Chapter 12 Financial Reporting for Leases

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Chapter 12 Financial Reporting for Leases

• Slides Authored by Brian LeventhalUniversity of
  Illinois at Chicago
• FINANCIAL REPORTING ANALYSIS 2e
• REVSINE COLLINS JOHNSON

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I. Evolution of Lease Accounting

• A. A lease is a contract in which the owner of an
  asset (the lessor) conveys to another party (the
  lessee) the right to use that asset.
• 1. This right is granted in exchange for a fee
  (the lease payment) that is usually paid in
  installments.
• 2. Legal title to the asset typically remains
  with the lessor.

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I. Evolution of Lease Accounting

• A. A lease is a contract in which the owner of an
  asset (the lessor) conveys to another party (the
  lessee) the right to use that asset.
• 3. At its inception, a lease is what is usually
  called a mutually unperformed contract, meaning
  that neither party to the lease arrangement has
  yet performed all of the duties called for in the
  contract.

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I. Evolution of Lease Accounting

• B. SFAS No. 13 spells out the current GAAP for
  leases.
• 1. Prior to its issuance, virtually all leases
  were accounted for using the operating lease
  approach.
• a. The accounting for operating leases conforms
  to the legal structure of lease arrangements.
• b. Since lease contracts typically do not convey
  title, the asset remains on the books of the
  lessor.

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I. Evolution of Lease Accounting

• B. SFAS No. 13 spells out the current GAAP for
  leases.
• 1. Prior to its issuance, virtually all leases
  were accounted for using the operating lease
  approach.
• c. The lessee does not immediately record as a
  liability the stream of future payments called
  for in the contract because the lessee is not
  legally obligated to make the payments until the
  lessor performs the duties specified in the
  contract.

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I. Evolution of Lease Accounting

• B. SFAS No. 13 spells out the current GAAP for
  leases.
• 1. Prior to its issuance, virtually all leases
  were accounted for using the operating lease
  approach.
• d. Upon payment of the stipulated rental, the
  lessee debits rent expense and credits cash.
• e. The lessor records rent revenue as performance
  takes place.

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I. Evolution of Lease Accounting

• B. SFAS No. 13 spells out the current GAAP for
  leases.
• 2. The term off-balance sheet financing means the
  lessee has financed the acquisition of asset
  services without recognizing a liability on the
  financial statements.
• a. GAAP requires footnote disclosure of the
  minimum lease payments required under operating
  leases.
• b. The appendix to this chapter explains how to
  make adjustments for off-balance sheet leases.

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I. Evolution of Lease Accounting

• B. SFAS No. 13 spells out the current GAAP for
  leases.
• 3. Operating leases result in lower
  debt-to-equity ratios and higher return on asset
  ratios, and may improve a lessees ability to
  obtain future credit, ceteris paribus.

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I. Evolution of Lease Accounting

• C. More recently, the SEC took a property rights
  approach to the accounting for leases, but even
  this approach stopped short of requiring balance
  sheet measures of leases that conveyed property
  rights. 

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II. Lessee Accounting

• A. Lessees must capitalize leases that meet
  certain specified criteria.
• B. Leases that do not meet the SFAS No. 13
  criteria cannot be capitalized, and are accounted
  for as operating leases as described in the
  previous section.

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II. Lessee Accounting

• C. If at its inception a lease satisfies any one
  or more of the following criteria, it must be
  treated as a capital lease on the books of the
  lessee
• 1. The lease transfers ownership of the asset to
  the lessee by the end of the lease term.
• 2. The lease contains a bargain purchase option.
• 3. The noncancelable lease term is 75 percent or
  more of the estimated economic life of the leased
  asset.
• 4. The present value of minimum lease payments
  equals or exceeds 90 percent of the fair value of
  the leased asset. (This is also referred to as
  the recovery of investment criterion).

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II. Lessee Accounting

• D. Each criterion represents a condition under
  which property rights in the leased asset have
  been transferred to the lessee.

