Chapter 20: Accounting for Leases

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Have you ever leased a car?

Maybe rented an apartment?

Or even just a piece of equipment for a weekend project?

If you have, then you've actually been part of a lease transaction.

Maybe without even realizing the accounting side of it.

Absolutely.

And these aren't just everyday personal things.

Leases are really central to how major global businesses operate.

Yeah, they really are.

So today we're taking a deep dive into this complex but incredibly common world of leases in accounting.

Right.

Our mission is really to unpack why leases are so vital for businesses, look at how they're classified on the books, and crucially how they impact a company's financial statements.

And that affects everything, right?

From reported debt to profitability.

Exactly.

It touches so many areas.

Our goal here is to make these, let's face it, pretty intricate accounting concepts clear and accessible for you.

We want to show the powerful implications for, say,

investors and creditors.

And when you think about it, huge companies like Apple, ExxonMobil, UPS,

they rely heavily on leasing.

Oh, massively.

Apple, for instance, leases a lot of its prime retail locations.

We're talking billions, often, in future lease commitments on their books now.

Billions.

Wow.

And ExxonMobil.

They lease all sorts of things, drilling equipment, tankers, service stations.

It's fundamental to their operations.

And UPS, I imagine, with all their logistics.

Warehouses, aircraft,

office space, you name it, it powers their whole global network.

So understanding how these massive liabilities and the corresponding assets are presented on a company's financial statements, that's absolutely crucial, isn't it?

If you really want to understand their financial health.

Couldn't agree more.

It's fundamental.

So let's back up a bit.

What exactly is a lease at its core?

OK, so at its heart, it's a contractual agreement.

Pretty simple, really.

You have the lesser that's the owner of the property, and they grant the lessee the user the right to use that specific property for a set period.

And in return, the lessee makes payments.

Exactly.

A series of rental payments over that period.

Fundamentally, that's it.

It sounds just like leasing a car then.

You get to drive it, you benefit from it, but you don't actually own it.

End of the term, back it goes.

Precisely.

There's actually a great quote from Aristotle that fits perfectly here.

Wealth does not lie in ownership, but in the use of things.

Oh, that's interesting.

And a lot of modern companies really operate under that philosophy.

It's core to their strategy.

And we're not talking small change here, are we?

This leasing world is huge.

Oh, it's enormous.

It's a multi -trillion dollar industry.

It significantly impacts balance sheets, income statements across the globe.

You mentioned Delta Airlines earlier.

Yeah, good example.

For Delta, they're lease -related assets.

They represent over 10 % of their total assets and the lease liabilities.

Over 12 % of total liability.

Wow.

And the lease costs themselves make up nearly 8 % of their operating expenses.

So you see, this isn't some minor footnote.

It's a fundamental part of what investors and creditors look at very closely when they analyze Delta.

OK, so it's big business.

Why is leasing such a popular option, especially for the lessee, the company using the asset?

What are the big draws?

Well, there are some really powerful strategic advantages.

First off, it often offers 100 % financing, usually at fixed rates.

Ah, so conserving cash.

Exactly.

Think about a startup needing expensive equipment or maybe a company expanding rapidly.

Leasing lets them get those assets without a huge upfront capital hit.

Preserves precious cash.

And the fixed payments must help with budgeting, too.

Definitely.

Predictable payments plus it offers some protection against inflation.

It just makes financial planning a bit easier.

Well.

Another huge one is protection against obsolescence.

Right.

Things get outdated so fast these days.

Especially with technology.

Leasing allows companies to consistently get access to the latest and greatest new computer systems, advanced machinery, whatever it is, just by upgrading at the end of the lease term.

So they don't have to worry about selling off old depreciated equipment.

Exactly.

Avoids that whole headache and potential loss.

And I guess there's flexibility, too.

Huge flexibility.

Lease agreements can often be highly customized.

You can tailor payment structures, lease terms.

It fits the company's specific needs.

OK.

And you mentioned cost.

Can it actually be cheaper sometimes?

