Businesses generally acquire property rights in long-term assets through purchases that

are funded by internal sources or by externally borrowed funds. The accounting issues
associated with the purchase of long-term assets were discussed inChapter 9. Leasing is
an alternative means of acquiring long-term assets to be used by firms. Leases that are
not in-substance purchases provide for the right to use property by lessees, in contrast
to purchases that transfer property rights to the user of the long-term asset. Lease terms
generally obligate lessees to make a series of payments over a future period; thus, they
are similar to long-term debt. However, if a lease is structured in a certain way, it
enables the lessee to engage in offbalance sheet financing because certain leases are
not reported as long-term debt on the balance sheet. Business managers often wish to
use offbalance sheet financing to improve the financial position of their companies.
However, as noted earlier in the text, efficient market research suggests that offbalance
sheet debt is incorporated into user decision models in determining the value of a
company.
Leasing has become a popular method of acquiring property, because it has the
following advantages:
1. It offers 100 percent financing.
2. It offers protection against obsolescence.
3. It is often less costly than other forms of financing the cost of the acquisition of
fixed assets.
4. If the lease qualifies as an operating lease, it does not add debt to the balance
sheet.
Many long-term leases possess most of the attributes of long-term debt. That is, they
create an obligation for payment under an agreement that is noncancelable. The adverse
effects of debt are also present in leases in that an inability to pay can result in
insolvency. Consequently, even though there are statutory limitations on lease
obligations in bankruptcy proceedings, these limits do not affect the probability of the
adverse effects of nonpayment on asset values and credit standing in the event of
nonpayment of lease obligations. The statutory limitations involve only the evaluation of
the amount owed after insolvency proceedings have commenced.
Management's choice between purchasing and leasing should be a function of strategic
investment and capital structure objectives, not of leasing's effects on published
financial statements. When deciding whether to purchase or lease an asset, management
should consider the comparative costs of purchasing versus leasing the asset and the
availability of tax benefits, rather than focusing on perceived financial reporting
advantages. The tax benefit advantage is a major factor in leasing decisions. From a
macroeconomic standpoint, the tax benefits of owning assets may be maximized by
transferring them to the party in the higher marginal tax bracket. Firms with lower
effective tax rates may engage in more leasing transactions than firms in higher tax
brackets because the tax benefits are passed on to the lessor. El-Gazzar et al. found
evidence to support this theory: Firms with lower effective tax rates were found to have
a higher proportion of leased debt to total assets than did firms with higher effective tax
rates.1
Some lease agreements are in-substance long-term installment purchases of assets that
have been structured to gain tax or other benefits to the parties. Because leases can take
different forms, accountants must examine the underlying nature of the original

transaction to determine the appropriate method of accounting for these agreements.

Stated differently, the financial effects of leases should be reported in a manner that
describes the intent of the lessor and lessee (i.e., the substance of the agreement) rather
than the form of the agreement.

Accounting for Leases

Two methods for allocating lease revenues and expenses to the periods covered by the
lease agreement have emerged in accounting practice. One method, a capital lease, is
based on the view that the lease constitutes an agreement through which the lessor
finances the acquisition of assets by the lessee. Consequently, capital leases are insubstance installment purchases of assets. The other method is an operating lease and
is based on the view that the lease constitutes a rental agreement between the lessor and
lessee.
Two basic accounting questions are associated with leases: What characteristics of the
lease agreement require a lease to be reported as an in-substance long-term purchase of
an asset? Which characteristics allow the lease to be reported as a long-term rental
agreement?
The accounting profession first recognized the problems associated with leases
in Accounting Research Bulletin (ARB) No. 38. This release recommended that if a lease
agreement were in substance an installment purchase of property, the lessee should
report it as an asset and a liability. As with many of the ARBs, the recommendations of
this pronouncement were largely ignored in practice, and the lease disclosure problem
remained an important accounting issue.
In 1964, the APB issued Opinion No. 5, Reporting of Leases in Financial Statements of
Lessees (superseded). APB Opinion No. 5 required leases that were in-substance
purchases to be capitalized on the financial statements of lessees. This conclusion was
no match for the countervailing forces against the capitalization of leases that were
motivated by the ability to present a more favorable financial structure and patterns of
income determination. As a result, relatively few leases were capitalized under the
provisions of APB Opinion No. 5.
The APB also issued three other statements dealing with accounting for leases by lessors
and lessees: APB Opinion No. 7, Accounting for Leases in Financial Statement of
Lessors (superseded), APB Opinion No. 27, Accounting for Lease Transactions by
Manufacturers or Dealer Lessors (superseded), and APB Opinion No. 31, Disclosure of
Lease Transactions by Lessees (superseded). Nevertheless, the overall results of these
statements were that few leases were being capitalized and that lessor and lessee
accounting for leases lacked symmetry, because these four opinions allowed lessees and
lessors to report the same lease differently.
In November 1976, the FASB issued SFAS No. 13, Accounting for Leases (see FASB
ASC 840), which superseded APB Opinion Nos. 5, 7, 27, and 31. A major purpose
of SFAS No. 13 was to achieve a greater degree of symmetry of accounting between
lessees and lessors. In an effort to accomplish this goal, the statement established
standards of financial accounting and reporting for both lessees and lessors. As noted
above, one of the problems associated with the four opinions issued by the APB was that
they allowed differences in recording and reporting the same lease by lessors and