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II. Lessee Accounting

• E. Capital lease accounting
• 1. The lessee must recognize both an asset and a
  liability on its books as the dollar amount equal
  to the discounted present value of the minimum
  lease payments specified in the lease.
• a. Contingent payments are ignored.
• b. The discount rate that is used to determine
  the present value is the lower of the lessees
  incremental borrowing rate or the lessors rate
  of return that is implicit to the lease.
• c. The amount recorded for both the asset and the
  liability is equal only at the inception of the
  lease.

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II. Lessee Accounting

• E. Capital lease accounting
• 2. Each lease payment includes both interest
  (measured using the effective interest method)
  and principal reduction.
• 3. Depreciation expense in accordance with the
  lessees depreciation schedule for assets of this
  type is also recorded.
• 4. Executory costs, including maintenance,
  insurance, taxes and other incidental costs of
  using the leased asset, are omitted when
  determining minimum lease payments.
• a. Executory costs are not included in either the
  capitalized asset or the liability.
• b. Executory costs are treated as period costs
  that are charged to expense when paid.

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II. Lessee Accounting

• E. Capital lease accounting
• 5. A residual value guarantee requires a lessee
  to pay a lessor the difference if the actual
  market value of the leased asset falls below the
  guaranteed residual amount.
• a. The lessee must include the amount specified
  as the residual value guarantee in the
  computation of the minimum lease payment since
  the lessee potentially owes the full amount of
  the guarantee to the lessor.
• b. If the guaranteed residual at the end of the
  lease exceeds the market value of the leased
  asset, then the lessee records a loss equivalent
  to the cash paid to the lessor.
• c. If the guarantee requires no payment, then the
  remaining asset and liability balances are
  eliminated, with no resulting profit effect.

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II. Lessee Accounting

• F. Financial statement effects of capital versus
  operating lease treatment
• 1. The two methods give rise to identical
  cumulative total lifetime charges to expense.
• a. Under the operating lease method, the total
  lease expense over the life of the lease is equal
  to the total lease payments.

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II. Lessee Accounting

• F. Financial statement effects of capital versus
  operating lease treatment
• 1. The two methods give rise to identical
  cumulative total lifetime charges to expense.
• b. Under the capital lease method, the total
  lease expense over the life of the lease
  comprises both
• i. The interest payments, and
• ii. The amortization of the capitalized asset
  amount.

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II. Lessee Accounting

• F. Financial statement effects of capital versus
  operating lease treatment
• 2. However, the timing of the expense charges
  differs between the two methods.
• a. The capital lease approach leads to higher
  expense in the earlier years of the lease and
  lower expense in the later years.
• b. The operating lease approach leads to a
  constant lease expense each year.
• c. This accelerated recognition of lease
  exp.under the capital lease approach provides
  another reason why many lessees prefer the
  operating lease method.

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II. Lessee Accounting

• F. Financial statement effects of capital versus
  operating lease treatment
•   Capital leases result in higher operating
  income (earnings before interest and taxes) since
  annual straight-line depreciation expense is
  lower than the annual rental expense reported
  under the operating lease method. For an
  individual lease, this difference is never
  reversed and remains constant over the lease
  term, given constant lease payments and use of
  the straight-line depreciation method.

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II. Lessee Accounting

•   G. The current ratio deteriorates under the
  capital lease accounting because the current
  portion of the capital lease liability is
  reported as a current liability.

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II. Lessee Accounting

•  H. Cash flow statement implications also arise
  from lease treatment.
• 1. For capital leases, only the interest portion
  of each lease payment is reported as an operating
  cash outflow, while the principal reduction
  portion of each lease payment is reported as a
  financing cash outflow.
• 2. For operating leases, each lease payment is
  reported as an operating cash outflow.  

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III. Lessor Accounting

• A. From the perspective of the lessor, the lease
  is treated as a capital lease if a lease
  arrangement (1) transfers property rights in the
  leased asset to the lessee and (2) allows
  reasonably accurate estimates regarding the
  amount and collectibility of the eventual net
  cash flows to the lessor.
• 1. If both conditions for capital lease treatment
  are not simultaneously met, the lease must be
  treated as an operating lease.
• 2. In a capital lease, the leased asset is
  removed from the lessors books.

