Skip to content

 Browse
 Search
 Expand Nav
o Resource Centers
o Playlists
o History
o Topics
o Learning Paths
o Newsletters
o Highlights
o Settings
o Support
o Sign Out

Table of Contents for

Financial Accounting Theory and Analysis:
Text and Cases, 11th Edition

 Search in book...


 Toggle Font Controls

o Twitter
o Facebook
o Google Plus
o Email

Prev Previous Chapter
CHAPTER 12: Accounting for Income Taxes

Next Next Chapter
CHAPTER 14: Pensions and Other Postretirement Benefits
Businesses generally acquire property rights in long-term assets through purchases that are funded by internal
sources or by externally borrowed funds. The accounting issues associated with the purchase of long-term
assets were discussed in Chapter 9. Leasing is an alternative means of acquiring long-term assets to be used by
firms. Leases that are not in-substance purchases provide for the right to use property by lessees, in contrast to
purchases that transfer property rights to the user of the long-term asset. Lease terms generally obligate lessees
to make a series of payments over a future period; thus, they are similar to long-term debt. However, if a lease
is structured in a certain way, it enables the lessee to engage in off–balance sheet financing because certain
leases are not reported as long-term debt on the balance sheet. Business managers often wish to use off–
balance sheet financing to improve the financial position of their companies. However, as noted earlier in the
text, efficient market research suggests that off–balance sheet debt is incorporated into user decision models in
determining the value of a company.
Leasing has become a popular method of acquiring property, because it has the following advantages:

1. It offers 100 percent financing.

2. It offers protection against obsolescence.
3. It is often less costly than other forms of financing the cost of the acquisition
of fixed assets.
4. If the lease qualifies as an operating lease, it does not add debt to the balance
sheet.
Many long-term leases possess most of the attributes of long-term debt. That is, they create an obligation for
payment under an agreement that is noncancelable. The adverse effects of debt are also present in leases in that
an inability to pay can result in insolvency. Consequently, even though there are statutory limitations on lease
obligations in bankruptcy proceedings, these limits do not affect the probability of the adverse effects of
nonpayment on asset values and credit standing in the event of nonpayment of lease obligations. The statutory
limitations involve only the evaluation of the amount owed after insolvency proceedings have commenced.
Management's choice between purchasing and leasing should be a function of strategic investment and
capital structure objectives, not of leasing's effects on published financial statements. When deciding whether to
purchase or lease an asset, management should consider the comparative costs of purchasing versus leasing the
asset and the availability of tax benefits, rather than focusing on perceived financial reporting advantages. The
tax benefit advantage is a major factor in leasing decisions. From a macroeconomic standpoint, the tax benefits
of owning assets may be maximized by transferring them to the party in the higher marginal tax bracket. Firms
with lower effective tax rates may engage in more leasing transactions than firms in higher tax brackets because
the tax benefits are passed on to the lessor. El-Gazzar et al. found evidence to support this theory: Firms with
lower effective tax rates were found to have a higher proportion of leased debt to total assets than did firms with
higher effective tax rates.1
Some lease agreements are in-substance long-term installment purchases of assets that have been structured
to gain tax or other benefits to the parties. Because leases can take different forms, accountants must examine
the underlying nature of the original transaction to determine the appropriate method of accounting for these
agreements. Stated differently, the financial effects of leases should be reported in a manner that describes the
intent of the lessor and lessee (i.e., the substance of the agreement) rather than the form of the agreement.

Accounting for Leases

Two methods for allocating lease revenues and expenses to the periods covered by the lease agreement have
emerged in accounting practice. One method, a capital lease, is based on the view that the lease constitutes an
agreement through which the lessor finances the acquisition of assets by the lessee. Consequently, capital
leases are in-substance installment purchases of assets. The other method is an operating lease and is based on
the view that the lease constitutes a rental agreement between the lessor and lessee.
Two basic accounting questions are associated with leases: What characteristics of the lease agreement
require a lease to be reported as an in-substance long-term purchase of an asset? Which characteristics allow the
lease to be reported as a long-term rental agreement?
The accounting profession first recognized the problems associated with leases in Accounting Research
Bulletin (ARB) No. 38. This release recommended that if a lease agreement were in substance an installment
purchase of property, the lessee should report it as an asset and a liability. As with many of the ARBs, the
recommendations of this pronouncement were largely ignored in practice, and the lease disclosure problem
remained an important accounting issue.
In 1964, the APB issued Opinion No. 5, “Reporting of Leases in Financial Statements of Lessees”
(superseded). APB Opinion No. 5 required leases that were in-substance purchases to be capitalized on the
financial statements of lessees. This conclusion was no match for the countervailing forces against the
capitalization of leases that were motivated by the ability to present a more favorable financial structure and
patterns of income determination. As a result, relatively few leases were capitalized under the provisions
of APB Opinion No. 5.
The APB also issued three other statements dealing with accounting for leases by lessors and lessees: APB
Opinion No. 7, “Accounting for Leases in Financial Statement of Lessors” (superseded), APB Opinion No. 27,
“Accounting for Lease Transactions by Manufacturers or Dealer Lessors” (superseded), and APB Opinion No.
31, “Disclosure of Lease Transactions by Lessees” (superseded). Nevertheless, the overall results of these
statements were that few leases were being capitalized and that lessor and lessee accounting for leases lacked
symmetry, because these four opinions allowed lessees and lessors to report the same lease differently.
In November 1976, the FASB issued SFAS No. 13, “Accounting for Leases” (see FASB ASC 840), which
superseded APB Opinion Nos. 5, 7, 27, and 31. A major purpose of SFAS No. 13 was to achieve a greater
degree of symmetry of accounting between lessees and lessors. In an effort to accomplish this goal, the
statement established standards of financial accounting and reporting for both lessees and lessors. As noted
above, one of the problems associated with the four opinions issued by the APB was that they allowed
differences in recording and reporting the same lease by lessors and lessees; adherence to SFAS No.
13 substantially reduces (though it does not eliminate) this possibility.
The conceptual foundation underlying SFAS No. 13 is based on the view that “a lease that transfers
substantially all of the benefits and risks inherent in the ownership of property should be accounted for as the
acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing lease by the
lessor.”2 This viewpoint leads immediately to three basic conclusions: (1) The characteristics indicating that
substantially all the benefits and risks of ownership have been transferred to the lessee must be identified. These
types of leases should be reported as if they involved the purchase and sale of assets ( capital leases). (2) The
same characteristics should apply to both the lessee and lessor; therefore, the inconsistency in accounting
treatment that previously existed should be eliminated. (3) Those leases that do not meet the characteristics
identified in (1) should be accounted for as rental agreements (operating leases).
It has been suggested that the choice of structuring a lease as either an operating or a capital lease is not
independent of the original nature of leasing as opposed to buying the asset. As indicated earlier, companies
engaging in lease transactions may attempt to transfer the benefits of owning assets to the lease party in the
higher tax bracket. In addition, Smith and Wakeman identified eight nontax factors that make leasing more
attractive than purchasing:3

1. The period of use is short relative to the overall life of the asset.
2. The lessor has a comparative advantage over the lessee in reselling the asset.
3. Corporate bond covenants of the lessee contain restrictions relating to
financial policies the firm must follow (maximum debt-to-equity ratios).
 4. Management compensation contracts contain provisions expressing
compensation as a function of return on invested capital.
5. Lessee ownership is closely held, so that risk reduction is important.
6. The lessor (manufacturer) has market power and can thus generate higher
profits by leasing the asset (and controlling the terms of the lease) than by
selling the asset.
7. The asset is not specialized to the firm.
8. The asset's value is not sensitive to use or abuse (the owner takes better care
of the asset than does the lessee).
Obviously, some of these reasons are not subject to lessee choice but are motivated by the lessor and/or the
type of asset involved. However, short periods of use and the resale factor favor the accounting treatment of a
lease as operating, whereas the bond covenant and management compensation incentives favor a structuring of
the lease as a capital lease. In addition, lessors may be more inclined to seek to structure leases as capital leases
to allow earlier recognition of revenue and net income. That is, a lease that is reported as an in-substance sale
by the lessor allows revenue recognition (gross profit on sale) at the time of the original transaction in addition
to interest revenue over the life of the lease.