lessees; adherence to SFAS No. 13 substantially reduces (though it does not eliminate)
this possibility.
The conceptual foundation underlying SFAS No. 13 is based on the view that a lease
that transfers substantially all of the benefits and risks inherent in the ownership of
property should be accounted for as the acquisition of an asset and the incurrence of an
obligation by the lessee and as a sale or financing lease by the lessor. 2 This viewpoint
leads immediately to three basic conclusions: (1) The characteristics indicating that
substantially all the benefits and risks of ownership have been transferred to the lessee
must be identified. These types of leases should be reported as if they involved the
purchase and sale of assets (capital leases). (2) The same characteristics should apply to
both the lessee and lessor; therefore, the inconsistency in accounting treatment that
previously existed should be eliminated. (3) Those leases that do not meet the
characteristics identified in (1) should be accounted for as rental agreements (operating
leases).
It has been suggested that the choice of structuring a lease as either an operating or a
capital lease is not independent of the original nature of leasing as opposed to buying
the asset. As indicated earlier, companies engaging in lease transactions may attempt to
transfer the benefits of owning assets to the lease party in the higher tax bracket. In
addition, Smith and Wakeman identified eight nontax factors that make leasing more
attractive than purchasing:3
1. The period of use is short relative to the overall life of the asset.
2. The 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 debt-to-equity ratios).
4. Management compensation contracts contain provisions expressing
compensation as a function of return on invested capital.
5. Lessee ownership is closely held, so that risk reduction is important.
6. The 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 firm.
8. The asset's value is not sensitive to use or abuse (the owner takes better care of
the asset than does the lessee).
Obviously, some of these reasons are not subject to lessee choice but are motivated by
the lessor and/or the type of asset involved. However, short periods of use and the resale
factor favor the accounting treatment of a lease as operating, whereas the bond covenant
and management compensation incentives favor a structuring of the lease as a capital
lease. In addition, lessors may be more inclined to seek to structure leases as capital
leases to allow earlier recognition of revenue and net income. That is, a lease that is
reported as an in-substance sale by the lessor allows revenue recognition (gross profit
on sale) at the time of the original transaction in addition to interest revenue over the
life of the lease.

Criteria for Classifying Leases

In SFAS No. 13, the FASB outlined specific criteria for classifying leases as either capital
or operating leases. If at its inception the lease meets any one of the following four

criteria, the lessee will classify the lease as a capital lease; otherwise, it is classified as an
operating lease:
1. The lease transfers ownership of the property to the lessee by the end of the lease
term. This includes the fixed noncancelable term of the lease plus various
specified renewal options and periods.
2. The lease contains a bargain purchase option. This means that when the lessee
has the option to purchase the leased asset, at the inception of the lease the stated
purchase price is sufficiently lower than the fair market value of the property
expected at the date the option will become exercisable such that it appears to be
at a bargain price. In this case, exercise of the option appears to be reasonably
assured.
3. The 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.
4. At the beginning of the lease term, the present value of the minimum lease
payments (the amounts of the payments the lessee is required to make excluding
that portion of the payments representing executory costs such as insurance,
maintenance, and taxes to be paid by the lessee) equals or exceeds 90 percent of
the fair value of the leased property less any related investment tax credit
retained by the lessor. (This criterion is also ignored when the lease term falls
within the last 25 percent of the total estimated economic life of the leased
property.)
The criteria for capitalization of leases are based on the assumption that a lease that
transfers to the lessee the risks and benefits of using an asset should be recorded as an
acquisition of a long-term asset. However, the criteria are seen as arbitrary, because the
FASB provided no explanation for choosing a lease term of 75 percent or a fair value of
90 percent as the cutoff points. In addition, the criteria have been viewed as redundant
and essentially based on the fourth criterion.4
In the case of the lessor (except for leveraged leases, discussed later), if a lease meets
any one of the preceding four criteria plus both of the following additional criteria, it is
classified as a sales type or direct financing lease.
1. Collectibility of the 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.
The latter two criteria are prompted by the concept of conservatism. Accountants are
reluctant to report receivables when there is significant uncertainty regarding expected
future cash flows.

Accounting and Reporting by Lessees under SFAS No. 13

From the lessee's perspective, the primary concern in accounting for lease transactions
has historically been the appropriate recognition of assets and liabilities on the balance
sheet. This concern has overridden the corollary question of revenue recognition on the
part of lessors. Therefore the usual position of accountants has been that when a lease
agreement is in substance an installment purchase, lessees should account for the
leased property as an asset and report a corresponding liability. Failure to do so

results in an understatement of assets and liabilities on the balance sheet. Lease

