What Delta Airlines News Teaches Us About Accounting For Leases

Some companies, such as banks, large manufacturers, and airlines, have to make a big investment in assets to operate.

 

Delta Airlines, for example, has to lease gates and ticket counters at over 300 airports. How a business accounts for this type of spending has a big impact on company profit.

 

This excellent article from the Wall Street Journal explains how accounting for leases has changed, and the impact on the financial statements of airlines like Delta.

 

To understand leases, think about your car.

Leasing vs. Buying

 

Many of us have considered whether it’s make economic sense to lease a car rather than buy it.

 

• Buy a car: If you purchase a car, you own the assets once the loan is paid off.

 

• Lease a car: A lease means that you’re essentially renting a car. You don’t own an asset at the end of the lease period. Sure, the lease may include an option to buy the leased car, but you can decline that offer and simply turn the car over when the lease ends.

 

Accounting for leases is similar.

 

Lease Accounting

 

To account for leases, you designate a lease as an operating lease or a finance lease, but there’s been a big change.

 

Here’s how the AICPA explains it:

 

“The core principle of the new leases standard is that lessees should recognize assets and liabilities arising from all leases, except for leases with a lease term of 12 months or less.”

 

An example

 

Let’s assume that the Riverside Café decides to lease some large refrigerators for the restaurant.

 

An operating lease means that the cost of the lease is simply expensed. Riverside debits an expense account, Refrigerator Lease Expense, and credits Cash for each lease payment. This would only apply if the lease term was for 12 months or less.

 

A finance lease is different.

 

If Riverside chooses to treat the lease as a capital lease, the restaurant creates an asset account, and sets up a liability account for the payments. In essence, the restaurant is taking out a loan from the lessor to purchase the asset (refrigerators).

 

How is the dollar amount of the asset and the liability determined?

 

Present value

 

Riverside uses the present value of the leased asset, using a discount rate that is typically the interest rate expected on a loan.

 

Let’s say that Riverside is leasing refrigerators at a cost of $10,000 for 5 years. The current interest rate for a 5-year loan is 8%. This present value calculator indicates that the present value is $6,806 (with rounding).

 

Riverside debit Refrigerator Lease (asset account) for $6,806, credits Refrigerator Lease Liability (liability account) for $6,806.

 

Each time that Riverside makes a lease payment, some of the payment is posted to reduce the lease liability, and a portion is recorded as interest expense. It’s the same process that is used when you make a payment on your home loan.

 

What’s the impact of recording far more leases with an asset and liability account?

 

Balance Sheet Impact

 

The Wall Street Journal makes this comment:

 

“Under the new rules, the interest rates companies pay on their debt can be used to discount the future value of their leases. Risky companies pay higher rates, and so benefit more than safer companies in discounting their leases, thereby reducing their reported liabilities.”

 

To understand this concept, think about two people want to borrow $10,000 to buy a car.

Two borrowers

 

Borrower A has good credit, and can borrow at the 5-year, 8% interest explained above. The present value of $10,000 at 8% for 5 years is $6,806.

 

However, Borrower B has poor credit, and must borrow at 12% for 5 years. Using the same present value calculator, the present value of $10,000 is only $5,674.

 

The 4% higher interest rate decreases the present value by over $1,000.

 

The irony?

 

Companies with poorer credit ratings now post lower liability balances for leases.

 

Does it matter?

 

Quite a bit, actually.

 

Moody’s and Standard and Poors (S&P) rate companies, based on creditworthiness. Here’s how they changed their analysis of Delta.

 

“Ratings firm Moody’s Corp. cut Delta’s operating-lease liabilities almost in half, from $11.2 billion to $6.8 billion, when the airline adopted the new accounting rule for its end-2018 balance sheet. Rival ratings firm S&P Global Inc. lowered Delta’s lease liability from $10.6 billion to $7.2 billion.”

 

These changes dramatically improve some of Delta’s financial ratios- ratios that analysts use to judge performance.

An important ratio

 

One of the most popular tools to measure financial performance is EBITDA. This ratio takes company earnings and adds back some items, including interest expense and tax expense.

 

You can assess a company’s debt load reviewing the ratio: (Debt) / (EBITDA). If a business is growing earnings (in the denominator), debt could increase and the ratio may stay the same.

 

Here’s how Delta’s ratio looks now:

 

“Moody’s adjusted Delta’s leverage ratio—or debt compared to earnings before interest, tax, depreciation and amortization—from 3 to 2.5.”

 

The Lesson

 

Most balance sheet now a have much larger balance for leases than in the past. Lease liabilities are adjusted to present value, and the interest rate assumption has a big impact on the dollar amount of the lease liability.

 

My next book, 25 Intermediate Accounting Spreadsheets (and How to Use Them) will be out in 2020. The format will include a written discussion of a spreadsheet, with spreadsheet images, and a related video.

 

To learn more and get sample chapters of the book, watch this video.

 

For live CPA exam prep and accounting classes, join Conference Room for free. Members will be notified of course dates, times, costs, and how to attend these courses.

 

Get your questions answered to pass the CPA exam, and to learn accounting concepts.

 

Go to Accounting Accidentally for 300+ blog posts and 450+ You Tube videos on accounting and finance:

 

Good luck!

Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

(email) ken@stltest.net

(Image) Airplane by muffinmax71xx

(website and blog) https://www.accountingaccidentally.com/