Criteria for Classifying Leases

In SFAS No. 13, the FASB outlined specific criteria for classifying leases as either capital or operating leases.
If at its inception the lease meets any one of the following four criteria, the lessee will classify the lease as a
capital lease; otherwise, it is classified as an operating lease:

1. The lease transfers ownership of the property to the lessee by the end of the
lease term. This includes the fixed noncancelable term of the lease plus
various specified renewal options and periods.
2. The lease contains a bargain purchase option. This means that when the
lessee has the option to purchase the leased asset, at the inception of the
lease the stated purchase price is sufficiently lower than the fair market
value of the property expected at the date the option will become exercisable
such that it appears to be at a bargain price. In this case, exercise of the
option appears to be reasonably assured.
3. The lease term is equal to 75 percent or more of the estimated remaining
economic life of the leased property, unless the beginning of the lease term
falls within the last 25 percent of the total estimated economic life of the
leased property.
4. At the beginning of the lease term, the present value of the minimum lease
payments (the amounts of the payments the lessee is required to make
excluding that portion of the payments representing executory costs such as
insurance, maintenance, and taxes to be paid by the lessee) equals or
exceeds 90 percent of the fair value of the leased property less any related
investment tax credit retained by the lessor. (This criterion is also ignored
when the lease term falls within the last 25 percent of the total estimated
economic life of the leased property.)
The criteria for capitalization of leases are based on the assumption that a lease that transfers to the lessee the
risks and benefits of using an asset should be recorded as an acquisition of a long-term asset. However, the
criteria are seen as arbitrary, because the FASB provided no explanation for choosing a lease term of 75 percent
or a fair value of 90 percent as the cutoff points. In addition, the criteria have been viewed as redundant and
essentially based on the fourth criterion.4
In the case of the lessor (except for leveraged leases, discussed later), if a lease meets any one of the
preceding four criteria plus both of the following additional criteria, it is classified as a sales type or direct
financing lease.

1. Collectibility of the minimum lease payments is reasonably predictable.

2. No important uncertainties surround the amount of unreimbursable costs yet
to be incurred by the lessor under the lease.
The latter two criteria are prompted by the concept of conservatism. Accountants are reluctant to report
receivables when there is significant uncertainty regarding expected future cash flows.

Accounting and Reporting by Lessees under SFAS No. 13

From the lessee's perspective, the primary concern in accounting for lease transactions has historically been the
appropriate recognition of assets and liabilities on the balance sheet. This concern has overridden the corollary
question of revenue recognition on the part of lessors. Therefore the usual position of accountants has been that
when a lease agreement is in substance an installment purchase, lessees should account for the “leased”
property as an asset and report a corresponding liability. Failure to do so results in an understatement of assets
and liabilities on the balance sheet. Lease arrangements that are not considered installment purchases constitute
off–balance sheet financing arrangements and should be properly disclosed in the footnotes to financial
statements.
This position has evolved over time. As early as 1962, the accounting research division of the AICPA
recognized that there was little consistency in the disclosure of leases by lessees and that most companies were
not capitalizing leases. It therefore authorized a research study on the reporting of leases by lessees. Among the
recommendations of this study were the following:
To the extent that leases give rise to property rights, those rights and related liabilities should be
measured and incorporated in the balance sheet. To the extent that rental payments represent a means
of financing the acquisition of property rights which the lessee has in his possession and under his
control, the transaction constitutes the acquisition of an asset with a related obligation to pay for it.

To the extent, however, that the rental payments are for services such as maintenance, insurance,
property taxes, heat, light, and elevator service, no asset has been acquired, and none should be
recorded.

The measurement of the asset value and the related liability involves two steps: (1) determining the
part of the rentals that constitutes payment for property rights, and (2) discounting these rentals at an
appropriate rate of interest.5
The crucial difference in the conclusion of this study and the practice that existed when the conclusion was
reached was the emphasis on property rights (the right to use property), as opposed to the rights in property—
ownership of an equity interest in the property.
The APB considered the recommendations of this study and agreed that certain lease agreements should
result in the lessee's recording an asset and liability. The Board concluded that the important criterion to be
applied was whether the lease was in substance a purchase—that is, rights in property, rather than the existence
of property rights. This conclusion indicated that the APB agreed that an asset and liability should be recorded
when the lease transaction was in substance an installment purchase in the same manner as other purchase
arrangements. The APB, however, did not agree that the rights to use property in exchange for future rental
payments give rise to the recording of assets and liabilities, because no equity in property is created.
In Opinion No. 5, the APB asserted that a noncancelable lease, or one that is cancelable only on the
occurrence of some remote contingency, was probably in substance a purchase if either of the two following
conditions exists:6

1. The initial term is materially less than the useful life of the property, and the
lessee has the option to renew the lease for the remaining useful life of the
property at substantially less than the fair rental value.
 2. The lessee has the right, during or at the expiration of the lease, to acquire
the property at a price that at the inception of the lease appears to be
substantially less than the probable fair value of the property at the time or
times of permitted acquisition by the lessee.
The presence of either of these two conditions was seen as convincing evidence that the lessee was building
equity in the property.
The APB went on to say that one or more of the following circumstances tend to indicate that a lease
arrangement is in substance a purchase:

1. The property was acquired by the lessor to meet the special needs of the
lessee and will probably be usable only for that purpose and only by the
lessee.
2. The term of the lease corresponds substantially to the estimated useful life
of the property, and the lessee is obligated to pay costs such as taxes,
insurance, and maintenance, which are usually considered incidental to
ownership.
3. The lessee has guaranteed the obligations of the lessor with respect to the
leased property.
4. The lessee has treated the lease as a purchase for tax purposes.
In addition, a lease might be considered a purchase if the lessor and lessee were related even in the absence
of the preceding conditions and circumstances. In that case, a lease should be recorded as a purchase if a
primary purpose of ownership of the property by the lessor is to lease it to the lessee and (1) the lease payments
are pledged to secure the debts of the lessor or (2) the lessee is able, directly or indirectly, to significantly
control or influence the actions of the lessor with respect to the lease.
These conclusions caused controversy in the financial community, because some experts believed that they
resulted in disincentives to leasing. Those holding this view maintained that noncapitalized leases provide the
following benefits:

1. Improved accounting rate of return and debt ratios, thereby improving the
financial picture of the company
2. Better debt ratings
3. Increased availability of capital
On the other hand, the advocates of lease capitalization hold that these arguments are, in essence, attempts to
deceive users of financial statements. That is, a company should fully disclose the impact of all its financing
and investing activities and not attempt to hide the economic substance of external transactions. (This issue is
discussed in more detail later in the chapter.)