arrangements that are not considered installment purchases constitute offbalance
sheet financing arrangements and should be properly disclosed in the footnotes to
financial statements.
This position has evolved over time. As early as 1962, the accounting research division of
the AICPA recognized that there was little consistency in the disclosure of leases by
lessees and that most companies were not capitalizing leases. It therefore authorized a
research study on the reporting of leases by lessees. Among the recommendations of this
study were the following:
To the extent that leases give rise to property rights, those rights and related liabilities should be
measured and incorporated in the balance sheet. To the extent that rental payments represent a
means of financing the acquisition of property rights which the lessee has in his possession and
under his control, the transaction constitutes the acquisition of an asset with a related obligation
to pay for it.
To the extent, however, that the rental payments are for services such as maintenance, insurance,
property taxes, heat, light, and elevator service, no asset has been acquired, and none should be
recorded.
The measurement of the asset value and the related liability involves two steps: (1) determining
the part of the rentals that constitutes payment for property rights, and (2) discounting these
rentals at an appropriate rate of interest.5
The crucial difference in the conclusion of this study and the practice that existed when
the conclusion was reached was the emphasis on property rights (the right to use
property), as opposed to the rights in propertyownership of an equity interest in the
property.
The APB considered the recommendations of this study and agreed that certain lease
agreements should result in the lessee's recording an asset and liability. The Board
concluded that the important criterion to be applied was whether the lease was in
substance a purchasethat is, rights in property, rather than the existence of property
rights. This conclusion indicated that the APB agreed that an asset and liability should
be recorded when the lease transaction was in substance an installment purchase in the
same manner as other purchase arrangements. The APB, however, did not agree that the
rights to use property in exchange for future rental payments give rise to the recording
of assets and liabilities, because no equity in property is created.
In Opinion No. 5, the APB asserted that a noncancelable lease, or one that is cancelable
only on the occurrence of some remote contingency, was probably in substance a
purchase if either of the two following conditions exists:6
1. The initial term is materially less than the useful life of the property, and the
lessee has the option to renew the lease for the remaining useful life of the
property at substantially less than the fair rental value.
2. The lessee has the right, during or at the expiration of the lease, to acquire the
property at a price that at the inception of the lease appears to be substantially
less than the probable fair value of the property at the time or times of permitted
acquisition by the lessee.

The presence of either of these two conditions was seen as convincing evidence that the
lessee was building equity in the property.
The APB went on to say that one or more of the following circumstances tend to indicate
that a lease arrangement is in substance a purchase:
1. The property was acquired by the lessor to meet the special needs of the lessee
and will probably be usable only for that purpose and only by the lessee.
2. The term of the lease corresponds substantially to the estimated useful life of the
property, and the lessee is obligated to pay costs such as taxes, insurance, and
maintenance, which are usually considered incidental to ownership.
3. The lessee has guaranteed the obligations of the lessor with respect to the leased
property.
4. The lessee has treated the lease as a purchase for tax purposes.
In addition, a lease might be considered a purchase if the lessor and lessee were related
even in the absence of the preceding conditions and circumstances. In that case, a lease
should be recorded as a purchase if a primary purpose of ownership of the property by
the lessor is to lease it to the lessee and (1) the lease payments are pledged to secure the
debts of the lessor or (2) the lessee is able, directly or indirectly, to significantly control
or influence the actions of the lessor with respect to the lease.
These conclusions caused controversy in the financial community, because some experts
believed that they resulted in disincentives to leasing. Those holding this view
maintained that noncapitalized leases provide the following benefits:
1. Improved accounting rate of return and debt ratios, thereby improving the
financial picture of the company
2. Better debt ratings
3. Increased availability of capital
On the other hand, the advocates of lease capitalization hold that these arguments are,
in essence, attempts to deceive users of financial statements. That is, a company should
fully disclose the impact of all its financing and investing activities and not attempt to
hide the economic substance of external transactions. (This issue is discussed in more
detail later in the chapter.)

Capital Leases
The view expressed in APB Opinion No. 5 concerning the capitalization of leases that are
in-substance installment purchases is significant from a historical point of view, for
two reasons. First, in SFAS No. 13, the FASB based its conclusion on the concept that a
lease that transfers substantially all of the benefits and risks of the ownership of
property should be accounted for as the acquisition of an asset and the incurrence of an
obligation by the lessee, and as a sale or financing by the lessor. Second, to a great
extent, the accounting provisions of SFAS No. 13 applicable to lessees generally
follow APB Opinion No. 5.
The provisions of SFAS No. 13 require a lessee entering into a capital lease agreement to
record both an asset and a liability at the lower of the following:
1. The sum of the present value of the minimum lease payments at the inception of
the lease (see the following discussion)
2. The fair value of the leased property at the inception of the lease

The rules for determining minimum lease payments were specifically set forth by the
FASB. In summary, payments that the lessee is obligated to make or can be required to
make, with the exception of executory costs, should be included. Consequently, the
following items are subject to inclusion in the determination of the minimum lease
payments:
1. Minimum rental payments over the life of the lease
2. Payment called for by a bargain purchase option
3. Any guarantee by the lessee of residual value at the expiration of the lease term
4. Any penalties that the lessee can be required to pay for failure to renew the lease
Once the minimum lease payments are known, the lessee must compute their present
value. The interest rate to be used in this computation is the smaller of the lessee's
incremental borrowing rate or the lessor's implicit rate (if known). The lessee's
incremental borrowing rate is the rate that would have been charged had the lessee
borrowed funds to buy the asset with repayments over the same term. If the lessee can
readily determine the implicit interest rate used by the lessor, and if that rate is lower
than his or her incremental borrowing rate, then the lessee is to use the lessor's implicit
interest rate to calculate the present value of the minimum lease payments. If the lessee
does not know the lessor's interest rate (a likely situation), or if the lessor's implicit
interest rate is higher than the lessee's incremental borrowing rate, the lessee and lessor
will have different amortization schedules to recognize interest expense and interest
revenue, respectively.
Capital lease assets and liabilities are to be separately identified in the lessee's balance
sheet or in the accompanying footnotes. The liability should be classified as current and
noncurrent on the same basis as all other liabilitiesthat is, according to when the
obligation must be paid.
Unless the lease involves land, the asset recorded under a capital lease is to be amortized
by one of two methods. Leases that meet either criterion 1 or 2 on page 463 are to be
amortized in a manner consistent with the lessee's normal depreciation policy for owned
assets. That is, when the lease automatically transfers ownership of the leased property
or contains a bargain purchase option (capital lease criterion 1 or 2 is met), it is
presumed that the lessee will eventually have title to the asset and should amortize the
leased asset over its economic life. For all other capital leases, the asset will revert to the
lessor at the end of the lease term; thus, leases that do not meet capital lease criterion 1
or 2 should be amortized in a manner consistent with the lessee's normal depreciation
policy, using the lease term as the period of amortization. In conformity with APB
Opinion No. 21, Interest on Receivables and Payables (see FASB ASC 835-30),SFAS
No. 13 requires that each minimum payment under a capital lease be allocated between
a reduction of the liability and interest expense. This allocation is to be made in such a
manner that the interest expense reflects a constant interest rate on the outstanding
balance of the obligation (i.e., the effective interest method). Thus, as with any loan
payment schedule, each successive payment allocates a greater amount to the reduction
of the principal and a lesser amount to interest expense. This procedure results in the
loan being reflected on the balance sheet at the present value of the future cash flows
discounted at the effective interest rate.

