418 Chapter 13 Leases

CHAPTER 13 Leases Business firms 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 in Chapter 9. Leasing is an alternative means of acquiring long-term assets to be used by business 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 longterm asset. Lease terms generally obligate lessees to make a series of payments over a future period. As such, they are similar to long-term debt. However, if a lease is structured in a certain way, it enables the lessee to engage in off balance sheet financing (discussed in Chapter 11) because certain leases are not recorded as long-term debt on the balance sheet. Business managers frequently wish to use off balance sheet financing in order to improve the financial position of their companies. However, as noted earlier in the text, efficient market research indicates that off balance sheet financing techniques are 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 frequently 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. 416

Introduction 417 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 may 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 is a function of strategic investment and capital structure objectives, the comparative costs of purchases of assets versus leasing assets, the availability of tax benefits, and 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 since 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. Since leases may take different forms, it is necessary to examine the underlying nature of the original transaction to determine the appropriate method of accounting for these agreements. That is, they should be reported in a manner that describes the intent of the lessor and lessee rather than the form of the agreement. Over the years, two methods for allocating lease revenues and expenses to the periods covered by the lease agreement have emerged in accounting practice. One method, termed 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 in-substance installment purchases of assets. The other method is termed 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: (1) What characteristics of the lease agreement require a lease to be reported as an insubstance long-term purchase of an asset? (2) Which characteristics allow the lease to be recorded 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 record it as an asset and a liability. As with many of the ARBs, the recommendations of this pronouncement were largely ignored 1. Shamir M. El-Gazzar, Steven Lilien, and Victor Pastena, Accounting for Leases by Lessees, Journal of Accounting and Economics (October 1986), pp. 217 237.

418 Chapter 13 Leases in practice, and the lease disclosure problem remained an important accounting issue. Later, in 1964, the Accounting Principles Board issued Opinion No. 5, Reporting of Leases in Financial Statements of Lessees. The provisions of 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, APB Opinion No. 27, Accounting for Lease Transactions by Manufacturers or Dealer Lessors, and APB Opinion No. 31, Disclosure of Lease Transactions by Lessees. Nevertheless, the overall result of these statements was that few leases were being capitalized and that lessor and lessee accounting for leases lacked symmetry. That is, these four Opinions allowed differences in recording and reporting the same lease by lessors and lessees. In November 1976, the FASB issued SFAS No. 13, Accounting for Leases, 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 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 that indicate that substantially all the benefits and risks of ownership have been transferred to the lessee must be identified. These leases should be recorded 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 2. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 13, Accounting for Leases (Stamford, CT: FASB, 1976), par. 60. This statement was amended in 1980 to incorporate several FASB pronouncements that expanded on the principles outlined in the original pronouncement.

Criteria for Classifying Leases 419 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 purchase. 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 frequently allows for revenue recognition 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 to help classify leases as either capital or operating leases. In the case of the lessee, if at its inception the lease meets any one of the following four criteria, the lease is classified 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 the stated purchase price is sufficiently lower than the expected fair market value of the property at the date the option becomes exercisable and 3. Clifford Smith Jr. and L. Macdonald Wakeman, Determinants of Corporate Leasing Policy, Journal of Finance (July 1985), pp. 895 908.

420 Chapter 13 Leases that exercise of the option appears, at the inception of the lease, 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). 4 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 (see the article by Coughlan on the Web page for Chapter 13). 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 (a capital 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. 5 Accounting and Reporting by Lessees under SFAS No. 13 Historically, the primary concern in accounting for lease transactions by lessees has been the appropriate recognition of assets and liabilities on the lessee s 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 if the lease agreement is in substance an installment purchase, the leased property should be accounted for as an asset by the lessee, together with its 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 off balance sheet financing arrangements and should be properly disclosed in the footnotes to financial statements. 4. Ibid., par. 7. 5. Ibid., par. 8.

Accounting and Reporting by Lessees under SFAS No. 13 421 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, then, that leases give rise to property rights, those rights and related liabilities should be measured and incorporated in the balance sheet. To the extent, then, that the 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) the determination of the part of the rentals which constitutes payment for property rights, and (2) the discounting of these rentals at an appropriate rate of interest. 6 The crucial difference in the conclusion of this study and the existing practice was the emphasis on property rights (the right to use property), as opposed to the rights in property ownership of 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 purchase, that is, rights in property, rather than the existence of property rights. This conclusion indicated that the APB agreed that assets and liabilities 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 right to use property in exchange for future rental payments gives rise to the recording of assets and liabilities, since no equity in property is created. In Opinion No. 5, the APB asserted that a noncancelable lease, or a lease cancelable only on the occurrence of some remote contingency, was probably in substance a purchase if either of the two following conditions exists. 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 6. John H. Myers, Accounting Research Study No. 4, Reporting of Leases in Financial Statements (New York: AICPA, 1962), pp. 4 5.