Capital Leases
The view expressed in APB Opinion No. 5 concerning the capitalization of leases that are “in-substance
installment purchases” is significant from a historical point of view, for two reasons. First, in SFAS No. 13, the
FASB based its conclusion on the concept that a lease that “transfers substantially all of the benefits and risks
of the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an
obligation by the lessee, and as a sale or financing by the lessor.” Second, to a great extent, the accounting
provisions of SFAS No. 13 applicable to lessees generally follow APB Opinion No. 5.
The provisions of SFAS No. 13 require a lessee entering into a capital lease agreement to record both an
asset and a liability at the lower of the following:
 1. The sum of the present value of the minimum lease payments at the
inception of the lease (see the following discussion)
2. The fair value of the leased property at the inception of the lease
The rules for determining minimum lease payments were specifically set forth by the FASB. In summary,
payments that the lessee is obligated to make or can be required to make, with the exception of executory costs,
should be included. Consequently, the following items are subject to inclusion in the determination of the
minimum lease payments:

1. Minimum rental payments over the life of the lease

2. Payment called for by a bargain purchase option
3. Any guarantee by the lessee of residual value at the expiration of the lease
term
4. Any penalties that the lessee can be required to pay for failure to renew the
lease
Once the minimum lease payments are known, the lessee must compute their present value. The interest rate
to be used in this computation is the smaller of the lessee's incremental borrowing rate or the lessor's implicit
rate (if known). The lessee's incremental borrowing rate is the rate that would have been charged had the lessee
borrowed funds to buy the asset with repayments over the same term. If the lessee can readily determine the
implicit interest rate used by the lessor, and if that rate is lower than his or her incremental borrowing rate, then
the lessee is to use the lessor's implicit interest rate to calculate the present value of the minimum lease
payments. If the lessee does not know the lessor's interest rate (a likely situation), or if the lessor's implicit
interest rate is higher than the lessee's incremental borrowing rate, the lessee and lessor will have different
amortization schedules to recognize interest expense and interest revenue, respectively.
Capital lease assets and liabilities are to be separately identified in the lessee's balance sheet or in the
accompanying footnotes. The liability should be classified as current and noncurrent on the same basis as all
other liabilities—that is, according to when the obligation must be paid.
Unless the lease involves land, the asset recorded under a capital lease is to be amortized by one of two
methods. Leases that meet either criterion 1 or 2 on page 463 are to be amortized in a manner consistent with
the lessee's normal depreciation policy for owned assets. That is, when the lease automatically transfers
ownership of the leased property or contains a bargain purchase option (capital lease criterion 1 or 2 is met), it
is presumed that the lessee will eventually have title to the asset and should amortize the leased asset over its
economic life. For all other capital leases, the asset will revert to the lessor at the end of the lease term; thus,
leases that do not meet capital lease criterion 1 or 2 should be amortized in a manner consistent with the lessee's
normal depreciation policy, using the lease term as the period of amortization. In conformity with APB Opinion
No. 21, “Interest on Receivables and Payables” (see FASB ASC 835-30), SFAS No. 13 requires that each
minimum payment under a capital lease be allocated between a reduction of the liability and interest expense.
This allocation is to be made in such a manner that the interest expense reflects a constant interest rate on the
outstanding balance of the obligation (i.e., the effective interest method). Thus, as with any loan payment
schedule, each successive payment allocates a greater amount to the reduction of the principal and a lesser
amount to interest expense. This procedure results in the loan being reflected on the balance sheet at the present
value of the future cash flows discounted at the effective interest rate.

Disclosure Requirements for Capital Leases

SFAS No. 13 also requires the disclosure of additional information for capital leases. The following
information must be disclosed in the lessee's financial statements or in the accompanying footnotes:

1. The gross amount of assets recorded under capital leases as of the date of
each balance sheet presented by major classes according to nature or
function
2. Future minimum lease payments as of the date of the latest balance sheet
presented, in the aggregate and for each of the five succeeding fiscal years
 3. The total minimum sublease rentals to be received in the future under
noncancelable subleases as of the date of the latest balance sheet presented
4. Total contingent rentals (rentals on which the amounts depend on some
factor other than the passage of time) actually incurred for each period for
which an income statement is presented

Operating Leases
Lessees classify all leases that do not meet any of the four capital lease criteria as operating leases. Failure to
meet any of the criteria means that the lease is simply a rental arrangement and, in essence, should be
accounted for in the same manner as any other rental agreement, with certain exceptions. The rent payments
made on an operating lease are normally charged to expense as they become payable over the life of the lease.
An exception is made if the rental schedule does not result in a straight-line basis of payment. In such cases,
the rent expense is to be recognized on a straight-line basis unless the lessee can demonstrate that some other
method gives a more systematic and rational periodic charge.
In Opinion No. 31, the APB observed that many users of financial statements were dissatisfied with the
information being provided about leases. Although many criticisms were being voiced over accounting for
leases, the focus of this opinion was on the information that should be disclosed about noncapitalized leases.
The following disclosures are required for operating leases by lessees:

1. For operating leases having initial or remaining noncancelable lease terms in

excess of one year,
a. Future minimum rental payments required as of the date of the latest
balance sheet presented in the aggregate and for each of the five
succeeding fiscal years
b. The total of minimum rentals to be received in the future under
noncancelable subleases as of the date of the latest balance sheet
presented
2. For all operating leases, rental expense for each period for which an income
statement is presented, with separate amounts for minimum rentals,
contingent rentals, and sublease rentals
3. A general description of the lessee's leasing arrangements including, but not
limited to, the following:
a. The basis on which contingent rental payments are determined
b. The existence and terms of renewals or purchase options and
escalation clauses
c. Restrictions imposed by lease agreements, such as those concerning
dividends, additional debt, and further leasing
The FASB contends that the preceding accounting and disclosure requirements for capital and operating
leases by lessees give users information useful in assessing a company's financial position and results of
operations. The requirements also provide many specific and detailed rules, which should lead to greater
consistency in the presentation of lease information.

Accounting and Reporting by Lessors

The major concern in accounting for leases in the financial statements of lessors is the appropriate allocation of
revenues and expenses over the period covered by the lease. This concern contrasts with the lessee's focus on
the balance sheet presentation of leases. As a general rule, lease agreements include a specific schedule of the
date and amounts of payments the lessee is to make to the lessor. The fact that the lessor knows the date and
amount of payment does not necessarily indicate that revenue should be reported in the same period the cash is
received. To measure the results of operations more fairly, accrual accounting often gives rise to situations in
which revenue is recognized in a period other than when payment is received.
The nature of the lease and the rent schedule might make it necessary for the lessor to recognize revenue that
is more or less than the payments received in a given period. Furthermore, the lessor must allocate the
acquisition and operating costs of the leased property, together with any costs of negotiating and closing the
lease, to the accounting periods receiving benefits in a systematic and rational manner consistent with the
timing of revenue recognition. The latter point is consistent with the application of the matching principle in
accounting—that is, determining the amount of revenue to be recognized in a period and then ascertaining
which costs should be matched with that revenue.
Historically, the criterion for choosing between accounting for lease revenue as a sale, as a financing, or as
an operating lease was based on the accounting objective of fairly stating the lessor's periodic net income.
Whichever approach would best accomplish this objective should be followed. SFAS No. 13 set forth specific
criteria for determining the type of lease as well as the reporting and disclosure requirements for each type.
According to SFAS No. 13, if at its inception a lease agreement meets the lessee criteria for classification as
a capital lease and if the two additional criteria for lessors contained on page 462 are met, the lessor is to
classify the lease as either a sales-type lease or a direct financing lease, whichever is appropriate. All other
leases, except leveraged leases (discussed in a separate section), are to be classified as operating leases.