Disclosure Requirements for Capital Leases

SFAS No. 13 also requires the disclosure of additional information for capital leases. The
following information must be disclosed in the lessee's financial statements or in the
accompanying footnotes:
1. The 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
3. The 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 depend on some factor
other than the passage of time) actually incurred for each period for which an
income statement is presented

Operating Leases
Lessees classify all leases that do not meet any of the four capital lease criteria as
operating leases. Failure to meet any of the criteria means that the lease is simply a
rental arrangement and, in essence, should be accounted for in the same manner as any
other rental agreement, with certain exceptions. The rent payments made on an
operating lease are normally charged to expense as they become payable over the life of
the lease. An exception is made if the rental schedule does not result in a straight-line
basis of payment. In such cases, the rent expense is to be recognized on a straight-line
basis unless the lessee can demonstrate that some other method gives a more systematic
and rational periodic charge.
In Opinion No. 31, the APB observed that many users of financial statements were
dissatisfied with the information being provided about leases. Although many criticisms
were being voiced over accounting for leases, the focus of this opinion was on the
information that should be disclosed about noncapitalized leases.
The following disclosures are 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 in the aggregate and for each of the five
succeeding fiscal years
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 leases, rental expense for each period for which an income
statement is presented, with separate amounts for minimum rentals, contingent
rentals, and sublease rentals
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

The FASB contends that the preceding accounting and disclosure requirements for
capital and operating leases by lessees give users information useful in assessing a
company's financial position and results of operations. The requirements also provide
many specific and detailed rules, which should lead to greater consistency in the
presentation of lease information.

Accounting and Reporting by Lessors

The major concern in accounting for leases in the financial statements of lessors is the
appropriate allocation of revenues and expenses over the period covered by the lease.
This concern contrasts with the lessee's focus on the balance sheet presentation of
leases. As a general rule, lease agreements include a specific schedule of the date and
amounts of payments the lessee is to make to the lessor. The fact that the lessor knows
the date and amount of payment does not necessarily indicate that revenue should be
reported in the same period the cash is received. To measure the results of operations
more fairly, accrual accounting often gives rise to situations in which revenue is
recognized in a period other than when payment is received.
The nature of the lease and the rent schedule might make it necessary for the lessor to
recognize revenue that is more or less than the payments received in a given period.
Furthermore, the lessor must allocate the acquisition and operating costs of the leased
property, together with any costs of negotiating and closing the lease, to the accounting
periods receiving benefits in a systematic and rational manner consistent with the
timing of revenue recognition. The latter point is consistent with the application of the
matching principle in accountingthat is, determining the amount of revenue to be
recognized in a period and then ascertaining which costs should be matched with that
revenue.
Historically, the criterion for choosing between accounting for lease revenue as a sale, as
a financing, or as an operating lease was based on the accounting objective of fairly
stating the lessor's periodic net income. Whichever approach would best accomplish this
objective should be followed. SFAS No. 13 set forth specific criteria for determining the
type of lease as well as the reporting and disclosure requirements for each type.
According to SFAS No. 13, if at its inception a lease agreement meets the lessee criteria
for classification as a capital lease and if the two additional criteria for lessors contained
on page 462 are met, the lessor is to classify the lease as either asales-type lease or
a direct financing lease, whichever is appropriate. All other leases, except leveraged
leases (discussed in a separate section), are to be classified as operating leases.

Sales-Type Leases
The lessor should report a lease as a sales-type lease when at least one of the capital
lease criteria is met, both lessor certainty criteria are met, and there is a manufacturer's
or dealer's profit (or loss). This implies that the leased asset is an item of inventory and
that the seller is earning a gross profit on the sale. Sales-type leases arise when
manufacturers or dealers use leasing as a means of marketing their products.
Table 13.1 depicts the major steps involved in accounting for a sales-type lease by a
lessor. The amount to be recorded as gross investment (a) is the total amount of the
minimum lease payments over the life of the lease, plus any unguaranteed residual value
accruing to the benefit of the lessor. Once the gross investment has been determined, it

