Financial Reporting
for Leases
Revsine/Collins/Johnson/Mittelstaedt: Chapter 12
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning objectives
1. The structure of a lease.
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 financial statement effects of executory costs, residual values,
purchase options and other aspects of lease contracts.
5. The effects of capital lease versus operating lease treatment on
the lessee’s financial statements.
6. Lessor accounting rules and how the financial reporting
incentives of lessors are very different from that of lessees.
12-2
Learning objectives:
Continued
7. The difference between sales-type, direct financing, and operating
lease treatment by lessors.
8. How different lease accounting treatments can affect income and
net asset balances.
9. Sale/leaseback arrangements and other special leasing situations.
10. The key differences between current GAAP and IFRS requirements
for lease accounting and the changes proposed by the FASB and
the IASB.
11. 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
Lease
Capital
Sales-type
Direct-financing
Operating
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
“Lease back” allows
use to be retained
Second
Company
 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.”
Non-recourse
financing
Lessor
Bank
1
Standard
lease
contract
2
Lessee
 Lessor then buys an asset and
leases it.
 A leveraged lease does not
affect the lessee’s accounting.
 The lessor must use the “directfinancing” approach and special
details apply (ASC 840).
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