Financial Reporting for Leases

1
Financial Reportingfor Leases

• Revsine/Collins/Johnson Chapter 12

2
Learning objectives

• The difference between capital leases and
  operating leases.
• Lessees incentives to keep leases off the
  balance sheet.
• The criteria used to classify leases on the
  lessees books.
• The treatment of executory costs, residual
  values, and other aspects of lease contracts.
• The effects of capital lease versus operating
  lease treatment on the lessees financial
  statements.
• How analysts can adjust for ratio distortions
  from off-balance sheet leases when comparing
  firms.

3
Learning objectivesContinued

• Lessor accounting rules and how the financial
  reporting incentives of lessors are very
  different from that of lessees.
• The difference between sales-type, direct
  financing, and operating lease treatment by
  lessors.
• How different lease accounting treatments can
  affect income and net asset balances.
• Sale/leaseback arrangements and other special
  leasing situations.
• How to use lease footnote disclosures.

4
Lease contracts
Right to use
Lessee
Lessor
Wants to use the asset
Owns the asset
Lease payment

• 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.

5
Evolution of lease accountingOperating lease
approach

• SFAS No 13 spells out GAAP for leases. Before it
  was issued in 1976, virtually all leases were
  accounted for using the operating lease approach.
• Heres an example

Month 1
Month 2
5 year term of lease
2,000 payment
Lease signed and Iris moves in
2,000 payment
6
Evolution of lease accountingEntries for Iris
Company (lessee)

• At inception, when the lease contract is signed
• At the end of each month

No Entry Executory (unperformed) contract
DR Rent expense
2,000 CR Lease liability

2,000 To accrue a liability for that portion of
the contract that has been performed.
DR Lease liability
2,000 CR Cash

2,000 To record the payment of the stipulated
rental fee at the end of the month.
7
Evolution of lease accountingEntries for Crest
Company (lessor)

• At inception, when the lease contract is signed
• At the end of each month

No Entry Executory contract
DR Cash
2,000 CR Rental
revenue
2,000 To record the rental payment
received each month.
DR Depreciation expense leased building
2,000 CR Accumulated depreciation
leased building 2,000 The building
remains an asset on the books, periodic
depreciation is recorded.
8
Evolution of lease accountingWhy lessees like
the operating lease approach

• The operating approach does not reflect the
  cumulative economic liability for all future
  lease payments on the balance sheet.
• Keeping the lease obligation (and asset) off of
  the balance sheet may
• Reduce the likelihood of debt covenant violation.
• Improve the ability to obtain additional loans in
  the future.
• Improve financial performance ratios like ROA
• However, GAAP does require footnote disclosure of
  this off-balance sheet lease obligation.

NOPAT
ROA seems higher when leased assets are not
included here.
ROA
Average assets
9
Evolution of lease accountingThe SECs
initiative

• The SEC issued ASR No. 147 in 1973 to improve
  financial reporting for leases.
• The SEC took a property rights approach to lease
  accounting
• The lease conveys property rights (an asset) to
  the lessee.
• The payment stream represents the lessees
  liability.
• Under this capital lease approach, the lessee
  makes the following entry when the lease is
  signed

DR Leased asset (to reflect the property right,
not ownership of the asset)
XXX CR Lease
obligation (to reflect the liability arising
from future lease payments)
XXX
10
Evolution of lease accountingOverview of the
two approaches
11
Lessee accountingSFAS 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.

12
Lessee accountingCapital 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

13
Lessee accountingCapital lease accounting
overview

• The balance sheet amount shown for the lease
  asset and liability are equal only at the
  inception and at the end of the lease
• The leased asset is amortized over time using a
  depreciation schedule for assets of this type.
• The lease obligation is reduced in accordance
  with the payment schedule once interest is
  accrued using the effective interest method.