It can be.

Sometimes it's less costly financing.

For example, maybe a startup doesn't have enough taxable income to really benefit from depreciation deductions if they bought the asset outright.

Right.

But the lesser, maybe a big financial institution, they can use those tax benefits and they might pass some of those savings onto the lessee through lower rental payments.

Ah, like a win -win situation.

Exactly.

It can work out well for both sides.

So speaking of the lessers, the owners.

Yeah.

What's in it for them?

Well, they benefit greatly, too.

First, they earn profitable interest margins.

Lease payments always have an interest component baked in.

OK.

So it's a revenue stream.

Definitely.

And leasing also stimulates sales.

It helps customers afford more expensive product through those manageable payments.

Think car dealerships moving more cars because leasing makes them accessible.

Right.

Brings more customers in the door.

And just like we mentioned, the tax benefits for lessees indirectly, lessers get them directly.

Imagine a wealthy investor buying, say,

a Boeing 737 and leasing it to an airline.

That investor gets a significant tax deduction from depreciating the plane.

That allows them to offer a lower rental rate to the airline, making it more attractive.

Interesting.

And what about when the lease ends?

Ah, that's another big one for lessers.

Yeah.

Potentially high residual value.

When you return that leased car, the dealership can turn around and sell it as a used car, right?

Yeah.

Potentially profiting again from the same asset.

But, and this is a big but.

Here comes the catch.

Here's where it gets really interesting and sometimes really painful for the lesser.

What happens if that estimate of the residual value, what it'll be worth at the end, goes horribly wrong?

Ah, so the risk is on the lesser there.

Yes.

This brings us to what we might call residual value regret.

It's fascinating how critical that initial estimate is.

Does it ever go unexpectedly well?

Oh, absolutely.

Citigroup once estimated commercial aircraft would be worth maybe 5 % of their purchase price at lease end.

They actually came back worth 150%, a huge unexpected profit.

Wow.

But the flip side.

The flip side can be brutal.

Automakers have really felt this.

Ford once took a $2 .1 billion write down when SUV resale values just plummeted unexpectedly.

2 .1 billion.

Ouch.

Yeah.

And Fiat Chrysler, now Stellantis, they famously got out of the leasing game altogether for a while because they kept losing money on residual values.

And wasn't there a story with the Chevy Volt?

Yes.

GM had a tough time there.

Government subsidies made the lease cost super low, right?

So something like two -thirds of all Volt sales were actually leases.

OK.

But when those cars came back off lease, the demand for used electric cars without those subsidies,

it just wasn't there.

Resale values tanked.

So GM ended up losing money instead of making it on the resale.

Significant losses.

And it even hurt sales of new Volts because the resale value was so poor.

It just shows the huge financial risk if you misjudge that future value.

OK.

So it's complex.

There's risk.

There's reward.

How do companies actually account for all this?

How do leases get classified?

Right.

That's the crucial next step.

For both the lessee and the lesser, the core question boils down to this.

Does the lease effectively transfer control of the asset, basically?

The benefits and risks similar to ownership to the lessee?

Or does it just give them the right to use it for a while?

And why does that distinction matter so much for the accounting?

Well, interestingly, under the newer accounting standards, both major types of leases, finance and operating now, require capitalizing the least assets and liabilities on the balance sheet.

That was a big change.

OK.

So both show up on the balance sheet now.

Yes.

But the income statement impact, that's where the significant difference really lies.

And that difference really affects how a company's financial health and performance are perceived.

Right.

That makes sense.

So how do they make that distinction?

Is it just a judgment call?

No.

There are specific tests.

A lease is classified as a finance lease if it's non -cancellable, and it meets at least one of five specific tests.

Only one.

Only one.

If it doesn't meet any of these five, then it's classified as an operating lease.

And these tests are designed to see if it feels more like ownership.

Exactly.

They assess if the lessee has effectively gained control over the assets, economic benefits for most of its life.

Let's quickly walk through them.

Test number one.

