In the previous chapter, we saw how companies account for their long-term debt. The focus of that discussion was bonds and notes. In this chapter we continue our discussion of debt, but we now turn our attention to liabilities arising in connection with leases. Leases that produce such debtor/creditor relationships are referred to as capital leases by the lessee and as either direct financing or sales-type leases by the lessor. We also will see that some leases do not produce debtor/creditor relationships, but instead are accounted for as lease agreements. These are designated operating leases.
1.Identify and describe the operational, financial, and tax objectives that motivate leasing. 2.Explain why some leases constitute lease agreements and some represent purchases/sales accompanied by debt financing. 3.Explain the basis for each of the criteria and conditions used to classify leases. 4.Record all transactions associated with operating leases by both the lessor and lessee. 5.Describe and demonstrate how both the lessee and lessor account for a capital lease. 6.Describe and demonstrate how the lessor accounts for a sales-type lease. 7.Explain how lease accounting is affected by the residual value of a leased asset. 8.Describe the way a bargain purchase option affects lease accounting. 9.Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs, and contingent leases. 10.Explain sale-leaseback agreements and other special leasing arrangements and their accounting treatment. 11.Discuss the primary differences between U.S. GAAP and IFRS with respect to leases.
Part A: Accounting by the Lessor and Lessee
I.Advantages of Leasing
A.Leasing is used as a means of “off-balance-sheet financing.” 1.Can avoid negatively affecting the debt-equity ratio and other mechanical indicators of riskiness. 2.Assumes market is naive, and is “fooled” by off-balance-sheet financing. B.Achieves operational objectives by facilitating asset acquisition to overcome: 1.Uncertainty or cash flow problems.
2.Time constraints and/or bureaucratic control systems. 3.Fear of obsolescence.
C.Achieves tax objectives: A lessee often can negotiate lower lease payments if it allows the lessor to retain ownership and thus benefit from depreciation deductions when: 1.The lessee has little or no taxable income and will get little benefit from depreciation deductions. 2.The lessee has sufficient taxable income to take advantage of the depreciation deductions, but is in lower tax brackets than lessors.
II.In keeping with the concept of “substance over form” a lease is accounted for as either: A.A lease agreement or
B.A purchase/sale accompanied by debt financing (T15-1)
III.Lease Classification (T15-2)
A.A lessee should classify a lease transaction as a capital lease if it is noncancellable and if one or more of four classification criteria are met: (T15-2) 1. The agreement specifies that ownership of the asset transfers to the lessee. 2. The agreement contains a bargain purchase option. 3. The noncancellable lease term is equal to 75% or more of the expected economic life of the asset. 4. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset. B.Otherwise, it is an operating lease.
C.A lessor records a lease as a direct financing lease or a sales-type lease only if two conditions relating to revenue realization are met in addition to one of the four classification criteria. 1. The collectibility of the lease payments must be reasonably predictable. 2. If any costs to the lessor have yet to be incurred, they are reasonably predictable. (Performance by the lessor is substantially complete.)