Accounting For Leases|
Capital Vs. Operating Leases|
This paper will outline the differences in accounting treatment of and criteria for determining whether leases should be accounted for as either a capital lease or an operating lease. I will be limiting my discussion to the accounting treatment of leases by the lessee. This paper will discuss the current accounting treatment for the two types of leases according to Canadian GAAP and will tie in elements of the conceptual framework to the treatment of leases from CICA handbook section 1000, followed by a discussion on accounting theories related to lease treatment, and finally current issues outlined in academic research concerning lease treatment by the lessee. There are two major classifications of leases. Capital leases and operational leases. A Capital lease is defined in the CICA handbook as “a lease that, from the point of view of the lessee, transfers substantially all the benefits and risks incident to ownership of property to the lessee” (CICA, 2010, Section 3065, ¶3). In order for a lease to be classified as a capital lease, the life of the lease must exceed 75% of the life of the leased item, there must be a transfer of ownership at the end of the lease or a bargain purchase option, and the present value of the lease payments must exceed 90% of the fair market value of the asset (Grossman, A., & Grossman, S., 2010). An operational lease is described by the CICA handbook as “a lease in which the lessor does not transfer substantially all the benefits and risks incident to ownership of property” (CICA, 2010, Section 3065, ¶3). It is very important for accountants to classify leases properly because the Accounting treatment differs for the two types of leases and the decision on which accounting treatment to use will affect a company’s bottom line. As stated in the CICA handbook, a capital lease should be accounted for as an asset as well as an obligation. This means that a lease is both a benefit and a liability to a company (CICA, 2010, Section 3065, ¶15). The leased asset should be valued by calculating the present value of the minimum lease payment less executory costs which include things like maintenance costs, interest, and property taxes. If the executory costs cannot be determined, an estimation of these costs should be used. The amortization period for the asset should be the period of expected use of the leased item and the accounting treatment should be similar to that of the lessee’s similar assets. If the leased asset is to be transferred to the lessee at the end of the lease, or if there is a bargain purchase option on the lease, which is an option for the lessee to purchase the leased asset at a price that is significantly lower than the fair value, the leased asset should be amortized during the period of the expected economic life of the asset (CICA, 2010, Section 3065, ¶3, 16, 17). Lease payments reduce a portion of the lease obligation on the lessee’s books and cover executory costs. The lease obligation is only taken off the books of the lessee when the lease is fully terminated and or expired (CICA, 2010, Section 3065, ¶19). Operating leases are handled differently. Most operating leases are on a short term basis and do not account for a significant amount of the useful life of an asset. An operating lease is simply recorded as an expense on the income statement and a decrease of cash on the balance sheet of the company. Operating leases are generally favoured by accountants for reasons discussed in further sections of this paper. The agency theory states that rational agents are those that are risk adverse, which means they try and stay away from risky ventures; self interested which means that they will base their actions on what will yield them the greatest benefit; and effort adverse which means that have a tendency to shirk and do as little work as they can in order...