is to be discounted to its present value (b) using an interest rate that causes the
aggregate present value at the beginning of the lease term to be equal to the fair value of
the leased property. The rate thus determined is referred to as the interest rate implicit
in the lease (the lessor's implicit rate).
The difference between the gross investment (a) and the present value of the gross
investment (b) is to be recorded as unearned interest income (c). The unearned interest
income is to be amortized as interest income over the life of the lease using the interest
method described in APB Opinion No. 21 (see FASB ASC 835-30). Applying the interest
method results in a constant rate of return on the net investment in the lease. The
difference between the gross investment (a) and the unearned interest income (c) is the
amount of net investment (d), which is equal to the present value of the gross
investment (b). The net investment is classified as a current or noncurrent asset on the
lessor's balance sheet in the same manner as all other assets. Income from sales-type
leases is thus reflected by two amounts: (1) the gross profit (or loss) on the sale in the
year of the lease agreement and (2) interest on the remaining net investment over the
life of the lease agreement.
TABLE 13.1 Accounting Steps for Sales-Type Leases

For sales-type leases, because the critical event is the sale, the initial direct costs
associated with obtaining the lease agreement are written off when the sale is recorded
at the inception of the lease. These costs are disclosed as selling expenses on the income
statement.

Direct Financing Leases

When at least one of the capital lease criteria and both lessor certainty criteria are met,
but the lessor has no manufacturer's or dealer's profit (or loss), lessors account for the

lease as a direct financing lease. Under the direct financing method, the lessor is
essentially viewed as a lending institution for revenue recognition purposes. As with a
sales-type lease, each payment received for a direct financing lease must be allocated
between interest revenue and recovery of the net investment. Because the net receivable
is essentially an installment loan, in the early periods of the lease a significant portion of
the payment is recorded as interest; but each succeeding payment will result in a
decreasing amount of interest revenue and an increasing amount of investment
recovery, because the amount of the net investment is decreasing.
The FASB adopted the approach of requiring lessors to record the total minimum lease
payments for direct financing leases as a gross receivable on the date of the transaction
and to treat the difference between that amount and the asset cost as unearned income.
Subsequently, as each rental payment is received, the gross receivable is reduced by the
full amount of the payment, and a portion of the unearned income is transferred to
earned income.
Table 13.2 illustrates the accounting steps for direct financing leases. Gross investment
(a) is determined in the same way as in sales-type leases, but unearned income (c) is
computed as the difference between gross investment and the cost (b) of the leased
property. The difference between gross investment (a) and unearned income (c) is net
investment (d), which is the same as (b) in the sales-type lease.
TABLE 13.2 Accounting Steps for Direct Financing Leases

Initial direct costs (e) in financing leases are treated as an adjustment to the investment
in the leased asset. Because financing the lease is the revenue-generating activity, SFAS
No. 91 (see FASB ASC 310-20) requires that this cost be matched in proportion to the
recognition of interest revenue. In each accounting period over the life of the lease, the
unearned interest income (c) minus the indirect cost (e) is amortized by the effective

interest method. Because the net investment is increased by an amount equal to the
initial direct costs, a new effective interest rate must be determined in order to apply the
interest method to the declining net investment balance. Under direct financing leases,
the only revenue reported by the lessor is disclosed as interest revenue over the lease
term. Since initial direct costs increase the amount disclosed as the net investment, the
interest income reported represents interest net of the write-off of the initial direct cost.

Disclosure Requirements for Sales-Type and Direct Financing Leases

In addition to the specific procedures required to account for sales-type and direct
financing leases, the FASB established certain disclosure requirements. The following
information is to be disclosed when leasing constitutes a significant part of the lessor's
business activities in terms of revenue, net income, or assets:
1. The components of the net investment in leases as of the date of each balance
sheet presented:
a.
Future minimum lease payments to be received with deduction for any
executory costs included in payments and allowance for uncollectibles
b. The unguaranteed residual value
c. Unearned income
2. Future minimum lease payments to be received for each of the five succeeding
fiscal years as of the date of the latest balance sheet presented
3. 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)
4. Total contingent rentals included in income for each period for which an income
statement is presented
5. A general description of the lessor's leasing arrangements
The Board indicated that these disclosures by the lessor, as with the disclosures by
lessees, would aid the users of financial statements in their assessment of the financial
condition and results of operations of lessors. Note also that these requirements make
the information disclosed by lessors and lessees more consistent.

Lessor Operating Leases

Leases that do not meet the criteria for classification as sales-type or direct financing
leases are accounted for as operating leases by the lessor. As a result, the lessor's cost of
the leased property is reported with or near other property, plant, and equipment on the
lessor's balance sheet and is depreciated following the lessor's normal depreciation
policy.
Rental payments are recognized as revenue when they become receivable unless the
payments are not made on a straight-line basis. In that case, as with the lessee, the
recognition of revenue is to be on a straight-line basis. Initial direct costs associated
with the lease are to be deferred and allocated over the lease term in the same manner
as rental revenue (usually on a straightline basis). However, if these costs are not
material, they may be charged to expense as incurred.
If leasing is a significant part of the lessor's business activities, the following information
is to be disclosed 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

Sales and Leasebacks

In a sale and leaseback transaction, the owner of property sells the property and then
immediately leases it back from the buyer. These transactions commonly occur when
companies have limited cash resources or when the transaction results in tax
advantages. Tax advantages occur because the sales price of the asset is usually its
current market value, and this amount generally exceeds the carrying value of the asset
on the seller's books. Therefore the tax-deductible periodic rental payments are higher
than the previously recorded amount of depreciation expense.
Most sales and leaseback transactions are treated as a single economic event, according
to the lease classification criteria previously discussed on pages 461 and 462. That is, the
lessee-seller applies the SFAS No. 13 criteria to the lease agreement and records the
lease as either a capital or operating lease, and the gain on the sale is amortized over the
lease term; however, if a loss occurs, it is recognized immediately. Even so, in certain
circumstances where the lessee retains significantly smaller rights to use the property, a
gain may be immediately recognized. In this case it is argued that two distinctly
different transactions have occurred, because the rights to use have changed.

