1. 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

2. CHAPTER 13
LEASES

3. 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

4. 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

5. 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?

6. 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?

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

8. 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

9. 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

10. 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

11. 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)

12. 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

13. 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

14. 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

15. 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.

16. 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.

17. 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

18. 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.

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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.

27. 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

28. Leveraged Leases Three parties Equity holder Asset user Debt Holder
Lessor
Asset user
Lessee
Debt Holder
Long-term financier

29. Leveraged Leases Lessee periodic payments assigned Finances purchase
to debt holders
Finances purchase
of assets
Financing Company
Transfer use
of the asset
Lessor
Lessee

30. 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

31. 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

32. 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.

33. 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).

34. 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.

35. 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.

36. International Accounting
The IASB has issued pronouncements on the following items affecting leases:
IAS No. 17 , Accounting for Leases
IAS No. 40 , Investment Property

37. 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

38. 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.

39. 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)

40. 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.