422 Chapter 13 Leases to be substantially less than the probable fair value of the property at the time or times of permitted acquisition by the lessee. 7 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. 8 In addition, the 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 control or influence significantly the actions of the lessor with respect to the lease. 9 These conclusions caused controversy in the financial community because some individuals 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 financial statement users. 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.) 7. Accounting Principles Board, Opinion No. 5, Reporting of Leases in Financial Statements of Lessees (New York: AICPA, 1964), par. 10. 8. Ibid., par. 11. 9. Ibid., par. 12.

Accounting and Reporting by Lessees under SFAS No. 13 423 Capital Leases The views expressed in APB Opinion No. 5 concerning the capitalization of those leases that are in-substance installment purchases are 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 Board. In summary, those 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 the 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. 10 Once the minimum lease payments or fair market value is determined, the next step is to compute the present value of the lease payments. The interest rate to be used in this computation is generally the lessee s incremental borrowing rate. This is the rate the lessee would have been charged had he or she 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 for calculating 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 10. SFAS No. 13, op. cit., par. 5.

424 Chapter 13 Leases be classified as current and noncurrent on the same basis as all other liabilities, that 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 pages 419 and 420 are to be amortized in a manner consistent with the lessee s normal depreciation policy for owned assets. That is, the asset s economic life to the lessee is used as the amortization period. Leases that do not meet criterion 1 or 2 but meet either criterion 3 or 4 are to 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, 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 are dependent on some factor other than the passage of time) actually incurred for each period for which an income statement is presented. 11 Operating Leases All leases that do not meet any of the four criteria for capitalization are to be classified as operating leases by the lessee. 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 11. Ibid., par. 16.

Accounting and Reporting by Lessees under SFAS No. 13 425 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, Disclosure of Lease Commitments by Lessees, 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. 12 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 to 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 12. Ibid., par. 16.

426 Chapter 13 Leases 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 recorded in the same period the cash is received. Accrual accounting frequently gives rise to situations in which revenue is recognized in a period other than when payment is received, in order to measure the results of operations more fairly. The nature of the lease and the rent schedule may 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 accounting, that is, determining the amount of revenue to be recognized in a period and then ascertaining which costs should be matched with that revenue. The criterion for choosing between accounting for lease revenue by either the capital or operating methods historically was based on the accounting objective of fairly stating the lessor s periodic net income. Whichever method 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 lessor criteria for classification as a capital lease and if the two additional criteria for lessors contained on page 420 are met, the lessor is to classify the lease either as a sales-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 A capital lease should be recorded as a sales-type lease by the lessor when there is a manufacturer s or dealer s profit (or loss). This implies that the leased asset is an item of inventory and 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 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.

Accounting and Reporting by Lessees under SFAS No. 13 427 TABLE 13.1 Accounting Steps for Sales-Type Leases Gross investment (a) minus Present value of gross investment (b) equals Unearned income (c) Gross investment (a) minus Unearned income (c) equals Net investment (d) Sales (e) minus Cost of goods sold (f) equals Profit or loss (g) 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). This amount is classified as a current or noncurrent asset on the lessor s balance sheet in the same manner as all other assets. Revenue 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. 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 no manufacturer s or dealer s profit (or loss) is recorded, a capital lease should be accounted for as a direct financing lease by the lessor. Under the direct financing method, the lessor is essentially viewed as a lending institution for revenue recognition purposes. If a lessor records a capital lease under the direct financing method, each payment must be allocated between interest revenue and investment recovery. In the early periods of the agreement, a significant portion of the payment will be recorded as interest, but each succeeding payment will result in a decreasing amount of interest revenue and an increasing amount of investment recovery due to the fact that the amount of the net investment is decreasing.