Leveraged Leases
A leveraged lease is a special leasing arrangement involving three different parties: the
equity holderthe lessor; the asset userthe lessee; and the debt holdera long-term
financer.7 A leveraged lease may be illustrated as in Figure 13.1.
FIGURE 13.1 Leveraged Lease

The major issue in accounting for leveraged leases is whether the transaction should be
recorded as a single economic event or as separate transactions. All leveraged leases
meet the criteria for direct financing leases. However, a leveraged lease might be
accounted for as a lease with an additional debt transaction or as a single transaction.
The FASB determined that a leveraged lease should be accounted for as a single
transaction, and it provided the following guidelines.
The lessee records the lease as a capital lease. The lessor records the lease as a direct
financing lease. The lessor's investment in the lease is the net result of several factors:
1. Rentals receivable, net of that portion of the rental applicable to principal and
interest on the nonrecourse debt
2. A receivable for the amount of the investment tax credit to be realized on the
transaction
3. The estimated residual value of the leased asset
4. Unearned and deferred income consisting of the estimated pretax lease income
(or loss), after deducting initial direct costs remaining to be allocated to income
over the lease term and the investment tax credit remaining to be allocated to
income over the lease term
Once the original investment has been determined, the next step is to project cash
receipts and disbursements over the term of the lease and then compute a rate of return
on the net investment in the years in which it is positive. Annual cash flow is the sum of
gross lease rental and residual value (in the final year), less loan interest payments plus
or minus income tax credits or charges, less loan principal payments, plus investment
tax credit realized. The rate that is applied to the net investment in the years in which
the net investment is positive that will distribute the net income to those years. This rate
is to be calculated by a trial-and-error process.
This method of accounting for leveraged leases was considered to associate the income
with the unrecovered balance of the earning asset in a manner consistent with the
investor's view of the transaction. Income is recognized at a level rate on net investment
in years in which the net investment is positive and is thus identified as primary
earnings from the lease.
In recent years companies have tried to circumvent SFAS No. 13. These efforts are used
mainly by lessees who do not wish to report increased liabilities or adversely affect their
debt-to-equity ratios. However, unlike lessees, lessors do not wish to avoid reporting

lease transactions as sales-type or direct financing leases. Consequently, the objective is

to allow the lessee to report a lease as an operating lease while the lessor reports it as
either a sales-type or direct financing lease.

Financial Analysis of Leases

In Chapter 11 we illustrated some procedures that a financial analyst might use to
evaluate a company's long-term debt position and indicated that the use of operating
leases can affect this type of analysis. The use of leases can also have an impact on a
company's liquidity and profitability ratios. That is, a company employing operating
leases to acquire its assets will have a relatively better working capital position and
relatively higher current and return-on-assets (ROA) ratios than it would if it had
recorded the transaction as a capital lease.
To illustrate, Samson Company has the following summarized balance sheet on
December 31, 2012, before entering into a lease transaction:

Assume that the company enters into a lease agreement on December 31, 2012, whereby
it promises to pay a lessor $10,000 annually for the next five years for the use of an
asset. If the lease is accounted for as an operating lease, neither the asset nor the liability
is reported on Samson's balance sheet, and its working capital, current ratio, and ROA
ratios for December 31, 2013, will appear as follows (assume the company earned net
income of $25,000 during 2013):

Alternatively, if the lease is recorded as a capital lease, the discounted present values of
both the asset and liability are recorded on the company's balance sheet. In addition, the
lease liability is separated into its current and long-term components, and the
company's December 31, 2013, balance sheet will now appear as follows (assuming a
discount rate of 10 percent):

The company's working capital, current ratio, and ROA ratio now become

If a company makes extensive use of operating leases, its working capital, current ratio,
and quick ratio, illustrated inChapter 8, and its ROA ratio, illustrated in Chapter 7, are
all overstated when the effects of the company's lease-financing policy are incorporated
into the analysis. The extent of these overstatements can be estimated by discounting
the firm's current obligation for one year to arrive at the current portion of its lease
obligation and the remaining obligations to arrive at the long-term obligation. The sum
of these two amounts is equal to the amount capitalized as a leased asset. 8For example,
Hershey discloses the following future minimum lease payment obligations in its 2011
annual report ($000 omitted):

Discounting these amounts at the company's approximate average borrowing rate of 7

percent results in an increase in current liabilities of approximately $15.8 million, an
increase in long-term obligations of approximately $34.4 million, and an increase in

total assets of approximately $33.0 million.9 The financial statement impact of

capitalizing Hershey's operating leases is minimal in that their total amount is small in
comparison to the company's total assets and total liabilities. Incorporating these
capitalized amounts into the calculation of the current ratio results in a fractional
decrease from the previously calculated amount of 1.170:1 to 1.167:1. The quick ratio also
slightly declined from the previously calculated amount of 0.63:1 to 0.60:1. Adding the
discounted value of the leased assets to Hershey's total assets resulted in a decline in its
adjusted ROA from 11.9 to 11.7 percent.