300,000
PV of MLP
300,000
PV of MLP
Payments and interest
Amortization
0
0
Inception
End of Lease
Inception
End of Lease
Lease Asset
Lease liability
14
Lessee accountingEffective interest method
79,139.18-19,680.77
250,860.82 x 10
15
Lessee accountingAnnual cost of leased asset
300,000 5 years
16
Lessee accountingCapital lease journal entries

• At inception, when the lease contract is signed

DR Leased asset capital lease
300,000 CR
Obligation under capital lease
300,000
PV of MLP
17
Lessee accountingCapital lease summary
18
Lessee accountingExecutory costs

• These are the costs of using the assetsuch as
  maintenance, taxes, and insurance.
• Accordingly, they are omitted when determining
  minimum lease payments and the capitalized amount
  shown for the leased asset.
• Instead, they are charged to expense when
  incurred

DR Obligation under capital lease
49,139.18 DR Interest expense

30,000.00 DR Miscellaneous lease expense
2,000.00 CR
Cash
81,139.18
Executory costs
19
Lessee accountingResidual value guarantees

• Suppose Lessee Corp. guarantees that the asset
  will be worth no less than 20,000 when the lease
  ends.
• Residual value guarantees of this sort protect
  the lessor against two business risks
• Unforeseen technological or marketplace changes
  that erode asset value.
• Possibility that the lessee does not take proper
  care of the asset.
• With this guarantee, the new present value of
  minimum lease payments becomes

Without guarantee
With guarantee
20
Lessee accountingResidual value guarantee
details
(312,418.40 - 20,000) 5 years
79,139.18 -26,452.11
264,521.06 x 10
21
Lessee accountingResidual value guarantee
journal entries

• At inception, when the lease contract is signed
• When Lessee Corp. returns the asset worth at
  least 20,000 to the lessor

DR Leased asset capital lease
312,418.40 CR Obligation
under capital lease
312,418.40
DR Obligation under capital lease
20,000.00 CR Leased asset
capital lease
20,000.00
22
Lessee accountingPayments in advance

• The lease contracts described thus far all
  involve payments that occur at the end of each
  period.

Inception
Year 1
Year 2
Term of lease
XX
XX
Present values
23
Lessee accountingAmortization with payments in
advance
The payment is smaller than before because it is
made at the beginning of each period.
228,055 x 10
300,00 5 years
24
Lessee accountingFinancial statement effects
Lessee Company Pattern of Expense Recognition
Capital Versus Operating
Rental payment
Interest plus depreciation
25
Lessee accountingUse of operating and capital
leases
26
Lessee accountingFootnote disclosure
Off-balance sheet obligation
Balance sheet liabilities
27
Lessee accountingAdjusting income
28
Lessee accountingBalance sheet and ratio effects

• Capital lease accounting can effect the current
  ratio. Consider the Lessee Corp. lease at
  inception (Exhibit 12.1)

Capital lease
Operating lease
Current assets Current liabilities
Current assets Current liabilities
Increased by 49,139
Unchanged
29
Lessor accountingCapital and operating leases
Lease
Capital
Operating
Sales-type
Direct-financing
Operating

• From the lessors 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.

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Lessor accountingDecision tree

• Asset removed from books.
• Financing profit only

• Asset removed from books.
• Two profit streams
• Manufacturers/dealers profit
• Financing profit over time

• Asset remains on books.
• Rental income over time

31
Lessor accountingSales-type lease example
Recognized over time as earned
Recognized at inception
32
Lessor accountingDirect-financing lease example
Recognized over time as earned
33
Lessor accountingSFAS No. 13 criteria for
capital lease treatment
Type 1 characteristics (at least one of these is
met)
Type 2 characteristics (and both of these are
met)

• Ownership is transferred to lessee by end of
  lease term.
• Lease contains a bargain purchase option.
• Noncancelable lease term is 75 or more of
  estimated economic life.
• Present value of minimum lease payments exceeds
  90 of the FMV of the leased asset.

• Collectability of minimum lease payments is
  reasonably assured.
• There are no important uncertainties surrounding
  the amount or unreimbursable costs yet to be
  incurred by the lessor under the lease.