428 Chapter 13 Leases For direct financing leases, the FASB adopted the approach of requiring the recording of the total minimum lease payments as a receivable on the date of the transaction and treating the difference between that amount and the asset cost as unearned income. Subsequently, as each rental payment is received, the 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. 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 revenuegenerating activity, SFAS No. 91 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 recorded 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. TABLE 13.2 Accounting Steps for Direct Financing Leases Gross investment (a) minus Cost (b) equals Unearned income (c) Gross investment (a) minus Unearned income (c) equals Net investment (d) Unearned income (c) minus Initial direct costs (e) equals Unearned income to be authorized (g)

Accounting and Reporting by Lessees under SFAS No. 13 429 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. 13 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. Operating Leases Those 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 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 receivables 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 straight-line basis). However, if these costs are not material, they may be charged to expense as incurred. 13. Ibid., par. 23.

430 Chapter 13 Leases 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. 14 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 frequently occur when companies have limited cash resources or when they result 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 419 and 420. That is, the lessee-seller applies the SFAS No. 13 criteria to the lease agreement and records the lease as either capital or operating and the gain or on the sale is amortized over the lease term, whereas, if a loss occurs, it is recognized immediately. However, 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 defined as a special leasing arrangement involving three different parties: (1) the equity holder the lessor; (2) the asset user the lessee; and (3) the debtholder a long-term financer. 15 A leveraged lease may be illustrated as follows: 14. Ibid., par. 23. 15. A fourth party may also be involved when the owner-lessor initially purchases the property from a manufacturer.

Accounting and Reporting by Lessees under SFAS No. 13 431 Finances purchase of asset Financing Company Lessee periodic payments assigned to debt holder Lessor Transfers use of the asset Lessee 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, and the investment in capital leases 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. 16 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 those 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 to be used in the computation is that which when applied to the net investment in the years in which the net investment is positive will distribute the net income to those years. 17 In a footnote to an illustration of the allocation of annual cash flow to investment and income, SFAS No. 13 includes the following comment: 16. FASB Statement No. 13, op. cit., par. 43. 17. Ibid., par. 44.

432 Chapter 13 Leases [The rate used for the allocation] is calculated by a trial and error process. The allocation is calculated based upon an initial estimate of the rate as a starting point. If the total thus allocated to income differs under the estimated rate from the net cash flow the estimated rate is increased or decreased, as appropriate, to devise a revised allocation. This process is repeated until a rate is selected which develops a total amount allocated to income that is precisely equal to the net cash flow. As a practical matter, a computer program is used to calculate [the allocation] under successive iterations until the correct rate is determined. 18 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-equity ratios. However, unlike lessees, lessors do not wish to avoid recording lease transactions as capital leases. Consequently, the trick is to allow the lessee to record a lease as an operating lease while the lessor records it as either a sales-type or direct financing. 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 ratio and return on assets ratios than it would have if it had recorded the transaction as a capital lease. To illustrate, Samson Company has the following summarized balance sheet on December 31, 2005, prior to entering into a lease transaction: Current assets $ 50,000 Long-term assets 250,000 Total assets $300,000 Current liabilities $ 20,000 Long-term debt 130,000 Stockholders equity 150,000 Total liabilities and stockholders equity $300,000 18. Ibid., par. 123.

Financial Analysis of Leases 433 Assume that the company enters into a lease agreement on December 31, 2005, 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 recorded on Samson s balance sheet, and its working capital, current ratio, and return on assets ratios for December 31, 2006, will appear as follows (assume the company earned net income of $25,000 during 2006): Working capital = $50,000 20,000 = $30,000 Current ratio = $50,000 $20,000 = 2.5:1 Return on asset ratio = $25,000 $300,000 19 = 8.3% Alternatively, if the lease agreement is recorded as a capital lease, the discounted present value of both the asset and liability is 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, 2006, balance sheet will now appear as follows (assuming a discount rate of 10 percent): Current assets $ 50,000 Long-term assets 250,000 Capital leases 37,908 Total assets $337,908 Current liabilities $ 20,000 Current lease obligation 9,091 Long-term debt 130,000 Long-term lease obligation 28,817 Stockholders equity 150,000 Total liabilities and stockholders equity $337,908 The company s working capital, current ratio, and return on assets ratios will now be computed: Working capital = $50,000 29,091 = $20,909 Current ratio = $50,000 $29,091 = 1.7:1 Return on asset ratio = $25,000 $318,945 20 = 7.8% Both Best Buy and Circuit City rely mainly on operating leases to finance their retail outlets. As a result, their balance sheets do not fully disclose their long-term investments in property, plant, and equipment. For example, the 19. Assume the company s total assets remained constant throughout the year. 20. ($300,000 + 337,908) 2.

