Chapter 16 Leases The lease contract Capitalization Evolution

Chapter 16: Leases The lease contract Capitalization Evolution of lease accounting Economic consequences of lease capitalization. G 4+1 proposal on leases

The Lease Contract is A legal document conveying use of property for a fixed period of time in exchange for rent or other compensation A conveyance because the lessee acquires an interest in property for a fixed period of time A contract because the lessor promises the lessee quiet enjoyment of the property during the lease term in exchange for the promise of periodic payments

Legal Form of a Lease Contract An executory (unperformed) contract A lessor (legal owner) transfers possession of a leased asset to a lessee for a fixed period of time in exchange for a series of rents A lessee’s performance is executory because future rents are due one period at a time

Purchase Arrangement vs. True Lease Purchase arrangements include v outright cash sales v credit sales v installment sales, v secured credit sales v conditional sales Title passes to the user of the property in all instances except leases and conditional sales

Leases and Conditional Sales Title passes in a conditional sale when final payment is made, but this does not necessarily occur with a lease Leases in which the title passes at the end of the lease term or in which a bargain purchase option exists are virtually the same as conditional sales with respect to legal ownership

Capitalization Strong argument for capitalization can be made for leases that resemble conditional sales agreements Capitalization of leases that are virtually conditional sales agreements. . . consistent with the true legal nature of the transaction

Lease Capitalization Lessee’s viewpoint, a lease must be accounted for as either a rental agreement or v a purchase equivalent with debt financing v Lessor’s viewpoint, the transaction must be treated as either a rental agreement or v a sale equivalent with debt financing (if it is a sales-type lease) or a loan equivalent (if it is a financing-type lease) v

Accounting Policy The heart of the policy is classification of leases as either operating or v capital leases v Arguments against lease capitalization verifiability v use of present value discounting techniques introduced less reliable accounting numbers into the financial statements v

Capitalization for Lessees Legal approach Material equity Transfer of the benefits and risks of ownership

Lease Accounting Standards ARB 38 APB Opinion No. 5 APB Opinion No. 10 APB Opinion No. 31 SFAS No. 13 (as Amended Through SFAS No. 98)

Lease Accounting Standards APB Opinion No. 7 issued in 1966 v first standard to address lessor accounting v APB Opinion No. 27 SFAS No. 13 v lessee and lessor accounting achieved near symmetry

Sale and Leaseback Occurs when the owner of an asset legally sells it and enters into a lease agreement to lease the asset back Lessor (new legal owner) and lessee (original legal owner) both use the standard criteria for classifying such a lease as operating or capital

Leveraged Leases From a lessee’s viewpoint, a leveraged lease is not any different from other leases From lessor’s viewpoint. . . possibly v is the same as a conventional financing-type lease with an additional debt transaction between the lessor and the third party v is to regard a leveraged lease as a unique type of lease warranting special rules applicable to its special circumstances

Economic Consequences costs of complying with lease capitalization more critical concern has been whether lease capitalization might provide disincentives for leasing itself

SFAS No. 13 Survey and capital market research supports the position that the reporting of capital leases is useful and relevant. However, a strong case can be made for capitalizing all leases extending beyond one year. This type of rigid uniformity would eliminate the attempts to circumvent SFAS No. 13

G 4+1 proposal on leases G 4+1 the major standard-setting bodies from v v v Australian Accounting Standards Board Canadian Accounting Standards Board New Zealand Financial Reporting Standards Board United Kingdom Accounting Standards Board United States Financial Accounting Standards Board The International Accounting Standards Committee participates in the work of the G 4+1 as an observer

G 4 + 1 Report It would eliminate the distinction between operating and financing leases by making all leases financing leases. It would move leases from the area of finite uniformity to rigid uniformity. In addition, for the lessee it would result in showing operating leases as assets which would certainly be the case since they embody the definition of assets from the conceptual framework.

Improving Accounting Standards In line with the G 4+1 Report, eliminate the distinction between operating and capital leases. All leases should become capital leases.

Chapter 16: Leases The lease contract Capitalization Evolution of lease accounting Economic consequences of lease capitalization. G 4+1 proposal on leases