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III. Lessor Accounting

• A. From the perspective of the lessor, the lease
  is treated as a capital lease if a lease
  arrangement (1) transfers property rights in the
  leased asset to the lessee and (2) allows
  reasonably accurate estimates regarding the
  amount and collectibility of the eventual net
  cash flows to the lessor.
• 3. There are two types of capital leases for
  lessors
• a. A sales-type lease exists when the lessor is a
  manufacturer or dealer.
• b. A direct financing lease exists when the
  lessor is a financial institution.

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III. Lessor Accounting

• B. Sales-type leases can serve as a marketing
  tool since leasing arrangements generate sales
  from potential customers who are unwilling or
  unable to buy the assets outright for cash.
• 1. The lessor earns a profit from two sources
• a. A manufacturers or dealers profit which is
  the difference between the cash selling price and
  its cost to the manufacturer or dealer.
• b. A financing profit which is the difference
  between the total (undiscounted) lease payments
  and the cash selling value of the leased asset.

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III. Lessor Accounting

• B. Sales-type leases can serve as a marketing
  tool since leasing arrangements generate sales
  from potential customers who are unwilling or
  unable to buy the assets outright for cash.
• 2. At inception of the lease
• a. The lessor records an asset called Gross
  investment in leased assetthe sum of the
  minimum lease payments plus the guaranteed
  residual value of the asset at the end of the
  lease term. (Think of this asset account as an
  account receivable).
• b. The lessor credits sales revenue for the cash
  selling price (fair market value) of the leased
  asset.

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III. Lessor Accounting

• B. Sales-type leases can serve as a marketing
  tool since leasing arrangements generate sales
  from potential customers who are unwilling or
  unable to buy the assets outright for cash.
• 2. At inception of the lease
• c. The lessor credits Unearned financing income
  for the excess of the gross investment in leased
  assets over its fair market value.
• d. Cost of goods sold and the reduction in
  inventory are also recorded.

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III. Lessor Accounting

• B. Sales-type leases can serve as a marketing
  tool since leasing arrangements generate sales
  from potential customers who are unwilling or
  unable to buy the assets outright for cash.
• 3. Financing profit is recognized over the life
  of the lease.
• a. The total cash receipt is credited to the
  Gross investment in leased assets account.
• b. Annual financing profit is calculated using
  the effective interest method and is debited to
  the Unearned financing income account.

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III. Lessor Accounting

• C. Direct financing leases exist when a
  third-party financial institution provides
  lessees with the means for financing asset
  acquisitions.
• 1. These organizations acquire assets from
  manufacturers by paying the fair market value and
  then leasing the asset to the lessee.
• 2. These lessors earn their profit from a single
  sourcethe finance fee that they charge the
  lessee for financing the asset acquisition.

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III. Lessor Accounting

• C. Direct financing leases exist when a
  third-party financial institution provides
  lessees with the means for financing asset
  acquisitions.
• 3. At inception of the lease
• a. The lessor records an asset called Gross
  investment in leased assetthe sum of the
  minimum lease payments plus the guaranteed
  residual value of the asset at the end of the
  lease term. (Think of this asset account as an
  account receivable).

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III. Lessor Accounting

• C. Direct financing leases exist when a
  third-party financial institution provides
  lessees with the means for financing asset
  acquisitions.
• 3. At inception of the lease
• b. The lessor credits the equipment account for
  the fair market value of the leased asset.
• c. The lessor credits Unearned financing income
  for the excess of the gross investment in leased
  assets over its fair market value.

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III. Lessor Accounting

• C. Direct financing leases exist when a
  third-party financial institution provides
  lessees with the means for financing asset
  acquisitions.
• 3. At inception of the lease
• b. The lessor credits the equipment account for
  the fair market value of the leased asset.
• c. The lessor credits Unearned financing income
  for the excess of the gross investment in leased
  assets over its fair market value.

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III. Lessor Accounting

• C. Direct financing leases exist when a
  third-party financial institution provides
  lessees with the means for financing asset
  acquisitions.
• 4. Financing profit is recognized over the life
  of the lease.
• a. The total cash receipt is credited to the
  Gross investment in leased assets account.
• b. Annual financing profit is calculated using
  the effective interest method and is debited to
  the Unearned financing income account.