Current Developments
In March 2009, the FASB and IASB announced a joint project on accounting for leases.
The boards indicated that the project was needed because the existing accounting model
for leases has been criticized for failing to meet the needs of users of financial
statements. In particular, many users think that operating leases give rise to assets and
liabilities that should be recognized in the financial statements of lessees. Consequently,
users routinely adjust current and future obligations in an attempt to recognize those
assets and liabilities and reflect the effect of lease contracts in profit or loss. In 2005, the
SEC estimated that $1.25 trillion dollars of liabilities had been omitted from balance
sheets because of operating lease classifications.10 However, the information available to
users in the notes to the financial statements was viewed as insufficient for them to
make reliable estimations to account for these omissions. As a result,
1. The existence of two different accounting models for leases means that similar
transactions can be accounted for very differently. This reduces comparability for
users.
2. The current standard provides opportunities to structure transactions to achieve
a particular lease classification, that is, financial engineering. As a result, if the
lease is classified as an operating lease, the lessee obtains a source of financing
that can be difficult for users to comprehend. Therefore, lease structuring to meet
various accounting goals has developed into an entire industry.
Preparers and auditors have also criticized the existing lease accounting model for its
complexity. In particular, it has proved difficult to define the dividing line between
capital leases and operating leases in a principled way. Consequently, the standards use
a mixture of subjective judgments and bright-line tests (specific rules) that can be
difficult to apply. Some have argued that the existing accounting model is conceptually
flawed. In particular:
1. On entering a lease contract, the lessee obtains a valuable right (the right to use
the leased item). This right meets the Boards' definitions of an asset. Similarly,
the lessee assumes an obligation (the obligation to pay rentals) that meets the
Boards' definitions of a liability. However, if the lessee classifies the lease as an
operating lease, that right and obligation are not recognized.
2. There are significant and growing differences between the accounting model for
leases and other contractual arrangements. This has led to inconsistent
accounting for arrangements that meet the definition of a lease and similar
arrangements that do not.
The original project focused on accounting for lease arrangements within the scope of
existing lease accounting literature and considered only lessee accounting for leases.

Later, after reviewing the responses to this discussion paper, the Boards amended their
proposal to include both lessees and lessors. The Boards' revised views on lease
accounting were published in a proposed Accounting Standards Update (ASU), Leases:
Preliminary Views.11
The proposed ASU required balance sheet recognition of all leases. The lessee records an
intangible asset for the right to use the leased asset and a liability for the obligation to
make lease payments (right-of-use model). The ASU proposes two models for lessors,
depending on the terms of the lease and the effect on the lessor. The first is
the performance obligation approach, which recognizes the lessor's risks or benefits.
The second is the derecognition approach, which is to be used when the lessor has
minimal risk exposure.
The performance obligation approach is used when the lessor retains exposure to
significant risks or benefits associated with the leased asset. Under this approach, the
lessor continues to recognize the underlying leased asset on the balance sheet as well as
a lease receivable. The accounting treatment by the lessor is symmetrical to that used by
the lessee. A lessor would apply the derecognition approach when it is not exposed to
significant risks or benefits associated with the leased asset. In essence, the lessor sells
a portion of the leased asset, recognizes profit or loss, and derecognizes the leased asset.
The remaining portion of the carrying amount of the underlying asset not considered
sold is reclassified as a residual asset.
The key aspects of this proposal were

The basic principle is that lease contracts give rise to assets and liabilities that
should be reflected in the balance sheets of lessees and lessors. As such,
calculated financial ratios (leverage ratios, for example) would be more complete
and comparable.

All lessees would use a single method of accounting for all leases. Balance sheets
of lessees would include both assets representing the right to use the leased asset
and liabilities arising from lease contracts at the present value of the expected
lease payments.

The accounting by a lessor would reflect its exposure to the risks or benefits of the
underlying leased asset. A lessor that has transferred significant risks or benefits
would recognize a gain or loss upon lease commencement. When the lessor
retains significant risks or benefits in the leased asset, it would recognize income
over the lease term.

The FASB maintained that the proposed improvements would provide a more complete
and accurate portrayal of an entity's financial position, providing relevant information
to users about operating capacity, leverage, and return on capital.
On September 14, 2010, the FASB published a questionnaire for investors and analysts
that asked how the proposed new leases guidance might affect financial statement users'
analysis. Feedback from the respondents indicated that the proposed requirements were
overly complex and costly to implement. An additional downside for lessees will be
significantly increased liabilities their balance sheets, which could have an impact on

