Capital Leases. The accountants are at it again. You have gone off and leased something for a long period of time – substantially its whole life. The accountant (being ever the closet economist) gives you the old “ah-ha”. Your lease is really, from an economic standpoint, a purchase and finance in “disguise”. The accountant will then derive the amount “loaned” and the amount “paid”. After doing so, the accountant will book the value of the asset you “bought”, the “debt” (liability) for the finance, and the implied interest expense (which was used to derive it all in the first place). All of this, mind you, to make your financial statements more clear to the reader. Please download the free capital lease excel spreadsheet example: Capital Leases
How does your accountant do this? First, a long lease, if you squint hard enough, could look like a purchase. There is a series of payments and you get the substantial economic use of the asset’s life. Just like back-solving a mortgage, if you know the payments, the term, number of payments, and the rate, you can solve for the underlying principal. This is just what the accountants do. They use the NPV under a prevailing interest rate to determine the principal amount. Row 37 in the example contains lease payments. The spreadsheet calculates the term of the lease in cell C43 and the NPV of the lease in cell C41. Once you know the principal amount, you can solve for the interest and principal in an amortization table. Rather than use excel formulas, this is done directly in Rows 50-52. Now, you know the fake interest cost, fake principal payment, and fake asset amount (which is equal to the fake debt amount at inception). The accountant in you, will, of course, amortize the fake asset as you normally would a similar real asset in your business. Here, the model amortizes over a straight line with a duration of the lease on rows 46-48. The “debt” is paid down using the fake principal payments on rows 54-56.
Now that you have all of the pieces, the task is to plug them into the three statements of the model so that it works. Here is another example of how using broad formulas and layouts can make a model easier to build, de-bug, read, and use. You could have tried to directly embed these functions into the three statements, but you and your users will have a much better time of it if you use more space and take fewer steps inside each cell. This model contains only the lease so that it is very clear what is happening.
Start with the income statement. The expenses in this case are the wasting (amortization) of the asset and the interest expense. Recall your accountant has divided your lease payment up into principal and interest. As with a loan, paying back what you “borrowed” is not a cost. Only the interest is a cost. This example again assumes the life of the asset is equal to the lease term (you hand it back). Therefore, the asset is consumed over the period of the lease. This consumption of the asset is the other expense.
Skip to cash flow. Here, as always, the net income comes in. Then the non-cash items (typically D&A) are adjusted from net income. The amortization is, of course, non-cash and is adjusted out. Now you see the operating cash flow is only the interest portion of the lease payment (tax is ignored here for clarity in the example, but its addition will not change the model function). The other part of the lease payment, the principal, is in financing cash flow as you are repaying a “debt”. The total cash flow is, of course, the lease payment.
Back to the balance sheet. You would not want this transaction to upset the balance of your balance sheet. In column B the starting entry is shown for explanatory purposes. This entry would ordinarily not be shown in a model, since a typical booking would happen during a period, not at the end of a period. The starting point for the lease is to book on the asset and equal liability. Then, as in your detail below, the asset is amortized down and the liability is paid off. Since net income and cash flow reflect the other transactions, everything balances out. The balance sheet mechanics for the asset and liability here refer down to the detail rather than to the cash flow or income statements. It is more proper to have the assets and liabilities adjust from the cash flow / income statement. That way, if something changes there, you don’t have a mysterious problem with the balance sheet. The off statement references are used in this example to quickly guide you to the section explaining how the lease works.