Sales-Type Leases
The lessor should report a lease as a sales-type lease when at least one of the capital lease criteria is met, both
lessor certainty criteria are met, and there is a manufacturer's or dealer's profit (or loss). This implies that the
leased asset is an item of inventory and that the seller is earning a gross profit on the sale. Sales-type leases
arise when manufacturers or dealers use leasing as a means of marketing their products.
Table 13.1 depicts the major steps involved in accounting for a sales-type lease by a lessor. The amount to
be recorded as gross investment (a) is the total amount of the minimum lease payments over the life of the
lease, plus any unguaranteed residual value accruing to the benefit of the lessor. Once the gross investment has
been determined, it is to be discounted to its present value (b) using an interest rate that causes the aggregate
present value at the beginning of the lease term to be equal to the fair value of the leased property. The rate thus
determined is referred to as the interest rate implicit in the lease (the lessor's implicit rate).
The difference between the gross investment (a) and the present value of the gross investment (b) is to be
recorded as unearned interest income (c). The unearned interest income is to be amortized as interest income
over the life of the lease using the interest method described in APB Opinion No. 21 (see FASB ASC 835-30).
Applying the interest method results in a constant rate of return on the net investment in the lease. The
difference between the gross investment (a) and the unearned interest income (c) is the amount of net
investment (d), which is equal to the present value of the gross investment (b). The net investment is classified
as a current or noncurrent asset on the lessor's balance sheet in the same manner as all other assets. Income
from sales-type leases is thus reflected by two amounts: (1) the gross profit (or loss) on the sale in the year of
the lease agreement and (2) interest on the remaining net investment over the life of the lease agreement.

TABLE 13.1   Accounting Steps for Sales-Type Leases

 For sales-type leases, because the critical event is the sale, the initial direct costs associated with obtaining
the lease agreement are written off when the sale is recorded at the inception of the lease. These costs are
disclosed as selling expenses on the income statement.

Direct Financing Leases

When at least one of the capital lease criteria and both lessor certainty criteria are met, but the lessor has no
manufacturer's or dealer's profit (or loss), lessors account for the lease as a direct financing lease. Under the
direct financing method, the lessor is essentially viewed as a lending institution for revenue recognition
purposes. As with a sales-type lease, each payment received for a direct financing lease must be allocated
between interest revenue and recovery of the net investment. Because the net receivable is essentially an
installment loan, in the early periods of the lease a significant portion of the payment is recorded as interest;
but each succeeding payment will result in a decreasing amount of interest revenue and an increasing amount
of investment recovery, because the amount of the net investment is decreasing.
The FASB adopted the approach of requiring lessors to record the total minimum lease payments for direct
financing leases as a gross receivable on the date of the transaction and to treat the difference between that
amount and the asset cost as unearned income. Subsequently, as each rental payment is received, the gross
receivable is reduced by the full amount of the payment, and a portion of the unearned income is transferred to
earned income.
Table 13.2 illustrates the accounting steps for direct financing leases. Gross investment (a) is determined in
the same way as in sales-type leases, but unearned income (c) is computed as the difference between gross
investment and the cost (b) of the leased property. The difference between gross investment (a) and unearned
income (c) is net investment (d), which is the same as (b) in the sales-type lease.

TABLE 13.2   Accounting Steps for Direct Financing Leases

 Initial direct costs (e) in financing leases are treated as an adjustment to the investment in the leased asset.
Because financing the lease is the revenue-generating activity, SFAS No. 91 (see FASB ASC 310-20) requires
that this cost be matched in proportion to the recognition of interest revenue. In each accounting period over the
life of the lease, the unearned interest income (c) minus the indirect cost (e) is amortized by the effective
interest method. Because the net investment is increased by an amount equal to the initial direct costs, a new
effective interest rate must be determined in order to apply the interest method to the declining net investment
balance. Under direct financing leases, the only revenue reported by the lessor is disclosed as interest revenue
over the lease term. Since initial direct costs increase the amount disclosed as the net investment, the interest
income reported represents interest net of the write-off of the initial direct cost.

Disclosure Requirements for Sales-Type and Direct Financing Leases

In addition to the specific procedures required to account for sales-type and direct financing leases, the FASB
established certain disclosure requirements. The following information is to be disclosed when leasing
constitutes a significant part of the lessor's business activities in terms of revenue, net income, or assets:

1. The components of the net investment in leases as of the date of each

balance sheet presented:
a. Future minimum lease payments to be received with deduction for
any executory costs included in payments and allowance for
uncollectibles
b. The unguaranteed residual value
c. Unearned income
2. Future minimum lease payments to be received for each of the five
succeeding fiscal years as of the date of the latest balance sheet presented
3. The amount of unearned income included in income to offset initial direct
costs charged against income for each period for which an income statement
is presented (for direct financing leases only)
4. Total contingent rentals included in income for each period for which an
income statement is presented
5. A general description of the lessor's leasing arrangements
 The Board indicated that these disclosures by the lessor, as with the disclosures by lessees, would aid the
users of financial statements in their assessment of the financial condition and results of operations of lessors.
Note also that these requirements make the information disclosed by lessors and lessees more consistent.

Lessor Operating Leases

Leases that do not meet the criteria for classification as sales-type or direct financing leases are accounted for
as operating leases by the lessor. As a result, the lessor's cost of the leased property is reported with or near
other property, plant, and equipment on the lessor's balance sheet and is depreciated following the lessor's
normal depreciation policy.
Rental payments are recognized as revenue when they become receivable unless the payments are not made
on a straight-line basis. In that case, as with the lessee, the recognition of revenue is to be on a straight-line
basis. Initial direct costs associated with the lease are to be deferred and allocated over the lease term in the
same manner as rental revenue (usually on a straightline basis). However, if these costs are not material, they
may be charged to expense as incurred.
If leasing is a significant part of the lessor's business activities, the following information is to be disclosed
for operating leases:

1. The cost and carrying amount, if different, of property on lease or held for
leasing by major classes of property according to nature or function, and the
amount of accumulated depreciation in total as of the date of the latest
balance sheet presented
2. Minimum future rentals on noncancelable leases as of the date of the latest
balance sheet presented, in the aggregate and for each of the five succeeding
fiscal years
3. Total contingent rentals included in income for each period for which an
income statement is presented
4. A general description of the lessor's leasing arrangements

Sales and Leasebacks

In a sale and leaseback transaction, the owner of property sells the property and then immediately leases it back
from the buyer. These transactions commonly occur when companies have limited cash resources or when the
transaction results in tax advantages. Tax advantages occur because the sales price of the asset is usually its
current market value, and this amount generally exceeds the carrying value of the asset on the seller's books.
Therefore the tax-deductible periodic rental payments are higher than the previously recorded amount of
depreciation expense.
Most sales and leaseback transactions are treated as a single economic event, according to the lease
classification criteria previously discussed on pages 461 and 462. That is, the lessee-seller applies the SFAS No.
13 criteria to the lease agreement and records the lease as either a capital or operating lease, and the gain on the
sale is amortized over the lease term; however, if a loss occurs, it is recognized immediately. Even so, in certain
circumstances where the lessee retains significantly smaller rights to use the property, a gain may be
immediately recognized. In this case it is argued that two distinctly different transactions have occurred,
because the rights to use have changed.

Leveraged Leases
A leveraged lease is a special leasing arrangement involving three different parties: the equity holder—the
lessor; the asset user—the lessee; and the debt holder—a long-term financer. 7 A leveraged lease may be
illustrated as in Figure 13.1.