First, the transfer of ownership test.

Pretty straightforward.

Does ownership of the asset actually transfer to the lessee by the end of the lease term?

If yes, finance lease.

Done.

Simple enough.

Number two.

The purchase option test.

Is there a purchase option at the end that's considered a bargain, meaning it's reasonably certain the lessee will exercise it because the price is so much lower than the expected fair value?

Like buying that leased Honda Accord for $1 ,000 when it's really worth $10 ,000.

Exactly.

That signals it's really more like a finance purchase, so finance lease.

Got it.

Third test.

Third is the lease term test, often called the 75 % test.

Is the lease term, including any bargain renewal options, 75 % or more of the asset's total estimated economic life?

Bargain renewal options, like super cheap rent to extend the lease.

Right.

If renewing is almost a given because the rent drops significantly, you have to include that renewal period in the lease term calculation.

This test basically asks, is the lessee using the asset for the vast majority of its useful life?

Okay, makes sense.

Fourth,

the present value test, or the 90 % test.

Does the present value of the lease payments equal or exceed substantially, all defined as 90 % or more of the asset's fair value at the start of the lease?

So are the payments basically covering almost the entire cost of the asset?

That's the idea.

When calculating those lease payments, you include fixed payments, some variable payments that are essentially fixed, and any residual value the lessee guarantees.

And what discount rate do you use for that present value calculation?

Ideally, you use the interest rate implicit in the lease, set by the lesser, if it's known to the lessee.

If not, the lessee uses their own incremental borrowing rate, what it would cost them to borrow similar funds.

Okay, one test left.

The fifth and final one is the alternative use test.

Is the asset so specialized that it essentially has no alternative use to the lesser at the end of the lease term?

Ah, like something custom -built.

Exactly.

Think of those custom hydraulic lifts built specifically for Amazon's unique loading docks.

If that asset is tailor -made for the lessee and wouldn't be useful to anyone else without major changes, it's a finance lease.

The lesser has effectively given up any other use for it.

So just one of those five needs to be met for it to be a finance lease?

Correct.

Non -cancellable lease plus meets one of the five tests equals finance lease.

Otherwise, it's an operating lease.

Okay.

So let's talk about the accounting itself now.

How does it look on the lessee's books?

Let's start with a finance lease.

All right.

For finance leases, from the lessee's perspective, at the very beginning, they recognized two things on their balance sheet.

A right of use, our OU asset, and a lease liability.

Both recorded at the same amount?

Yes, initially.

They're both valued at the present value of the lease payments that we just discussed.

So if Starbucks leases a big coffee bean roaster, they put an OU asset and a lease liability on their balance sheet.

This grosses up their balance sheet, showing the economic reality of this long -term commitment.

Which wasn't always the case before the new standards, right?

Exactly.

This was a major change, bringing potentially huge obligations onto the balance sheet.

So what happens after that initial recording?

How are the payments handled?

Subsequent accounting is kind of like how you'd account for a loan or a mortgage.

Each lease payment the lessee makes has two components.

Interest in principle?

Essentially, yes.

There's an interest expense component, calculated using the effective interest method on the outstanding lease liability.

And the rest of the payment reduces the lease liability itself.

Okay.

And what about the ROU asset?

Does that just sit there?

No.

Just like any other long -term asset you own and use, the ROU asset is amortized.

It's typically expensed on a straight -line basis over the lease term.

This creates amortization expense.

So for a finance lease, the lessee sees two separate expenses hitting their income statement each period.

Interest expense and amortization expense.

Precisely.

That's the key income statement impact for a lessee's finance lease.

Okay.

Now what about operating leases for the lessee?

You said they also record an ROU asset and liability now?

Yes.

The initial balance sheet recognition is similarly ROU asset and lease liability recorded at the present value of lease payments.

This ensures that the obligation is visible on the balance sheet, promoting transparency.

But the subsequent accounting,

you said that's where the big difference is.

This is the key distinction, yes, and kind of the aha moment.

