FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
10TH EDITION
RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
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 offbalance sheet financing of assets
Advantages of Leasing




100 percent financing
Protection against obsolescence
Frequently less costly than other
forms of financing the cost of the
acquisition of fixed assets
Does not add debt to the balance sheet
Management’s Choice Between
Purchasing and Leasing

Function of:



Strategic investment and
capital structure objectives
Comparative costs
Availability of tax benefits

Question:

When does the acquisition of
rights to use property
become an in-substance
property right?
Types of Leases
Capital lease
lease is in substance a longterm 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
2
3
4
Period of use is short relative
to the overall life of the asset
Lessor has a comparative
advantage over the lessee in
reselling the asset
Corporate bond covenants of the
lessee contain restrictions relating to financial policies
the firm must follow (maximum to debt to equity
ratios)
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
6
7
8
Lessee ownership is closely held so that
risk reduction is important
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
The asset is not specialized to the firm
The asset’s value is not sensitive to use or abuse (owner
takes better care of the asset than does the lessee)
Criteria for Classifying Leases

For lessees
1
2
3
Lease transfers ownership of the property to
the lessee by the end of the lease term
Lease contains a bargain purchase option
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 lessee’s incremental
borrowing rate


Minimum lease payments consist of:
1
2
3
4

Unless lessor’s implicit rate is known and lower.
Rental payments over the life of the lease
Any bargain purchase option
Any guaranteed residual value of the property
by the lessee
Any penalties for failure to renew the lease
by the lessee
Periodic expenses are interest expense
and depreciation on leased asset
Lease
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
4
Total minimum sublease rentals to be
received in the future under noncancelable
subleases
 As of the date of the latest balance sheet
presented.
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
For operating leases having initial or remaining noncancelable lease
terms in excess of one year:
1.
a)
b)
Future minimum rental payments required as of the date of the latest
balance sheet presented
The total of minimum rentals to be received in the future under
noncancelable subleases as of the date of the latest balance sheet
presented.
For all operating leases
2.
a)
b)
Rental expense for each period for which an income
statement is presented
With separate amounts for minimum rentals, contingent
rentals and sublease rentals.
Disclosures Required for Operating
Leases by Lessees
3
a
b
c
A general description of the lessee's
leasing arrangements including, but not
limited to the following:
The basis on which contingent rental payments are determined.
The existence and terms of renewals or purchase options and
escalation clauses.
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
2
Collectability of minimum lease payments is
reasonably predictable
No important uncertainties surround the amount of
unreimbursable costs yet to be incurred by the
lessor under the lease
Sales-Type Leases

Involves manufacturer's or dealer’s profit

Implication


Leased asset is an item of inventory
Seller (lessor)


Is earning a profit on the sale of the property
As well as interest over the life of the lease
Accounting by Lessors

Concern


Appropriate allocation of revenues and expenses
to the lease period
Capital leases are then classified by lessors
as either:


Sales-type
Direct financing
Direct Financing Lease



No profit is recorded at the inception of the
lease
Lessor is viewed as a lending institution
financing the purchase of an asset
Revenue is interest earned
over the life of the lease
Disclosures Required by Lessors for Sales
Type and Direct Financing Leases
1.
The components of the net investment in leases as of the date of each
balance sheet presented
a)
b)
c)
2.
3.
4.
5.
Future minimum lease payments to be received
The unguaranteed residual value
Unearned income
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
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)
Total contingent rentals included in income for each period for
which an income statement is presented
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


and the amount of accumulated depreciation in total

2
3
4
According to nature or function,
As of the date of the latest balance sheet presented.
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.
Total contingent rentals included in income
 For each period for which an income statement is presented.
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
payments assigned
to debt holders
Finances purchase
of assets
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 company’s 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 lessee’s
incremental borrowing rate
Lessor accounting wasn’t 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




Lessor accounting will incorporate a consumption model that is
symmetrical to lessee accounting.


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.
It’s likely that most lessors of property will continue to qualify for an approach
similar to today’s operating lease accounting, recognizing income on a straightline 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.
b.
Investment property is measured at fair value
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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