FIGURE 13.1   Leveraged Lease

 The major issue in accounting for leveraged leases is whether the transaction should be recorded as a single
economic event or as separate transactions. All leveraged leases meet the criteria for direct financing leases.
However, a leveraged lease might be accounted for as a lease with an additional debt transaction or as a single
transaction. The FASB determined that a leveraged lease should be accounted for as a single transaction, and it
provided the following guidelines.
The lessee records the lease as a capital lease. The lessor records the lease as a direct financing lease. The
lessor's investment in the lease is the net result of several factors:

1. Rentals receivable, net of that portion of the rental applicable to principal

and interest on the nonrecourse debt
2. A receivable for the amount of the investment tax credit to be realized on the
transaction
3. The estimated residual value of the leased asset
4. Unearned and deferred income consisting of the estimated pretax lease
income (or loss), after deducting initial direct costs remaining to be allocated
to income over the lease term and the investment tax credit remaining to be
allocated to income over the lease term
Once the original investment has been determined, the next step is to project cash receipts and disbursements
over the term of the lease and then compute a rate of return on the net investment in the years in which it is
positive. Annual cash flow is the sum of gross lease rental and residual value (in the final year), less loan
interest payments plus or minus income tax credits or charges, less loan principal payments, plus investment tax
credit realized. The rate that is applied to the net investment in the years in which the net investment is positive
that will distribute the net income to those years. This rate is to be calculated by a trial-and-error process.
This method of accounting for leveraged leases was considered to associate the income with the unrecovered
balance of the earning asset in a manner consistent with the investor's view of the transaction. Income is
recognized at a level rate on net investment in years in which the net investment is positive and is thus
identified as “primary” earnings from the lease.
In recent years companies have tried to circumvent SFAS No. 13. These efforts are used mainly by lessees
who do not wish to report increased liabilities or adversely affect their debt-to-equity ratios. However, unlike
lessees, lessors do not wish to avoid reporting lease transactions as sales-type or direct financing leases.
Consequently, the objective is to allow the lessee to report a lease as an operating lease while the lessor reports
it as either a sales-type or direct financing lease.

Financial Analysis of Leases

In Chapter 11 we illustrated some procedures that a financial analyst might use to evaluate a company's long-
term debt position and indicated that the use of operating leases can affect this type of analysis. The use of
leases can also have an impact on a company's liquidity and profitability ratios. That is, a company employing
operating leases to acquire its assets will have a relatively better working capital position and relatively higher
current and return-on-assets (ROA) ratios than it would if it had recorded the transaction as a capital lease.
To illustrate, Samson Company has the following summarized balance sheet on December 31, 2012, before
entering into a lease transaction:

Assume that the company enters into a lease agreement on December 31, 2012, whereby it promises to pay a
lessor $10,000 annually for the next five years for the use of an asset. If the lease is accounted for as an
operating lease, neither the asset nor the liability is reported on Samson's balance sheet, and its working capital,
current ratio, and ROA ratios for December 31, 2013, will appear as follows (assume the company earned net
income of $25,000 during 2013):

Alternatively, if the lease is recorded as a capital lease, the discounted present values of both the asset and
liability are recorded on the company's balance sheet. In addition, the lease liability is separated into its current
and long-term components, and the company's December 31, 2013, balance sheet will now appear as follows
(assuming a discount rate of 10 percent):

The company's working capital, current ratio, and ROA ratio now become
 If a company makes extensive use of operating leases, its working capital, current ratio, and quick ratio,
illustrated in Chapter 8, and its ROA ratio, illustrated in Chapter 7, are all overstated when the effects of the
company's lease-financing policy are incorporated into the analysis. The extent of these overstatements can be
estimated by discounting the firm's current obligation for one year to arrive at the current portion of its lease
obligation and the remaining obligations to arrive at the long-term obligation. The sum of these two amounts is
equal to the amount capitalized as a leased asset. 8 For example, Hershey discloses the following future
minimum lease payment obligations in its 2011 annual report ($000 omitted):

Discounting these amounts at the company's approximate average borrowing rate of 7 percent results in an
increase in current liabilities of approximately $15.8 million, an increase in long-term obligations of
approximately $34.4 million, and an increase in total assets of approximately $33.0 million. 9 The financial
statement impact of capitalizing Hershey's operating leases is minimal in that their total amount is small in
comparison to the company's total assets and total liabilities. Incorporating these capitalized amounts into the
calculation of the current ratio results in a fractional decrease from the previously calculated amount of 1.170:1
to 1.167:1. The quick ratio also slightly declined from the previously calculated amount of 0.63:1 to 0.60:1.
Adding the discounted value of the leased assets to Hershey's total assets resulted in a decline in its adjusted
ROA from 11.9 to 11.7 percent.

Current Developments
In March 2009, the FASB and IASB announced a joint project on accounting for leases. The boards indicated
that the project was needed because the existing accounting model for leases has been criticized for failing to
meet the needs of users of financial statements. In particular, many users think that operating leases give rise to
assets and liabilities that should be recognized in the financial statements of lessees. Consequently, users
routinely adjust current and future obligations in an attempt to recognize those assets and liabilities and reflect
the effect of lease contracts in profit or loss. In 2005, the SEC estimated that $1.25 trillion dollars of liabilities
had been omitted from balance sheets because of operating lease classifications. 10 However, the information
available to users in the notes to the financial statements was viewed as insufficient for them to make reliable
estimations to account for these omissions. As a result,

1. The existence of two different accounting models for leases means that
similar transactions can be accounted for very differently. This reduces
comparability for users.
2. The current standard provides opportunities to structure transactions to
achieve a particular lease classification, that is, financial engineering. As a
result, if the lease is classified as an operating lease, the lessee obtains a
 source of financing that can be difficult for users to comprehend. Therefore,
lease structuring to meet various accounting goals has developed into an
entire industry.
Preparers and auditors have also criticized the existing lease accounting model for its complexity. In
particular, it has proved difficult to define the dividing line between capital leases and operating leases in a
principled way. Consequently, the standards use a mixture of subjective judgments and bright-line tests
(specific rules) that can be difficult to apply. Some have argued that the existing accounting model is
conceptually flawed. In particular:

1. On entering a lease contract, the lessee obtains a valuable right (the right to
use the leased item). This right meets the Boards' definitions of an asset.
Similarly, the lessee assumes an obligation (the obligation to pay rentals)
that meets the Boards' definitions of a liability. However, if the lessee
classifies the lease as an operating lease, that right and obligation are not
recognized.
2. There are significant and growing differences between the accounting model
for leases and other contractual arrangements. This has led to inconsistent
accounting for arrangements that meet the definition of a lease and similar
arrangements that do not.
The original project focused on accounting for lease arrangements within the scope of existing lease
accounting literature and considered only lessee accounting for leases. Later, after reviewing the responses to
this discussion paper, the Boards amended their proposal to include both lessees and lessors. The Boards'
revised views on lease accounting were published in a proposed Accounting Standards Update (ASU), “Leases:
Preliminary Views.”11
The proposed ASU required balance sheet recognition of all leases. The lessee records an intangible asset for
the right to use the leased asset and a liability for the obligation to make lease payments (right-of-use model).
The ASU proposes two models for lessors, depending on the terms of the lease and the effect on the lessor. The
first is the performance obligation approach, which recognizes the lessor's risks or benefits. The second is
the derecognition approach, which is to be used when the lessor has minimal risk exposure.
The performance obligation approach is used when the lessor retains exposure to significant risks or benefits
associated with the leased asset. Under this approach, the lessor continues to recognize the underlying leased
asset on the balance sheet as well as a lease receivable. The accounting treatment by the lessor is symmetrical to
that used by the lessee. A lessor would apply the derecognition approach when it is not exposed to significant
risks or benefits associated with the leased asset. In essence, the lessor “sells” a portion of the leased asset,
recognizes profit or loss, and derecognizes the leased asset. The remaining portion of the carrying amount of
the underlying asset not considered “sold” is reclassified as a residual asset.
The key aspects of this proposal were

