When should a lease be recorded on the balance sheet? If a lease is included on the balance sheet, how do you determine the asset value and loan balance? These are frequent questions as the use of leases for machinery, buildings, and other assets becomes more common. Recent changes in accounting standards suggest that many leases are substitutes for purchasing assets and therefore should be listed on the balance sheet.
There are two types of leases: 1) Operating leases, which generally have a shorter life than the asset being leased, and 2) Finance leases, sometimes called capital leases, which often span a substantial part of the life of the asset. In agriculture, land rental arrangements are the most common type of operating lease. While accounting standards suggest that some operating leases should be listed on the balance sheet, the Farm Financial Standards Council Guidelines recommend that land leases be treated as operating expenses rather than balance sheet assets.
Our accounting friends give us no such break on finance leases. A finance lease is often used as a direct substitute for purchasing and financing the asset with borrowed money. Therefore, they should be included on the Balance Sheet according to current accounting guidelines. The major criteria for determining if a lease is a finance lease are:
- The lease transfers ownership of the property to the lessee at the end of the lease term, or
- The lessee has an option to purchase the asset that is reasonable certain to be executed, or
- . The lease term covers the major part of the remaining economic life of the asset.
Refer to Appendix G of the Financial Guidelines for Agriculture for more information on finance lease criteria.
Once it is decided to place a leased asset1 on the balance sheet, the question becomes how to value the lease and how to determine the lease liability. The asset value should be the present value of the stream of lease payments. The lease liability is determined by amortizing the lease at the stated interest rate. If an interest rate is not stated in the contract, it is suggested that the current rate for traditional loans for similar assets types be used. Sounds complicated? Fortunately, the FINPACK Loan Calculator can make it easy (or at least easier).
This is the same example illustrated in the Farm Financial Standards Guidelines except we have
converted it to January 1 payments for simplicity.
- 5 annual payments of $11,991 with the first payment paid in advance;
- Interest rate of 10%
- Lease commences on January 1, 2022
Use the loan calculator to find the present value of the 4 remaining payments:
- First payment date: December 31, 2022
- Payment frequency: Annual
- Loan Period: 4 years
- Scheduled Payment: $11,991
- Solve for the present value by clicking on Amount Borrowed. The present value of the future
payments is $38,009.
The final step is to add the initial payment. The initial balance sheet value of the leased asset is $11,991 plus $38,009 = $50,000.
The recommendation is to amortize or depreciate this value using a straightline approach over the term of the lease. The important thing is that the asset value should be zero at the end of the lease.
The initial lease liability is the present value of the remaining payments, $38,009 from the previous loan
It may be helpful to print the Payment Schedule from the loan calculator to determine the principal, interest expense, and the principal balance after each lease payment. Alternatively, the loan calculator can be used each year to calculate the present value of the remaining payments.
Financial Analysis and Cash Flow
Once entered on the balance sheet, it is important not to double count the lease expense. For finance leases, depreciation and interest are the only expenses related to the lease. However, producers are very likely to erroneously include lease payments in operating expenses. Financial lease payments are not expenses and should not be entered as such when completing a financial analysis (Schedule F Cash to Accrual or FINAN) or a cash flow projection. Depreciation expense is calculated based on the change in the asset value. Interest expense needs to be manually added if the producer’s records do not include this amount. Interest expense can be taken from the repayment schedule or, if not available, the interest portion of the payment can be calculated based on the principal reduction. For example, for year 1 of this example:
Total lease payment – Principal payment = Interest expense
$11,991 – ($38,009 – $29,872) = $ 3,854