key performance indicators. The result could be lower asset turnover ratios, lower
return on capital, and an increase in debt-to-equity ratios, which could affect borrowing
capacity or compliance with loan covenants. Additionally, there is an income effect when
calculating earnings before interest, taxes, depreciation, and amortization (EBITDA).
That is, capitalizing operating leases results in eliminating rent expense on the operating
leases and replacing it with interest expense on the previously unrecorded lease
obligations and depreciation expense on the right-of-use assets. EBITDA is calculated
before interest expense and depreciation expense; thus, the increased income statement
expenses do not result in reductions to EBITDA. Consequently, EBITDA with lease
capitalization is greater than EBITDA measured under operating lease treatment by the
amount of rent expense. The impact on EBITDA is important, because it is often used by
firms to measure performance in financial covenants and incentive compensation
agreements.12
Subsequently, on July 21, 2011, the Boards announced that the proposed ASU would be
reexposed, because the revised requirements were sufficiently different from the
requirements in the original exposure draft. On May 16, 2013 the IASB and FASB jointly
issued a revised exposure draft on leases. This revised exposure draft attempts to
address the criticisms directed at the 2010 exposure draft, while still meeting the core
objective of recognizing leased assets and liabilities on the balance sheet. It proposes a
dual approach, which will result in a different pattern of income and expense
recognition depending on the nature of the underlying asset and whether the lessee
acquires or consumes more than an insignificant portion of the leased asset.
Lessees will recognize a right-of-use asset and a liability to make lease payments on the
balance sheet for all leases (except short-term leases of 12 months or less). The income
statement will reflect either a front-loaded expense pattern (similar to today's capital
leases) or straight-line expense (similar to current operating leases). For most leases of
assets other than property (for example, equipment, aircraft, cars, trucks), a lessee
would classify the lease as a Type A lease and

Recognize a right-of-use asset and a lease liability, initially measured at the

present value of lease payments

Recognize the amortization of the discount on the lease liability as interest

separately from the amortization of the right-of-use asset.

For most leases of property (that is, land and/or a building or part of a building), a
lessee would classify the lease as a Type B lease and

Recognize a right-of-use asset and a lease liability, initially measured at the

present value of lease payments

Recognize a single lease cost, combining the amortization of the discount on the
lease liability with the amortization of the right-of-use asset, on a straight-line
basis

The accounting treatment by a lessor would depend on whether the lessee is expected to
consume more than an insignificant portion of the economic benefits of the underlying
asset. This assessment would depend on the nature of the underlying asset. For most
leases of assets other than property, a lessor would classify the lease as a Type A lease
and

Derecognize the underlying asset and recognize a right to receive lease payments
(the lease receivable) and a residual asset (representing the rights the lessor
retains relating to the underlying asset)

Recognize the amortization of the discount on both the lease receivable and the
residual asset as interest income over the lease term

Profit on the receivable is recognized immediately; profit on the residual is

deferred until the underlying asset is re-leased or sold

For most leases of property, a lessor would classify the lease as a Type B lease and would
apply an approach similar to existing operating lease accounting in which the lessor
would

Continue to recognize the underlying asset

Recognize lease income over the lease term typically on a straight-line basis

Comments on the new proposal were due September 13, 2013, and the Boards hoped to
have a final standard early in 2014. However, final passage of the new lease standard
remains problematic. Three of the seven FASB members have presented alternative
views. These views reflect concerns about whether all of the core objectives of the project
have been met, the cost-benefit of the proposal, the dual model, and the usefulness of
the proposed disclosures. Two IASB members have presented alternative views that
support the application of a single lease model. Both sets of alternative views also
include some concerns with the proposed accounting for variable leases payments and
renewal options.

International Accounting Standards

The IASB has issued pronouncements on the following items affecting leases:

IAS No. 17, Accounting for Leases

IAS No. 40, Investment Property

IAS No. 17, Accounting for Leases, deals with lease accounting issues. This standard,
which was slightly revised by the IASB's improvement project, is quite similar to U.S.
GAAP, as outlined in SFAS No. 13. One difference in terminology, however, is that insubstance purchases of assets are termed financing leases in IAS No. 17, rather than

capital leases. IAS No. 17 indicates that a lease is to be classified as a finance lease if it
transfers substantially all the risks and rewards incident to ownership. All other leases
are classified as operating leases, and this classification is made at the inception of the
lease. Whether a lease is a finance lease or an operating lease depends on the substance
of the transaction rather than the form. Situations that would normally lead to a lease
being classified as a finance lease include the following:
1. The lease transfers ownership of the asset to the lessee by the end of the lease
term.
2. The lessee has the option to purchase the asset at a price that is expected to be
sufficiently lower than fair value at the date the option becomes exercisable that,
at the inception of the lease, it is reasonably certain that the option will be
exercised.
3. The lease term is for the major part of the economic life of the asset, even if title is
not transferred.
4. At the inception of the lease, the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset.
5. The lease assets are of a specialized nature such that only the lessee can use them
without major modifications being made.
In addition, the terminology sales-type financing and direct financing are not used in
conjunction with the reporting requirements specified for lessors. Nevertheless, the
required accounting treatment for lessors is similar to that outlined in SFAS No. 13. The
major change in the new standard is that initial direct costs incurred by lessors must
now be capitalized and amortized over the lease term. The alternative in the original IAS
No. 17 to expense initial direct costs up front has been eliminated.
IAS No. 40 defined investment property as property (land, or a building or part of a
building, or both) held (by the owner or by the lessee under a finance lease) to earn
rentals or for capital appreciation or both. Examples of leased investment property are a
building leased out under an operating lease and a vacant building held to be leased out
under an operating lease.
In accounting for these properties under IAS No. 40, an enterprise must choose one of
two models:
1. A fair value model whereby investment property is measured at fair value, and
changes in fair value are recognized in the income statement.
2. A cost model as described in IAS No. 16, Property, Plant, and Equipment,
whereby investment property is measured at depreciated cost (less any
accumulated impairment losses). An enterprise that chooses the cost model
should disclose the fair value of its investment property.
IAS No. 40 indicates that the model chosen must be used to account for all of its
investment properties, and a change from one model to the other model should be made
only if the change will result in a more appropriate presentation. The standard states
that this is highly unlikely to be the case for a change from the fair value model to the
cost model.