 The basic principle is that lease contracts give rise to assets and liabilities
that should be reflected in the balance sheets of lessees and lessors. As such,
calculated financial ratios (leverage ratios, for example) would be more
complete and comparable.
 All lessees would use a single method of accounting for all leases. Balance
sheets of lessees would include both assets representing the right to use the
leased asset and liabilities arising from lease contracts at the present value of
the expected lease payments.
 The accounting by a lessor would reflect its exposure to the risks or benefits
of the underlying leased asset. A lessor that has transferred significant risks
 or benefits would recognize a gain or loss upon lease commencement. When
the lessor retains significant risks or benefits in the leased asset, it would
recognize income over the lease term.
The FASB maintained that “the proposed improvements would provide a more complete and accurate
portrayal of an entity's financial position, providing relevant information to users about operating capacity,
leverage, and return on capital.”
On September 14, 2010, the FASB published a questionnaire for investors and analysts that asked how the
proposed new leases guidance might affect financial statement users' analysis. Feedback from the respondents
indicated that the proposed requirements were overly complex and costly to implement. An additional
downside for lessees will be significantly increased liabilities their balance sheets, which could have an impact
on key performance indicators. The result could be lower asset turnover ratios, lower return on capital, and an
increase in debt-to-equity ratios, which could affect borrowing capacity or compliance with loan covenants.
Additionally, there is an income effect when calculating earnings before interest, taxes, depreciation, and
amortization (EBITDA). That is, capitalizing operating leases results in eliminating rent expense on the
operating leases and replacing it with interest expense on the previously unrecorded lease obligations and
depreciation expense on the right-of-use assets. EBITDA is calculated before interest expense and depreciation
expense; thus, the increased income statement expenses do not result in reductions to EBITDA. Consequently,
EBITDA with lease capitalization is greater than EBITDA measured under operating lease treatment by the
amount of rent expense. The impact on EBITDA is important, because it is often used by firms to measure
performance in financial covenants and incentive compensation agreements.12
Subsequently, on July 21, 2011, the Boards announced that the proposed ASU would be reexposed, because
the revised requirements were sufficiently different from the requirements in the original exposure draft. On
May 16, 2013 the IASB and FASB jointly issued a revised exposure draft on leases. This revised exposure draft
attempts to address the criticisms directed at the 2010 exposure draft, while still meeting the core objective of
recognizing leased assets and liabilities on the balance sheet. It proposes a dual approach, which will result in a
different pattern of income and expense recognition depending on the nature of the underlying asset and
whether the lessee acquires or consumes more than an insignificant portion of the leased asset.
Lessees will recognize a right-of-use asset and a liability to make lease payments on the balance sheet for all
leases (except short-term leases of 12 months or less). The income statement will reflect either a front-loaded
expense pattern (similar to today's capital leases) or straight-line expense (similar to current operating leases).
For most leases of assets other than property (for example, equipment, aircraft, cars, trucks), a lessee would
classify the lease as a Type A lease and

 Recognize a right-of-use asset and a lease liability, initially measured at the

present value of lease payments
 Recognize the amortization of the discount on the lease liability as interest
separately from the amortization of the right-of-use asset.
For most leases of property (that is, land and/or a building or part of a building), a lessee would classify the
lease as a Type B lease and

 Recognize a right-of-use asset and a lease liability, initially measured at the

present value of lease payments
 Recognize a single lease cost, combining the amortization of the discount on
the lease liability with the amortization of the right-of-use asset, on a
straight-line basis
The accounting treatment by a lessor would depend on whether the lessee is expected to consume more than
an insignificant portion of the economic benefits of the underlying asset. This assessment would depend on the
nature of the underlying asset. For most leases of assets other than property, a lessor would classify the lease as
a Type A lease and
  Derecognize the underlying asset and recognize a right to receive lease
payments (the lease receivable) and a residual asset (representing the rights
the lessor retains relating to the underlying asset)
 Recognize the amortization of the discount on both the lease receivable and
the residual asset as interest income over the lease term
 Profit on the receivable is recognized immediately; profit on the residual is
deferred until the underlying asset is re-leased or sold
For most leases of property, a lessor would classify the lease as a Type B lease and would apply an approach
similar to existing operating lease accounting in which the lessor would

 Continue to recognize the underlying asset

 Recognize lease income over the lease term typically on a straight-line basis
Comments on the new proposal were due September 13, 2013, and the Boards hoped to have a final standard
early in 2014. However, final passage of the new lease standard remains problematic. Three of the seven FASB
members have presented alternative views. These views reflect concerns about whether all of the core
objectives of the project have been met, the cost-benefit of the proposal, the dual model, and the usefulness of
the proposed disclosures. Two IASB members have presented alternative views that support the application of a
single lease model. Both sets of alternative views also include some concerns with the proposed accounting for
variable leases payments and renewal options.

International Accounting Standards

The IASB has issued pronouncements on the following items affecting leases:

 IAS No. 17, “Accounting for Leases”

 IAS No. 40, “Investment Property”
IAS No. 17, “Accounting for Leases,” deals with lease accounting issues. This standard, which was slightly
revised by the IASB's improvement project, is quite similar to U.S. GAAP, as outlined in  SFAS No. 13. One
difference in terminology, however, is that in-substance purchases of assets are termed financing leases in IAS
No. 17, rather than capital leases. IAS No. 17 indicates that a lease is to be classified as a finance lease if it
transfers substantially all the risks and rewards incident to ownership. All other leases are classified as
operating leases, and this classification is made at the inception of the lease. Whether a lease is a finance lease
or an operating lease depends on the substance of the transaction rather than the form. Situations that would
normally lead to a lease being classified as a finance lease include the following:

1. The lease transfers ownership of the asset to the lessee by the end of the
lease term.
2. The lessee has the option to purchase the asset at a price that is expected to
be sufficiently lower than fair value at the date the option becomes
exercisable that, at the inception of the lease, it is reasonably certain that the
option will be exercised.
3. The lease term is for the major part of the economic life of the asset, even if
title is not transferred.
4. At the inception of the lease, the present value of the minimum lease
payments amounts to at least substantially all of the fair value of the leased
asset.
 5. The lease assets are of a specialized nature such that only the lessee can use
them without major modifications being made.
In addition, the terminology sales-type financing and direct financing are not used in conjunction with the
reporting requirements specified for lessors. Nevertheless, the required accounting treatment for lessors is
similar to that outlined in SFAS No. 13. The major change in the new standard is that initial direct costs incurred
by lessors must now be capitalized and amortized over the lease term. The alternative in the original IAS No.
17 to expense initial direct costs up front has been eliminated.
IAS No. 40 defined investment property as property (land, or a building or part of a building, or both) held
(by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both.
Examples of leased investment property are a building leased out under an operating lease and a vacant
building held to be leased out under an operating lease.
In accounting for these properties under IAS No. 40, an enterprise must choose one of two models:

1. A fair value model whereby investment property is measured at fair value,

and changes in fair value are recognized in the income statement.
2. A cost model as described in IAS No. 16, “Property, Plant, and Equipment,”
whereby investment property is measured at depreciated cost (less any
accumulated impairment losses). An enterprise that chooses the cost model
should disclose the fair value of its investment property.
IAS No. 40 indicates that the model chosen must be used to account for all of its investment properties, and a
change from one model to the other model should be made only if the change will result in a more appropriate
presentation. The standard states that this is highly unlikely to be the case for a change from the fair value
model to the cost model.