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III. Lessor Accounting

• C. Direct financing leases exist when a
  third-party financial institution provides
  lessees with the means for financing asset
  acquisitions.
•   Most lessors net the Unearned financing
  income account against the Gross investment in
  leased asset account. Under both the sales-type
  and direct financing leases, this net amount
  equals the fair value of the equipment leased.
  This parallels, in many ways, the accounting for
  sales under the installment sales method,
  discussed in detail in Chapter 3, where the
  deferred gross profit is often deducted on the
  balance sheet from gross installment accounts
  receivable. Note that this accounting
  understates the net realizable value of these
  net receivables relative to the actual gross
  collections that are expected.

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III. Lessor Accounting

• D. Lessors operating leases result when the
  leased asset is not considered sold.
• 1. The leased asset remains on the books of the
  lessor.
• 2. Rental revenue is recognized when each lease
  payment is earned.
• 3. Depreciation expense in accordance with the
  lessors depreciation schedule for assets of this
  type is also recorded each period.

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III. Lessor Accounting

• E. A lease meeting at least one of the Type I
  characteristics and both of the Type II
  characteristics is a capital lease.
• 1. Type I characteristics are identical to the
  lessees criteria for capital lease treatment.
• a. The lease transfers ownership of the asset to
  the lessee by the end of the lease term.
• b. The lease contains a bargain purchase option.
• c. The noncancelable lease term is 75 percent or
  more of the estimated economic life of the leased
  asset.
• d. The present value of minimum lease payments
  equals or exceeds 90 percent of the fair value of
  the leased asset.

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III. Lessor Accounting

• E. A lease meeting at least one of the Type I
  characteristics and both of the Type II
  characteristics is a capital lease.
• 2. Type II characteristics establish the
  appropriate time for recognizing income on the
  lessors books.
• a. The collectibility of the minimum lease
  payments is reasonably predictable.
• b. There are no uncertainties surrounding the
  amount of unreimbursable costs yet to be incurred
  by the lessor under the lease.

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III. Lessor Accounting

• E. A lease meeting at least one of the Type I
  characteristics and both of the Type II
  characteristics is a capital lease.
• 3. SFAS No. 13 tries to establish symmetry in the
  accounting for leases by lessors and lessees, but
  this symmetry is not perfect.

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III. Lessor Accounting

• F. Financial statement effects of direct
  financing versus operating leases
• 1. Income over the life of the lease is
  unaffected by the accounting method used.

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III. Lessor Accounting

• F. Financial statement effects of direct
  financing versus operating leases
• 2. However, the timing of income does differ
  between the two methods.
• a. The direct financing method recognizes income
  sooner.
• b. This income timing difference widens if an
  accelerated depreciation method, as opposed to
  the straight-line method, is used in conjunction
  with the operating method.
• c. This front-ending of income under the direct
  financing method may explain why lessorsunlike
  lesseeshave never seriously opposed the property
  rights approach to lease accounting.

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III. Lessor Accounting

• F. Financial statement effects of direct
  financing versus operating leases
• 3. Other favorable financial statement effects
  under the direct financing method
• a. The lessors rate of return on gross asset
  ratio is usually improved in the early years of a
  particular lease. (This effect reverses as the
  lease grows older).
• b. The current ratio is also improved since the
  principal reduction over the next 12 months is
  classified as a current asset.

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IV. Additional Leasing Aspects

• A. A sale and leaseback condition exists when one
  company sells an asset to another company and
  immediately leases it back.
• 1. This is done as a way to finance asset
  acquisition and/or for tax reasons.

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IV. Additional Leasing Aspects

• A. A sale and leaseback condition exists when one
  company sells an asset to another company and
  immediately leases it back.
• 2. The lessee can treat the entire annual rental
  as a deductible expense for tax purposes.
• a. For example, the sale and leaseback of a
  building and land results in the deduction for
  tax purpose of the entire lease payment.
• b. If the lessee had continued to own the
  property, it could deduct depreciation only for
  the building itself, but not for the land on
  which the building is located.
• c. The cash infusion may help meet cash flow
  needs.

