Lease Accounting

Lease Players Leasing – renting an asset from a third party consistently for “the right to use” the property. Lessor – owner of the asset offering lease agreement for “the right to use” the property. Lessee – party in a lease agreement making payments to the owner for “the right to use” the property over the term of the lease.

Advantages of Leases  100% Financing – often requiring no money down  Protection from obsolescence – some agreements may allow old asset models to be traded in for new asset models mid-lease term  Flexible Contracts – less restrictive provisions than debt agreements.  Less Costly Financing – possibly, if the company is able to structure the lease as an Operating lease rather than a Capital lease for financial reporting purposes.

Operating Lease  Lessor (owner) transfers only “the right to use” the property to the Lessee.  Lessee does not assume risk of ownership.  Lessee reports lease payments as an operating expense on Income Statement.  Lessee does NOT report the operating lease the Balance Sheet as an Asset or Liability.

Capital Lease  Lessee assumes some risks of ownership and enjoys some benefits.  Lessee will report a Capital Lease on the Balance Sheet as both an Asset and a Liability.  Lessee will claim Depreciation Expense on the Asset and Interest Expense on payment of the Liability – exactly as if the property was purchased and financed with a loan agreement.

Criteria for Capital Lease  Is there a transfer of ownership ?  Is there a Bargain Purchase Option ?  Is the term of the lease > or = 75% of the asset’s economic useful life ?  Is the present value of the lease payments > or = 90% of the fair value of the leased asset ? If any one of these criteria are met, the lease must be reported as a Capital Lease on the Balance Sheet reporting both an Asset and Liability for the fair value of the lease agreement.

Additional Criteria for Lessor The Lessor must meet two additional criteria for a Capital lease  Collectability of the lease payments must be reasonably predictable  Lessors performance is substantially complete OR future costs are reasonably predictable.

New FASB Update ** A new accounting standard for Leases, issued in January of 2016 will now require Lessees to Report all Operating Leases with terms >12 months on the Balance Sheet as a “Right to Use” Asset and Liability. The Asset and Liability will be measured at the present value of the Operating Lease payments.

See Lecture Note Examples for further illustrations.