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and we're going to combine our last two learning objectives el OS o and P to explain and evaluate the concept of leasing and we're going to do this kind of like four ways we're going to do it from the point of the lessor and the point of the lessee and we're going to do it from an operating lease and a financing lease perspective so let's go ahead with this and this is a sort of a new entry into a level one this if you go back a couple of years this this didn't really exist at level one so that's kind of makes this reading an extra long reading this is tacked on to the end I think in your book it's and somewhere around 15 to 20 pages of details so let's see how quickly we can or how compact we can make this a lease is a contract between the owner of an asset the lease or and the user of the asset the lessee and there are advantages to leasing the big one is the conservation of cash and if I got a business and I need six trucks well if I got to buy six trucks I got to arrange financing make payments carry interest on that etc or I've got to use my own cash but if I can lease them well you can pretty much take delivery of most vehicles on a lease with the minimal amount of money down and you just pay a your operating fees per per month write a hedge against obsolescence at the end of three years I give it back or the end of two years at the end of five years whatever the length of the lease on the equipment is I give it back so I basically have a put option I can put the asset back to the to the owner of the of the asset and I don't have to worry that I have a write down or an impairment of a particular asset fewer restrictions and borrowing and it may even be cheaper than borrowing and there are tax advantages of using a lease as opposed to owning it and the tax advantages are not complete tax advantages but not absolute in the sense that one will be better than another the tax advantages come in the timing of the amounts of the deductions that you can use and we're going to see some examples of that let's look at things from a Lisi perspective from here on in and everything from here on in will be from the leases perspective until I get to the point where I say now let's look at it from the least source perspective okay so I'm not going to jump back and forth between Lisa and Lisi will stay with the lessee and will go back and forth between operating and financing leases okay GAAP something is classified as a capital lease if we're saying I Fri sifr just uses the term finance lease GAAP uses the term capital lease so it's classified as a capital lease if any of these four conditions are present ownership transfers to the lessee at the end of the term that means you make your last payment you own it it's yours well that's just basically seller financing right or to a bargain purchase option exists to make it a capital lease in the lease agreement it must specifically say at the end that the buyout is a market price at the time it cannot set a price saying for $1 $100 it must be a market determined price at the end of the lease period number three the term is greater than 75% of the useful life of the asset or number for the present value of all the payments at exception at inception are greater than 90 percent of the fair value greater than 90 percent that's easy to get around like if I'm trying to structure a capital lease that clearly looks like a finance lease if I'm trying to do that I'll maintain let's say that I want to help a customer out I'll maintain ownership of it I'll put market price in here I'll make an estimate of useful life that makes sure that we don't get to 75 and as much as I want all my money back I'll play with the discount rate I'll play with the discount rate so that the present value of all the payments come in less than 90 percent so this this can be managed quite effectively if these conditions don't exist you have an all rating lease well we know the conditions under which a lease is a capital lease under GAAP under IFRS all it is a finance lease when all risks and rewards of ownership are transferred to the lessee that is called a finance lease so let's look at the difference between an operating lease here and the capital and finance lease operationally and I'm not going to make a distinction between capital and finance every time that capital is GAAP and finances are IFRS I'm going to use them interchangeably so if I use the term finance lease you can you can just add the word capital to it if I use the word capital lease on its own it's it's the same thing from now on capital or finance pretend that's the same word an operating lease from the leases perspective there is no balance sheet effect it's an operating lease I only use it I don't own the asset I'm basically just renting it so no asset appears on my balance sheet I have rent expense or a leasehold expense that's it and I have cash outflow but my outflow is in the cash flow from operations section if I bought the asset with financing then that have cash flow from investing in cash flow from operations for the interest payment on it but here this is just pure expense cash flow from operation if it's a finance lease or a capital lease there is a least related asset and liability at inception I have if I lease a truck and let's say it's a capital lease or finance lease I have an asset on my balance sheet I also have a corresponding liability on the balance sheet I will list the present value of all the payments that's my carrying cost my original historical cost is the present value of all my payments because I'm getting rid of that interest right I'll pay the interest but that's not part of the cost the original cost that's cost of the financing so the present value of all the payments is entered into long-lived asset and it is depreciated which I do have a corresponding expense for depreciation also have a corresponding liability as well which is typically called obligation under capital lease and typically capital leases lasts more than a year so this is under the liability side you have to be aware of this there will be a current liability which is the portion of the obligation under capital leases that are due within 12 months and then there'll be a long-term liability which is the balance of it so whenever we see a company that has obligations under capital leases there'll be a current liability section a portion of it and a long-term liability so you have to look you have to add the two together to get the the total obligations under capital leases the liability is just the same thing as the as the balance sheet it's just the present value of the payments we don't include the interest on the liability now as we get a payment the payment is principal plus interest the principal will reduce the liability the interest that we that we pay will be an expense so let's say that every month we pay a thousand dollars and in the month that we pay the thousand eight hundred dollars of it is is to reduce the liability to hundreds interest when we make that payment our cash balance will drop by a thousand our liability will drop by eight hundred and our interest expense will increase by two hundred on the cash flow statement the interest that we pay ends up in cash flow from operations as a cash