Chapter 16: Leases

The lease contract

Capitalization

Evolution of lease accounting

Economic consequences of lease capitalization.

G4+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 outright cash sales credit sales installment sales, secured credit sales 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 a purchase equivalent with debt financing

Lessor’s viewpoint, the transaction must be treated as either a rental agreement or a sale equivalent with debt financing (if it is a sales-

type lease) or a loan equivalent (if it is a financing-type lease)

Accounting Policy

The heart of the policy is classification of leases as either operating or capital leases

Arguments against lease capitalization verifiability use of present value discounting techniques introduced

less reliable accounting numbers into the financial statements

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 first standard to

address lessor accounting

APB Opinion No. 27 SFAS No. 13 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 leasesFrom lessor’s viewpoint...possibly is the same as a conventional financing-type

lease with an additional debt transaction between the lessor and the third party

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

G4+1 proposal on leases

G4+1 the major standard-setting bodies from 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 G4+1 as an observer

G4 + 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 G4+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.

G4+1 proposal on leases