Accounting for Leases - Paper
Accounting Treatment of Leases
The accounting treatment of leases has undergone sweeping change over the past three decades. At one time leases were not disclosed in financial statements at all. Gradually lease disclosure was required, and appeared first in the footnotes to the financial statements. With only minimal disclosure, leasing was attractive to certain firms as an “off-balance-sheet” method of financing. There is, however, no evidence that such financing had a favorable effect on company valuation, all other things being the same. Nevertheless, many companies proceeded on the assumption that “off-balance-sheet” financing was a good thing. Then came the Financial Accounting Standards Board Statement No. 13 (called FASB 13) in 1976 with an explicit ruling that called for the capitalization on the balance sheet of certain types of lease.3
In essence, this statement says that if the lessee acquires essentially all of the economic benefits and risks of the leased property, then the value of the asset along with the corresponding lease liability must be shown on the lessee’s balance sheet.
Capital and Operating Leases
Leases that conform in principle to this definition are called capital leases. More specifically, a lease is regarded as a capital lease if it meets one or more of the following conditions:
1. The lease transfers ownership of the asset to the lessee by the end of the lease period.
2. The lease contains an option to purchase the asset at a bargain price (i.e., less than the fair market value of the asset at the end of the lease term).
3. The lease period equals 75 percent or more of the estimated economic life of the asset.
4. At the beginning of the lease, the present value of the minimum lease payments equals
90 percent or more of the fair market value of the leased asset.4
If any of these conditions is met, the lessee is said to have acquired most of the economic benefits and risks associated with the leased property.
The accounting treatment of leases has undergone sweeping change over the past three decades. At one time leases were not disclosed in financial statements at all. Gradually lease disclosure was required, and appeared first in the footnotes to the financial statements. With only minimal disclosure, leasing was attractive to certain firms as an “off-balance-sheet” method of financing. There is, however, no evidence that such financing had a favorable effect on company valuation, all other things being the same. Nevertheless, many companies proceeded on the assumption that “off-balance-sheet” financing was a good thing. Then came the Financial Accounting Standards Board Statement No. 13 (called FASB 13) in 1976 with an explicit ruling that called for the capitalization on the balance sheet of certain types of lease.3
In essence, this statement says that if the lessee acquires essentially all of the economic benefits and risks of the leased property, then the value of the asset along with the corresponding lease liability must be shown on the lessee’s balance sheet.
Capital and Operating Leases
Leases that conform in principle to this definition are called capital leases. More specifically, a lease is regarded as a capital lease if it meets one or more of the following conditions:
1. The lease transfers ownership of the asset to the lessee by the end of the lease period.
2. The lease contains an option to purchase the asset at a bargain price (i.e., less than the fair market value of the asset at the end of the lease term).
3. The lease period equals 75 percent or more of the estimated economic life of the asset.
4. At the beginning of the lease, the present value of the minimum lease payments equals
90 percent or more of the fair market value of the leased asset.4
If any of these conditions is met, the lessee is said to have acquired most of the economic benefits and risks associated with the leased property.