For an operating lease, instead of separate interest and amortization expenses, the lessee recognizes a single, usually straight -line, lease expense on the income statement over the lease term.

Just one expense line.

Just one line item.

Lease expense.

It smooths out the cost over the lease term.

But how does the ROU asset get reduced then, if there's no separate amortization expense?

This is where it gets a little clever.

The reduction in the ROU asset, the amortization component, essentially becomes a plug figure each period.

A plug.

What do you mean?

It means the amount of ROU asset reduction is calculated as the difference between the straight -line lease expense and the calculated interest expense on the liability for that period.

The goal is to make sure the total expense hitting the income statement is that smooth, straight -line amount.

So the ROU asset amortization adjusts to make the math work for a level expense profile.

Exactly.

It ensures the income statement reflects a consistent rental cost, even though the underlying interest portion changes over time.

That is a significant difference in presentation from the finance lease.

It really is.

And it's even more interesting when you look globally.

Under US GAAP, you have this distinction.

Finance leases with separate interest amortization and operating leases with the single straight -line expense.

But under IFRS, the international standards, they basically treat all leases as finance leases from the lessee's perspective.

Oh, really?

So internationally, everything shows separate interest and amortization?

Generally, yes.

So that single lease expense approach for operating leases is unique to US GAAP.

It highlights how different frameworks can represent the same underlying transaction quite differently on the income statement, which definitely impacts comparing companies across borders.

Fascinating.

So think about McDonald's leasing that flippy robot.

Under US GAAP, if it's an operating lease, they'd book the asset and liability, but then just record a steady lease expense each month.

Correct.

That monthly entry effectively combines the interest component and the plug amortization amount into one number.

Okay.

That clarifies the lessee side.

Let's flip it over.

What about lesser accounting?

The owner leasing out the asset.

Right.

The lesser's perspective.

They also classify leases primarily into sales type leases, which correspond to the lessee's finance lease and operating leases.

Do they use the same five tests?

Yes, essentially.

If the lease meets any of those five tests, indicating the lessee has gained control, then the lesser is deemed to have given up control.

This means the lesser has satisfied a performance obligation, similar to making a sale.

So they account for it like a sale?

Pretty much, assuming payment collection is probable.

At the start of the lease, the lesser records a lease receivable.

What goes into that receivable?

It's the present value of the rental payments they expect to receive, plus the present value of the residual value of the asset at the end of the lease, whether it's guaranteed by the lessee or not.

Wait, they include unguaranteed residual value too.

Why?

Because the asset comes back to them, the lesser.

So its expected residual value is part of the total economic value they expect to realize from the transaction.

It's part of their receivable in an economic sense.

Okay, that makes sense.

What else do they record initially?

At the same time, they recognize sales revenue and cost of goods sold.

This reflects the sale aspect and any immediate selling profit they make.

They also remove the leased asset from their inventory.

So going back to Coffee and Beans leasing the roaster to Starbucks,

if it's a sales type lease for Coffee and Beans?

They book the lease receivable, recognize sales revenue, likely the PV of lease payments plus PV of residual value, record cost of goods sold, their cost of the roaster, and take the roaster out of inventory.

They book the profit upfront.

And then as they receive payments over time?

They recognize interest revenue on the lease receivable using the effective interest method, just like earning interest on any loan.

Got it.

Now, what if it's an operating lease for the lesser?

None of the five tests were met.

Okay, this is quite different from a sales type lease for the lesser.

The key thing is the lesser continues to recognize the leased asset on their own balance sheet.

They don't treat it like a sale at all?

Nope, because they haven't transferred control according to the tests.

They still effectively own the asset and retain the risks and rewards of ownership.

So how do they account for the payments they receive?

They recognize lease revenue typically on a straight line basis over the lease term as they earn it.

And what about the assets still sitting on their books?

Crucially, they continue to depreciate that leased asset over its useful life, just like any other piece of property, plan or equipment they own and use.

So MISO Robotics leasing Flippy to McDonald's as an operating lease.

