CHAPTER 13 LEASES. Introduction Property rights are acquired by the purchase of assets Rights to use property are acquired by leases Some leases allow.

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

Management’s Choice Between Purchasing and Leasing

Function of: Strategic investment and

capital structure objectives Comparative costs Availability of tax benefits

Question: When does the acquisition of

rights to use property become an in-substance property right?

Types of Leases

What are decision criteria for deciding whether a lease is capital or operating?

Capital lease lease is in substance a long-term purchase of an asset

lease is a rental agreementOperating lease

Historical Perspective

ARB No. 38 APB Opinion No. 5 APB Opinion No. 7 APB Opinion No. 27 APB Opinion No. 31

Historical Perspective Problems:

Criteria in these four APB Opinions did not result in the capitalization of many leases

There was a lack of symmetry between lessee and lessor accountings

Result: SFAS No. 13

Conceptual Foundation of SFAS No. 13

Capital lease transfers substantially all of the benefits and risks of ownership

from the lessor to the lessee

Conclusion Must identify the characteristics that indicate

transfer of benefits and risks Same characteristics should apply to both lessors

and lessees Those leases that do not satisfy the

characteristics should be classified as operating leases

Reasons Why Leasing May Be More Attractive Than Buying an Asset

1 Period of use is short relative to the overall life of the asset

2 Lessor has a comparative advantage over the lessee in reselling the asset

3 Corporate bond covenants of the lessee contain restrictions relating to financial policies the firm must follow (maximum to debt to equity ratios)

4 Management compensation contracts contain provisions expressing compensation as a function of return on invested capital

Reasons Why Leasing May Be More Attractive Than Buying an Asset

5 Lessee ownership is closely held so that risk reduction is important

6 Lessor (manufacturer) has market power and can thus generate higher profits by leasing the asset (and controlling the terms of the lease) than by selling the asset

7 The asset is not specialized to the firm8 The asset’s value is not sensitive to use or abuse (owner

takes better care of the asset than does the lessee)

Criteria for Classifying Leases

For lessees1 Lease transfers ownership of the property to

the lessee by the end of the lease term 2 Lease contains a bargain purchase option 3 Lease term is equal to 75 percent or more of

the estimated remaining economic life of the leased property unless the beginning of the lease term falls

within the last 25 percent of the total estimated economic life of the leased property

Criteria for Classifying Leases

4 Present value of the minimum lease payments at the beginning of the lease term equals or exceeds 90

percent of the fair value of the leased property

less any related investment tax credit retained by the lessor

Lease

Recording Capitalized Leases

For lessees Present value of minimum lease payments is

computed and capitalized at lessee’s incremental borrowing rate unless lessor’s implicit rate is known and lower.

Minimum lease payments consist of:1 Rental payments over the life of the lease2 Any bargain purchase option3 Any guaranteed residual value of the property

by the lessee4 Any penalties for failure to renew the lease

by the lessee Periodic expenses are interest expense

and depreciation on leased asset

Disclosures Required by Lessees for Capitalized Leases

1 Gross amount of assets recorded under capital leases as of the date of each balance sheet presented by major classes according to

nature or function.

2 Future minimum lease payments as of the date of the latest balance sheet

presented in the aggregate and for each of the five

succeeding fiscal years.

Disclosures Required by Lessees for Capitalized Leases

3 Total minimum sublease rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet

presented.4 Total contingent rentals

rentals on which the amounts are dependent on some factor other than the passage of time

actually incurred for each period for which an income statement is presented.

Operating Lease

Operating leases All leases which do not

meet any of the four capitalization criteria

Periodic payments are recorded as rent expense

Income Statement

Rent Expense

Disclosures Required for Operating Leases by Lessees

1. For operating leases having initial or remaining noncancelable lease terms in excess of one year:

a) Future minimum rental payments required as of the date of the latest balance sheet presented

b) The total of minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented.

2. For all operating leasesa) Rental expense for each period for which an income

statement is presented

b) with separate amounts for minimum rentals, contingent rentals and sublease rentals.

Disclosures Required for Operating Leases by Lessees

3 A general description of the lessee's leasing arrangements including, but not limited to the following:

a The basis on which contingent rental payments are determined.b The existence and terms of renewals or purchase options and

escalation clauses.c Restrictions imposed by lease agreements, such as those concerning

dividends, additional debt, and further leasing

Criteria for Classifying Leases

For lessors previous four criteria plus:

1 Collectability of minimum lease payments is reasonably predictable

2 No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease

Sales-Type Leases Involves manufacturer's or dealer’s profit

Implication Leased asset is an item of inventory Seller (lessor)

is earning a profit on the sale of the property as well as interest over the life of the lease

Accounting by Lessors

Concern Appropriate allocation of revenues and expenses

to the lease period Capital leases are then classified by lessors

as either: Sales-type Direct financing

Direct Financing Lease No profit is recorded at the inception of the

lease Lessor is viewed as a lending institution

financing the purchase of an asset Revenue is interest earned

over the life of the lease

Disclosures Required by Lessors for Sales Type and Direct Financing Leases

1. The components of the net investment in leases as of the date of each balance sheet presented

2. Future minimum lease payments to be received 3. The unguaranteed residual value4. Unearned income5. Future minimum lease payments to be received for each of the five

succeeding fiscal years as of the date of the latest balance sheet presented6. The amount of unearned income included in income to offset initial direct

costs charged against income for each period for which an income statement is presented (For direct financing leases only)

7. Total contingent rentals included in income for each period for which an income statement is presented

8. A general description of the lessor's leasing arrangements

Operating Leases Do not meet criteria for

classification as either sales-type or direct financing leases are

recorded as operating leases by lessors

Periodic payments are recorded as rent revenue and leased asset is depreciated

Disclosures Required by Lessors for Operating Leases

1 The cost and carrying amount, if different, of property on lease or held for leasing by major classes of

property according to nature or function,

and the amount of accumulated depreciation in total as of the date of the latest balance sheet presented.

2 Minimum future rentals on noncancelable leases as of the date of the latest balance sheet presented in the aggregate and for each of the five succeeding fiscal years.

3 Total contingent rentals included in income for each period for which an income statement is presented.

4 A general description of the lessor's leasing arrangements.

Sale and Leaseback

Owner sells property and then immediately leases it back

Usually treated as a single economic event with the gain or loss on the sale

being amortized over the lease term

Leveraged Leases Three parties

Long-term financierDebt Holder

LesseeAsset user

LessorEquity holder

Leveraged Leases

Finances purchaseof assets

Lessee periodicpayments assigned

to debt holdersFinancing Company

Lessor Lessee

Transfer useof the asset

FASB Decision on Accounting for Leveraged Leases

Should transaction be recorded as a single economic event or as separate transactions? Accounted for as a single transaction Accounted for as a capital lease by the

lessee and as a direct financing lease by the lessor

Financial Analysis of Leases

Company employing operating leases as opposed to capital leases will report a relatively higher working capital

position and relatively higher current and return on

assets ratios Analyze footnotes to a company’s financial

statements to determine the impact of the use of

operating leases its financial position

IAS No. 17

Amended to be effective 1/1/99 Added enhanced disclosure requirements Requirements similar to SFAS No. 13 Difference in terminology –

Financial leases rather than capital leases for lessee Terms sales-type and direct financing not used for lessors

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Prepared by Kathryn Yarbrough, MBA