Cases

 Case 13-1 Capital versus Operating Leases

On January 2, 2014, two identical companies, Daggar Corp. and Bayshore Company, lease similar assets with
the following characteristics:

1. The economic life is eight years.

2. The term of the lease is five years.
3. Lease payment of $20,000 per year is due at the beginning of each year
beginning January 2, 2008.
4. The fair market value of the leased property is $96,000.
5. Each firm has an incremental borrowing rate of 8 percent and a tax rate of
40 percent.
Daggar capitalizes the lease, whereas Bayshore records the lease as an operating lease. Both firms depreciate
assets by the straight-line method, and both treat the lease as an operating lease for federal income tax purposes.

Required:

a. Determine earnings (i) before interest and taxes and (ii) before taxes for both
firms. Identify the source of any differences between the companies.
b. Compute any deferred taxes resulting from the lease for each firm in the first
year of the lease.
 c. Compute the effect of the lease on the 2014 reported cash from operations
for both firms. Explain any differences.
d. Compute the effect of the lease on 2014 reported cash flows from investing
activities for both firms. Explain any differences.
e. Compute the effect of the lease on 2014 reported cash flow from financing
activities for both firms. Explain any differences.
f. Compute the effect of the lease on total 2014 cash flows for both companies.
Explain any differences.
g. Give reasons why Daggar and Bayshore might have wanted to use different
methods to report similar transactions.

 Case 13-2 Lessee and Lessor Accounting for Leases

On January 2, 2014, Grant Corporation leases an asset to Pippin Corporation under the following conditions:

1. Annual lease payments are $10,000 for 20 years.

2. At the end of the lease term, the asset is expected to have a value of $2,750.
3. The fair market value of the asset at the inception of the lease is $92,625.
4. The estimated economic life of the lease is 30 years.
5. Grant's implicit interest rate is 12 percent; Pippin's incremental borrowing
rate is 10 percent.
6. The asset is recorded in Grant's inventory at $75,000 just prior to the lease
transaction.
Required:

a. What type of lease is this for Pippin? Why?

b. Assume Grant capitalizes the lease. What financial statement accounts are
affected by this lease, and what is the amount of each effect?
c. Assume Grant uses straight-line depreciation. What are the income
statement, balance sheet, and statement of cash flow effects for 2014?
d. How should Grant record this lease? Why? Would any additional
information be helpful in making this decision?
e. Assume that Grant treats the lease as a sales-type lease and the residual
value is not guaranteed by Pippin. What financial statement accounts are
affected on January 2, 2014?
f. Assume instead that Grant records the lease as an operating lease and uses
straight-line depreciation. What are the income statement, balance sheet, and
statement of cash flow effects on December 31, 2014?

 Case 13-3 Application of SFAS No. 13

On January 1, 2014, Lani Company entered into a noncancelable lease for a machine to be used in its
manufacturing operations. The lease transfers ownership of the machine to Lani by the end of the lease term.
The term of the lease is eight years. The minimum lease payment made by Lani on January 1, 2014, was one of
eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital
lease by the lessee were met.

Required:

a. What is the theoretical basis for the accounting standard that requires certain
long-term leases to be capitalized by the lessee? Do not discuss the specific
criteria for classifying a specific lease as a capital lease.
b. How should Lani account for this lease at its inception and determine the
amount to be recorded?
c. What expenses related to this lease will Lani incur during the first year of
the lease, and how will they be determined?
d. How should Lani report the lease transaction on its December 31, 2014,
balance sheet?

 Case 13-4 Lease Classifications

Doherty Company leased equipment from Lambert Company. The classification of the lease makes a
difference in the amounts reflected on the balance sheet and income statement of both Doherty and Lambert.

Required:

a. What criteria must be met by the lease so that Doherty Company can
classify it as a capital lease?
b. What criteria must be met by the lease so that Lambert Company can
classify it as a sales-type or direct financing lease?
c. Contrast a sales-type lease with a direct financing lease.

 Case 13-5 Lease Accounting: Various Issues

On January 1, Borman Company, a lessee, entered into three noncancelable leases for brand-new equipment:
Lease J, Lease K, and Lease L. None of the three leases transfers ownership of the equipment to Borman at the
end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the
minimum lease payments—excluding that portion of the payments representing executory costs such as
insurance, maintenance, and taxes to be paid by the lessor and including any profit thereon—is 75 percent of
the excess of the fair value of the equipment to the lessor at the inception of the lease over any related
investment tax credit retained by the lessor and expected to be realized by the lessor. The following
information is peculiar to each lease:

1. Lease J does not contain a bargain purchase option; the lease term is equal
to 80 percent of the estimated economic life of the equipment.
2. Lease K contains a bargain purchase option; the lease term is equal to 50
percent of the estimated economic life of the equipment.
3. Lease L does not contain a bargain purchase option; the lease term is equal
to 50 percent of the estimated economic life of the equipment.
Required:
 a. How should Borman Company classify each of the three leases, and why?
Discuss the rationale for your answer.
b. What amount, if any, should Borman record as a liability at the inception of
the lease for each of the three leases?
c. Assuming that the minimum lease payments are made on a straight-line
basis, how should Borman record each minimum lease payment for each of
the three leases?

 Case 13-6 Sales Type versus Direct Financing Leases

Part 1: Capital leases and operating leases are the two classifications of leases described in FASB
pronouncements from the standpoint of the lessee.

Required:

a. Describe how a capital lease would be accounted for by the lessee both at
the inception of the lease and during the first year of the lease, assuming the
lease transfers ownership of the property to the lessee by the end of the
lease.
b. Describe how an operating lease would be accounted for by the lessee both
at the inception of the lease and during the first year of the lease, assuming
the lessee makes equal monthly payments at the beginning of each month of
the lease. Describe the change in accounting, if any, when rental payments
are not made on a straight-line basis. Do not discuss the criteria for
distinguishing between capital leases and operating leases.
Part 2: Sales-type leases and direct financing leases are two of the classifications of leases described in FASB
pronouncements, from the standpoint of the lessor.

Required:
Compare and contrast a sales-type lease with a direct financing lease as follows:

a. Gross investment in the lease

b. Amortization of unearned interest income
c. Manufacturer's or dealer's profit
Do not discuss the criteria for distinguishing between the leases described above and operating leases.

 Case 13-7 Lease Issues

Milton Corporation entered into a lease arrangement with James Leasing Corporation for a certain machine.
James's primary business is leasing, and it is not a manufacturer or dealer. Milton will lease the machine for a
period of three years, which is 50 percent of the machine's economic life. James will take possession of the
machine at the end of the initial three-year lease and lease it to another, smaller company that does not need the
most current version of the machine. Milton does not guarantee any residual value for the machine and will not
purchase the machine at the end of the lease term.
Milton's incremental borrowing rate is 10 percent, and the implicit rate in the lease is 8½ percent. Milton has
no way of knowing the implicit rate used by James. Using either rate, the present value of the minimum lease
payment is between 90 and 100 percent of the fair value of the machine at the date of the lease agreement.
 James is reasonably certain that Milton will pay all lease payments, and because Milton has agreed to pay all
executory costs, there are no important uncertainties regarding costs to be incurred by James.

Required:

a. With respect to Milton (the lessee), answer the following:

i. What type of lease has been entered into? Explain the reason for your
answer.
ii. How should Milton compute the appropriate amount to be recorded
for the lease or asset acquired?
iii. What accounts will be created or affected by this transaction, and
how will the lease or asset and other costs related to the transaction be
matched with earnings?
iv. What disclosures must Milton make regarding this lease or asset?
b. With respect to James (the lessor), answer the following:
i. What type of leasing arrangement has been entered into? Explain the
reason for your answer.
ii. How should this lease be recorded by James, and how are the
appropriate amounts determined?
iii. How should James determine the appropriate amount of earnings to
be recognized from each lease payment?
iv. What disclosures must James make regarding this lease?