MISO keeps Flippy on its balance sheet, depreciates it each year, and records the payments from McDonald's as lease revenue.

Exactly, no upfront profit, just steady revenue recognition and ongoing depreciation of their asset.

Okay, let's touch on a few trickier areas.

You mentioned residual values being complex.

Can we dive a bit deeper there?

Sure.

From the lessee's side, if there's a guaranteed residual value, GRV.

Meaning the lessee promises the asset will be worth at least a certain amount at the end.

Right.

For the classification tests, like the 90 % PV test, the full GRV amount is included in the present value calculation.

But for measuring the initial lease liability, the lessee only includes the present value of the amount they actually expect to owe.

What do you mean?

If the lessee guarantees $5 ,000, but expects the asset will actually be worth $6 ,000 at the end, they don't expect to owe anything.

So zero GRV goes into the liability calculation.

But if they expect it to be worth only $3 ,000, they anticipate owing the $2 ,000 difference.

That $2 ,000, its present value, is included in the initial lease liability.

Ah, okay.

Only the probable payout affects the liability.

What about an unguaranteed residual value for the lessee?

Much simpler for the lessee.

It's not included in their classification test, their liability measurement.

It's purely the lesser's risk and potential reward.

Now flip to the lesser.

You said they include all residual value, guaranteed or unguaranteed, in their lease receivable for a sales type lease.

Yes.

But there's a nuance for unguaranteed residual value, URV, in a sales type lease.

While the URV is included in the lease receivable, the sales revenue and cost of goods sold recognize that the start are both reduced by the present value of that URV.

Reduced?

Why?

Does that change the profit?

Interestingly, the gross profit, sales revenue, minus COGS, remains the same.

Reducing both sides effectively defers recognition of the profit related to the uncertain URV until the end of the lease.

It reflects that the lesser hasn't fully sold.

The residual value component, since its return isn't guaranteed by the lessee.

It's a subtle but important adjustment for accurate revenue recognition timing.

Okay, that's quite detailed.

What about other common adjustments, like property taxes or insurance?

Good question.

Those are called executory costs.

If the lease payments include these costs, a gross lease, then they're just part of the fixed payments included in the lease liability calculation.

And if the lessee pays them separately?

If it's a net lease where the lessee pays taxes and insurance directly, those costs are treated as variable payments and simply expensed as incurred by the lessee.

They don't go into the initial ROU asset or liability calculation.

What about prepayments or incentives, like paying the first month's rent upfront, or the landlord giving cash to fix up the space?

Those directly adjust the initial ROU asset balance for the lessee.

Lease prepayments increase the ROU asset, while lease incentives received decrease it.

They don't affect the liability, just the asset side.

And one more,

initial direct costs, like commissions or legal fees to get the lease done.

These are costs that wouldn't have been incurred if the lease hadn't been executed.

For the lessee, these costs are added to the ROU asset amount.

Added to the asset, not the liability.

Correct.

For the lessee, in a sales type lease with a profit, these costs are expensed immediately as selling expenses.

In an operating lease, the lesser defers and amortizes these costs over the lease term.

Quickly, you mentioned bargain purchase options earlier.

How does that affect amortization?

Right.

If a BPO exists and exercise is reasonably certain, the lessee accounts for it similarly to a GRV where payment is expected.

The key difference is the ROU asset amortization period.

It's amortized over the asset's total economic life, not just the lease term, because the lessee effectively expects to own it long -term.

And short -term leases.

Anything less than a year.

Leases with a term of 12 months or less have a practical shortcut option for lessees.

They can elect not to recognize the ROU asset and liability, and simply expense the lease payments as incurred, usually straight line.

Ah, simpler accounting for very short leases.

Yes, but there's a catch.

If the lease contains renewal options that the lessee is reasonably certain to exercise, and those options extend the total term beyond 12 months, you can't use the short -term lease exception.

You have to consider the likely four -term.

Got it.

So, pulling this all together, what's the big picture impact on financial statements and analysis?