434 Chapter 13 Leases following has been extracted from Circuit City s footnotes to its fiscal 2003 financial statements: The company conducts a substantial portion of its business in leased premises. The company s lease obligations are based upon contractual minimum rates. Rental expense and sublease income for all operating leases are summarized as follows: Years Ended February 28 (Amounts in thousands) 2003 2002 2001 Minimum rentals $373,333 $357,849 $345,230 Rentals based on sales volume 177 292 1,229 Sublease income (47,791) (46,814) (44,214) Net rental expense $325,719 $311,327 $302,245 The company computes rent based on a percentage of sales volumes in excess of defined amounts in certain store locations. Most of the company s other leases are fixed-dollar rental commitments, with many containing rent escalations based on the Consumer Price Index. Most leases provide that the company pay taxes, maintenance, insurance and operating expenses applicable to the premises. The initial term of most real property leases will expire within the next twenty years; however, most of the leases have options providing for additional lease terms of five to twenty-five years at terms similar to the initial terms. In accordance with SFAS No. 13, Accounting for Leases, the company recognizes rental expense from operating leases on a straight-line basis. Accrued straight-line rent is presented separately on the consolidated balance sheets and was $97.4 million at February 28, 2003, and $77.9 million at February 28, 2002. Future minimum fixed lease obligations, excluding taxes, insurance and other costs payable directly by the company, as of February 28, 2003, were: (Amounts in thousands) Operating Operating Capital Lease Sublease Fiscal Leases Commitments Income 2004 $1,768 $333,487 $(49,875) 2005 1,798 331,807 (47,882) 2006 1,807 329,929 (45,522) 2007 1,853 324,806 (41,540) 2008 1,853 317,866 (39,315) After 2008 9,153 2,843,091 (368,925) Total minimum lease payments 18,232 $4,480,986 $(593,059) Less amounts representing interest (7,144) Present value of net minimum capital lease payments $11,088

International Accounting Standards 435 As a result, the company s working capital, current ratio, and quick ratio illustrated in Chapter 8 and its return on assets ratio illustrated in Chapter 7 are all overstated when the effects of the company s lease financing policy is incorporated into the analysis. The extent of these overstatements can be estimated by discounting the 2003 obligation of $321,729,000 for one year to arrive at the current portion of its lease obligation and the remaining $4,480,986,000 to arrive at the long-term obligation. The sum of these two amounts is equal to the amount capitalized as a leased asset. 21 International Accounting Standards 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 in-substance purchases of assets are termed financing leases in IAS No. 17 rather than capital leases. In addition, the terminology sales-type 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. The comparative analysis of IAS No. 17 and SFAS No. 13 by the FASB staff indicated that companies following the international standard would tend to follow U.S. GAAP. However, concern was voiced that the guidance provided by IAS No. 17 is broader and less specific than that provided in SFAS No. 13. For example, it was noted that SFAS No. 13 requires that certain criteria be assessed in determining whether a lease qualifies as a capital lease, whereas IAS No. 17 requires a judgmental determination based on the substance of the leasing transaction. The staff study also revealed that much of the reporting and disclosure guidance of IAS No. 17 was presented as a suggestion or was optional, which makes it difficult to determine if these provisions must be followed, and if not, how accounting and reporting under IAS No. 17 would differ from accounting and reporting under SFAS No. 13. 22 None of these issues was addressed in the revised IAS No. 17. 21. In order to make this calculation, a discount factor must be assumed, and the annual amounts of the total of $2,843,091,000 payments due after 2008 must be estimated. If a discount rate of 6 percent and equal annual payments for the remaining fourteen years of the stated twenty-year lease obligation after 2008 of $1,753,262,000 are assumed, the present value of the current obligation is $352,202,000, the present value of the long-term obligation is $2,638,213,000, and the property under leased assets is $2,990,415,000. Adding this amount to Circuit City s total assets significantly reduces the company s return on assets ratio. A more sophisticated method of arriving at these amounts is contained in the reading on the Web page for Chapter 14. 22. Financial Accounting Standards Board, The IASC U.S. Comparison Project: A Report on the Similarities and Differences between IASC Standards and U.S. GAAP, 2nd. ed., Carrie Bloomer, ed. (Norwalk, CT: FASB, 1999), pp. 187 205.