do on your tax return will not necessarily determine what you, what choice you make for financial reporting purposes. >> I suppose you are going to tell us that a company could use the operating lease method for the financial statements and the capital lease method for taxes. What nonsense. >> Actually yeah. A lot of companies strive to get capital lease treatment for taxes and operating lease treatment for the financial statements on the same lease contract. Capital lease treatment for taxes is preferred because you recognize interest expense and depreciation expense, both of which reduce your taxable income, and save you on taxes early on in the lease life. Operating lease treatment is often preferred for the books because it keeps the asset and liability off the balance sheet, making a lot of your ratios look better. So your ROA looks better, your debt to equity looks better, so, yeah, a lot of companies try to use these different criteria to do capital lease method for taxes and operating lease method for the financial statements. So let's start looking at some examples. So first of all on January first 2010, Ople incorporated signs a three year lease on a super computer, which is delivered that day. The lease requires payments of $19,709 at the end of each year. So three annual lease payments. There's no bargain purchase option or ownership transfer at the end of the lease. So that first criteria is not tripped, the first criteria for capital lease accounting. Ople's managers estimate that the lease lease term is 60% of the asset's life. So the third criteria is not tripped, and Ople's managers compute the present value of the lease payments as $44,264 using a 16% interest rate. This is a present value of 88. This present value is 88.5% of the current market value of $50,000. So if you, if you just bought this computer on the open market, it would be $50,000. The present value of the lease payments is 44,264, which is only 88.5%. So none of the four criteria are tripped. And so Ople can use operating lease accounting. And if you want to verify the present value calculation, you could put in three years, 16% interest, the payment of $19,709. If you plug that into Excel, you'll get the 44,264, which is less than 90%, Ople can use operating lease accounting. So what we need to do now is the journal entry that Ople would do on the day that the operating lease starts. So I'll bring up the pause sign and give you a chance to try this journal entry if you want. And the answer is there is no entry so under operating lease accounting, you would not make any entry, not record any asset or liability on the day that the super computer is delivered. >> No entry! Seriously, no entry! Surely, you must have to record a liability for the lease payments! >> Yeah, I agree. This is weird because you signed a non-cancellable contract to make these lease payments in the future. Sounds like a liability, but I guess the idea here is that since you don't satisfy those criteria, you're not using up a lot of the asset's life.l So at any point you could give the asset back to the lessor to get out of the contract and then not have to make those future payments. So I guess the default case is, there's enough uncertainty here that we're not going to view those payments as a liability. I agree, it's sort of a stretch, so. It just is. This is the way we do it for operating lease treatment. [SOUND] Okay now it's December 31, 2010, the end of the first year. And Ople makes its lease payment of 19,709. Why don't you go ahead and try to do the journal entry for this lease payment? So under operating lease treatment what we're going to do is debit rent expense, an expense that'll go on the income statement for 19,709, and we will credit cash for 19,709 for the cash payment. On December 31, 2011, the end of the second year, Ople makes its lease payment of $19,709. Why don't you try to do the journal entry for this one? The answer here is same entry different period. So its debit rent expense 19,709. Credit cash 19,709. So we recognize the cash payment as an expense on the income statement. Now it's December 31, 2012. It's the last lease payment. Ople makes it lease payment of 19,709. I'll bring up the pause sign and everybody try to do the journal entry this time. And again under operating lease treatment it's always the same journal entry, credit cash for the amount of the cash payment and then debit rent expense for that amount of the cash payment so the cash payment is expensed on the income statement when you make the payment. So to summarize for Ople, there was nothing that we recorded on January 1st. And then at the end of the three years, we made a cash payment, and that cash payment showed up as an expense, which then went into retained earnings. The total of the three cash payments and the total of the expenses was 59,127. >> I do declare this is a simple accounting method. I like it. But y'all said earlier that the price of the computer was $50,000. Ople paid $59,127 in lease payments. Why did Ople pay more to lease it? Are they run by a bunch of Yankees? >> I don't know whether Ople is run by a bunch of Yankees, but it actually makes sense that the sum of the lease payments $59,127, is greater than the cash price of buying the machine three years ago, $50,000. That's because that extra $9,127 represents financing cost, or interest costs. The lessor is essentially lending money to Ople, and they need to get paid for that. They need to get interest. And so you end up paying a higher amount by financing it over three years. That represents the implicit interest built into the lease contract. 