 Case 13-8 Lease Capitalization Criteria

On January 1, 2014, Von Company entered into two noncancelable leases for new machines to be used in its
manufacturing operations. The first lease does not contain a bargain purchase option; the lease term is equal to
80 percent of the estimated economic life of the machine. The second lease contains a bargain purchase option;
the lease term is equal to 50 percent of the estimated economic life of the machine.

Required:

a. What is the theoretical basis for requiring lessees to capitalize certain long-
term leases? Do not discuss the specific criteria for classifying a lease as a
capital lease.
b. How should a lessee account for a capital lease at its inception?
c. How should a lessee record each minimum lease payment for a capital
lease?
d. How should Von classify each of the two leases? Why?

FASB ASC Research

For each of the following FASB ASC research cases, search the FASB ASC database for information to
address the issues. Copy and paste the FASB paragraphs that support your responses. Then summarize briefly
what your responses are, citing the pronouncements and paragraphs used to support your responses.

 FASB ASC 13-1 Initial Direct Cost Incurred by the Lessor

Search the FASB ASC database to address the following questions. For each question, copy and paste your
research findings and then write a short summary of your response to each question. Remember to cite your
research findings.

1. How does the FASB define initial direct cost associated with leasing?
2. How do lessors account for initial direct costs incurred for a sales-type
lease?
3. How do lessors account for initial direct costs incurred for an operating
lease?

 FASB ASC 13-2 Interpretations for Lease Accounting

The EITF issued numerous interpretations of lease accounting.

1. List some examples of the topics covered by these interpretations.

2. Write a brief summary of three of these interpretations.

 FASB ASC 13-3 Profit on Time-Sharing Transactions

The FASB ASC states that for purposes of recognizing profit on time-sharing transactions, it is necessary that
such transfer be nonreversionary. If the title is reversionary, how should the transaction be recorded?

 FASB ASC 13-4 Impact of Sale-Leaseback on Rate-Making

Accounting for sale-leaseback transactions in accordance with the FASB ASC guidance can result in a
difference between the timing of income and expense recognition required by that subtopic and the timing of
income and expense recognition for rate-making purposes. How should companies account for that difference?

 FASB ASC 13-5 Definition of Arrangement

The FASB ASC specifies the conditions under which an arrangement qualifies as a lease. What is an
arrangement? When does it qualify as a lease?

 FASB ASC 13-6 Definition of Lease Fiscal Funding Clause

The FASB ASC defines lease fiscal funding clauses. What is a fiscal funding clause? How should companies
account for fiscal funding clauses?

 FASB ASC 13-7 Economic Life of Airport Terminal Facilities

The FASB ASC indicates that because of special provisions normally present in leases involving terminal
space and other airport facilities owned by a government unit or authority, the economic life of such facilities
for purposes of classifying the lease is essentially indeterminate. Likewise, the concept of fair value is not
applicable to such leases. Because such leases also do not provide for a transfer of ownership or a bargain
purchase option, they are classified as operating leases. Leases of other facilities owned by a government unit
or authority wherein the rights of the parties are essentially the same as in a lease of airport facilities shall also
be classified as operating leases. Examples of such leases may be those involving facilities at ports and bus
terminals. The FASB specifies the conditions that must apply to meet this guidance. What are those
conditions?

Room for Debate

  Debate 13-1 Operating versus Capital Leases
Under SFAS No. 13, leases that do not meet one of the four criteria for a capital lease are treated as operating
leases.
Team Debate:

Team Argue for the capitalization of leases that do not meet any of the SFAS No. 13 criteria for a capital lease.
1: Your argument should take into consideration the conceptual framework definitions of assets and
liabilities.

Team Argue against the capitalization of leases that do not meet any of the SFAS No. 13 criteria for a capital
2: lease. Your argument should take into consideration the matching principle and full disclosure.

 Debate 13-2 Lease Accounting Symmetry

An objective of SFAS No. 13 is that lessors and lessees should account for leases similarly.

Team Debate:

Team Argue that a lessee should be able to account for a lease as operating leases while lessors may treat the
1: same lease as a sales-type lease.

Team Argue that if the lessor accounts for a lease as a sales-type lease, the lessee should similarly account for
2: the lease as a capital lease.
1. Shamir M. El-Gazzar, Steven Lilien, and Victor Pastena, “Accounting for Leases by Lessees,”  Journal of Accounting and
Economics (October 1986): 217–237.
2. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 13, “Accounting for Leases”
(Stamford, CT: FASB, 1976), para. 60. This statement was amended in 1980 to incorporate several FASB pronouncements
that expanded on the principles outlined in the original pronouncement.
3. Clifford Smith, Jr., and L. Macdonald Wakeman, “Determinants of Corporate Leasing Policy,” Journal of Finance (July
1985): pp. 895–908.
4. J. Coughlan, “Regulations, Rents and Residuals,” Journal of Accountancy 33, no. 2 (Feb. 1980): 63–80.
5. John H. Myers, Accounting Research Study No. 4, “Reporting of Leases in Financial Statements” (New York: AICPA,
1962), 4–5.
6. Accounting Principles Board, Opinion No. 5, “Reporting of Leases in Financial Statements of Lessees” (New York:
AICPA, 1964), para. 10.
7. A fourth party may also be involved when the owner-lessor initially purchases the property from a manufacturer.
8. To make this calculation, a discount factor must be assumed, and the annual amounts of the total of payments due after
2011 must be estimated to determine the present value of the long-term obligation and the property under leased assets. The
discounted value of the property under leased assets is then added to total assets, which will reduce the company's return-on-
assets ratio.
9. The book value of the lease liability will always exceed the recorded value of the asset, because the liability is being
reduced using the interest method while the asset is being depreciated by the straight-line method, and it is necessary to
make an additional assumption about the relationship between the liability and asset values. Imhoff et al. (1991)
demonstrated that the unrecorded asset will generally fall between 60 and 80 percent of the unrecorded liability.
Consequently, the unrecorded asset was estimated as 70% of the value of the unrecorded liability. There are also deferred tax
and stockholder equity issues when operating leases are assumed to be capitalized. See E. A. Imhoff, R. C. Lipe, and D. W.
Wright, “Operating Leases: Impact of Constructive Capitalization.” Accounting Horizons 5(1) (1991): 51–63 for a complete
discussion of this issue.
10. Report and Recommendations Pursuant to Section 401(c) of the Sarbanes–Oxley Act of 2002 on Arrangements with
Off–Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers (Washington, DC:
Securities and Exchange Commission, 2005), http://www.sec.gov/news/studies/soxoffbalancerpt.pdf.
11. FASB. Proposed Accounting Standards Update, Leases (Topic 840), (Norwalk, CT: FASB, 2010).
12. Mynatt et al. found that the 2010 proposal, if adopted, would have a material and statistically significant impact on ROA,
the debt/equity ratio and EBITDA for the industries studied. P. Mynat, D. Schauer, and R. Schroeder, “The Impact of the
FASB–IASB Lease Proposal on Lessees: Evidence from Four Industry Groups,” Journal of Business and Behavioral
Sciences. 23, no. 2 (Spring 2011): 109–123.
Prev Previous Chapter
CHAPTER 12: Accounting for Income Taxes

Next Next Chapter
CHAPTER 14: Pensions and Other Postretirement Benefits

Find answers on the fly, or master something new. Subscribe today. See pricing
options.

Back to top

 Browse
 Resource Centers
 Playlists
 History
 Topics
 Learning Paths
 Highlights
 Settings
 Support
 Sign Out

© 2019 O'Reilly Media, Inc. Terms of Service / Privacy Policy