This seems like a huge shift.

It absolutely is.

This is where it really matters for anyone looking at company financials.

The single biggest impact of the new standards was the massive grossing up of balance sheets.

Meaning assets and liabilities both went way up.

Way up.

Companies like Walgreens, AT &T, CVS, Walmart, FedEx.

We saw trillions of dollars in ROU assets and corresponding lease liabilities appear on balance sheets that were previously hidden, or off balance sheet, disclosed only in the footnotes.

And that must change key financial ratios significantly.

Dramatically.

Take return on assets, ROA, net income divided by assets.

Since assets jump up significantly, but net income doesn't necessarily change much in the short term, ROA typically decreases.

Okay.

What about debt ratios?

Solvency metrics definitely change.

Debt to equity ratios naturally increase because lease liabilities are now explicitly included as debt.

Interest coverage ratios might decrease because the interest component of finance leases, or the total lease expense for operating leases, impacts the calculation.

So it paints a potentially riskier picture.

It paints a more transparent picture of a company's true financial leverage and obligations.

It's not just an accounting exercise.

It could affect property taxes based on higher reported assets, maybe how management performance is measured, and definitely how debt covenants are written and monitored.

Lenders needed to adjust their agreements.

It really forces a clearer view.

Absolutely.

The required disclosures are also much more extensive now, detailing the nature of leases, assumptions used, lease costs, maturity analyses of liabilities, much more visibility.

Before we wrap up, can you briefly touch on sale leasebacks?

You mentioned Darden selling Red Lobster.

Sure.

A sale leaseback is just what it sounds like.

A company sells an asset it owns and then immediately leases it back from the buyer.

Why would they do that?

Often for liquidity, it generates immediate cash from an owned asset while letting them continue using it.

It can also offer flexibility and maybe some tax advantages.

How is it accounted for?

Is it always treated as a sale?

Not necessarily.

The accounting hinges on whether control of the asset has truly transferred from the seller lessy to the buyer lesser based on revenue recognition principles.

If control has transferred, it's treated as a sale, recognized gain loss, derecognized asset, and then the leaseback portion is accounted for like any other lease, operating or finance.

And if control hasn't transferred?

Then it's considered a failed sale.

The seller keeps the asset on its books, continues depreciating it, and treats the cash received from the buyer essentially as a loan of financing liability.

Okay.

And one last specialized item.

Direct financing leases for lessers.

Right.

This is a less common lesser classification.

It occurs when the lesser gives up control based on the tests, so it feels like a sales type lease.

But there's significant third party involvement, like a third party guaranteeing the residual value.

How does that change the lesser's accounting from a regular sales type lease?

The key difference is no immediate selling profit is recognized by the lesser.

Instead, the profit is deferred and recognized as interest revenue over the lease life.

Why defer the profit?

Because the lesser hasn't fully transferred all the risks.

They might still have credit to that third party guarantor, for example.

So deferring the profit better reflects the timing of when that risk is resolved and the profit is truly earned.

It's a nuanced distinction mainly affecting lessers like banks or finance companies.

Wow.

Okay.

We've certainly covered a lot of ground there.

We really have.

We've navigated the pretty complex world of lease accounting from why companies lease to how leases get classified, the detailed accounting entries, and crucially the significant impact on financial statements and key metrics.

So for our listeners, you should now have a much better grasp of why companies choose to lease, how these deals were reflected on the books, and why these details, which might seem small, can actually have massive implications for a company's reported financial health.

It really matters for anyone analyzing those financial reports.

Absolutely.

And maybe a final thought to leave everyone with.

Given this dramatic increase we've seen in reported assets and liabilities for so many companies because of these leasing standards, how might this change the way we as analysts or investors or just informed observers evaluate corporate performance and risk in the years ahead?

That's a great question to ponder.

It really forces us to think not just about the numbers themselves but about what those numbers truly represent regarding a company's obligations and operational structure.

Well said.

Thanks for joining us on this deep dive into lease accounting.