Financial Reporting for Leases Chapter 12

Learning objectives The structure of a lease. Lessee’s incentives to keep leases off the balance sheet. The criteria used to classify leases on the lessee’s books. The financial statement effects of executory costs, residual values, purchase options and other aspects of lease contracts. The effects of capital lease versus operating lease treatment on the lessee’s financial statements. Lessor accounting rules and how the financial reporting incentives of lessors are very different from that of lessees. 12-2

Learning objectives: Continued The difference between sales-type, direct financing, and operating lease treatment by lessors. How different lease accounting treatments can affect income and net asset balances. Sale/leaseback arrangements and other special leasing situations. The key differences between current GAAP and IFRS requirements for lease accounting and the changes proposed by the FASB and the IASB. How to use financial statement disclosure to estimate the financial statement effects of treating operating leases as capital leases. 12-3

Lease contracts Right to use Owns the asset Lessor Lessee Wants to use the asset Lease payment A lease contract conveys the right to use an asset in exchange for a fee (the lease payment). The lessor typicall retains legal title to the assets which reverts to the lessor at the end of the lease term. The asset’s expected fair value at the end of the lease is the residual value. At its inception, a lease is a mutually unperformed contract meaning that neither party has yet performed all of the duties called for in the contract. The accounting for unperformed contracts is controversial. 12-4

Evolution of lease accounting: Overview of the two approaches Differences between operating and capital leases 12-5

Lessee accounting: ASC 840 Criteria for Capital Lease Treatment If, at inception, the lease satisfies any one or more of the following criteria, it must be treated as a capital lease on the books of the lessee: The lease transfers ownership of the asset to the lessee at the end of the lease term. The lease contains a bargain purchase option. The non-cancelable lease term is 75% or more of the estimated economic life of the leased asset. The present value of the minimum lease payments equals or exceeds 90% of the current fair market value of the leased asset. 12-6

Lessee accounting: Capital lease treatment illustrated ASC 840 requires that the lease asset and liability initially be recorded at a dollar amount equal to the discounted present value of the minimum lease payments: 12-7

Lessee accounting: Capital lease summary Lessees’ Accounting for Capital Leases 12-8

Lessor accounting: Capital and operating leases Sales-type Direct-financing Operating From the lessor’s perspective, a capital lease must both: Transfer property rights in the leased asset to the lessee, and Allow reasonably accurate estimates regarding the amount and collectibility of the eventual net cash flows to the lessor. When both conditions are not simultaneously met, the lease must be treated as an operating lease. 12-9

Lessor accounting: Expanded decision tree Figure 12.6 12-10

Lessor accounting: Implied rate of return on direct-financing lease 12-11

Additional leasing aspects: Sale and leaseback “Sale” transaction transfers title to asset First Company Second Company “Lease back” allows use to be retained First Company gets a $1 million cash infusion and can treat the entire annual rental ($120,000) as a deductible expense for tax purposes. The same ASC 840 criteria are used to determine if the lease qualifies for capital or operating lease treatment. 12-12

Additional leasing aspects: Leveraged lease Lessor borrows money from a third-party. This non-recourse loan provides the “leverage.” Lessor then buys an asset and leases it. A leveraged lease does not affect the lessee’s accounting. The lessor must use the “direct-financing” approach and special details apply (ASC 840). Non-recourse financing Lessor Bank 1 Standard lease contract 2 Lessee 12-13

Global Vantage Point Comparison of IFRS and GAAP Lease Accounting IFRS and U.S. GAAP are similar – differences include: Differences between the concepts of operating leases and capital leases (called finance leases in IFRS). Classification depends on which party has the risks and rewards of ownership. Difference in the ability to classify some assets held under leases as investment property. Lessors have the choice between fair value and historical cost for investment property provided to lessees under operating leases. 12-14

Summary The treatment of leases in ASC 840 represents a compromise between the “unperformed contracts” and “property-rights” approaches. FASB ASC 840 adopts a middle-of-the-road approach and specifies precise intermediate circumstances under which leases are capitalized. Several of the lease capitalization criteria rely on bright-line rules, which allows lease contracts to be structured in ways that avoid required capitalization. Because the proportion of operating lease payments to capital lease payments can vary greatly between firms in the same industry, analysts must often constructively capitalize operating leases to make valid comparisons. 12-15

Summary concluded Lessors’ use of the capital lease approach accelerates income recognition in contrast to the timing of income recognition under the operating lease approach. IFRS also distinguishes between operating and capital (finance) leases. The FASB and IASB have issued a jointly developed exposure draft on lease accounting. The proposed accounting adopts a “right-of-use” approach and would require lessees to treat most leases as capital leases. 12-16