'Kay, let's get another example. On January 1, 2010, Caple Incorporated signs a three-year lease for a supercomputer, which is delivered that day. The lease terms require payments of $19,709 at the end of each year. There's no bargain purchase option or ownership transfer so the first two criteria are not triggered. Caple's managers estimate the lease term is 60% of the asset's life so the third criteria is not triggered. And Caple's managers compute the present value of the lease payments as 45,000, using a 15% rate. This present value is 90% of the current market rate of 50,000. And here are the details on the present value calculations if you want to confirm it. But what I noticed is the present value is 90% of the current market value of 50,000 which means this trips that fourth criteria and Caple will have to use capital lease treatment for this contract. >> This sounds like the exact same lease contract as Ople signed for the exact same super computer. How can Caple's be capital lease method and Ople's be operating lease method? >> Yes this example was designed so that Ople and Caple had exactly the same lease contracts, exactly the same super computer, exactly the same dates. But yet they have different accounting treatment. And that's because to do the accounting treatment to judge these four criteria, they require some estimates by managers. So managers have to estimate what discount rate or interest rate they're facing on the lease contract. They also have to estimate what's the total asset life so they can do that 75% of asset life calculation. So, yeah managers have a little bit of discretion here. And they could use that discretion and estimates to actually get the lease accounting method that they want. So Caple has to use capital lease treatment. Why don't I throw up the pause sign, and see if you can do the journal entry that Caple would have to make on January 1, 2010, using capital lease treatment for this lease. So the journal entry here is we're going to debit a lease asset for 45,000 and credit a lease liability for 45,000. The 45,000 is the present value of the lease payments. And so, we're going to treat this as if we borrowed money. To buy an asset and both have the asset and the liability on the balance sheet. Once we have that asset and liability there, then Caple has to do the following subsequent accounting. The lease asset's going to be depreciated on a straight line basis for three years, and we'll assume no salvage value. So it's going to be treated just like you would treat any other long lived asset. The lease liability's going to be accounted for using the effective interest method. So part of the lease payments going to be going to interest expense. Part of it's going to be considered payment of principal which will reduce the balance in that lease liability account. The interest expense will be calculated based on the beginning balance in the lease liability account times 15%, which is the effective interest rate. The rate that was in effect when the lease contract started, and this will be treated just like we did mortgage payable. >> This sounds like a combination of what we learned last week for long lived assets and what we learned this week for long term debt. Is there anything new here? >> In terms of the accounting mechanics no there isn't anything new here the journal entry that we did for the lease payment is going to be exactly the same as we did for mortgages earlier in the week. And the journal entry due for depreciation is going to be exactly what we did last week for depreciation. So while the concept of leased assets and whether they go on the balance sheet or not is new, the accounting mechanics are actually just a nice review of things you should've learned over the last couple of weeks. So continuing on with the example. On December 31, 2010, Caple has to make its lease payment of 19,709. Caple also has to recognize the depreciation the supercomputer, so it needs to make two journal entries. I will throw up the pause sign so that you can try these. Although it may be difficult to get the numbers. So for now, just try to get the accounts that would be involved. So we start with a credit to cash for 19,709, because that's the cash lease payment that we're making. We're going to debit interest expense for 6,750. Now under the effective interest method we take the balance in the lease liability account, 45,000 times that effective rate 15% to get interest expense of 6,750 and then we're going to debit the lease liability to reduce the liability, this is like the payment of principal 12,959, and this is plug. It's just the cash minus the interest expense, whatever's left over goes to pay down the principle goes to reduce the lease liability. We also have to do depreciation expense of 15,000. That's the $45,000 asset value with no salvage value divided by 3 years on a straight line basis, 15,000 per year. And we credit accumulated depreciation for 15,000. So the total expense for the first year is 21,750. That's 6,750 of interest expense plus 15,000 of depreciation expense, and after we do this journal entry the balance in the lease liability account is 32,041. It's the original balance of $45,000, minus $12,959 that we just reduced the lease liability account. On December 31, 2011, Caple has to make its next lease payment of $19,709. Caple also has to recognize depreciation on the supercomputer. So I'll put up the pause sign and you can try the journal entries here if you'd like. Okay. So we again start with cash, we're paying our cash lease payments so we credit cash. Interest expense now is only going to be 4,806. Because remember the beginning balance in the lease liability count is 32,041. We take that times 15% to get the interest expense. Then the lease liability is going to be the, it's the cash that we paid minus the interest expense so the lease liability goes down by another 14,903. We recognize another year of straight-line depreciation expense and accumulated depreciation at 15,000 so debit depreciation expense, credit accumulated depreciation. So notice that the total expense in year two is 19,806. That's 4,806 plus 15,000, the interest expense plus the depreciation. And the ending balance in the lease liability is 17,138. So we came into year two with a balance of 32,041. We subtract 14,903, which is the debit that we have above. So at the end of the year, the balance is now 17 138. [SOUND] On December 31 2012, Caple makes another lease payment of 19709, that's the last lease payment. They also have to recognize depreciation on the super computer. So I'll put up the pause sign if you want to try the last set of journal entries. So we're going to credit cash for 19,709 for that last week payment, we debit interest expense, now the total is 2,571. That's that beginning balance of 17,138 times 15%. And then the plug goes to least liability, 19,709 minus the interest expense of 2,571. Note that the plug is 17,138, which is going to zero out this account. And then we do one more year of depreciation expense. Which will make the lease asset fully depreciated. The total expense this year is $17,571, that's 2,571 of interest plus the 15,000 of depreciation, and the ending balance of lease liability as I mentioned is zero, so this last debit brings the account down to zero. So to summarize what happened over the last three years for Caple, is on