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. Therefore a capital lease is involved. If a lease does not meet any of these conditions, it is classified (for accounting purposes) as an operating lease.5 Essentially, operating leases give the lessee the right to use the leased property over a period of time, but they do not give the lessee all of the benefits and risks that are associated with the asset.
Recording the Value of a Capital Lease. With a capital lease, the lessee must report the value of the leased property on the asset side of the balance sheet. The amount reflected is the present value of the minimum lease payments over the lease period. If executory costs, such as insurance, maintenance, and taxes, are a part of the total lease payment, these are deducted, and only the remainder is used for purposes of calculating the present value. As required by the accounting rules, the discount rate employed is the lower of (1) the lessee’s incremental borrowing rate, or (2) the rate of interest implicit in the lease if, in fact, that rate can be determined.
The present value of the lease payments should be recorded as an asset on the lessee’s balance sheet. (If the fair market value of the leased property is lower than the present value of the minimum lease payments, then the fair market value would be shown.) A corresponding liability is also recorded on the balance sheet, with the present value of payments due within one year being reflected as current liabilities and the present value of payments due after one year being shown as noncurrent liabilities. Information on leased property may be combined with similar information on assets that are owned, but there must be a disclosure in a footnote with respect to the value of the leased property and its amortization. The capital-leaserelated portions of a hypothetical balance sheet might look like the following:
Gross fixed assets
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