outflow and the principle that we pay ends up on the cash flow from financing section also as a cash outflow so why don't we see what that looks like under both conditions of Finance lease in an operating lease company a lease is an asset for four years and it's going to pay ten thousand dollars per year and the discount rate that's being used is seven percent so how would we record that as a finance lease how would we record that as an operating lease let's do the operating lease that's really easy what do we record every year rent expense of ten thousand we're done that's it that's nice and simple nothing goes on the balance sheet we have no asset no liability we simply just have an expense of course our after tax expense is $10,000 one minus our tax rate so our true cost of leasing it would be our after tax expense because this 10,000 does give us some tax shield of whatever our tax rate is right well if it's a finance lease while now we got to do some work we got to put an asset on the books and a liability on the books we're paying ten thousand a year the discount rate is seven percent we got to find the present value of all those payments you can treat this like you would with any time value of money a stream of flows because it's a constant stream of flow every year we don't have to use anything but a calculator for this our future value will be zero our payment is ten thousand RI y equals seven or N equals four just like you would with any bond pricing there's your inputs compute present value we get thirty three thousand eight seventy two so that's our asset we have a beginning a liability of thirty three eight seventy two and we have a beginning asset of thirty three eight seven two so let's have a look at what happens with our liability thirty three thousand eight seven two year one we make a ten thousand dollar payment we have an interest expense of two thousand three hundred and seventy one our principal reduction is seven thousand six hundred and twenty nine the carrying value of our liability drops to twenty six two four three by the end of year one so our interest how did we get that well we have seven percent right we have 33 8 7 2 s our beginning balance multiply it by seven percent in the first year we'll pay twenty three seventy one in the second year take your gear declining balance we have twenty six two four three outstanding multiplied by seven percent we get eighteen thirty seven so we this is this is called an amortization schedule when we get to the reading on fixed income there's a whole section in there on asset backed securities you'll you'll be sort of ahead of the game if you understand these amortization schedules when you get to amortization schedules there now one important point or sorry two important points to go through here the beginning liability this gets recorded on the balance sheet the interest payment shows up on the income statement as interest as an interest Spence and in the cash flow from operations section as a cash outflow the principle payment is recorded as a cash outflow in the cash in the cash flow from financing section secondly this is the amortization schedule of the liability of the liability it in no way matches the depreciation schedule of the asset in other words just because we have a principle reduction of seven thousand six hundred and twenty nine dollars in year one off of the liability does not necessarily mean that the appreciation will equal that amount as well depreciation doesn't necessarily equal that so the asset may take a different journey on its way to 0 then the liability does just keep that in mind that depreciation may be calculated differently we might have we might be leasing this over four years on a finance lease but expect to realize six years useful life out of it and in which case our financing doesn't match our liability in that sense but we might be concerned with minimizing our interest expense in the near term and not too concerned about about matching our debt with our asset life we might have a different depreciation schedule altogether so don't don't take this liability amortization schedule as also the asset depreciation schedule so let's look at some financial statement effects and we'll move on to some ratio effects later let's look at our balance sheet effects for doing all this and we'll look at certain items assets current liabilities long-term liabilities in cash under finance lease vs. and operating lease under a finance lease our assets will be higher because we record an asset under operating we say lower only because finance is higher if it were an operating lease for an asset the real answer here would be no change but we're just comparing the two it's finance versus operating so it's not as if if we operate if we took an asset on an operating lease suddenly our assets would be lower they wouldn't be no change but compared to a financing lease I used word'll over here so the assets are going to be listed higher our current liabilities will be higher why because you have the current portion of obligations under capital leases the next 12 months of payments have to be listed in the current liability section so they'll be higher long-term liabilities will be higher as well because while most leases last more than one year so they'll end up in the long term liability section and your cash is the same whether you have a finance lease or an operating lease because typically and we're making the assumption that on delivery no payment is due yet or it would be the same payment due if it's called an annuity due if the lease is not structured as an annuity remember an annuity has a payment at the end of the period and annuity due has a payment at the beginning of the period so if the leases are structured so that your first payment is here for this period of time then it would still be the same effect whether it be financing or operating you make a payment on day one it's just you're buying something different under each of these conditions the income statement effect here's our financing lease here's our operating lease let's look at the financing lease notice here there's our depreciation expense notice that it does not match the principle reduction as I said so we're going to do four years straight-line depreciation on this of 84-68 a year our interest expense in the first year is twenty three seventy one noticed that on an operating lease we're paying ten thousand dollars a year every year but on a financing lease in the first year we're recognizing more expense so the income statement has a bigger hit in the first basically we're looking here the first two years so in the early years we'll call these early years in the early years there's a bigger hit to net income but look what happens in the later years it becomes cheaper from from a net income perspective on the financing lease because we have interest that is declining every year so the big point here is that our depreciation schedule does not match our principal repayment schedule so on day one the asset equals the liability but as on each successive year after the anniversary date or after the inception date that asset does not necessarily have to equal its liability as for operating it's just rent expense of ten thousand a year that's it under both conditions it's 40 thousand