- Let's do a simple numerical example
using a hypothetical company
to illustrate how the new lease accounting rules work.
Kylie Company has leased a store location
under a 20-year non-cancel level agreement.
The annual lease payment is $11,746.
If Kylie had purchased the store location,
the cash price would have been $100,000.
If Kylie had borrowed the $100,000 to purchase the store,
the interest rate on the loan would have been 10%,
and the annual loan payment would have been $11,746.
Now note in this example the lease payment
and the loan payment are the same.
This is not necessarily always going to be the case.
This depends on the length of the lease
relative to the useful life of a leased asset,
the borrowing capacity of the company signing the lease,
market conditions for the leasing company and so forth.
Now where does that 10% interest rate come from?
One of two places.
First, the leasing company,
the company that legally owns the store location
and that will receive the lease payments
must have used some kind of interest rate
in calculating the $11,746 annual payment for the 20 years.
If Kylie Company can find out that interest rate,
then that is the interest rate that is used.
Alternatively, if Kylie Company can't find out
the leasing company's interest rate,
then Kylie Company can use the interest rate
that it would expect to pay on a loan
to borrow the $100,000 to buy the store.
This interest rate reflects Kylie Company's riskiness,
current market conditions, and the fact
that the store location itself
serves as collateral for the loan.
In this case, we'll say that careful analysis
indicates that the interest rate to be used is 10%.
Let's say that the lease goes into effect
on January 1st of year one.
On that date, Kylie Company will record
a leased asset of $100,000
and a lease liability of $100,000.
For recording of the $11,746 lease payment each year,
the lease must be classified as a finance lease
or an operating lease using the principles
based version of the old lease classification criteria.
Well let's say that the lease satisfies
at least one of the four criteria
so it's classified as a finance lease.
For finance leases, the income statement
contains two different expenses,
interest expense on the lease liability
computed using the 10% interest rate,
and depreciation expense on the leased asset
computed using the 20-year length of the lease.
Annual depreciation expense is easily computed.
$100,000 leased asset divided by 20 years
equals $5,000 in annual depreciation expense.
Now interest expense for year one is computed as follows.
The $100,000 lease liability times the 10% interest rate
or in year one, $10,000 of interest expense.
So the total expense associated
with this finance lease in year one is $15,000.
That's the $5,000 in depreciation expense
plus the $10,000 in interest expense.
Note that with respect to interest expense,
I'm very careful to say year one interest expense.
Interest expense in year two will be a bit lower
because the $1,746 surplus amount paid in year one,
that's 11,746 payment less the $10,000 in interest expense,
goes to reduce the amount of the lease liability.
So at the beginning of year two,
the amount of the lease liability is only $98,254.
So interest expense in year two will be just $9,825,
that's $98,254 times 10%.
The amount of interest expense
will continue to go down each year.
For example, in year 20, the amount of interest expense
will be just $1,068.
Now in contrast, the depreciation expense each year
will be the same, $5,000.
With a finance lease, total expense in year one is $15,000.
Total expense in year 20 is $6,068
which comes from $1,068 in interest expense
plus $5,000 in depreciation expense.
Now, if a lease fails to satisfy
any of the four lease classification criteria,
the lease is an operating lease.
Both the leased asset and the lease liability
are still on the balance sheet
but the income statement contains just one expense,
lease expense which is equal
to the amount of the $11,746 payment.
The amount of lease expense is the same each year.
This table summarizes the new lease accounting rule.
As you can see, whether it's a finance lease,
or an operating lease, assets and liabilities
are now on the balance sheet.