Introduction Property rights are acquired by the
purchase of assets Rights to use property are acquired by
leases Some leases allow lessees to use off-
balance sheet financing of assets
Advantages of Leasing
100 percent financing Protection against obsolescence Frequently less costly than other
forms of financing the cost of the acquisition of fixed assets
Does not add debt to the balance sheet
Management’s Choice Between Purchasing and Leasing
Function of: Strategic investment and
capital structure objectives Comparative costs Availability of tax benefits
Question: When does the acquisition of
rights to use property become an in-substance property right?
Types of Leases
What are decision criteria for deciding whether a lease is capital or operating?
Capital lease lease is in substance a long-term purchase of an asset
lease is a rental agreementOperating lease
Historical Perspective
ARB No. 38 APB Opinion No. 5 APB Opinion No. 7 APB Opinion No. 27 APB Opinion No. 31
Historical Perspective Problems:
Criteria in these four APB Opinions did not result in the capitalization of many leases
There was a lack of symmetry between lessee and lessor accountings
Result: SFAS No. 13
Conceptual Foundation of SFAS No. 13
Capital lease transfers substantially all of the benefits and risks of ownership
from the lessor to the lessee
Conclusion Must identify the characteristics that indicate
transfer of benefits and risks Same characteristics should apply to both lessors
and lessees Those leases that do not satisfy the
characteristics should be classified as operating leases
Reasons Why Leasing May Be More Attractive Than Buying an Asset
1 Period of use is short relative to the overall life of the asset
2 Lessor has a comparative advantage over the lessee in reselling the asset
3 Corporate bond covenants of the lessee contain restrictions relating to financial policies the firm must follow (maximum to debt to equity ratios)
4 Management compensation contracts contain provisions expressing compensation as a function of return on invested capital
Reasons Why Leasing May Be More Attractive Than Buying an Asset
5 Lessee ownership is closely held so that risk reduction is important
6 Lessor (manufacturer) has market power and can thus generate higher profits by leasing the asset (and controlling the terms of the lease) than by selling the asset
7 The asset is not specialized to the firm8 The asset’s value is not sensitive to use or abuse (owner
takes better care of the asset than does the lessee)
Criteria for Classifying Leases
For lessees1 Lease transfers ownership of the property to
the lessee by the end of the lease term 2 Lease contains a bargain purchase option 3 Lease term is equal to 75 percent or more of
the estimated remaining economic life of the leased property unless the beginning of the lease term falls
within the last 25 percent of the total estimated economic life of the leased property
Criteria for Classifying Leases
4 Present value of the minimum lease payments at the beginning of the lease term equals or exceeds 90
percent of the fair value of the leased property
less any related investment tax credit retained by the lessor
Lease
Recording Capitalized Leases
For lessees Present value of minimum lease payments is
computed and capitalized at lessee’s incremental borrowing rate unless lessor’s implicit rate is known and lower.
Minimum lease payments consist of:1 Rental payments over the life of the lease2 Any bargain purchase option3 Any guaranteed residual value of the property
by the lessee4 Any penalties for failure to renew the lease
by the lessee Periodic expenses are interest expense
and depreciation on leased asset
Disclosures Required by Lessees for Capitalized Leases
1 Gross amount of assets recorded under capital leases as of the date of each balance sheet presented by major classes according to
nature or function.
2 Future minimum lease payments as of the date of the latest balance sheet
presented in the aggregate and for each of the five
succeeding fiscal years.
Disclosures Required by Lessees for Capitalized Leases
3 Total minimum sublease rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet
presented.4 Total contingent rentals
rentals on which the amounts are dependent on some factor other than the passage of time
actually incurred for each period for which an income statement is presented.
Operating Lease
Operating leases All leases which do not
meet any of the four capitalization criteria
Periodic payments are recorded as rent expense
Income Statement
Rent Expense
Disclosures Required for Operating Leases by Lessees
1. For operating leases having initial or remaining noncancelable lease terms in excess of one year:
a) Future minimum rental payments required as of the date of the latest balance sheet presented
b) The total of minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented.
2. For all operating leasesa) Rental expense for each period for which an income
statement is presented
b) with separate amounts for minimum rentals, contingent rentals and sublease rentals.
Disclosures Required for Operating Leases by Lessees
3 A general description of the lessee's leasing arrangements including, but not limited to the following:
a The basis on which contingent rental payments are determined.b The existence and terms of renewals or purchase options and
escalation clauses.c Restrictions imposed by lease agreements, such as those concerning
dividends, additional debt, and further leasing
Criteria for Classifying Leases
For lessors previous four criteria plus:
1 Collectability of minimum lease payments is reasonably predictable
2 No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease
Sales-Type Leases Involves manufacturer's or dealer’s profit
Implication Leased asset is an item of inventory Seller (lessor)
is earning a profit on the sale of the property as well as interest over the life of the lease
Accounting by Lessors
Concern Appropriate allocation of revenues and expenses
to the lease period Capital leases are then classified by lessors
as either: Sales-type Direct financing
Direct Financing Lease No profit is recorded at the inception of the
lease Lessor is viewed as a lending institution
financing the purchase of an asset Revenue is interest earned
over the life of the lease
Disclosures Required by Lessors for Sales Type and Direct Financing Leases
1. The components of the net investment in leases as of the date of each balance sheet presented
2. Future minimum lease payments to be received 3. The unguaranteed residual value4. Unearned income5. Future minimum lease payments to be received for each of the five
succeeding fiscal years as of the date of the latest balance sheet presented6. The amount of unearned income included in income to offset initial direct
costs charged against income for each period for which an income statement is presented (For direct financing leases only)
7. Total contingent rentals included in income for each period for which an income statement is presented
8. A general description of the lessor's leasing arrangements
Operating Leases Do not meet criteria for
classification as either sales-type or direct financing leases are
recorded as operating leases by lessors
Periodic payments are recorded as rent revenue and leased asset is depreciated
Disclosures Required by Lessors for Operating Leases
1 The cost and carrying amount, if different, of property on lease or held for leasing by major classes of
property according to nature or function,
and the amount of accumulated depreciation in total as of the date of the latest balance sheet presented.
2 Minimum future rentals on noncancelable leases as of the date of the latest balance sheet presented in the aggregate and for each of the five succeeding fiscal years.
3 Total contingent rentals included in income for each period for which an income statement is presented.
4 A general description of the lessor's leasing arrangements.
Sale and Leaseback
Owner sells property and then immediately leases it back
Usually treated as a single economic event with the gain or loss on the sale
being amortized over the lease term
Leveraged Leases
Finances purchaseof assets
Lessee periodicpayments assigned
to debt holdersFinancing Company
Lessor Lessee
Transfer useof the asset
FASB Decision on Accounting for Leveraged Leases
Should transaction be recorded as a single economic event or as separate transactions? Accounted for as a single transaction Accounted for as a capital lease by the
lessee and as a direct financing lease by the lessor
Financial Analysis of Leases
Company employing operating leases as opposed to capital leases will report a relatively higher working capital
position and relatively higher current and return on
assets ratios Analyze footnotes to a company’s financial
statements to determine the impact of the use of
operating leases its financial position
IAS No. 17
Amended to be effective 1/1/99 Added enhanced disclosure requirements Requirements similar to SFAS No. 13 Difference in terminology –
Financial leases rather than capital leases for lessee Terms sales-type and direct financing not used for lessors
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Prepared by Kathryn Yarbrough, MBA