CHAPTER 13

LEASES
 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
 Managements 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

Capital lease lease is in substance a long-

term purchase of an asset

Operating lease lease is a rental agreement

What are decision criteria for deciding

whether a lease is capital or operating?
 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 firm

8 The assets value is not sensitive to use or abuse (owner
takes better care of the asset than does the lessee)
 Criteria for Classifying Leases
For lessees
1 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
 Recording Capitalized Leases

For lessees
Present value of minimum lease payments is
computed and capitalized at lessees incremental
borrowing rate
Unless lessors implicit rate is known and lower.
Minimum lease payments consist of:
1 Rental payments over the life of the lease Lease
2 Any bargain purchase option
3 Any guaranteed residual value of the property
by the lessee
4 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 SFAS No. 13)
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 Income Statement

All leases which do not

meet any of the four
capitalization criteria
Periodic payments are
recorded as rent
expense 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 leases

a) 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 dealers 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
a) Future minimum lease payments to be received
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
Lessor 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
Three parties

Equity holder Lessor

Asset user Lessee

Debt Holder Long-term financier

 Leveraged Leases
Lessee periodic
Finances purchase payments assigned
of assets to debt holders
Financing Company

Transfer use
of the asset
Lessor Lessee
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 companys financial
statements
To determine the impact of the use of
operating leases its financial position
 Current Developments
March 2009: FASB & IASB announced joint
project on accounting for leases
Lessee should
Initially measure both its right-of-use asset and lease
obligations at present value of expected lease
payments
Discount estimated lease payments using lessees
incremental borrowing rate
Lessor accounting wasnt covered in the original
proposal; however, an exposure draft was
released in August 2010 that incorporated lessor
accounting.
 Current Developments
Lessor - Two different accounting models would apply
to lessors:
1. The performance obligation approach and
2. The derecognition approach.
Both models would require a lessor to recognize a lease
receivable for estimated future lease payments.
If lessor retains significant risks or benefits associated with the
underlying property
Continue to recognize the underlying property and recognize a liability to deliver
its use to the lessee over the estimated lease term (the performance obligation
approach).
If the lessor does not retain significant risks or benefits associated
with the underlying property
Derecognize the portion of that property representing the cost of the right-of-use
sold to the lessee,
Reclassify the remaining portion as a residual asset representing its rights to the
underlying property at the end of the lease term, and
Recognize an immediate profit or loss on the transaction (the derecognition
approach).
 Current Developments

July 21, 2011: Boards announced proposed ASU would be reexposed

because the revised requirements were sufficiently different from the
requirements in the original exposure draft.
Later, in 2012, FASB and IASB announced that they had completed their re-deliberations
on the lease project after two meetings during which they made several key decisions.
Boards agreed to a dual approach for lessee accounting
Allowing straight-line expense recognition for some leases (the SLE approach).
Other leases will follow an interest and amortization approach with a front-loaded expense
recognition pattern (similar to that proposed in the 2010 exposure draft).
Under either model, all leases will be recognized on the balance sheet unless the
maximum lease term is 12 months or less.
 Current Developments

Classification of a lease
Will be based on the principle of consumption of the underlying asset.
Generally, lessees will recognize expense on a straight-line basis for leases of
property (land, a building or part of a building, or both).
Accounting for other types of leases, such as equipment, generally will follow the
interest and amortization approach, resulting in front-loaded expense.
Lessor accounting will incorporate a consumption model that is
symmetrical to lessee accounting.
Its likely that most lessors of property will continue to qualify for an approach
similar to todays operating lease accounting, recognizing income on a straight-
line basis over the lease term.
For leases of assets other than property, including equipment,
lessors will generally apply the receivable and residual approach.
Lessor will recognize upfront profit, a receivable for a portion of the asset and a
residual asset.
International Accounting

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.

Improvements project added enhanced disclosure requirements
Also major change is that initial direct costs incurred by lessors must now be
capitalized and amortized over the lease term.
The alternative treatment in the original IAS No. 17 to expense initial direct
costs up front was eliminated.
Requirements similar to SFAS No. 13
Difference in terminology
Financing leases rather than capital leases for lessee
Terms sales-type and direct financing not used for lessors
IAS No. 40 - Investment Property
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.
Under IAS No. 40 , an enterprise must choose one of two models:
1. A fair value model:
a. Investment property is measured at fair value
b. Changes in fair value are recognized in the income statement.
2. A cost model as described in IAS No. 16 , Property, Plant, and
Equipment,
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

Model chosen must be used to account for all of its investment

properties
Change from one model to the other model should be made only if the
change will result in a more appropriate presentation.
 IAS No. 40 Investment Property

Defined investment property as property held to earn

rentals or for capital appreciation or both
Two models:
Fair value model
Cost model (See IAS No. 16)
 End of Chapter 13

Prepared by Kathryn Yarbrough, MBA

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