1. Financial Reporting for Leases Revsine/Collins/Johnson/Mittelstaedt: Chapter 12 Copyright © 2009 by The McGraw-Hill Companies, All Rights Reserved. McGraw-Hill/Irwin

2. RCJM: Chapter 12 © 2009 2 Learning objectives 1.The difference between capital leases and operating leases. 2.Lessee’s incentives to keep leases off the balance sheet. 3.The criteria used to classify leases on the lessee’s books. 4.The treatment of executory costs, residual values, and other aspects of lease contracts. 5.The effects of capital lease versus operating lease treatment on the lessee’s financial statements. 6.How analysts can adjust for ratio distortions from off-balance sheet leases when comparing firms.

3. RCJM: Chapter 12 © 2009 3 Learning objectives: Continued 7.Lessor accounting rules and how the financial reporting incentives of lessors are very different from that of lessees. 8.The difference between sales-type, direct financing, and operating lease treatment by lessors. 9.How different lease accounting treatments can affect income and net asset balances. 10.Sale/leaseback arrangements and other special leasing situations. 11.How to use lease footnote disclosures.

4. RCJM: Chapter 12 © 2009 4 Lease contracts  A lease contract conveys the right to use an asset in exchange for a fee (the lease payment).  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. LesseeLessor Wants to use the asset Owns the asset Right to use Lease payment

5. RCJM: Chapter 12 © 2009 5 Evolution of lease accounting: Overview of the two approaches

6. RCJM: Chapter 12 © 2009 6 Lessee accounting: SFAS No. 13 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.

7. RCJM: Chapter 12 © 2009 7 Lessee accounting: Capital lease treatment illustrated  SFAS No. 13 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:

8. RCJM: Chapter 12 © 2009 8 Lessee accounting: Effective interest method

9. RCJM: Chapter 12 © 2009 9 Lessee accounting: Capital lease summary

10. RCJM: Chapter 12 © 2009 10 Lessor accounting: Capital and operating leases  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. Lease Sales-typeDirect-financingOperating CapitalOperating

11. RCJM: Chapter 12 © 2009 11 Lessor accounting: Expanded decision tree

12. RCJM: Chapter 12 © 2009 12 Lessor accounting: Implied rate of return on direct-financing lease

13. RCJM: Chapter 12 © 2009 13 Additional leasing aspects: Sale and leaseback  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 SFAS No. 13 criteria are used to determine if the lease qualifies for capital or operating lease treatment. Second Company First Company “Sale” transaction transfers title to asset “Lease back” allows use to be retained

14. RCJM: Chapter 12 © 2009 14 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 (SFAS No. 13). LessorBank Lessee Non-recourse financing Standard lease contract 1 2

15. RCJM: Chapter 12 © 2009 15 Summary  The treatment of leases in SFAS No. 13 represents a compromise between the “unperformed contracts” and “property-rights” approaches.  SFAS No. 13 adopts a middle-of-the-road approach and specifies precise intermediate circumstances under which leases are capitalized.  Several of the lease capitalization criteria are arbitrary, 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.

16. RCJM: Chapter 12 © 2009 16 Summary concluded  The FASB has issued 10 statements on leases subsequent to SFAS No. 13 and numerous interpretations of the original statement in an effort to close the loopholes for keeping leases off the balance sheet.  New loopholes are likely to be discovered and invented.  When lessors use the capital lease approach, income recognition is accelerated and financial statement ratios are improved. It is not surprising that capital leases appear frequently on lessor’s financial statements.