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 lease is in substance a longterm 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 1 Period of use is short relative to the overall life of the asset 2 Lessor has a comparative advantage over the lessee in reselling the asset 3 Corporate bond covenants of the lessee contain restrictions relating to financial policies the firm must follow (maximum to debt to equity ratios) 4 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 5 Lessee ownership is closely held so that risk reduction is important 6 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 7 The asset is not specialized to the firm 8 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 1 Lease transfers ownership of the property to the lessee by the end of the lease term 2 Lease contains a bargain purchase option 3 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 4 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: 1 2 3 4 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 1 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. 2 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 3 Total minimum sublease rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented. 4 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 All leases which do not meet any of the four capitalization criteria Periodic payments are recorded as rent expense Rent Expense Disclosures Required for Operating Leases by Lessees 1. For operating leases having initial or remaining noncancelable lease terms in excess of one year: a) b) 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. 2. For all operating leases a) Rental expense for each period for which an income statement is presented b) with separate amounts for minimum rentals, contingent rentals and sublease rentals. Disclosures Required for Operating Leases by Lessees 3 A general description of the lessee's leasing arrangements including, but not limited to the following: a b The basis on which contingent rental payments are determined. The existence and terms of renewals or purchase options and escalation clauses. c 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: 1 Collectability of minimum lease payments is reasonably predictable 2 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 1. 2. 3. 4. 5. 6. 7. 8. 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 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 1 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. 2 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. 3 Total contingent rentals included in income for each period for which an income statement is presented. 4 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 Lessor Asset user Lessee Debt Holder Long-term financier Leveraged Leases Lessee periodic payments assigned 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 Both Best Buy and Circuit City rely mainly on operating leases to finance their retail outlets. balance sheets do not fully disclose their long term investments in property, plant and equipment IAS No. 17 Amended to be effective 1/1/99 Added enhanced disclosure requirements Requirements similar to SFAS No. 13 Difference in terminology – Financial leases rather than capital leases for lessee Terms sales-type and direct financing not used for lessors FASB staff review indicated while requirements were similar ability to use judgment rather than specific criteria make provisions of IAS No. 17 somewhat optional Prepared by Richard Schroeder, DBA Kathryn Yarbrough, MBA Copyright © 2005 John Wiley & Sons, Inc. 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