Measurability
Critical event
34
Lessor accountingExpanded decision tree
35
Lessor accountingDirect-financing lease
treatment illustrated
Also equals the present value of MLP plus GRV
36
Lessor accountingImplied rate of return on
direct-financing lease
PV of MLP
PV of GRV
37
Lessor accountingAmortization schedule for
direct-financing lease
258,699.85 x 11
79,189.18 - 22,881.94
38
Lessor accountingJournal entries for
direct-financing lease

• At inception, when the lease contract is signed

DR Gross investment in leased asset
415,695.90 CR Equipment

304,359.49 CR Unearned financing
income leases
111,336.41
39
Lessor accountingJournal entries for an
operating lease

• At inception, when the lease contract is signed

No Entry Asset remains on lessors books
40
Lessor accountingComparison of operating and
direct-financing
79,139.18 - 56,871.90
41
Lessor accountingJournal entries for sales-type
lease

• At inception, when the lease contract is signed

Manufacturers profit recognized at inception
DR Gross investment in leased asset
415,695.90 DR Cost of goods sold
240,000.00
CR Sales revenue
304,359.49
CR Unearned financing income leases
111,336.41 CR
Inventory
240,000.00
42
Lessor accountingSales-type lease with
executory costs

• Suppose Lessor Company also promises to provide
  maintenance services on the leased asset for an
  additional annual fee of 2,000.
• The gross investment calculation is now

43
Additional leasing aspectsSale and leaseback
Sale transaction transfers title to asset
Second Company
First Company
Lease back allows use to be retained

• 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.

44
Additional leasing aspectsSale and leaseback
(continued)

• However, First Companys gain cannot be
  recognized immediately.
• If it qualifies as a capital lease, First Company
  would make the following entries at inception

• Amortized using the some rate and life used for
  leased asset

200,000 deferred gain
200,000 deferred gain

• Amortized in proportion to rental payments

Capital lease
Operating lease
DR Cash (or receivable)
1,000,000 CR Plant and
equipment
800,000 CR Deferred gain

200,000 DR Leased asset capital
leases 1,000,000
CR Obligation under capital leases
1,000,000
45
Additional leasing aspectsLeveraged 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 lessees
  accounting.
• The lessor must use the direct-financing
  approach and special details apply (SFAS No. 13).

Non-recourse financing
Lessor
Bank
1
Standard lease contract
2
Lessee
46
Additional leasing aspectsTax accounting

• U.S. income tax laws also distinguish between
  operating leases and capital leases.
• However, the tax criteria are not the same as
  SFAS No. 13.
• Firms often favor one treatment for tax purposes
  and another treatment for financial reporting
  purposes

Financial reporting
Income tax
Lessee
Operating
Capital
Lessor
Capital
Operating
Accelerates expense recognition
Delays revenue recognition
47
Additional leasing aspectsLessors disclosures
48
Additional leasing aspectsLessors disclosures
(concluded)
Expected cash flow
49
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.

50
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 lessors financial statements.

51
AppendixConstructive capitalization

• Some companies structure lease contracts to evade
  capital lease criteria, thereby keeping most of
  their leases off the balance sheet.
• Other companies have a large proportion of
  capital leases.
• The most straightforward method for making
  balance sheet data comparable is to treat all
  leases as if they were capital leases. This is
  called constructive capitalization.

Operating leases


Capital leases
Firm 1
Firm 2
52
AppendixOperating lease footnote

• To estimate the balance sheet liability that
  would have been recorded under the capital lease
  approach, we need to calculate the present value
  of the MLP.

53
AppendixDetermining the discount rate

• Two alternatives for determining the discount
  rate can be used
• The weighted-average discount rate implicit in
  capital leases.
• The weighted-average discount rate on long-term
  debt.
• Heres how to find the discount rate implicit in
  capital leases
• A similar approach is used to find the discount
  rate on long-term debt

54
AppendixEstimating payments beyond five years
Panel at bottom Page 664
55
AppendixLease asset liability (payments at
year-end)
56
AppendixLease asset liability (payments at
start of year)
57
AppendixAlbertsons capitalized leased asset

• A footnote reveals that
• Applying this same proportion to the companys
  operating leases yields

321 million
257
257 million
80
321
Net capital lease assets
Net capital lease obligations
80
1,920 million
1,536 million
Capitalized operating lease asset
Capitalized operating lease obligation
58
AppendixFinancial statement impact
59
AppendixFinancial ratio impact