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IV. Additional Leasing Aspects

• A. A sale and leaseback condition exists when one
  company sells an asset to another company and
  immediately leases it back.
• 3. Treatment of the difference between the sale
  price and the carrying value of the asset on the
  lessees books is treated as a deferred gain and
  is amortized into income using the same rate and
  life that is used to amortize the asset itself.
• a. If the lease is an operating lease to the
  lessee, the gain is amortized in proportion to
  the rental payment.
• b. The lessee immediately recognizes any loss.

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IV. Additional Leasing Aspects

• B. Leveraged leases and leases involving real
  estate require specialized accounting rules.

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IV. Additional Leasing Aspects

• C. The U.S. income tax rules also distinguish
  between operating and capital leases.
• 1. The tax criteria for differentiating them are
  not the same as the SFAS No. 13 criteria.
• 2. Lessees prefer the capital lease approach
  because it accelerates recognition of expense and
  thereby lowers the discounted present value of
  their tax liability.

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IV. Additional Leasing Aspects

• C. The U.S. income tax rules also distinguish
  between operating and capital leases.
• 3. Lessors prefer the operating lease approach on
  the tax return because it delays recognition of
  revenues and lowers the present value of the tax
  liability.
• 4. Synthetic leases allow lessees to achieve
  operating lease treatment for financial purposes
  and capital lease treatment for tax purposes.

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IV. Additional Leasing Aspects

• D. Lessors disclosures
• 1. Capital and operating leases must be disclosed
  separately.
• 2. A minimum lease payment schedule must be
  provided.
• 3. The components of the net investment in
  capital leases are delineated, as are the cost
  and accumulated depreciation of assets under
  operating leases.

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IV. Additional Leasing Aspects

• E. The criteria that trigger capital lease
  treatment are easily evaded. Operating leases
  predominate in financial reporting, but the
  proportion of operating lease payments to capital
  lease payments can vary greatly between firms in
  the same industry.   

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V. Appendix  Making Balance Sheet Data
Comparable by Adjusting for Off-Balance Sheet
Leases

• A. The most straightforward method for making
  lessees balance sheet data comparable is to
  treat all leases as if they were capital leases.

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V. Appendix  Making Balance Sheet Data
Comparable by Adjusting for Off-Balance Sheet
Leases

• B. If operating leases were treated as capital
  leases, the liability that would appear on the
  balance sheet is the discounted present value of
  the total net minimum operating lease payments.
• 1. A discount rate must be selected.
• a. The weighted average discount rate for all
  capital lease commitments is appropriate if it is
  disclosed.
• b. The weighted average rate on outstanding
  long-term debt provides a reasonable estimate of
  the lease discount rate.

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V. Appendix  Making Balance Sheet Data
Comparable by Adjusting for Off-Balance Sheet
Leases

• B. If operating leases were treated as capital
  leases, the liability that would appear on the
  balance sheet is the discounted present value of
  the total net minimum operating lease payments.
• 2. Aggregated payments in later years must be
  estimated.
• a. Assume that the minimum lease payment five
  years out continues for the number of years
  required to account for the aggregate amount.

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V. Appendix  Making Balance Sheet Data
Comparable by Adjusting for Off-Balance Sheet
Leases

• B. If operating leases were treated as capital
  leases, the liability that would appear on the
  balance sheet is the discounted present value of
  the total net minimum operating lease payments.
• 2. Aggregated payments in later years must be
  estimated.
• b. Assume that the decline in the minimum lease
  payments over the next five years continues
  during the years that are aggregated.

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V. Appendix  Making Balance Sheet Data
Comparable by Adjusting for Off-Balance Sheet
Leases

• C. Next, an estimate of the capital lease asset
  is required.
• 1. Assume that the liability and the asset
  continue, beyond lease inception, to be equal.

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V. Appendix  Making Balance Sheet Data
Comparable by Adjusting for Off-Balance Sheet
Leases

• C. Next, an estimate of the capital lease asset
  is required.
• 2. However, since lease assets are generally less
  than lease liabilities throughout the life of the
  lease, a percentage of the liability can be
  attributed to the asset.
• a. The relationship depends on the discount rate.
• b. The relationship depends on the duration of
  the lease term.