Liquidity, Solvency, and Activity Analysis

Lease (lessee view)

Contract to use an asset for payments—classified as operating or capital

Operating lease (old GAAP)

Rental: recognize rent expense as time passes and only current amount due as liability

Capital lease (old GAAP)

Substance = purchase: record leased asset and lease liability at PV of future payments

Why prefer operating lease?

Smaller reported liabilities (off-balance sheet financing) and simpler accounting

Off-balance sheet financing

Obligations not shown as liabilities (e.g.

Substance over form (leases)

If lease transfers most risks/benefits

Capital lease—4 triggers (lessee)

Any one: title transfers

bargain purchase option

lease term ≥75% of asset life

PV of payments ≈ asset’s FV

Number of triggers needed

One criterion met → capital lease

Operating lease—initial entry (prepaid)

Dr Prepaid Rent

Cr Cash (if paid in advance)

then expense over time

Operating lease—expense

Dr Rent Expense

Cr Prepaid Rent (or Cash if paid at period end)

Capital lease—initial measurement

Record asset and liability at PV of lease payments (usually annuity

consider timing)

Incremental borrowing rate

Lessee’s rate for a similar loan used to discount payments (unless implicit rate known & lower)

Capital lease—first payment (annuity due)

Dr Lease Liability

Cr Cash (reduces principal immediately)

Capital lease—subsequent interest

Interest Expense = beginning liability × effective rate (effective interest method)

Capital lease—depreciation

Depreciate leased asset over lease term (or useful life if title/BPO) typically straight-line

Annuity due vs ordinary annuity

Annuity due payments at period start (includes (1+i) factor in PV)

ordinary at period end

Lessee reporting—operating vs capital

Operating: only current payable/prepaid

Capital: recognize asset

liability

Why leases matter

Classification dramatically affects leverage

IFRS vs U.S. GAAP (legacy)

IFRS used principles (risks & rewards) without bright lines

U.S. GAAP used 4 bright-line tests

Deferred income taxes—why exist

Timing differences between U.S. GAAP and tax code recognition of revenues/expenses

Deferred tax liability (DTL)—definition

Liability for taxes payable in future due to current temporary differences

DTL—creation pattern

GAAP income > taxable income now (tax pushed to future) → record tax expense & DTL

Installment sales—tax deferral

For taxes

Matching principle and DTL

Recognize tax expense now with GAAP income

defer cash payment via DTL

DTL journal (creation)

Dr Income Tax Expense

Cr Deferred Tax Liability

Cr/Dr Income Taxes Payable (for current portion)

DTL reversal

When item becomes taxable later: Dr Deferred Tax Liability

Cr Income Taxes Payable

Postretirement benefits—definition

Employer-promised benefits after retirement (e.g.

Postretirement benefits—recognition

Expense and liability accrued during employees’ service years (not when paid)

Why estimates are hard

Unknown lifespans

Actuary’s role

Estimates future benefit cash flows using statistics/assumptions

Postretirement liability—measurement

PV of estimated future benefit payments (actuarial estimate discounted to today)

Impact of recognizing benefits

Increases transparency

may lead firms to reduce/modify retiree benefits

Debt-to-equity ratio

Total liabilities ÷ total shareholders’ equity (leverage indicator)

High debt-to-equity—meaning

Greater financial risk and potential ROE amplification (financial leverage)

Times interest earned (TIE)

(Earnings before interest & taxes

TIE—interpretation

Measures ability to cover interest

higher = safer

Operating lease disclosure

Future minimum lease payments must be disclosed in notes (even if not on balance sheet)

Capital lease balance sheet effects

Increases assets and liabilities

changes ROA/ROE and leverage

Capital lease income statement pattern

Higher interest + depreciation early (vs straight rent)

Preferred GAAP rates for leases

Use lower of lessee’s incremental borrowing rate or lessor’s implicit rate (if known)

Lease term vs useful life (depr.)

If title/BPO → use useful life

otherwise use lease term

Operating lease—no asset recognized

Only prepaid rent if pay in advance

no leased asset on lessee’s books

DTL magnitude

Temporary difference × enacted tax rate

Temporary vs permanent differences

Temporary reverse in future (DTL/asset)

permanent never reverse (no deferred taxes)

Example—capital lease first entries

Dr ROU Asset (PV)

Cr Lease Liability (PV)

then Dr Lease Liability

Cr Cash for first payment

Example—operating lease first entries

Dr Prepaid Rent

Cr Cash (if paid at start)

then Dr Rent Expense monthly

Why managers like operating leases

Lowers reported debt and can improve ratios like debt-to-equity and TIE

Key ratios & leases

Capitalizing leases raises debt and interest

Disclosure importance

Off-balance sheet obligations in notes are critical for a full leverage picture