Example of Operating Lease Capitalization
Example of Operating Lease Capitalization
Information:
Reported financial numbers:
Net income = 4 million
Total assets = 40 million
Total liabilities = 25 million
Total equity = 15 million
Example of Operating Lease Capitalization
Assumptions for the example:
- an incremental borrowing interest rate of 10%;
- the average remaining life of the operating leases is 15 years;
- all scheduled cash flows occur at beginning of the year;
- the unrecorded leased asset equals 70 percent of the unrecorded lease liabilities;
- the combined effective tax rate is 40%.
Other information:
The present value of all future cash flows of the operating leases (the unrecorded lease liabilities) equals $10 million dollars.[1]
Example of Operating Lease Capitalization
The following partial balance sheet presents the impact of constructive capitalization of operating leases on assets, liabilities and equity:
Balance Sheet (partial)
12/31/2015
(in millions)
Assets: Liabilities:
Unrecorded lease Assets 7 Unrecorded Lease Liabilities 10
(unrecorded liabilities * 70%) Tax Savings a (1.2)
((7-10) x tax rate 40%)
Net Liability Effect 8.8
Stockholders’ Equity:
Cumulative Effect on Retained Earnings Net of Tax Consequences
(7-10) x (1-40%) (1.8)
7 7.0
a.Tax savings are income tax savings for the capital leases resulting from a greater amount of lease expense associated with the capital leases than with the operating leases. The difference in expense charges between the two lease methods equals the difference between the unrecorded lease assets and the unrecorded lease liabilities. This is because the difference between the unrecorded assets and unrecorded liabilities = amortization expense – (lease payment – interest expense)
= amortization expense + interest expense – lease payment (the rental expense).
The sum of amortization expense and interest expense is the expense charged under capital leases while the rental expense is the expense charged under operating leases. Thus, the difference between unrecorded assets and unrecorded liabilities is also the difference in expense charges between the two lease methods.
Example of Operating Lease Capitalization
Reported financial ratios: Adjusted financial ratios with operating leases capitalized:
ROA = 4/40 = 10% ROA = (4-0.36)/ (40+7) = 7.72%
D/E = 25/15 = 1.67 D/E = (25+8.8)/(15-1.8) = 2.56
Note: Assuming the lease capitalization impact on equity is -$2.4 for 2014 (i.e., 20% higher than that of 2015). The lease capitalization impact on the net income of 2015 = (-3- (-2.4)) x (1-40%) = -0.36
[1] You need to compute this amount for the project based on the method described in Imhoff, etc. (1991). This method is also described in page one of this outline.
Example of Operating Lease Capitalization