January 1, 2010, they booked the asset and the liability. They paid the same amount of cash, 59,127, they had exactly the same retained earnings, yet 59,127. But the timing of the expenses changed and of course we had the lease asset and lease liability which we worked down over time. Now the lease asset is the net book value, it's the lease asset minus the accumulated depreciation. But here you can see they both started at 45,000 and both ended up at zero at the end of the lease. >> Well I never. All that this rigmarole method does is change the timing of the expenses. The cash is the same so why bother? Y'all need to get a life. >> Well in this rigamaro old method doesn't even change the expenses that much. The expenses are a little bit lower under the operating method early on and a little bit higher later on. So I guess if you wanted smaller expenses earlier on in the least term operating would make sense, but the big difference here the big impact between capital and operating lease is on the balance sheet and the fact that capital has these assets and liabilities on the balance sheet and I'll show you that on the next slide. So, let's just put the two summary side by side so that we can just directly compare operating lease method and capital lease method as you can see capital lease method have higher expenses in the earlier years than operating lease method. But then a lower expense in the later year. And as we talked about, the total expense over the lease term is the same, so we're just shifting the timing of the expenses between the two methods. Capital leases of course have higher asset and liabilities. Because they have them on balance sheet, where as the operating lease method, all the stuff is off-balance sheet. Capital lease versus operating lease also effects the statement of cash flow, so we want to, I want to talk about that quickly. So going back to Ople with the operating lease, they may be three cash payments every year of 19,709. And that would be considered an operating cash flow as rent expense. Caple made exactly the same cash payments. So their total cash outflows are the same, but the interest expense portion is considered operating whereas the portion of the cash that went to reduce the liabilities considered financing. So as a result, capital leases always have higher cash from operations. The rent expense is operating cash flow for operating leases. So all that cash outflow reduces the operating. Whereas for capital, we're only reducing the operating cash flow by the interest expense portion because we consider some of it financing. And then of course the depreciation expense which you have under capital. Is irrelevant for cash flow, it would reduce that income but then be added back, having no impact at all on cash flow. >> Well thank you very much. Even though the cash payments are the same, the computer is the same, and the lease contract is the same, you have different effects on the SCF. >> Let's cut to the chase. Do companies play with their estimates so that they can justify using the method that makes their financial statements look the best? >> You're welcome, I'm glad I could give you two methods that complicated things. Although notice no one method dominates the other because capitol lease actually gives you better cash flow even though it might be hurting your earnings early on, and hurting your ratios. But to get to the question of whether managers are playing with these estimates to try to get certain lease treatment, yeah, I think that probably goes on, as do many other people in the financial markets. And as a result, there's a movement to change the rules to try to get rid of any game-playing incentives that might exist. So as it turns out these differences between capitol lease method and operating lease method have been quite controversial, because the operating lease method is allowing firms to keep what some people view as substantial financial obligations off of their balance sheets. So if you look at leverage ratios like debt to equity or rations like ROE or ROA, they're very distorted by this difference between operating lease and capital lease treatment. So so both the FASB and the IASB both have proposals to get rid of operating lease accounting. Basically if you had a long-term non-cancellable lease, you'll have some kind of asset and liability no matter what. The leasing industry is spending billions or maybe even trillions of dollars fighting against this change. And even though it's a proposal, it hasn't gotten anywhere yet but this is something to watch for that might come down the road in the future. Until then, a quick and dirty thing that you might want to do to adjust for this operating lease effect when calculating ratios is to try to capitalize them. So the big problem is, is on the balance sheet, you could also adjust the income statement and cashless statement but that tends not to be as big of a deal. So I'm just going to focus on the balance sheet. What you can do is there is going to be a footnote which would give you the future operating lease payments. So like we saw Ople had the 19,709. So in a footnote you can see these future payments that a company's going to make under these leases. You can calculate the present value of those lease payments using some kind of reasonable interest rate, and then put those present value as part of long term assets. And it's part of long term debt, and then recalculate all your ratios. Or as long as you don't tell anybody, a quick and dirty shortcut is to just multiply rent expense by eight to estimate the asset and liability. Now obviously that's a very crude method because it doesn't ad, allow for differences in interest rates. But it actually performs pretty well in most circumstances so, it would be a quick way to try to estimate that. I'm not going to do that in this video but what I'll do is when we look at the 3M financial statements, I'll show you how to do this calculation. So normally at this point in the week we would have a video that would be a disclosure example, where we would see how some of these concepts we've been studying show up in financial statement disclosures. But you guys have watched a lot of video this week, especially with all that time value of money stuff at the start. So instead, in the next video we'll move right to the 3M financial statements. And we'll look at those financial statements to see how some of those concepts show up in the disclosure. I'll see you then. >> See you next video.
