RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 10TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY 4

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 Capital lease Operating 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 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 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 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 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 Unless lessor’s implicit rate is known and lower. Minimum lease payments consist of: 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) 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. 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 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 Rent Expense Operating leases All leases which do not meet any of the four capitalization criteria Periodic payments are recorded as rent expense

Disclosures Required for Operating Leases by Lessees For operating leases having initial or remaining noncancelable lease terms in excess of one year: 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 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 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: 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 The components of the net investment in leases as of the date of each balance sheet presented 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 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. 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 Asset user Debt Holder Lessor Asset user Lessee Debt Holder Long-term financier

Leveraged Leases Lessee periodic payments assigned Finances purchase 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: The performance obligation approach and 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. 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 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: A fair value model: Investment property is measured at fair value Changes in fair value are recognized in the income statement. 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 Copyright © 2011 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.